Beacon-omics 101: What are mortgage-backed securities?
This article first appeared in the St. Louis Beacon, Dec. 1, 2008 - To construct a global financial meltdown, start with some building blocks called "mortgage-backed securities."
What are they?
In a nutshell: A borrower goes to a lender to arrange financing to buy a house. The lender gives the borrower the money but then sells the loan – or portions of it – to a third-party financial company. That company further divvies up the loan among investors who will share the profits from the loan repayment but also the risk should the homeowner default.
The banker serves as a middleman in this model, linking the borrower on Main Street with the investment markets of Wall Street. All works well, until the borrower – and hundreds and thousands of other borrowers – stop making their monthly mortgage payments. The money stops flowing, and they all fall down.
Looking back, it is easy to see the pitfalls of mortgage-backed securities. So, why did so many financiers think they were such a good idea?
We put that question to Rik Hafer, chairman of the department of economics and finance at Southern Illinois University-Edwardsville during a recent interview. Hafer, a former research economist for the Federal Reserve Bank of St. Louis, offered one of the best non-technical explanations we've found.
"From a finance standpoint, it's exactly what you want financial markets to do, in this sense: Suppose you have a 20-year mortgage, and there's an insurance company that needs money 20 years in the future because it knows from its actuarial tables that it will need to pay someone's life insurance policy 20 years from now. So it purchases the 20th year of your mortgage. Someone else needs money in 16 years. Someone else needs money in nine years. And so they buy these promises to pay at nine years, 16 years, 20 years," Hafer explained.
"These companies will take pools of mortgages and split them up into separate little packages that benefit someone's need for money down the road, and there's a fee and there's a structure and all that. And that's incredibly efficient. That makes funding efficient. The collateral is the house, in that sense," he said. "So, you've created these really sexy financial instruments, which are really making the financial market increase the efficiency of how we finance things, decrease the cost of borrowing for people who want to borrow. We all benefited, and we were able to see the cost of financing go down."
Hafer said the system worked well, even internationally, as long as housing prices were rising, interest rates were affordable and mortgage payments were being made.
"It works truly well until 2004-05, when the Fed starts raising rates, interest costs get too high for some people who now get turned around on their mortgages or they have to refinance their three-year balloons, and they can't at the existing rates. Now, all of a sudden those mortgages aren't being repaid," Hafer said.
"That just ripples up the line into the mortgage-backed securities market. Because now the payment for the 20th year that the insurance company bought is not coming through. Now, what do you do? It's all leveraged. When they talk about de-leverage, that's what's going on. You've leveraged this payment into these other instruments, and now you start going in reverse."
Hafer said that financial institutions that have failed, such as Washington Mutual, made a classic error: They failed to diversify and were too heavily invested in mortgage-backed securities. Lehman Brothers, for example, was pooling the securities in an innovative way."But when things turned down, they were impacted very severely," Hafer said.
Hafer points out that there were warnings. In April 2007, for example, Moody's and Standard and Poor's downgraded mortgage trusts, citing increased default risks.
"The attitude was, well, the market will figure it out," Hafer said. "And I think markets do figure things out, but there was no regulatory framework to step in and monitor what these organizations were doing, in terms of some of these securities. So that persisted; nothing was done. And then it just kept snowballing because these things spread out to the financial system. So, everybody owned a chunk of something. As the real estate market started to cool down, and housing prices began to fall, you started seeing these effects on other financial institutions."
Part of the problem can be blamed on the human factor: "You ride the horse as long as you can," Hafer said.
"Think about the competition. If you don't do it, someone else will. If they make money and you don't, your shareholders won't like you. In recent times there has been a real pressure on companies, in general, to meet quarterly earnings forecasts. Historically, if you look back in old finance books and books on stock market theory, you don't see that. And you don't see that in other countries as much as you do here. Think about how the stock market reacts when somebody misses their quarterly earnings forecast by even a penny."
Mortgage-backed security: A type of asset-backed security that issecured by a mortgage or collection of mortgages. These securities mustalso be grouped in one of the top two ratings as determined by anaccredited credit rating agency and usually pay periodic payments.Furthermore, the mortgage must have originated from a regulated andauthorized financial institution.
Source: www.investopedia.com, a Forbes digital company