What are Mortgage-Backed Securities?

Although it is not yet widely known in the Philippines as an investment tool, Mortgage-Backed Securities (MBS) have been in vogue in the United States and other western nations. In fact, these financial instruments played a huge role in the financial crisis of 2008 caused by a huge number of borrowers who defaulted on their residential mortgages. To get an idea of what that was all about, read my previous blog where I posted an article from Wikipedia about the documentary movie “The Inside Job.” So what is an MBS and how is it sold and used as an investment vehicle?

Generally, real estate investments are classified into three categories: (1) Agricultural; (2) Residential; and (3) Commercial. MBS falls under the second category. In an MBS transaction, an issuer sells bonds to investors that are backed by a pool of mortgages. Specifically, the issuer acquires mortgage loans from various third-party lenders and other mortgage loan sellers (“originators”), pools those loans, and transfers them to a trust. The trust then issues certificates that are secured by some or all of the pooled mortgage loans and pays a yield to the investor linked to the cash flow—i.e., the principal and/or interest payments—from the loans. This process is called securitization.

If the borrowers whose mortgage loans back the certificates fail to pay their mortgages, the holders of the certificates backed by the loans might not receive the yield that they expected. The securitization process takes this risk into account in calculating the price and expected yield of the bonds backed by pools of mortgages.

MBS can be backed by different kinds of loans. Mortgage loans are designated prime if the borrowers to whom the loans are made have good credit scores, the loans are fully documented, and the mortgage loans conform to specified guidelines. These loans are considered less risky to investors when securitized, and as a result, pay lower yields. Subprime mortgages are mortgage loans made to borrowers with weaker credit scores and less documentation of income or assets. These loans are riskier because the borrowers are considered more likely to default on their loans. Alt-A mortgages fall between the prime and subprime categories, often involving prime borrowers but lower documentation than would be required for a prime mortgage.

To ensure that the loans they are making are appropriate and that the borrowers can repay them, the originators of the loans have underwriting guidelines that guide their decisions concerning whether to issue a mortgage loan to a borrower. These guidelines, however, are subject to a variety of “exceptions,” which allow an originator to make loans that did not fully comply with guidelines.

When determining whether to purchase a mortgage loan certificate, an investor might consider various statistics regarding the loans underlying the securitization, which were generally provided to them by the sponsor and underwriter of the transaction (described below). These figures would generally be represented to the investor in a document called the prospectus supplement. For example, the prospectus supplement would state the percentage of properties that were occupied by their owners (“owner-occupancy rates”) and the loan-to-value (“LTV”) ratios of the loans (the relationship between the amount of the loan and the value of the property securing the loan). This would give the investor information about how likely the borrowers on the loans underlying the securitizations would be to default on their mortgages. In addition, the prospectus supplement also generally summarized the underwriting guidelines for certain of the mortgage lenders, also known as originators, and represented that the originators made loans in accordance with their underwriting guidelines.

Each securitization would be divided into tranches, representing different ‘slices’ of risk exposure.  Each tranche had its own risk profile and was assigned its own credit rating, with the most senior tranches generally being the least risky and junior tranches having a higher degree of risk exposure.  Investors would select a tranche for purchase based on their appetite for risk.

The date on which a securitization was issued is known as the securitization’s closing date.  Each securitization was assigned a CUSIP number: an alphanumerical identifier unique to that securitization.

MBS were sold to the public by large investment banks such as Morgan Stanley, Bear Stearns, Goldman Sachs, Merrill Lynch, and the Lehman Brothers as profitable and safe investment vehicles. Only time will tell if and when such instruments or those similar thereto will become popular investment instruments in the Philippines and other developing countries in Asia. When that time comes, you would better be prepared. Remember, knowledge is power!

What Caused the Financial Crisis of 2008?

To give you a basic understanding of what really happened in 2008, what follows is a summary of the 2010 documentary that I watched entitled “The Inside Job,” which  was taken from Wikipedia.

Part I: How We Got Here

The American financial industry was regulated from 1940 to 1980, followed by a long period of deregulation. At the end of the 1980s, a savings and loan crisis cost taxpayers about $124 billion. In the late 1990s, the financial sector had consolidated into a few giant firms. In March 2000, the Internet Stock Bubble burst because investment banks promoted Internet companies that they knew would fail, resulting in $5 trillion in investor losses. In the 1990s, derivatives became popular in the industry and added instability. Efforts to regulate derivatives were thwarted by the Commodity Futures Modernization Act of 2000, backed by several key officials. In the 2000s, the industry was dominated by five investment banks (Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns), two financial conglomerates (Citigroup, JPMorgan Chase), three securitized insurance companies (AIG, MBIA, AMBAC) and the three rating agencies (Moody’s, Standard & Poors, Fitch). Investment banks bundled mortgages with other loans and debts into collateralized debt obligations (CDOs), which they sold to investors. Rating agencies gave many CDOs AAA ratings. Subprime loans led to predatory lending. Many home owners were given loans they could never repay.

Part II: The Bubble (2001–2007)

During the housing boom, the ratio of money borrowed by an investment bank versus the bank’s own assets reached unprecedented levels. The credit default swap (CDS), was akin to an insurance policy. Speculators could buy CDSs to bet against CDOs they did not own. Numerous CDOs were backed by subprime mortgages. Goldman-Sachs sold more than $3 billion worth of CDOs in the first half of 2006. Goldman also bet against the low-value CDOs, telling investors they were high-quality. The three biggest ratings agencies contributed to the problem. AAA-rated instruments rocketed from a mere handful in 2000 to over 4,000 in 2006.

Part III: The Crisis

The market for CDOs collapsed and investment banks were left with hundreds of billions of dollars in loans, CDOs and real estate they could not unload. The Great Recession began in November 2007, and in March 2008, Bear Stearns ran out of cash. In September, the federal government took over Fannie Mae and Freddie Mac, which had been on the brink of collapse. Two days later, Lehman Brothers collapsed. These entities all had AA or AAA ratings within days of being bailed out. Merrill Lynch, on the edge of collapse, was acquired by Bank of America. Henry Paulson and Timothy Geithner decided that Lehman must go into bankruptcy, which resulted in a collapse of the commercial paper market. On September 17, the insolvent AIG was taken over by the government. The next day, Paulson and Fed chairman Ben Bernanke asked Congress for $700 billion to bail out the banks. The global financial system became paralyzed. On October 3, 2008, President Bush signed the Troubled Asset Relief Program, but global stock markets continued to fall. Layoffs and foreclosures continued with unemployment rising to 10% in the U.S. and the European Union. By December 2008, GM and Chrysler also faced bankruptcy. Foreclosures in the U.S. reached unprecedented levels.

Part IV: Accountability

Top executives of the insolvent companies walked away with their personal fortunes intact. The executives had hand-picked their boards of directors, which handed out billions in bonuses after the government bailout. The major banks grew in power and doubled anti-reform efforts. Academic economists had for decades advocated for deregulation and helped shape U.S. policy. They still opposed reform after the 2008 crisis. Some of the consulting firms involved were the Analysis Group, Charles River Associates, Compass Lexecon, and the Law and Economics Consulting Group (LECG). Many of these economists had conflicts of interest, collecting sums as consultants to companies and other groups involved in the financial crisis.

Part V: Where We Are Now

Tens of thousands of U.S. factory workers were laid off. The new Obama administration’s financial reforms have been weak, and there was no significant proposed regulation of the practices of ratings agencies, lobbyists, and executive compensation. Geithner became Treasury Secretary. Feldstein, Tyson and Summers were all top economic advisers to Obama. Bernanke was reappointed Fed Chair. European nations have imposed strict regulations on bank compensation, but the U.S. has resisted them. Trust remains questionable.