Friday, January 21, 2011
The Ten PM Tutorial v
at 10:00 PM
Mortgage Backed Securities (MBS): They are bonds made up of mortgages that have the same or very similar characteristics in terms of interest rates, risk, and period. The (theoretical) beauty of this sort of bond is that, as the name implies, it is backed by the property itself. Therefore, if the borrower goes into default, the idea was, the property can be foreclosed, sold at auction, and the money recovered. Hence—again, in theory—it was supposed to be a totally safe investment vehicle.
The kink in the system was, Mortgage Backed Securities depended on housing prices not falling. So long as they did not fall in price, the
Collateralized Debt Obligation (CDO): It is a bond made up of some item which is the collateral to the loan. Mortgage Backed Securities are a type of CDO.
Credit Default Swap (CDS): It is essentially an insurance contract, taken out on a bond. Suppose you, me, and Mary are trading bonds. Mary issues $1 million in bonds of her company, Mary Inc. You buy the bonds—but you’re not sure Mary will pay. So I sell you a CDS: If Mary fails to pay off her bond, I will pay it to you in her place.
Notice the name: “Credit Default Swap”. It is a swap (or insurance) for the case where a credit (or a bond) goes into default (or non-payment).
As you can see, this is really an insurance policy—but it is not regulated like insurance. In the case of fire, auto, and life insurance policies, government regulators all over the world make sure that the insurance companies that sell such policies have the money to pay off the claims.
But in the case of Credit Default Swaps, they were deliberately designed to fall in the cracks of regulation.
The Federal Reserve—under Chairman Alan Greenspan—should have regulated Credit Default Swaps. But he chose not to.
In 2008, a lot of mortgage loans had been given out to people who could not afford them. The reason was, mortgage providers wanted the fees: They would give a $600,000 mortgage to a Mexican gardener earning minimum wage, then turn around and sell the mortgage to investment banks. So the mortgage provider was no longer on the hook, if the Mexican gardener could no longer pay for the $600,000 mortgage.
The mortgage provider had collected his fee from the Mexican gardener, and collected his fee from the investment bank—so he didn’t care if the loan went into default, because when that happened, it wouldn’t be his problem.
So that’s why mortgage providers had such a huge incentive to give mortgages to people who should never have gotten mortgages: It wasn’t the Mexican gardener’s fault—it was the loan providers’ fault.
The investment bank took the Mexican gardener’s mortgage, and bundled it up into Mortgage Backed Securities—then sold them to customer, telling them that the bond was safe, because it was backed by the $600,000 house.
When the Mexican gardener (and everyone else) could no longer pay the mortgage, the house was foreclosed. Since several houses in a given market were all for sale for the same reason, housing prices in the neighborhood went down. Instead of $600,000, the house could only be sold for, say, $400,000—which was less than what was owed on the mortgage.
Hence, the houses were underwater: The loan was more than what they were worth on the market.
This effect started with the lowest class of mortgage loans—sub-prime mortgages—but it worked its way through all the mortgage loans in the U.S. housing market.
This started in 2006, but eventually reached the investment banks in 2008—they had bonds that were not worth what people thought they were. The losses were so big, that there was a panic.
That was—in essence—what happened in the fall of 2008: A classic bank panic, when everyone realized that the financial system was insolvent because of all these deals.
The banks were all bankrupt—and in 2008, people realized it.
After the panic, the regulators—that is, the Federal Reserve and the Treasury Department—did not do what they should have: They instead tried to prop up all the banks, and sweep the problems under a flood of money.
That is where we are today: The problems have been flooded with money—but the problems of insolvency have not gone away.