Mortgage-backed securities (MBS’s) are investment vehicles secured by mortgage loans. A later incarnation of the MBS is the Collateralized Debt Obligation, which figured prominently in the 2008 financial collapse.
In the movie version of Michael Lewis’s book “The Big Short”, Lewis Ranieri* (the banker who created the first MBS) is shown saying that the beauty of the MBS is that while the risk goes down, the yield goes up.
I understand why the risk goes down: by spreading the risk around, the chance of default is absorbed (at least, when (unlike in 2008) defaults are rare). Basically, it’s the same phenomenon that makes stock mutual funds less risky than individual stocks.
My question is: why would the yield go up?
*The movie is based on the true story told in the book. So I don’t know whether the real Lewis Ranieri ever said such a thing, only that the movie character based on him did.
Not positive but it may refer to the basic structure. Say all the separate mortgages are returning the same interest rate. The more you group into one MBS the higher the overall return. But the percentage of failures within the MBS is supposed to remain the same. Of course the failure rates were not calculated properly. The MBS were not rated correctly.
Structured pools of mortgages are often split into a risky piece (which pays very high returns) and a supposed un-risky piece. The unrisky piece has value for large institutional investors who need to show regulators and shareholders that they are safe and the risky piece has value for speculators who want to get high returns for their money. So it’s a win-win.
In the movie version of Michael Lewis’s book “The Big Short”, Lewis Ranieri* (the banker who created the first MBS) is shown saying that the beauty of the MBS is that while the risk goes down, the yield goes up./QUOTE]
The trouble with that statement is the difficulty in knowing exactly what he meant if he in fact said it. The yield on a mortgage (or bond) can mean different things and not one of them means the average (or expected) rate of return which is what should be connected to risk. (Risk can also mean a number of two things – the risk of default, or the daily fluctuation in prices caused mostly by changes in the interest rate, or the prepayment risk.)
Most commonly yield unmodified means yield to maturity. This is the rate of return you would earn over the life of the bond assuming no default, no prepayments or refinancing, and that you can reinvest all the payments you do receive in other products which have the same yield. It is quite possible to construct scenarios under which one measure of risk goes down and the yield to maturity goes up. So the statement is likely salesmanship.
That particular quote is not in the book (searching it online) and doesn’t make sense.
The original type of mortgage backed securities are where you take a bunch of mortgages and pass the cashflows from them on to a bunch of bonds investors buy all of which are the same. That has less idiosyncratic risk than buying one mortgage and having that particular homeowner fail to pay. It even has less idiosyncratic risk than a hometown bank buying (that is, issuing, lending on) 100’s of mortgages since while the specific situations of different borrowers wash out, the mortgages are still all from one area which can have an economic/housing downturn that’s not national (or worse than whatever is happening nationally on average, even post 2008 better to have NY area mortgages than Las Vegas area). But in theory you could buy lots of individual mortgages from all over without the bundling/bond part. The bundling bond part just makes it easier to do that.
But the yield on the bonds isn’t higher than the average all the mortgages in the bundle. It’s lower to the extent of the fees to the people doing the work of putting it together. Ideally that loss of yield is small enough to make sense in return for the added diversification.
The movie (and the crisis, to some degree at least) were about a type of structure where all the bonds are not the same. You still have the mortgage bundle on one side. But on the bond side you have bonds which yield more than the avg of the mortgages but whose holders absorb losses (people not paying their mortgage) from the mortgage pool first, and bonds which yield less than the average of the mortgages but whose holders only take losses after the losses exceed a certain amount. There are more than two sub-types or ‘tranches’, but that’s in principal how they are distinguished: who takes losses first and gets more yield, who is partly shielded from losses by that first group but gets less yield.
But again the average yield of all those bonds has be less than that of the underlying mortgages by the amount of the (greater in the more complicated case) fees.
The key mechanism of shock coming from the latter type of bonds was when tranches calculated to be extremely safe, enough shielded by loss taking by other tranche holders to gain a rating of AAA, began to also be viewed as likely to suffer losses because the overall mortgage default rate appeared headed to a much higher level than the computer modeling on which the high ratings were granted had assumed. Eventually few of those AAA bonds actually suffered any default losses, but that was only after a big, and costly to the real economy, knock on effect from the loss in confidence.
Or if it meant anything other than just another lie to try to sucker people into buying these securities. The guy was a crook & a scammer; why would we think his statements were anything more than salesman’s lies?
It’s perhaps a bit ambiguous, because it assumes that “even though the interest rate hasn’t gone down, we can sell it at a lower yield, which means that we can sell it for more money, which means we have created money that wasn’t there before, which is NOT what normal brokerage is about”.
The point of the statement is that the yield had gone up in relation to the risk, and the risk had gone down in relation to the yield, which is a magical break from the way normal finance swaps work (which is equal value on both sides).
With the normal financial securities market, as the risk goes UP, the yield goes UP.
As the risk goes DOWN, the yield goes DOWN.
They are tied together. They mean the same thing.
This scheme was different. It created value. It created value they could pocket. It wasn’t just a brokerage/margin deal: the risk goes DOWN, the yield isn’t DOWN .
Now you might say that the face value of the notes had changed, or that the cash value of the notes had changed. but brokers are used to a world where the face value is fixed, and the cash value is how many you are buying (and whatever they can get you to pay anyway) , and the “yield” number is the number that characterises the security.