The Problems of Securitizing Sub-Prime Loans

In October 2007, the board of directors of Merrill-Lynch, Smith & Fenner, one of the largest if not the largest brokerage houses in the United States, accepted the request for early retirement of its Chief Executive Officer. The brokerage firm disclosed that it has lost over $8 billion on its investments in sub-prime mortgage loans.1 Merrill Lynch was not the only financial giant to sustain enormous losses. The losses caused market liquidity to dry up. The U.S. government took steps to ease the pressure.2 But the high leverage of the system is still unravelling. The effect of these events spread abroad, and foreign regulators accused U.S. regulators of laxity - a drastic change from the usual complaints about U.S. strict regulation. More importantly, the scepter of a recession and even a depression has risen.3 It is still clouding the horizon. The crisis was triggered by securitized sub-prime mortgage loans. Like all good things securitization involves not only benefits but also business and legal risks to participants and sometimes to the financial system. The risks of securitization are reduced by strong market and cultural constrains, by the lawyers\u27 designs4 and by law. But occasionally these protective mechanisms fail. This Article discusses the securitization of sub-prime mortgage loans: an example of securitization gone wrong