Rescue Plan in the Works - What the Hell is a Mortgaged Backed Security?

And Why Should I Care?

The economy is in big trouble! Right? Everyone says so. But mortgage interests rates are low, and you can probably still sell your house for more than you paid for it just five, or even three, years ago. My friends who lost their jobs at mortgage companies have all found new ones, and even my friends in construction seem to be keeping busy. I keep hearing about people who will lose their homes because their adjustable rate mortgage payments went sky high. But I've never actually met anyone that has happened to.

Why is everyone so worried? It's obviously serious, but what's going on?

As a blogger my job is to pretend that I know more about things than I really do, form strong opinions on limited and half correct information, and from this foundation make firm pronouncements and predictions. It really is loads of fun. So, here goes.

The real question here is the broad one. What is going on and why is everyone worried?

Counterintuitively, let's start our off-the-cuff explanation with what's happening today, and then work backwards, with room for random tangential discussions or miscellaneous ponderings. I've been listening to various radio talk show hosts try to tell this story from the beginning, but they never seem to get to the end. So, by listening to these audio pundits, we may end up knowing a few more facts than we did before, but are still left wondering, "So what?"

Well, the news as of today is that a solution appears to be in the works. The world's central banks are going to set up various markets to purchase mortgaged-backed securities, known as mbs. These "securities" are usually like bonds, because they are considered a form of debt. But there are very few standards, so our MBA and CFA friends like t0 make up new kinds of securities, with variances on particular deals, that make this market fairly complex.

Because these securities are complex, it was hard to know what to pay for them. The answer to this was easy. Get a credt rating agency to rate them, and then sell them at an auction where , people are willing to pay for them based on the rating. Investment banks conduct these auctions. Everything was going great for several years, and the risks seemed low, because the securities were ultimately secured by real estate, a hard asset.

Not anymore, though, For months now, NOBODY wants to buy this stuff. At least the new stuff. There hasn't been a successful sale of new mbs paper since I think last October. Or maybe it was August. The mbs market did, indeed, crash.

But there was already a lot of this mbs crap out there, being held by the same institutions that want to sell more of it. The problem is that nobody believes they know what it is worth anymore. So nobody has any trust in the creditworthiness in these institutions that own a ton of it because a lot of their corporate value is based on the mbs securities that they own, but cannot sell. Uh oh. So the problem is not just that the mbs paper is difficult to value, but that the solvency and liquidity of the big investment firms that own it is therefore cast into doubt. SO, none of the financial players will lend each other any money, and they need to borrow money to operate.

That's the problem. And by identifying the problem, we can start to identify the solution. Securities backed by poorly underwritten mortages are undermining the financial institutions and markets. If the questionable securities can be exorcised, then the system will recover. So the way to get things going again is to find a way to flush out all of the tainted batches of mbs bonds that are stopping up the pipes. We need a plumber.

Bringing us to the question that one of my favorite professors used to ask, "So what?" I'm just a guy with a mortgage, what do I care?

Well, we care because if the mortgage securities are unsalable that means that there is a lot less money available for borrowing if you want to get a mortgage. BECAUSE, when these auctions sell the securities, the buyers pay the sellers cash. The sellers are the people who make mortgage loans to homeowners like you and me. So, after the auction they now have another pile of money to lend out, and they do the whole process again.

It's really a fairly simple model if you take out the fancy language. The money keeps circulating, which is what makes for a strong economy. Remember, the cash doesn't disappear, someone has it. The houses don't disappear, they are still standing. It's only when money stops circulating that we have a financial crisis. This is why President Bush wants to give us all $1,000 this summer. He hopes we'll all stupidly spend it and get the money circulating.

Now, if we were talking sales of commodities (stuff), this lack of available mortgage money would fall under the law of supply and demand, and the price would simply go up. But we are talking about lending here, so the rules are different. The price is the interest rate, and it has stayed about the same. SO, what has changed is credit qualifying requirements. That means that it is harder to qualify for a loan. This is called tight money. So a lot of people wake up to find that they cannot refinance their own mortgages, even for their own house. It's the same people, with the same house, for the same loan amount, calling the same lender, but in a different year . . . no loan. Sucks to be you.

But wait! That's not how it worked in It's A Wonderful Life! Jimmy Stewart took all of the money deposited in the bank by the good working people and lent it back to them as mortgages. There weren't any securitizations or investment banks or MBS or CDO's or rating agencies.

Well, yes, that's right. The old model was that banks took in deposits and used them to make loans. That model is still around, which is largely why you can still get a mortgage. If you can qualify. But most mortgage money now comes through the newer securitization model.

The alternative to the traditional depository bank model is the mbs model, as has been relentlessly and poorly explained in the media, which is a securitization model.

People say "ization" when they mean they want to turn something into something else. It's an annoying affectation people use to make their work sound more complicated than it is. For example "monetization of assets" means that someone's out of money and needs to sell some of their stuff, thus turning the stuff (assets) into money. "Monetization." "Securitization" just means that you want to turn mortgage loans into securities, specifically something that is basically a bond.

Securitization is actually a little more complicated than that, in how it is done, but the idea and the goal are the same. An important point to keep in mind is that securitization has replaced the typical depository bank model for about 2/3 of the mortgage market. This was OK until securitization collapsed, which has caused a serious reduction in the consumer purchasing ability in the housing market, which makes the housing market problems even worse than they would be anyway.

Just for fun let's walk through it. A bunch of guys say, "Hey, let's get rich in the mortgage business!" So they form Team Alpha. Team Alpha gets a hedge fund to give a line of credit, say $100 million, to lend people mortgage loans. This is called the aggregation funding. Team Alpha gets a licensed mortgage banker to make the loans with an agreement to buy them once they are made. They hire another company (or maybe the same one) to service the loans. They form a special company that will buy the mortgages until they have a few thousand loans, then sell the rights to the cash flow generated by the mortgage payments. These rights to the cash flow payments are the securities. But they sell these cash flow rights securities in a variety of pieces, called tranches. Tranche A may get all of the principal payments until they get all of their money back, plus a certain amount of interest, called a preferred return. Since this is the safest tranche, it can get a Triple A rating from a rating agency, and therefore Team Alpha can sell Tranche A at a high price, which translates into a very low interest rate. Tranche B may be cash flow only from interest payments made by the mortgage borrowers. Tranche C may be a seconday flow of principal payments. Tranche D may be any payments that are received from borrowers after the other tranches are paid off, and is called the residual.

If there is no cash flow, then the buyers of these securities don't get any money. That's the risk. Risk is supposd to be reflected in the credit rating the securities receive from rating agencies like Standard & Poors or Moodys. But people now realize that they seriously misunderstood the risk.

These deals are usually structured as private offerings to avoid a lot of the legal regulations that regular mortgages and securities exchanges have to comply with.

The result is that the securitization business is effectively an alternative banking system that has avoided the normal rules that provide checks and balances on our traditional banking system. And now it is in a shambles and this is causing our economy to falter. The economy is our social structure, so this disruption is our business and thus our government has the right and responsibility to get involved, diagnose the problems, and find and execute solutions. This is what makes this problem our business and the business of our government. We do not have to sit by while these greedy knuckleheads ruin our nation's economy.

In case you missed it, the last paragraph was a political statement advocating a change in government policy. I'm just saying.

Here is the solution to the immediate problem. It is two-fold.

On the macro scale, the Fed or Treasury will form a special guaranty agency that will provide secondary insurance to buyers of pools of mbs bonds for half of their aggregate face value. This will provide a floor on mbs value at 50% of face value. This will at least stabilize the secondary market, albeit with a lot of pain, but not allow securities holders to avoid the moral hazard of their risky investments. The good news is that there are hundreds of hedge funds out there with billions and billions of dollars who see this whole mess as an opportunity to buy these mortgage backed securities, or even the mortgages themselves, as vastly undervalued assets. This is what hedge funds are best at. So there are willing buyers. The big problem is that there is currently a dearth of financially healthy companies available to service these performing or semi-performing mortgages on a third party basis. (Mortgage servicers are in financial trouble because of what is called "servicing advances." Don't ask.) "So what?" you ask? Well, a servicer is required for our willing buyers to also be able buyers. So we do have potential investors who will buy these mbs pools at fire sale prices, if they can find someone to manage the loans for them.

On the micro side, a new program is needed that will provide new mortgage insurance on otherwise undoable refinances, up to 80% current loan to value of primary residences. As a condition for this insurance, the current holder of the mortgage will be required to provide the homeowner a loan for the balance of the amounts owed, on the same interest rate and term as the new mortgage. This will proved homeowner relief, without paying off the lenders who made irresponsible loans.

The solution is in sight. We have to shove this crap through the system or face the financial cesspool that Japan has been stuck in for 20 years. Let's take our lumps now and move on.