Economic Crisis – Mortgage Backed Securities
In my previous post on the current financial crisis, I reviewed the players involved in the crisis. I also covered how an overheated real estate market and lax lending standards were the tinder that helped fuel the financial crisis we’re now smack in the middle of.
In this post I’ll talk a little bit about what happened to all of those mortgages once a borrower closed on a house/apartment/condo and how they added to the fire.
Historically, banks originated loans and held them on their balance sheet as assets. They made money by lending at a higher rate than they paid on customers’ deposits. Since the banks were holding the loan on the balance sheet (i.e. they were hurt if the loan went into default or otherwise underperformed) they were generally very selective in the loans they made. This began to change when many of these banks and other lending institutions began to sell the mortgage loans they originated to financial institutions who would package them into mortgage backed securities (MBS) a type of asset-backed security.
These structured securities allowed the originating bank to book a profit on the loan quicker and also freed their balance sheet and enabled them to make more loans. Since the originating bank was no longer at risk if the loan went bad many began to relax their lending standards. In order for banks to sell their loans, the loans just had to meet the minimum standards of the Federal Housing Administration (FHA) — an entity whose stated goal was to boost the rate of homeownership in the United States.
Financial institutions then created the MBS and sold them to institutional investors who desired a “stable” asset that produced a regular level of income. The idea behind mortgage backed securities was that if you pooled a large enough number of mortgages you were actually decreasing your overall risk by diversifying through large numbers of individual loans and over various geographic areas. In other words, one bad loan wouldn’t ruin your day.
In addition, mortgage backed securities were divided into “tranches” based on risk level and interest rate, allowing buyers to make purchases based on level of risk they were willing to accept. The process for rating these tranches was similar to other fixed income securities. Rating agencies like Standard & Poor’s and Moody’s would give the tranches with the least risk investment grade ratings (think GE and Berkshire Hathaway debt), while slapping lower ratings on riskier tranches. So in many cases, a pile of high risk sub-prime loans were magically turned into supposedly high-quality, investment grade fixed income securities.
After securitizing and selling the loans, these financial institutions were able to buy more loans and repeat the process over and over again. As the real estate market continued to boom, all parties involved got hungrier and hungrier for more and more loans. Everyone involved was happy until the real estate bubble started to deflate. As defaults began to rise, the buyers of the MBS’s started to see losses that they weren’t expecting to see from such a supposedly high grade security. Buyers quickly stopped buying the MBS’s, sticking the financial institutions with a bunch of unsalable mortgages. That caused the financial institutions to stop buying new loans, which in turn meant that the originators had to hold them on their balance sheets and quickly curtail their new lending. In the end, this meant that a new home buyer suddenly had a lot more trouble finding a loan, which helped slow the pace of home buying. With new buyers kept at bay, home prices started to fall and those who had overextended themselves to buy a property found themselves without clear path to safety. It’s not too hard to see how this situation can feed on itself and create a downward spiral.
So now we have between $1 and $1.5 trillion dollars in sub-prime mortgages that no one wants and a large number of buyers who can’t keep up with the payment on loans they shouldn’t have taken out. The result? A frozen market. Individual and corporate balance sheets are now full of loans they don’t want, which restricts their ability to spend or lend additional money. And the spiral continues…
As always, please feel free to add to the commentary and ask any questions you might have.
Scott H
October 27th, 2008 at 8:00 pm
There is a principle called Ockham’s razor which is attributed to the 14th-century English logician and Franciscan friar, William of Ockham. It basically states that – “All other things being equal, the simplest solution is the best.”
The following are two simple ideas that effectively create the ideal social construct.
Simple Idea #1
1. Socialize ALL Land
2. Charge leases on ALL Land based on demand.
3. Return 100% of the resulting revenue to every man, woman and child in the form of a yearly dividend check.
4. Make the Universal Birthright of Land an Everlasting Standard in the education of every Child.
This effectively makes the average piece of Land Free for every Living Soul and restores our Natural Birthright as well as coupling our social construct to the Principles of Life.
Simple Idea #2
1. Remove ALL FORMS of taxation
2. Implement a Tax on ALL new goods based on the resources they contain and the resources they use in production and delivery (this can easily be implemented with the current barcode system used at the checkout)
3. Use this system to encourage/discourage various resource usages (High tax on non-renewable/ecosystem damaging products and low/no tax on renewable/ecosystem enhancing products) and to encourage purchasing of local products.
4. Use the resulting revenue to fund infrastructure expenses and the restoration of ecosystems..
This effectively encourages the creation/use of longer lasting, high quality products as well as encouraging recycling and reuse of existing products.
Idea #2 effectively constrains the ravaging appetite of the capitalistic consumer society within the Boundaries of Sustainability while Idea #1 effectively encloses both Sustainability and capitalism within the Principles of Life.
That’s it!!! The path to True Democracy. Simple and Effective
Scott
October 27th, 2008 at 8:15 pm
You are absolutely correct. You’ve hit the nail on the head regarding your description. i have a better solution than the current fiasco.
Ok here’s the plan.
Have a government sponsored loan available for every homeowner up to
$100,000 - provided the outstanding mortgage is more than $100,000. The loan
would be available at 0% interest plus the rate of inflation.
The catch is that the loan would be personally guaranteed and would survive
foreclosure and bankruptcy.
As part of this deal the lending institution would agree to reset the
balance of the loan to the prime rate.
The $100,000 would go to the bank to pay off part of the mortgage.
How much would this cost? Well we have 70 million homeowners and 50 million
with a mortgage. Since this isn’t limited to subprime it may be that all 50
million would take advantage of this offer. However, those who have a lower
interest than current prime probably wouldn’t take advantage. Also those
who have nearly paid off their mortage probably wouldn’t take advantage.
Let’s say 50% of of the 50 million homeowners take the government up on the
deal. That would cost $2.5 trillion.
Three thoughts on that $2.5 trillion.
First it would immediately solve the liquidity crisis because it would flow
back into the banking system immediately.
Second, since the $2.5 trillion would be a loan it would eventually be
repaid.
Third, the original value of the mortgage wouldn’t change. This is an
important point. Only those people who truly want to keep their homes would
take advantage of this plan.
There’s no uncertainty of how to value the bad loans.
There’s no buying distressed loans.
There’s no threat of the bailout causing housing prices to spiral downward
like the existing plan.
What’s wrong with buying the distressed assets?
You can’t reasonably value them. If you pay too much the taxpayer doesn’t
get their money back. If you pay too little you cause downward pressure on
housing prices.
Price tag too high? Ok, limit it just subprime or limit it to ARMs or limit it to geographic areas - there are many many ways to limit the price tag.
October 28th, 2008 at 9:17 am
I know we keep pointing to the FHA for encouraging the sub-prime market but it would seem to me that there is a lot of blame to go around. I still hold the Hedge funds who were insuring the MBS at fault. They started insuring them in an unregulated way by selling credit swaps and holding them in companies that had no assets. So when the market tanked, their losses were limited and everyone else took on the pain.
The poor smuck who just wanted a house like everyone else is not to blame. I know people who were buying 5 and 6 houses with no money down — they helped fuel this thing too. I even got sucked in and closed the deal on a new house before I sold my old one. I have taken a heavy hit to my personal wealth because of it but like 95% of other Americans, I am meeting my obligations because integrity matters.