Mortgage-Backed Securities are Actually Pretty Cool

No, I’m Not a Loan Officer

Given the state of the economy today and the general consensus about how we got into this mess, I imagine a lot of folks will be surprised to see anyone who doesn’t work on Wall Street going on record in favor of mortgage-backed securities. Most people blame them, along with credit default swaps and something called “derivatives,” for the end of the world as we know it. But mortgage-backed securities are really a good idea. At least, they would be if not for a few deceptive practices in the industry. Let me explain.

What They Are and How They Work

First, let’s make it clear what a mortgage-backed security actually is. Say Bob wants to buy a house. He doesn’t have enough money on hand, so he needs to borrow it from someone. You and I don’t have anywhere near enough money to lend Bob. Maybe we could come up with a hundred or a thousand dollars each, but two grand doesn’t do Bob much good. So he goes where the money is: a bank. The bank has a ton of money that people like you and me have given them to look after. The bank can lend Bob enough money to buy the house, but they’ll charge Bob a lot of interest, much more than it pays to its depositors (you and me). If you or I had enough cash to buy a house, we could lend Bob the money, and earn ten or twenty times more interest than what the bank pays us. But even if we had that kind of cash on hand, it wouldn’t be a good idea for us to lend it all to Bob. If he defaulted, we’d be out our investment. Sure, we’d have Bob’s house, but we’d probably take a loss unloading it. Even if Bob made all of his payments on time, we’d have tied up all of our cash for thirty years. Not a great idea for individuals to finance a mortgage, is it?

Hang on a second, though. The bank is lending Bob our money, and charging him, say, five percent interest. The bank only pays you and me about half a percent on our deposits (a savings account is basically a loan from you to the bank). That’s a huge markup! And the only reason they can lend Bob enough to buy a house is that you and I and thousands of others have lent them the money (in the form of our savings accounts) to do it. Some clever banker noticed this disparity, and probably had a conversation with himself much like what follows:

Hey, says the banker to himself, if I were to sell shares of Bob’s mortgage to a bunch of different people, they could earn more than half a percent on their money, and I could take a commission off the top. If Bob should default, the loss is spread out over a lot of people, so nobody will be hurt too badly. Oh, but they’d still lose all of their investment. Folks won’t like that. Hmmm, what if I were to take Bob’s mortgage, and bundle it together with about a thousand other people’s mortgages, and sell shares of that? That way, even if Bob defaults it won’t matter much, because the investors would still be earning from the other mortgagees. Mortgages are low-risk loans, so these mortgage mutual funds will be even lower-risk, since the risk is spread out over so many more people. Now instead of only getting a commission on the loans, I can also get a commission on every share of the fund that I sell! The investors will get access to the mortgage market, which they never had enough capital to get into before! They’ll be getting something like ten times what they were earning on their savings accounts, but won’t have to tie up their entire life’s savings. It’s a win-win! I gotta go tell my boss about this idea.

And the rest is history.

Where it Went Wrong

So how on Earth did this cause a collapse? So far in our story, nobody has done anything wrong. In fact, nobody has even done anything ethically questionable. But the seeds of doom have been sown. The bankers will soon face a problem of supply and demand. There will be a huge demand for these excellent new investments, but the supply will run out quickly. To generate more supply, that is, more mortgages to securitize, the bankers will slightly relax their standards for creditworthiness. The new bundles of securitized mortgages will get bought up fairly quickly, and soon demand will once again exceed supply. To get more supply, the banks will relax their standards once again. And so on. See where this is headed?

Race to the Bottom

Before the invention of the mortgage-backed security, banks were pretty careful about how much money they lent to whom. They would check to see how likely the borrower was to be able to repay the loan, they checked to see that the house was worth at least as much as the amount borrowed, they required a down payment, and so forth. If a borrower defaulted on a mortgage, the bank would be stuck with the house and would have to sell it to get their money back. This was almost always a lose-lose scenario. The borrower lost his house, and the bank lost a lot of its money. But at some point, the banks realized that since they were securitizing and selling off the mortgages, it didn’t matter to them if the borrower ever paid back on their loan. Someone else would own the debt. The bank would have already cashed in. The incentive to not lend money to people who wouldn’t be able to repay it had been removed. But the incentives to write loans (commissions, etc) were still in place.

No Guts, but Plenty of (Temporary) Glory

The banks began to write mortgages for anybody who wanted one, regardless of the borrowers ability to repay. You may have heard of the so-called NINA loan. NINA stands for No Income, No Assets. Banks were lending hundreds of thousands of dollars to people who had no job and no money, and passing the risk on to people who bought mortgage-backed securities. Why would Bob (remember Bob?) borrow such a preposterous amount of money if he knew he had no prospect of being able to repay? Because Bob’s loan officer fed him a line. 

Bob, he said, you can afford to borrow 150 grand to buy this house. You know why? Because in a year, this house will be going for 200 grand, or even more. You ever make 50 grand in a year, and not have to work for it? You’ll come out ahead. And you can take out another loan, and buy another house, and make another 50 grand. You can have the American dream!

Remember the late 90s and early 00s? Back then, people were doing exactly that. It was called flipping. So maybe Bob’s loan officer was trying to help Bob cash in on the trend, and wasn’t trying to take advantage of Bob’s relative financial naïveté. Either way, it didn’t matter, because Bob’s mortgage was going to get bundled up and sold, the bank would have offloaded the risk by the time it became apparent that the housing market couldn’t possibly keep going up at that rate, and Bob would end up stuck with a house that was worth less than what he borrowed to pay for it. The loan officer got a commission when he wrote Bob’s mortgage. The bank securitized Bob’s and hundreds of others’ mortgages and sold shares at a profit. The people who actually sold the securities got a commission on the sale. Who made money? The banks and their employees. Who took the risk? Bob and the investors.

But why would investors keep buying mortgage-backed securities if they were based on such risky loans? Wasn’t the demand pretty much entirely based on how low-risk these securities were meant to be? Yes, it was, but the investors who bought mortgage-backed securities were not told that they were buying securities made of the riskiest mortgages ever written. In fact, mortgage-backed securities were typically among the highest-rated investments available, even when they were made of NINA loans. I have no idea how or why this happened. Either the people in charge of rating the securities were asleep at the switch, assuming that one mortgage-backed security was as good as another, or they deliberately misrepresented the risks involved. That is a question for the Securities and Exchange Commission to investigate (if they ever get around to it).

By the time Bob and friends defaulted on their mortgages, the mortgages weren’t the bank’s problem anymore. Bob’s mortgage payments were going to individual investors, or 401k plans, or pension funds, or charitable endowment funds, or any number of other entities that bought mortgage-backed securities on the assumption that they were safe, long-term, low-risk, high-yield investments. But since Bob and friends couldn’t pay their mortgages, the value of those securities vanished. Bob needs to sell his house to pay back the loan, but so does everybody else, so home prices drop, and so on, leaving us where we are today.

How are Mortgage-Backed Securities not Bad, Again?

Look, the problem wasn’t caused by the securities themselves. It’s a Good Thing to allow small investors access to the profits generated by mortgage loans. The problems were caused by two factors. First, there was plenty of incentive to write loans, but no incentive to deny loans to people who couldn’t pay the loans back. See, the debt was being offloaded almost immediately, so the bank didn’t need to worry about whether the loan would be repaid. Second, there came to be an egregious misrepresentation of risk as incredibly risky mortgages were turned into highly rated, supposedly safe securities. If the originator of the loans had held on to some of that risk, they would certainly have been more careful about whom they lent money to. If the investors in mortgage-backed securities had been given accurate risk assessments, they would have stopped buying, the demand would have gone down, lending would have gone back to its usual level, and after a brief period of volatility, the housing market would have re-stabilized. It wasn’t the securities themselves, but the deception, malfeasance, and/or incompetence with which they were created and sold that was the problem.

So How do We Fix the Problem?

Of course, it’s too late for most of us. Lots of the mortgage-backed securities we (or our pension funds) bought are now worthless. But the concept of the mortgage-backed security is still sound. We can fix the problems that led to the collapse with a combination of transparency, accountability, regulation, and enforcement. If the creators of mortgage-backed securities had been up front about the sort of mortgages the securities were backed with, those securities would not have been in such high demand. There would have been no incentive to write risky mortgages, and no place to dump them to offload the risk. If the folks who rated mortgage-backed securities were held accountable for their rating, perhaps they would be more diligent in determining an accurate rating. If loan officers were held accountable for writing nonperforming loans, they would be more diligent in determining creditworthiness. If there were some sort of regulation on the creation and sale of mortgage-backed securities, say, a rule that a bank must maintain ownership of at least 60% of any mortgage they write, banks would be incentivized to loan only to people who can afford to repay. And if existing securities fraud laws were to be enforced, it’s possible that the folks who caused and profited from the housing bubble and collapse would be appropriately punished, serving as a deterrent to others who might be tempted to do something similar in the future.

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Comments 8 comments

Liano 6 years ago

"In fact, mortgage-backed securities were typically among the highest-rated investments available, even when they were made of NINA loans. I have no idea how or why this happened."

The short answer is: for decades mortgages were stead, solid performers - because lending standards were relatively tight, so not just most, but in fact the vast majority of people who got mortgages paid them. This provided a huge amount of data on which to predict continued solid performance by mortgages. When this changed, the market models couldn't adjust because they were build requiring mounds of data that wasn't available for the new situation - and people (both in and out of the ratings agencies) who knew how the models worked knew how to exploit them.

The long answer:

1.

Security ratings agencies use sophisticated mathematical models to determine how risky a particular security is. To build these models requires making some initial mathematical assumptions about the nature of the market for the commodity being securitized - mortgages in this case. Usually, that would work pretty well. The problem arose because the market had changed in a way that was not mathematically quantified: the banks had changed their lending standards. This non-mathematics change resulted in a significant mathematical effect: more mortgages went into defaults under the new lending standards than under the old ones.

Unfortunately its often the case that the more sophisticated the model, the greater the error it generates when given incorrect assumptions (sort of like the butterfly effect).

In this case, not only did the models fail to accurately predict the level of mortgage default risk, they also failed to predict how much of an error was inherent in their own predictions. The change in lending standards changed the mathematics of the mortgage market so completely that the models were making predictions about a market that continued to exist only in their own digital fantasies.

2.

This isn't to let the ratings agencies off the hook. They knew that lending standards had changed. But they didn't do much to account for them. The main reason for this is pretty simple: they didn't know how.

There were no sufficiently quantified studies on a mortgage market like the one they were now dealing with outside of the purely or mostly theoretical. The mathematical data they needed on the new mortgage market in order to build new models just didn't exist. In short, they could have changed their models, but they could not justify downgrading mortgage-backed securities with any solid data - and their customers would certainly want to see a justification for downgrading their products.

What they should have done is look at anyone asking them to rate securities built on mortgages under the new lending standards and said "we have no idea how to rate this because the lending standards have changed too much for our models to be reliable". But they didn't.

The basic reason is two-fold: first, they wanted the money, and second, admitting they didn't know how to rate something would weaken their credibility with their customers (and some would argue that would have destabilized the market anyway).

The big problem here - and one that any regulator fix to this mess needs to address - is that the ratings agencies' customers are the companies that are going to sell the securities the agencies rate. This is another incentive problem - the ratings market needs to be re-organized so that ratings agencies get paid by the people who buy the securities, not by the people who sell them.

3.

The same shady lender who was selling the line to Bob (you can buy this house for 150K and sell it next year for 200k, so don't worry about not being able to pay off the 150K loan), was selling the same kind of line to the rantings agencies and to his customers for the securities backed by the kind of junk loan he was selling to Bob.

Basically, Bob's lender took all the mortgages like the one he sold to Bob, put them all in a bundle, and said look, even if we take the ratings agencies' worst assumptions about how many of these loans are going to default, there are still a lot of good loans in the package. For example, the lender has a bundle of 10,000 loans. Run that bundle through the ratings agency models under the worst assumptions and the models say 1,000 (10%) would outright default, 2,000 (20%)would have significant issues, another 2,000 (20%) would have minor issues - that's still 5,000 (50%) of the loans that are top performers, 2,000 are darn good, and another 2,000 are not great but not terrible. Of course this is still using the ratings models that aren't accounting for the new, looser, lending standards. So these numbers are bogus to begin with. Nonetheless, maybe the shady lender gets this bundle of 10,000 loans into a B rated security. It should have been a junk security, because there is no way under the new lending standards that 5,000 of those loans are good.

But it gets much much worse than that.

Now that same lender says, I've got 20 bundles just like that. I merge them all together so I have one big bundle of 200,000 loans. Now, running that one big bundle through the ratings agencies' models and . . . there are only 10,000 loans (5%) predicted to default!!! And only 20,000 (10%) with significant issues!!! And only 20,000 (10%) with minor issues!!! And 150,000 show as dead solid good!!! In short, if the lender sells each bundle individually, he can only get a B rating or lower for the securities. Because the models show 50% of the loans have issues. But if he bundles them all into one big bundle, suddenly only 25% of the loans have issues, and only 5% are predicted to default, so he can get an A rating.

Why? Because the way the ratings agencies' models are designed, they assume that _a larger pool of loans means a lower chance that any particular loan will default_.

And that makes perfect sense if you have tight or even relatively tight lending standards. If you do a reasonable job of making sure the people you lend to are able to pay the loan back, the _total_ number of bad loans will be relatively low, and the _chance_ of picking out a bad loan from a pool of loans will _decrease_ as the size of the pool of loans you're picking form _increases_.

But if you loosen those standards so now you're lending to lots of people who probably can't pay the loan back, then this is reversed: the number of bad loans is high, and so the _chance_ of picking a bad loan from a pool of loans goes _up_ as the size of the pool increases.

Below this there is even more and deeper mathematical arcana and financial trickery. But that's the bulk of the answer to why NINA loans were still so highly rated for so long.


Jeff Berndt profile image

Jeff Berndt 6 years ago from Southeast Michigan Author

Liano, I think you've got an article here. You should consider publishing it yourself. Thanks!


Daniel Carter profile image

Daniel Carter 6 years ago from Western US

Very clear writing to a very frustrating and seemingly etherial subject, Jeff. Thanks for such a great hub! Looking forward to other great reads from you.


Jeff Berndt profile image

Jeff Berndt 6 years ago from Southeast Michigan Author

Thanks for the kind words, Daniel. Usually I stick to lighter subjects, but this particular one has been blown out of shape by ideologues on both ends of the political spectrum, to my great annoyance.


Evan G Rogers profile image

Evan G Rogers 6 years ago from Dublin, Ohio

First and foremost, indeed, I don't even really understand completely (at least, not the finer details) of what this 'Mortgage Backed Securities', But I can already know that they are probably a good thing if an entrepreneur thought it up and found customers for such a thing. Although, there might be a better alternative if we were to restrict government regulations et. al. (This is true of any industry, however).

Just a few comments as I read:

Quote:

"The bank has a ton of money that people like you and I have given them to look after."

Just a trivial point: it isn't exactly 100% accurate to say that we go to the bank to have them look after our money. We [i]are[/i] asking them to do so, but once they receive our money, they (Generally) inflate the money to ten times the amount (depending on the reserve ratio limits) by lending the money out. They aren't really looking after the money, they're investing it and making a profit (hopefully!) off of it. You point this out in the article, but I wanted to simply make a point bout it.

quote:

"The bankers will soon face a problem of supply and demand. There will be a huge demand for these excellent new investments, but the supply will run out quickly. To generate more supply, that is, more mortgages to securitize, the bankers will slightly relax their standards for creditworthiness...."

I'm not sure if this can be an end all to the reason why things went wrong. After all, when any sort of new, successful industry is generated demand has to increase (by definition, anything that goes from 0% to any number is an increase) - yet we don't see crashes of this magnitude in ... oh, say... USB port technology. USBs were once a new-fresh-off-the-press item, and demand for them SKY-ROCKETED (now they're everywhere! even in my phone!)... and yet there was no USB quality crash.

Or, perhaps Fruit would be a better example, demand for oranges tends to increase at certain times of the year, but we don't see moldy nasty bruised fruit on our super-market shelves.

I would have to think that something else altered the market - after all, I'm sure banks know VERY well that lowering credit rating standards is a horrendously risky thing to partake in.

If supply runs out, but demand is increasing, a MUCH more prudent move for banks would be to simply raise prices - they could earn more profits by simply raising the prices of the mortgage shares. This would begin to limit demand, and would generate more profits with the same supply.

I simply can't accept the "demand leads to inferior products" argument.

Quote:

"If a borrower defaulted on a mortgage, the bank would be stuck with the house and would have to sell it to get their money back. This was almost always a lose-lose scenario."

I would so much like to agree with this. In a true free-market banking system, this would be very true. Unfortunately, with Fractional Reserve Banking, the bank is putting up money that doesn't really exist. For example, if there are a total of 20,000 dollars of real money in it's vaults, it can (through loans) use $180,000 as collateral for loans - even though the money doesn't exist. There was a case where a farmer went against the bank arguing that they didn't actually put anything up for collateral because the money was created through FRB... and he won! (i would love to get the source, but my mind is friend - 14 hour jet lag is rough.)

Quote:

"but no incentive to deny loans to people who couldn’t pay the loans back."

This is the same argument as before: Banks just dropped standards to the point of horrible....

... but isn't the fact that the entire collapsed because of this (which is not true, but mainstream economists seem to believe it) incentive enough?

I have to reject that there "was no incentive" to reducing lending standards - if over 7,000 bank failures don't attest to incentives, then I don't know what will!

---

Well, all said, good article. I disagree with certain parts of it, but, at the very least, it was a great explanation of what these Mortgage Backed Securities were. It was well, and intelligently, written and argued. My disagreements simply stem from my (as your aware) constant arguing that the free-market doesn't make horrendous mistakes.

I'd like to add that You didn't seem to mention the Community Reinvestment Act - legislation that forced banks to lower their credit requirements for loans for certain people (the 'certain people' tended to be poor inner-city people). This government legislation was a very good reason why banks lowered their standards instead of increasing prices of loans et. al.

Here's an article that argues (using a book by THomas Sowell as a reference) that the fingerprints of government intervention were all over the crisis: http://blog.mises.org/10239/the-housing-boom-and-b...

And I would like to add that the real reason why the boom and bust of the 90s-00s took place was from manipulations in the money supply and interest rates. FOr more information you can look up "Austrian THeory of the Business Cycle", Thomas Woods Jr. explains it pretty well in many of his economics-related videos online.

Keep writing! See ya


nicomp profile image

nicomp 6 years ago from Ohio, USA

I think you left out the banks' motivation for the stupidly risky loans.


Jeff Berndt profile image

Jeff Berndt 6 years ago from Southeast Michigan Author

Oh? I thought I'd listed a few. Did I miss one?


nicomp profile image

nicomp 6 years ago from Ohio, USA

Barney Frank, Chris Dodd, and Franklin Raines.

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