Subprime Mortgage Crisis: Credit Risk

Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions.

This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk:

1. Credit risk - the risk that the homeowner or borrower will be unable or unwilling to pay back the loan;
2. Asset price risk - the risk that assets (MBS in this case) will depreciate in value, resulting in financial losses, markdowns and possibly margin calls;
3. Liquidity risk - the risk that a business entity will be unable to obtain financing, such as from the commercial paper market; and
4. Counterparty risk - the risk that a party to a contract will be unable or unwilling to uphold their obligations.

The aggregate effect of these and other risks has recently been called systemic risk, which refers to when formerly uncorrelated risks shift and become highly correlated, damaging the entire financial system.

When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets.

Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments.