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There are various reports about the possibility of securitising Northern Rock mortgages as a way out of the difficulty of raising new money to repay present public funding. J P Morgan are already reported as having bought £2.2 billion of mortgages themselves.
What are the principles behind any securitisation? Clearly, there must be a profitable trade for any financial institution doing such a deal. The securitisation will need some sort of guarantee to make a subsequent sale of "Northern Rock bonds" attractive. These bonds can then be sold on to institutional investors such as pension funds. The basic mechanism is much like "sub-prime" except that the quality of the borrowers will probably be somewhat better. However, one of the myriad factors is that Northern Rock took a large share of UK lending in the first seven months of 2007. Thus, the mortgage book may be exposed to falling house prices. So although it isn't a sub-prime problem now, a serious decline in residential property prices would cause bad debts in the future.
There will be a recession as people cut back on spending to service their existing debts, now made slightly more likely by the Bank of England's failure to cut interest rates this week. It follows that either investors are going to rediscover credit risk, or bond insurers are going to pay for those future bad debts, or the price of the bond insurance needed is likely to be rather high. In the last scenario, either yields must be depressed or mortgage interest rates must rise - which could happen even when base rates come down.
The search for yield was one of a number of factors leading to the present credit crisis. It will be ironic if there are any pension funds buying "Northern Rock bonds" to replace any losses in Northern Rock equity which they may have held. But somebody has to pay for future bad debts, this somebody being either the mortgage borrower, the investor or the taxpayer.
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