Economies: how top up loans killed AIG

This is how it works: lenders (however that is defined - banks, building societies, secondary lenders, etc.) all have a percentage of an asset's value that they regard as the base-line.

Usually, in the case of housing that base-line is around 70%. This means that the borrower has to come up with the balance, around 30% - often called "the deposit." Historically, this money would come from family or savings but as property prices escalated beyond that at which borrowers could save enough, a market grew for "secondary lenders." The term, at that time, had a specific meaning - they would lend money against a second mortgage to "top up" the borrowing required to purchase the house.

The secondary mortgage market was risky: if prices fell, then the margin shrank and the secondary lender, who gets paid only what is left after the first mortgage holder has been repaid in full. And if the borrower defaulted, then arrears, interest, penalty and costs of recovery all form part of the first mortgagee'scharge and, again, the margin available to the secondary lender shrank.

But, despite a crisis in the UK when many secondary lenders crashed and burned, some of the largest being taken over by mainstream banks, the process continued. It should be considered one of the factors that directly leads to house price inflation - including spiralling prices.

Many first lenders concluded that they could lend the balance of the money themselves - in effect providing the top up as part of the first mortgage. But they needed to cover the risks that had all-but-killed the secondary lending market.

The answer was insurance. This is not insuring the fabric of the building. It is insuring the difference between the prudent lending margin and the full purchase price. In rapidly rising markets, some even went so far as to lend up to 110% of the house price so as to allow purchasers to pay their legal costs, taxes, removals and even fitting out costs all with borrowed money - the balance over the prudent 70% being risk-free for the lender because even the premium for the top-up was included in the loan.

Worse, in effect in such cases if there is a claim, the insurer refunds the premium.

The insurance is risky for another reason: it includes a provision that, in the event of a claim, the borrower remains liable. But claims most often happen because of default due to lack of money - so that provision is most likely to be - literally - not worth the paper it is written on.

So we have the following - again brutal - analysis.

a) Borrowers want to buy things they can't afford.

b) Lenders who will take a first charge on the sale in the case of default are willing to lend more than is prudent having regard to a) the risk of asset depreciation and b) the reality that low prices are achieved on a forced sale.

c) Lenders are prepared to lend more than the prudent amount because they can lay off the risk of failure in relation to that higher amount by insurance

d) Insurers take that risk because for perhaps 80% of the time property prices don't stagnate or fall - and because they provide cashflow in a stock market environment of short-termism when today's profits are more important than tomorrow's survival.