I, Freddy the Pig, have a pot of money and I’d like to get into the mortgage lending business. Mortgage loans offer a nice return, they’re long term, and they’re historically fairly safe. But it’s not as if I can go out and originate loans myself. I’m not a banker. I don’t know beans about qualifying customers or appraising property. What to do?
The solution–let someone else originate the loans–someone who hopefully knows what they’re doing–and bundle them into a “mortgage-backed security” in which I can invest. I still don’t know anything about mortgages, but I don’t have to. The loan originators will handle it.
What if they exercise crappy judgment, and loan to a bunch of deadbeats, and all the mortgages of which I own a small piece default? Well, that didn’t seem very likely. Mortgage loans were an old business with well understood lending standards (X% of income and all that.) Even deadbeats didn’t default all that often, because (a) people don’t like to lose their homes; and (b) when in danger, they could flip the property for a higher price and pay off the loan. And in extremis, when people did default, the loan originator could flip the property and reclaim the balance. That’s why mortgages are asset-backed or collateralized debt obligations.
In fact, believe it or not, for a long time the greatest risk associated with mortgages was the risk of early payment. When interest rates fall, borrowers pay off and refinance, cheating the lender out of long-term gain.
As a further refinement, therefore, the repayments from a pot of mortgages could be separated into tranches with different risk characteristics. One tranche might have greater risk of early payment, another greater risk of default (not because of the mortgages themselves, but because of how the payments were assigned to tranches.) The safest tranches were considered safe indeed.
By now, you can probably see the problems with this model. First, for a variety of reasons (moral hazard, pressure and encouragement by government) lending standards deteriorated. Second, the property bubble burst, so houses at risk of default could no longer be flipped. And third, the economy teetered, so that more people lost their jobs and couldn’t make payments. Even the safest tranches not only looked like shit, but shit that was impossible to value.
Mortgages are just one example. Other “asset-backed securities” involve commercial real estate and commercial loans. All involve the same problems–deteriorating loan standards, more defaults, and suddenly worthless collateral.