The USA mortgage meltdown, which resulted in the current depression, was an event that had many causes. Among them was the financial device known as the “Mortgage Backed Security”-which was a way fro mortgage originators to bundle mortgage obligations, and sell them to investors. It isn’t such an outlandish idea-and had some good points:
-it allowed for greater liquidity for mortgage holders
-it (theoretically) broadened the investor market for mortgage debt
Of course, the bad points included the fact that there seemed to be no way to evaluate the risk, once defaults started on a large scale. One of the reasons why Lehman Brothers failed was because they held hundreds of millions of $ in MBS, and could not resell them (once they got a bad name).
Isn’t this just like the bond market? You have all kinds of bonds-from triple A to junk-with appropriate valuations. Or is a MBS totally worthless , once a large number of mortgage holders default?
In any case, was it the MBS or the dishonesty of the originators (of te mortgages) that caused the mess?
It’s not a depression. And the fact that you just said the US economy is in a depression probably ought to answer the question in your thread title.
There were a lot of problems. The subprime mortgages were a bad idea and were riding for a fall because a lot of the mortgage holders were, at some point, not going to be able to pay. That’s on the lenders and on the people who accepted the mortgages. The financial instruments composed of these mortgages were handled in a way that concentrated risk and they were rated like they were sure things, which obscured the dangers. So all of that was a bad idea.
In and of themselves there is nothing wrong with a Mortgage Backed Security (MBS).
Derivatives are basically a way to transfer risk and that can be a good and useful thing.
Where MBS failed was the bundling of mortgages in a way as to hide the real risk (and inappropriately gaining AAA ratings from the rating agencies) and that you could keep selling the risk over and over and over to people (basically I could sell 1,000 people the risk of a default on one home).
Mortgage backed securities weren’t the problem; lax regulation and fraud were.
Yeah, MBS have been around for decades. They only became toxic when the government stopped oversight/regulation of the mortgage originators, mortgage securitisers and credit ratings agencies.
We still haven’t heard most of the story. It’s coming out in dribs and drabs long after 99.9% of the country has forgotten about it. Look at this article from the weekend :
D. Keith Johnson, a former president of Clayton Holdings, a company that analyzed mortgage pools for the Wall Street firms that sold them, told the commission on Thursday that almost half the mortgages Clayton sampled from the beginning of 2006 through June 2007 failed to meet crucial quality benchmarks that banks had promised to investors. Yet, Clayton found, Wall Street was placing many of the troubled loans into bundles known as mortgage securities. Mr. Johnson said he took this data to officials at Standard & Poor’s, Fitch Ratings and to the executive team at Moody’s Investors Service…
According to testimony last week, from January 2006 to June 2007, Clayton reviewed 911,000 loans for 23 investment or commercial banks, including Citigroup, Deutsche Bank, Goldman Sachs, UBS, Merrill Lynch, Bear Stearns and Morgan Stanley. The statistics provided by these samples, according to Mr. Johnson and Vicki Beal, a senior vice president at Clayton who also testified before the inquiry commission, indicated that only 54 percent of the loans met the lenders’ underwriting standards, regardless of how stringent or weak they were.
Some 28 percent of the loans sampled over the period were outright failures — that is, they were unable to meet numerous underwriting standards and did not have positive factors that compensated for their failings. And yet, 39 percent of these troubled loans still went into mortgage pools sold to investors during the period, Clayton’s figures showed.
http://www.nytimes.com/2010/09/27/business/27ratings.html?_r=1
That is a little too late in the process. The start was the lack of standards for the generation of home loans. The fact that the banks had no intention of keeping the loans permitted them to not care at all how safe they were. They just sold the risk in huge portfolios. They passed them along and made billions while they did it, all the time well aware that the loans were dangerous.
What is “too late in the process”?
It is all a chicken or egg thing. A lot of money was looking for investments…mortgage backed securities seemed pretty safe so they sold them. More money came in they sold more and started running out of mortgages to sell. Answer? Relax lending requirements to make more loans. Sure there was more risk but the payoff more than made up for it. Rinse and repeat till the house of cards comes crashing down.
The banks were doing this eyes wide open and were making a fortune. No one was willing to point out the emperor had no clothes (well very few did but no one in a position to stop it).
Holy crap, I think that’s the company I worked for back in the '90s!
Apropos of nuthin’, but it inspired a couple seconds of trippin’ down memory lane…
When I got my home loan in the early 00s I figured out how much of a mortgage I could afford, then went to the bank to borrow the money. The loan guy at the bank tried to convince me that I could afford to borrow twice as much. He really tried to hard sell me into borrowing a lot more than I wanted to. He probably got more commission and what the hell did he care if I ended up not being able to pay? He knew his bank was going to sell the loan to someone else anyway. I’m glad I didn’t give in to the pressure.
Yes there were all sorts of problems but to be fair, there was never any rule on the books that would have prevented this. Two things happened, private label securitizations started to proliferate which decimated the lending standards AND the adminsitration ignored warnings by regulators that there was a looming problem because they didn’t want to kill the ONLY thing that was keeping people’s minds off of Iraq.
We are seeing one definitely bad side effect from all this. In their desire to make buying and selling the individual mortgage notes easier and cheaper, the banks and REIs contrived different ways of getting around the traditional requirements for selling real estate loans (physically signing the note over to the buyer of the note, going to the county recorder’s office and paying the fee to have the mortgage reassigned), which has resulted in the widespread breaking of chains of title in who knows how many properties. The reason we’re hearing about these different banks suspending their foreclosures is because, in an attempt to paper over their mistakes and laxity, they’ve been doing things such as backdating assignments and rubberstamping affidavits and even filing outright fabricated documents that are nothing more than frauds on the court. Congressman Alan Grayson has even petitioned the Florida courts to halt ALL foreclosures in the state (pending a state AG’s investigation) because they’ve become total kangaroo courts.
So…foreclosures being halted (which may be both a good and bad thing); widespread problems with chains of title; banks and “foreclosure mill” law firms lying to courts; and people who maybe could pay their mortgages after a modification not getting the time of day. I’m not sure the average person realizes how totally screwed up real estate has become in this country. Since I know some people simply can’t fathom that the banks would ever act so incompetently or maliciously, read about this Florida man who had his house foreclosed on him by Bank of America when he didn’t even have a mortgage!
I guess what I’m saying is that maybe a little less liquidity in the real estate loan market may be a good thing.
That might be where the problem started, but the simple fact is that mortgage buyers could have put a stop to the time bomb mortgages by refusing to buy them.
They didn’t bother to inspect them too closely because everyone thought the housing market would keep going up more or less forever.
So, no, mortgage backed securities weren’t a bad idea. Failing to perform due diligence was a bad idea, just as it always has been.
Same thing happened to us when we lived in the US, early 2000s. The loan guy was incredibly pushy and obnoxious about it, like we were idiots for not wanting to borrow more. When the stories starting coming out about people defaulting on their first mortgage payments, and people making barely over minimum wage getting half a million dollar mortgages, I didn’t doubt it for a second. And I just felt sorry for those people - I mean, they should have known better than to borrow that much, but people want to think that if you can trust any one, you can trust the bank.
A big problem was that mortgage based securities were essentially insurance but for legal reasons they were not sold as insurance. This allowed them to avoid the regulations that govern the insurance business. Businesses were able to deal in securities without a realisitc assessment of the risks involved or sufficient resources to pay off the possible liabilities.
One central liability was the failure to recognize how interconnected the risk was. The risks were not independent. A decline in the real estate market would affect a substantial number of individual policies simultaneously. It was like selling insurance to a hundred home owners who all lived along the same river - one flood could cause all hundred of them to file a claim in the same week.
Nemo, I think you’re thinking of credit default swaps, which are different from MBSs.
Theoretically yes. But realistically it doesn’t work like that. Nobody can buy and sell by themselves. The market requires us to deal with the beliefs. An individual can claim that market conditions are irrational and even prove his case. But if everyone else insists on holding their irrational beliefs, then the individual is forced to bow to the consensus in order to participate.
So it would have made no difference if some mortgage buyers had refused to jump into the market because they could see it had shakey foundations. Plenty of others were willing to step in and buy those risky mortgages and keep the bubble going. And when the bubble burst, the collapse hurt everyone - including those people who had foreseen the possibility of a collapse.
That’s what outside regulation is supposed to be for. It shouldn’t prevent people from making mistakes and hurting themselves. But it is needed to prevent people from making mistakes so huge that they hurt everyone else as well.
I think all of the points raised so far are valid - shoddy if not fraudulent ratings of securities, overly aggressive lending policies, lack of underwriting standards, probable deception in structuring MBS by loading them up with bad loans, unrealistic expectations for property values, and so on. There were so many opportunities to staunch the flow of red ink and so many failures. If any one of those factors hadn’t existed, there wouldn’t have been a crisis.
But underlying all of this was the fact that the entire financial system was overleveraged. MBS’s are just a part of that. You also have companies like AIG who were writing derivatives for amounts that did not reflect the risk they were taking and those derivatives were being backed up by the slimmest of capital requirements.
Add to that the fact that all of these instruments contributed to the availability of liquidity. Let’s say I sell you a credit default swap on $100M in GM bonds. Maybe I charge you a premium of $5M per year for my guarantee of GM’s debt. That $5M is now a predictable cash stream which I can bundle and sell as another derivative such as a total return swap. This now becomes yet another security that can become the basis for yet other derivatives or used for collateral to create new loans. And around we go.
I won’t pretend to fully understand derivatives, but the point is that you are creating new assets essentially out of thin air and those assets can become the basis for more assets and so on.
By itself that’s not too shocking since that’s how our fractional reserve banking system works. I deposit $100 and my bank takes $90 and loans it out. The guy who gets that $90 puts it in his bank and they loan out $81 (90% of the $90). And this continues indefinitely.
The difference is that my bank has to meet certain capital requirements. They can’t loan out $99 of my $100 because they are required to keep a certain percentage in reserve. Buyers and sellers of derivatives either had no such limitations or they were substantially more relaxed than those imposed on banks. The closer to zero the amount of reserves held by sellers of these instruments, the closer to infinity becomes the growth in the amount of money available.
Plus there was the idea of using one’s home as an ATM.
I worked at a community bank and sat at some meetings about allowing those 125% equity loans to be issued. I argued up and down that we shouldn’t allow them and we should stay mostly out of the subprime market, even as others were trying to sell the idea. I almost lost my job and was almost banned from further meetings. Fortunately the owner’s family saw sense and decided to wait and see; a year later everything crashed.
People should have known better, but they were pushed along by the herd mentality.
Also, when you talk about banks pushing people into subprime mortgages, check this even worse example.
Think of the economic impact if each buyer of a MBS had to do due diligence for each of the loans packaged within. It is impossible. Those few who did do checking were ignored, of course, but the way that the market was supposed to work was that the credit rating agencies would perform due diligence and assign a rating based on risk. Now, it appears that some of them more or less published their rating algorithms, which allowed the banks to create MBS packages with the lowest possible quality to get a AAA rating.
Even if someone had noticed that there was a disconnect in that AAA rated securities were getting returns you’d expect from riskier ones, anyone complaining too loudly and refusing to buy them would get lower returns and would get slammed in the market.