post a comment

profileking_gjh
HonorsConversion_KellyFinn.pptx
Home>Business & Finance homework help>post a comment

Mortgage-Backed Securities and the Financial Crisis

Kelly Finn

FNCE 4302

Mortgage-Backed Securities (MBS) are “pass-through” bundles of housing debt sold as investment vehicles

A mortgage-backed security, MBS, is a type of asset-backed security that pays investors regular payments, similar to a bond. It gets the title as a “pass-through” because the security involves several entities in the origination and securitization process (where the asset is identified, and where it is used as a base to create a new investment instrument people can profit off of).

Key Players involved in the MBS Process

[Mortgage] Lenders: banks who sell mortgages to GSE’s

GSE: Government Sponsored Entities created by the US Government to make owning property more accessible to Americans

1938: Fannie Mae (FNMA): Federal National Mortgage Assoc.

1970: Freddie Mac (FHLMC): Federal Home Loan Mortgage Corp.

Increase mortgage borrowing

Introduce competitor to Fannie Mae

1970: Ginnie Mae (GNMA): Government National Mortgage Assoc.

US Government: Treasury: implicit commitment of providing support in case of trouble

The several entities involved in the process make MBS a “pass-through”. Here we have 3 main entities that we’ll call “Key Players” for the purpose of this presentation which aims to provide you with a basic and simple explanation of MBS and their role in the financial crisis.

GSE’s created by the US Government in 1938

Part of FDR’s New Plan during Great Depression

Purpose: make owning property more accessible to more Americans

GSE (ex. Fannie Mae) buys mortgages (debt) from banks, & then pools mortgages into little bundles investors can buy (securitization)

Bank’s mortgage is exchanged with GSE’s cash

Created liquid secondary market for mortgages

Result:

1) Bank has more cash to lend out to people

2) Now all who want to a house (expensive) can get the money needed to buy one!

Where MBS came from & when

Yay for combatting homelessness and increasing quality of life for the common American!

Thanks Uncle Sam!

MBS have been around for a long time. Officially in the US, they have their origins in government. During the Great Depression in the 1930s, President Franklin Delano Roosevelt signed into creation Fannie Mae that was brought about to help ease American citizen’s difficulty in becoming homeowners. The sole purpose of a GSE thus was to not make profit, but to promote citizen welfare in regards to housing. Seeing that it was created by regulatory government powers, it earned the title of Government Sponsored Entity, which we will abbreviate as GSE. 2 other GSE’s in housing were created in later decades like Freddie Mae, to further stimulate the mortgage market alongside Fannie, and Ginnie which did a similar thing but only for certain groups of people (Veterans, etc) and to a much smaller scale.

How MBS works: Kelly is a homeowner looking to borrow a lot of money

*The Lender, who issued Kelly the mortgage, collects and hands off the payments to the GSE who bought Kelly’s mortgage off of the Lender

* The GSE pools together Kelly’s and other mortgage holder’s payments into an MBS and sells *Creators of the secondary market of mortgages

*Kelly now makes regular payments to the Lender to pay off the mortgage

*Buys the MBS from the GSE because is promised a constant stream of cash flows derived from the regular mortgage payments!

Homeowner

Mortgage Cash Flow

Lender

GSE

Investor

*Kelly applies to a bank (Lender) for a loan

*After Lender vets Kelly, she is granted a mortgage

Note: *lendor=bank, mortgage=loan

This is a simple representation of how a basic MBS works. In this example a person named Kelly gets a loan from a bank, the Lender. Because it’s a big loan, Kelly had to put up collateral so the bank would be incentivized to lend Kelly the money knowing if anything goes wrong, the bank has rights to Kelly’s collateral to sell and recover the loan amount.

At this point, Kelly and the Lender are happy. Kelly gets her big lump of money, and the bank is happy to give it to her because the bank earns interest, and can sleep happy at night knowing that there’s a back-up plan given the collateral if Kelly isn’t good for the money.

Over time, Kelly is required to periodically pay the bank the interest she owes on the loan. These payments are the cash flows from the mortgage. While she pays these to the bank, the bank doesn’t actually hold onto these cash flows. At some point prior, the bank sold Kelly’s mortgage for cash to a GSE so that the bank could have more cash to lend out for more business. The GSE is happy to buy the mortgages from the bank because it means fulfilling its mission of promoting homeownership among Americans, and is lucrative.

“How is an MBS lucrative for a GSE?” you might ask. Well you see the GSE gets pretty jiggy with the mortgages it now holds. The GSE has a ton of these mortgages and finds a way to add a second layer of financial instruments (where the mortgage, the loan, is the first).

By promising an investor a portion of the expected payment from a mortgage, the GSE can offer investor’s a valuable investment. Investors see the return and think it’s a pretty safe investment since the MBS is just a portion of a bunch of people’s promise to pay their mortgages regularly. So, they buy it.

What could go wrong?

It’s important to note that the main “pass-through” occurs at the hand off to an MBS investor from a mortgage payer’s payment. Yes the investor gets the payments passed on to her, but she also gets the risk of any payment irregularities associated with the mortgage passed on to her as well.

GSE operates as usual, buying mortgages from originators/lenders (banks who sell mortgages to people)

To do so, GSE must get the cash to buy the mortgages from originators/lenders

Because market perceives GSE’s as implicitly backed by the government, GSE’s borrow cheaply

+35 bps on long-term treasuries vs +70 for AAA corps. also securitizing mortgages

Result from GSE being able to borrow cheaply: monopoly on MBS market

1) can buy high volume of mortgages & operate on a large scale

2) pass on savings to investors, making GSE’ MBS’ attractive

MBS evolution pre-financial crisis (1/3)

GSEs were privatized in the later 1900s but still had a strong perceived association with the government. This association made GSE investment products appear less risky, causing the return:risk ratio to appear to be very attractive even against other investment options from regular corporations.

GSE was thus able to retain their stronghold in the MBS market even as other private competitors entered. They became more aggressive, especially because of high housing demand at the turn of the century, and were established monopolizers on the mortgage and MBS markets.

MBS evolution pre-financial crisis (2/3)

MBS attractiveness makes it popular among investors, who buy lots of it

More GSE MBS’ sold = higher profits for GSE = large reach of MBS

The cheap borrowing GSE’ enjoyed as a result to their association with the government and thus potential government protection, made their MBS’ very attractive. Because a lot of investors invested, and because the GSEs continued to issue MBS’ in the growth of the housing market, MBS turned out to be very profitable for both GSEs and investors alike.

Private firms on Wall Street encouraged to enter MBS securitization incentivized by

Low interest-rate environment

High profits produced by MBS monopolizers: the GSEs

Although had higher borrowing rates> GSE, found other ways to increase profit margins on MBS, securitizing mortgages with:

Adjustable-rates (uncertain cash flows)

Negative amortizing (pay low payments now, higher later)

To keep up, GSEs combat new MBS market entrants by purchasing and securitizing more, higher margins loans: subprime mortgages

MBS evolution pre-financial crisis (3/3)

Corporations on Wall Street could not pass up the opportunity for profit potential in the MBS market. They observed the profits of GSE’s and wanted in. Even though they could not compete on a cheap borrowing basis, they could compensate in other areas through financial engineering innovation.

These firms found many creative ways to squeeze out additional offered return from an MBS to investors. By far the most employed and popular, was selling MBS collateralized by not just any plain ol’ mortgage, but a subprime mortgage.

Subprime MBS explained by Margot Robbie in a bubble bath

Subprime mortgages are significant because as Margot Robbie explains, they mean “s***”.

For a person to get a subprime mortgage, they typically have to pay high rates for the loans because they are risky investments the bank makes.

There could be several reasons for this, but the major one is because the person is expected to be very unreliable in paying off their loans. In terms of a mortgage, this would mean, the person is expected to have a degree of difficulty paying their regular mortgage payments to the bank.

So you can imagine when an MBS is securitized (attached, based on) to a mortgage with an unreliable mortgage-payment-payer, the MBS is riskkkky. Yet, finance 101 tells us the more risk yields higher return. And in a low rate environment like the early 2000s saw, investors were hungry for return and willing to “turn a blind eye”.

2 Major, Fatal Assumptions with Subprime Mortgages

Key Players’ believed they had sufficient protection, and a plan to address any hiccups in the MBS pass-through process on the basis of 2 assumptions

1) People won’t default on their mortgages

Mortgage contract terms laid out & transparent

Homeowners know how much and when need to pay, there are no surprises

2) If people do default on their mortgages, the money lost on the mortgage will be recovered from seizing & selling the house/property

As an asset-backed security (ABS), a mortgage is money lent out collateralized against property, like a house

But investors aren’t stupid. They had enough rationale to justify their investments in MBS securitized by subprime mortgages. Heck, the GSE and MBS sellers had enough to justify even creating them and selling them.

Mortgages were typically a priority for the common man: it was a debt necessary to be paid off. History of the MBS showed that typically mortgage holders kept their promise to pay back (despite the refinancing risk). Not only that, but if a mortgage holder couldn’t make a payment, or finish paying off their mortgage, the bank had every right to this person’s home/property to sell it and recuperate the costs of the loan.

For these reasons, MBS creators/vendors and MBS investors had grounding to proceed with strong MBS market activity.

The Mortgage Market Meltdown

The Caveats to the 2 Assumptions: Mortgage Defaults & Loss Recovery

Housing Market Bubble Burst

Scale of subprime “NINJA” mortgages and MBS’

Unfortunately, not everything is as it seems. The MBS landscape and housing market began to change in the years leading up to the financial crisis.

Amidst the buying and selling frenzy of MBS, the housing market bubble began to deflate. Housing prices fluctuated downward and all of a sudden the value of mortgage holder’s collateral decreased. This means that the mortgage holder no longer had the sufficient capital (the house/property) to cover the mortgage’s collateral requirements, used to recover loan costs in the case of default.

So when mortgage holders began to default, not only was the bank no longer receiving payments, but the bank couldn’t even recover enough money to pay off the cost of the loan. The pass-through concept becomes very important here. If the bank isn’t getting the money promised and actually loses money from it, then all other involved entities lose too. Because MBS is a direct link between mortgage holders and banks, GSE’s, and MBS investors, everyone loses.

The second caveat is the prevalence of subprime mortgages. We briefly talked about how the MBS market grew and more MBS suppliers entered with innovative versions of the MBS, many of which were more risky. The poster child of such a version was the subprime mortgage.

The attractive returns offered to investors on subprime MBS created a lot of demand. That coupled with the fierce competition between MBS issuers (GSE and others), there was high demand for subprime mortgages. This high demand for subprime mortgages incentivized GSEs and others to be less stringent with assessment processes on potential mortgage holders of the subprime category. The assessment levels to determine how risky or not a potential mortgage holder was had already been bare especially compared to that for a non-subprime candidate.

The significance of this was that a low to non-existent audit of candidates meant any one, including the financially-ill, could manage to get a mortgage. Besides, if they could buy a house that was inflated by the housing market bubble, the candidate could claim enough collateral to get a mortgage, no questions asked. But here they are, truly unable to service the payments they owe on the mortgage, and undercollateralized with the housing market deflation.

1+1 = 2 = A recipe for disaster in the MBS market.

The financial crisis (1/2)

Massive, widespread mortgage defaults impacting all Key Players

GSE’s

Banks who

a) originated the mortgages, and

b) issued MBS’ themselves,

Investors

who invested trillions of dollars in the security, and

US Government

who was ultimately responsible of cleaning up the mess.

The huge MBS market, infected by many subprime mortgages, fell apart one defaults began to occur. It became a vicious cycle where each entity involved in the MBS origination, securitization, and investment areas of the process got screwed over.

But wait...

NOT

The MBS meltdown has large systemic impacts

Systemic risk: effects of one market failure into others

The meltdown spilled over quickly and broadly from Wall Street (Key Players) to Main Street (everyone else)

Exacerbating already tumultuous conditions in the American, and Global economy

An example: dried up liquidity for Small Businesses because of Wall Street

The housing market bubble pop and the subsequent subprime mortgage market breakdown seized up channels of liquidity

Everyone seemed to be short on actual money

Banks/GSEs had been promised and expected cash from mortgage payments

Mortgage holder’s who were never able to pay their payments in the first place (subprime) still don’t have money and can’t service the payments

If the banks, the GSEs don’t have money, they can’t pay investors

Investors who are insurance companies, commercial banks, and retail investors all lose the money invested in MBS

Banks can no longer afford to lend out money including those who need it to operate like small businesses

The financial crisis (2/2)

The systemic impact of the MBS meltdown could have it’s own course. For now, we will explore just one aspect of how it impacted stakeholders.

The example used here is the liquidity problem for both institutional and retail investors.

Since 2008:

Prevalence of subprime mortgages being issued by banks/loaned out have significantly decreased

Assessment on candidate’s credit has been restored and increased

The housing market has been restored from the crash it experienced after it’s bubble popped

inflated house prices adjusted to realistically reflect their value determined by supply and demand measures

The GSE’s Fannie Mae and Freddie Mac, who were privatized prior to the financial crisis, have become officially government-owned

With this “privilege”, they now guarantee their marketed MBSs.

3 Major Changes to MBS market post-financial crisis

Overall, the changes that have occurred in the MBS market correspond to stronger infrastructure of controls and default protection on behalf of the Key Players: the banks/lenders, the GSEs/firms securitizing MBS’.