Layman's terms of bundling & selling mortgages

Factual Questions
1

OK, from what I’ve seen on TV, heard on the radio, and have read on the Dope, to quote from a favorite TV show of mine, I have a “crude grasp of the general idea.” But I still have a bunch of questions about all of this.

This thread will probably be a little long because I am extremely ignorant of how most of this works, and I hope knowledgeable people will have the patience to answer these questions.

Oh, and I guess I should say I’m asking about practices here in America.

OK, so I understand that all or most of the companies that people got their mortgages from then sold those mortgages to other institutions such as banks. I also have heard that the mortgages got bundled and resold. I understand that banks (and other institutions) bundled mortgages and sold them to each other. Did the mortgage companies also bundle their mortgages and sell them to the banks, or does the bundling start at the banks?

Let’s say someone gets a $500,000 mortgage. Typically, what would that mortgage be sold for?
Say a $500,000, a $350,000, and a $400,000 mortgage are bundled up and sold. Typically, what would the bundle be worth?

I understand that if people were buying houses they could afford, everything would be fine, but that isn’t always the case, which leads me to some questions.

Say a bank has a $500,000 mortgage, or has that mortgage as part of a bundle. Say the owner defaults on the loan, and the house is foreclosed upon. What does that do to the mortgage’s worth? If the bank resells the house, does it have anything to do with the original mortgage, or would that result in a brand new mortgage? If so, is the $500,000 mortgage only worth what was paid on it, since there will be no more future payments?

Final question. Somehow, this is connected to the “credit crunch” in that it’s affecting the ability of banks to lend to the public, and each other. I think I’ve also heard that it’s affecting bonds too. What is the connection? Have banks been sinking most of their money into bad mortgage bundles, and now that they can’t make money from them, they don’t have much money to spend?

Anyway, I know that this is all complicated, but from other things I’ve seen, heard, and read, I think that if these questions will be answered from me, it would fill in a huge gap in my knowledge and understanding. Thank you.

2

The mortgage lending companies would typically have an <b>investment bank</b> (versus a deposit taking ordinary commercial bank, what you probably typically think of as a “bank” ) do the packaging and sale to institutional investors (which might be insurance funds, mutual funds, banks, pension funds, etc).

For the portfolios, the bundles would be large numbers of mortgages of similar characteristics, at least theoretically, such as length, size, interest rate, etc. The pricing would depend on the risk characteristics, such expected default rate, as well as terms of the mortgages. One could not give you a ‘typical’ price on the type of question you’re asking.

Otherwise, in Great Debates there is a fairly good thread on this crisis which already touches on most of your questions.

3

The seller would in theory get less than the face value of the mortgages, though, because he’s getting rid of risk (the motrgage might not be rapaid) and getting his money Now instead of Then.

4

So the mortgage company sells the mortgage to an investment bank, who then bundles up mortgages and sells them to individual investors, right?

Thank you, that helps eliminate some of my ignorance and helps me understand things a little bit better.

I’ve already read a lot, but haven’t seen these questions answered. Or maybe I’ve missed some threads, or maybe these questions have been answered but I’ve been to ignorant to figure it out.

At any rate, I guess I have just two more questions. Since it’s investment banks, and not deposit banks that are buying and selling these packages, why are deposit banks failing?

And for banks not loaning, is it because they paid a lot for these packages, the packages aren’t paying off, and so the lost a lot of money, and can’t afford to loan very much money?

Thank you.

5

Right. And I’m also assuming that the buyer is buying the mortgage in hopes of making money off of it, so paying face value wouldn’t earn them a profit.

6

Actually, the selling banks typically get more than face value. They couldn’t make money by lending $500,000 and then selling the mortgage for less than that. The mortgages are packaged together and then the entire package is split into “tranches” that provide a sliding risk/return profile based on the priority that they are paid from collections. For example, the $1,250,000 in the OP’s example might be split into a $1,000,000 “A tranche”, a $150,000 “B tranche” and a $100,000 “C tranche”. If any of the loans default, the C tranche does not get paid for those mortgages until they’re resolved, i.e., it’s the “first loss piece”, followed by the B then the A tranches. The A tranche only loses money if there is more than $250,000 in losses. For this example, let’s say the average interest rate on these mortgages is 7%. A pension fund, insurance company, or other risk-adverse entity would typically but the A tranche. Since it is relatively low risk, they may only require a return of 5% and would therefore pay significantly more than the $1,000,000 face value; let’s say $1,100,000. The B tranche is likely to be bought for near face value by someone able to take a little more risk, so let’s say that goes for $150,000. The C tranche (or lower, there are usually several more tranches than I’m using for this simplified example) is often purchase by a loan servicer since it often includes the servicing rights (and the servicing fees). Since it’s higher risk, it may go for slightly less than face value, let’s say $80,000. So the total in this example is $1,330,000.

7

I suppose it depends, but not precisely. The mortgage company (or bank, as banks proper do this as well, however non deposit takers depend on this to get funds) engages the investment bank or advisory firm to create the security - to “securitise” the given portfolio of loans - and sell it off into the market. Frequently the last or worst tranche (slice) of the package was retained by the investment bank (or sometimes by the originating party). Contractually the investment bank would not want to “own” most of this for very long as it would eat up capital.

Many reasons. Some later bought the securities - even if they were not in the business, they may have bought them as investments, some bought the mortgage companies as they looked profitable as recently as 2006, some may have investment bank operations as well as commercial bank operations, and were in the business. Others may have exposure to residential lending. Since the mortgage assets are now “unpriceable” that makes them essentially worthless (although many may end up being perfectly fine and paying in the end) currently, which requires write-downs in values, leading the bank to go under the required level of capital, or to have to meet margin calls due to legal covenants on its own financing, etc.

There is also a lot of fear of failure and no one is entirely sure where some of this stuff will pop up, so even banks that seem to have stayed out of direct involvement are facing ever increasing costs of self-financing.

Not precisely - and there are lots of different parts of the machine. I suppose the essentials are:
1: banks or other financial entities that bought these securities for investment, which had been using them as capital on their books against which THEY lend find themselves short on required capital, so they have to hoard cash, thus not lend
2: generalised fear of failures has raised the cost of financing for everyone, so again, banks are hoarding cash to cover current obligations, not lending to others due to the Unknown Unknowns
3: lack of confidence in the ratings on investment securities generally, which is leading to a pullback in money markets which is leading to cash hoarding, which is leading to less lending which leads, to cash hoarding - vicious instead of virtuous circle.

It seems clear much of the crunch now is not directly tied to these, but indirect.

However, the Great Debates thread people have touched on this and you would probably well in asking for clarifcations there.

8

Actually, you and everyone else have satisfied my curiosity. With this thread, and then other other threads I have already read, I think I now I have a basic understanding of what’s going on.

Thank you.