Mortgage-Backed Securities are Actually Pretty Cool

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.

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.

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?

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.

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.

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.

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.