Can someone explain to me what a "security" is and why bad mortgages became securities?

[Elspeth]

Thanks.

[izquierdista]

1. Once upon a time...

A bright banker decided to repackage bond payments. He sold the soon to be due payments to a short term investor, the mid-term payments to a medium length investor and the far in the future payments to a long term investor. Everyone was happy as long as the underlying bonds were sound and the payments were made. He turned the bond into a security with 3 tranches (slices).

Fast forward to the unregulated years of 2002-2005. A conniving mortgage broker got the bright idea to do the same thing with mortgages given to unemployed people who submitted fraudulent loan apps with ridiculous appraisals. Ta-da! Now what was once a mortgage is now a "security". Except that now, no one is exactly sure who services the original mortgage and the investor who put up the money is hung out to dry if one of the payments is missed.

[Elspeth]

2. So the problem was the type of payment that got repackaged, not the security itself?

?

[izquierdista]

5. It's like what the programmers say

Garbage in, garbage out.

Repackaging of bonds is old hat. Since a mortgage is a type of a bond (capital to be paid back with interest over a long time period), it should be possible to repackage them as well. Except Junior fired all the watchdogs and regulators and went off to cut brush. The people repackaging these mortgages and selling them as securities make Michael Milken look like a saint. When I bought a house in 2001, I was AMAZED at how lax the standards had fallen from my previous purchase in 1994.

To make it work right, the repackager has to figure in a default rate and price in some type of insurance so that defaults on individual loans are not seen by the buyer of the security. That was never done here. Since real estate prices go up and up and never down (:sarcasm:), it wasn't necessary to think that anyone would ever default on their loan.

[Elspeth]

8. So the repackagers realized the mortgages they were bundling were risky

and just figured they could get away with it because no one was looking over their shoulder? Didn't they care about the reputation of their companies?

[izquierdista]

14. What reputation?

When you can tack on extra points at the signing, when you have the buyers over a barrel, they will sign anything. Then, within a couple of weeks, you pass it along to some greedy banker who looks at only the yield, not the quality. Pigs at the trough who haven't eaten for 3 days aren't as greedy. We haven't seen the last of it. Bear Stearns is not the only pig out there who is going to have to do a serious writedown of their assets.

This in many ways is just like the S&L crisis of the late 80's. McCain should feel right at home dancing around this issue. He tap-danced his way out of censure so well the last time.

[Elspeth]

15. I was reading that the repeal of the Glass-Steagall act had something to do with

the deregulation problem. Apparently it was repealed in 1999.

[izquierdista]

26. It's more than just that

Glass-Steagall was a bit of overkill in the first place and never caught on outside the U.S. It put a damper on bankers speculating, but that can be done in a variety of ways, not just making securities dealing a separate business. What the repeal really signified was that the green light was on for any crazy scheme that could be dreamed up.

[Elspeth]

35. Do you forsee any laws in the future restricting banks from speculating in the wake of

this crisis?

[izquierdista]

38. Laws aren't the answer

Laws are just one tool in regulating any business. In most of Europe, banks have investment branches, where securities are bought and sold, and they aren't having a mortgage meltdown. What is needed is a slow, plodding approach, not frenetic trading of every new scrap of paper that is derived from some underlying asset.

If you look at bubbles of the past, starting with the Dutch tulip craze, you see that the problem is lots of money pouring into some new asset that is suddenly valuable and tradeable. Soon what was a few people swapping marbles turns into the floor of the New York Stock Exchange with people yelling bids and offers without any regard for the actual asset. Money gets sucked in and thrown about like a tornado was passing through. Finally it reaches the breaking point and prices crash down to the level that is actually supported by the value of the asset. For the average house, that is where monthly rent is 1/3 the monthly wage of the average worker. If you are making $1000 monthly payments on a house that "sells" for $600,000, something is out of whack and will readjust given time.

With consumers speculating on houses and banks speculating with the mortgages derived from those houses, the whole system was working up to a frenzy. The problem can be solved by using an old trick from FDR's day: bank holidays. Put a freeze on foreclosure proceedings, slow down the trading of mortgages, freeze adjustable mortgages from resetting, and stay evictions if the tenants/residents can make fractional, but regular payments. Laws are not needed at this point, but coherent executive orders could solve the problem in a matter of weeks. I expect Barack should have it cleared up by next March.

[SoCalDem]

3. It's like when contributors bundle..

Lenders bundled hundreds of mortgages together (good and bad) and sold them to anyone who would buy them..:grr:

A big ole game of High-finance hot potato..

[Taxmyth]

4. Security or Securities

Are investment instruments that have evidence of being secured by debt or equity. A group of mortgages can be packaged together and sold as a Security or as different types of Securities, for example Short term, mid range, long term. The practice is fairly common as Banks can't afford to have all their money tied up in loans like Mortgages.

As more and more Mortgages are becoming delinquent these Securities are losing value putting Mortgage Companies and Banks at huge risk for massive losses. The reason for the "Bad Mortgages" are many including fraud, insufficient documentation when the loan was created, divorce and the general tanking of the US Economy.

[Selatius]

6. Security is, traditionally, stocks and bonds, but the definition has broadened.

A mortgage-backed security is sort of similar in that if you buy one, you assume ownership of a debt that someone has to pay. Before, the debtor paid someone else, but since you bought the debt, the debtor now has to send his payments to you.

When you buy a bond, for instance, you give money to someone else to use. This person then has to pay you back interest (or a coupon, usually a monthly basis or quarterly and so on) for the privilege of using your money. If you wish, you can sell your bond to someone else, and the person whom you gave the bond would then have to send payments to the new owner.

The problem is many lenders saw they could make a killing by misrepresenting the financial condition of the mortgage-backed securities they were selling. They knew it, and they foolishly sidestepped checking people's credit and income to see if they can afford the mortgages in question because they knew they could then sell the risky security off to someone else and let them eat the loss.

Banks on both sides got greedy. Commercial banks were loosening requirements for mortgages, and investment banks were more than willing to buy "good" securities to pad their profit margins and cash flow statements. Bear Stearns was the biggest investment bank to go down in flames because of this excess in greed.

[soothsayer]

9. Yup! It's actually a sound idea because say you deposit $300k in a bank.

Now someone borrows that $300k to buy a house, which they'll repay at 6% interest over the next 30 years. Now the bank is sitting there without any of (your) money to lend. The bank is the primary mortgage lender. So a secondary mortgage company like Fannie Mae or Freddie Mac, for a small fee, buys that mortgage (gives the bank that $300k back, plus a taste of the interest I think) and others like it and bundles them all together and sells them to folks looking for a guaranteed 6% return on their money for the next umpteen years. And Fannie and Freddie promise to pay for any of the (normally very few) mortgages in that big fat bundle that go bad, so people are not afraid to buy these MBS (mortgage backed securities) because they're easy to sell to others because they're generally safe (so they're very liquid). And that's how you keep liquidity in the market (keeping money in the lenders' coffers) and that's how people can buy houses.

[melm00se]

13. without a steady source of

replacement capital, banks and other lenders would quickly run out of cash to loan thereby making loans more scarce, difficult and more expensive to obtain (I am sure there are many here to remember the complaint: "You can only get a loan when you don't need a loan").

So to replace the capital, mortgages are bundled up and sold at a discount: face value (principle + interest paid over the life of the loan) less a certain percentage. The lender may choose (or be allowed) to retain the servicing rights (payment acceptance, crediting, collections, escrow collection and payment etc) and that is usually paid at a rate of 0.5 - 1% of the loan balances per month (you service $100,000,000 in mortgages you earn $500K to $1MM a month. from that you pay for: the equipment, the software, the insurance, the salaries, the benefits of the people necessary to run this business).

All of this works back to the situation where loans, due to competition, were "cheap" and relatively easy to obtain. Unfortunately, the competition aspect drove certain individuals and institutions into certain bad and unacceptable behaviors to win the business.

I do see a significant change in the mortgage origination process coming. IMO, you will see regulations that prohibit "brokers" from representing multiple lenders and some mechanism where the originator gets financially stung when then originate a bad loan, ditto for the originating lender even after they sell it out onto the secondary market. that will curb a lot of abuse.

[Elspeth]

20. Who actually has legal ownership of the mortgage itself?

In other words, who gets the house if the owner defaults? The institution that bought the securities (like Fannie Mae) or the original lending bank?

[sergeiAK]

22. Generally the original bank

As they are the ones servicing the loan. Once they sell it though, the funds go to the purchaser of the MBS that the mortgage was sold as a part of.

[Elspeth]

31. So the buyers of the securities cannot go after the houses directly

But only put pressure on the banks?

[soothsayer]

27. It's proving to be tricky to find out who holds the actual pieces of paper

[Elspeth]

32. I can see why.

Has there been a court decision on this?

[Elspeth]

18. I see. So the advantage is that banks can do more lending, hence more customers

And the risk should normally be pretty low. Was it just the lending to the sub prime market, then, that gummed up the works here?

[fed-up]

12. "by misrepresenting the financial condition of the mortgage-backed securities they were selling"

in a nutshell

[Elspeth]

19. Why was the financial condition of these securities so bad?

And why did people assume they were actually ok? (The AAA ratings, I'm guessing, but didn't anyone ask about the quality of the loans?)

[Elspeth]

7. Thanks. This is actually very helpful

:)

[A HERETIC I AM]

24. If getting 20% accurate information and 80% misinformation is "helpful"...

As BooinBloo suggested below, check the Wikipedia entry on "Security".

Then check out their entry on http://en.wikipedia.org/wiki/Bond_%28finance%29">Bonds, their entry on http://en.wikipedia.org/wiki/Collateralized_mortgage_obligation">Collateralized Mortgage Obligations (CMO's) (carefully read the sections that speak of "Tranches") and their entry on Mortgage Backed Securities.

Also, in order to better understand what Fannie Mae & Freddie Mac do, you should read their "About Us" pages.

Here's the one for Fannie
Here's the one for Freddie

It would also help if you understood the difference between them and Ginnie Mae. One is a Government agency that guarantees loan payments, the other two are Private corporations that are known as "Government Sponsored Entities" that actually buy mortgages. The way they do that is by issuing Bonds.

If you own a bond, you do NOT have a right to the house or houses underlying the bond. All you are entitled to is a stream of income, typically paid bi-annually and at maturity you get your principal back, which is, with very few exceptions, $1000 per bond. One exception is known as a "Pass-Through Security" in which both interest and principal payments are received by the bond holder and if not retired early, the bond would mature at zero. Another exception would be a default.

Unless you can sort through the wrong answers, you're really better off researching directly to find the answers to questions like the one you posed in your OP. I know DU'rs mean well, but the amount of misinformation and misunderstanding about Bonds, the Bond market, how Bonds are issued and sold, how they are priced and why, and the interest rate they pay is regularly demonstrated on threads like this.

www.investopedia.com is a good site for definitions of financial terms.

[ThomWV]

10. A "Security" is a financial instrument that is 'secured' by a valuable asset.

A mortgage has property (land and possibly buildings) behind it 'securing' the loan. Some financial instruments (means of conveying money or contractual instrument for the same purpose) have no security behind them, as an example a loan of cash for which there is no collateral.

One way of thinking about it that will get you right most of the time is asking yourself if the financial vehicle you are looking at is "secured (tied) to the earth" meaning is there something of substance that will be turned over to the lender if the agreed to payments aren't made.

Use the word that way and you won't get yourself into trouble and you'll be well on the way to being able to distinguish between finance and economics, two words that do not refer to the same thing.

[Elspeth]

16. Thanks. But if the securities had real homes behind them...

shouldn't the people or institutions that bought the securities be able to lay claim to the house once the buyers default on their mortgage?

[ThomWV]

36. Once they bundle it all up the individual properties lose their identity

Let me see if I can explain it in some sort of understandable fashion.

Let's say that you have 10 mortages that are extremely sound. Each one of them is for a mid sized home - lets say every one of them cost $200,000, and every one of they is being bought by well established people who are completely likely to be able and willing to pay off the full loan at the stated terms; dream borrowers.

If you bundle all 10 of those loans together you have a $2M package that is risk free. Let us say that at todays rates the very best borrowers get the lowest rate and let's make that 5%.

Now lets bundle together another set of loans. Lets make these average working people, some of whom will lose their jobs over the next 30 years, and let's make the homes more modest; $100,000 each. We've got 20 of these with people wanting mortgages so the value of the homes is also $2M. We expect 2 of the mortages will default, history has shown us that is how it will work. So to make up for money that will not be repaid when the defaults come around we'll raise the interest rate for this bundle so that the final payout is idential to what we got from the first package. Let's say that we have to charge 9% interest to accomplish this.

Now lets say that we want to bundle together some packages that will earn 7% and sell them to the public. In order to arrive at the package we want to sell we take 7.5 houses from the first group and 3.8 houses from the second group and pool them then sell the package. Then we take the remaining homes, the 2.5 great loans and the 6.2 less reliable loans and use them as the building blocks for more bundles - taking some good and some potentially bad loans and bundling them to find a mix that deserves some interest rate between the best and worst the market will clear at any given time.

Now the rub. In a time of 6% loans advertised on TV every 20 minutes it becomes very difficult to get someone to sign onto a loan at 10% interest - unless you hide the rate from the applicant. That is what they did with the ARMs. They sold loans by pointing out the low initial rate and ignoring the increase in rate that was going to come in time.

So the point is that although the loans were secure and in fact hard assetts back the loans its not necessairly individual homes, it can just as easily be fractional parts of homes that make up the bundles.

[BlooInBloo]

11. Check wikipedia. Then also look up Mortgage Backed Securities. Then ask questions.

[Elspeth]

17. Thanks for the marching order, Bloo, but I find Wikipedia to be of varying accuracy

Some topics are very well covered and others are pretty slipshod. It all depends on who writes the article and who adds to it. I know there are some very intelligent folks on DU and some who have worked on Wall Street or who have investments. I figure they'll want to be helpful to another Duer. Since you don't, don't bother replying. No one appreciates a skunk who just wants to spray a stink for the hell of it.

[BlooInBloo]

21. Hahaha. I was a modeler for a large financial institution's MBS group (prepayment modeling)...

... And I had noticed that the wiki article was quite adequate.

But whatever - best of luck to you.

[Elspeth]

33. NWMT

Edited to add:

Figure it out.

[Dreamer Tatum]

23. Before we all start condemning the market for mortgage securities, remember one thing

MBS help create and ensure liquidity for the mortgage market. Before the GSEs and MBS, it was MUCH harder
to get a mortgage and MUCH harder to buy a house. Helping to make purchase money available has helped fulfill
the dreams of literally millions of people.

[izquierdista]

25. Yes it did

Including the unemployed, people without down payments, confidence tricksters, meth addicts, and anyone else who could fog a mirror. I may be old-fashioned, but I think that people who ask for a loan should have the ability and intent to pay it back someday.

[BlooInBloo]

28. Um, it kinda doesn't count if those dreams are dashed 3 years later...

... In particular, the separation of the risk-originator from the risk-ender-upper is a structural problem (that's more specific than everybody's favorite blanket term "deregulation"). That's why, to vary the example, there exist lemon-laws in the used car market world. To keep the risk-originator (the used car dealer who bought the car) in the risk-game. Merely putting lipstick on the pig-of-a-car does not solve the used car salesman's risk problem, thanks to lemon laws - by contrast with the (lack of) rules concerning MBS bundles.

There are other things in play as well, but when the risk creator is able to easily pass on the risk (for $), there's little-to-no incentive to not make riskier and riskier bets.

And it's aggravated when the risk creator has reason to believe that the lender of last resort will step in. (The fundamental asymmetry between the irresponsible lender and the irresponsible borrower.)

[Selatius]

29. That's why I heard horror stories of lenders giving mortgages without credit checks.

The aim for some of these lenders was simply to manufacture the mortgage and sell it off at a profit. If that is how one makes money, it doesn't make sense to throw obstacles in the way to the pursuit of that profit, such as credit checking potential customers and seeing if they actually have the income to handle the monthly payments. Most of these stories were coming out of inner-city areas where fly-by-night lenders operated.

Whenever there are no rules or regulations at play, the lowest common denominator always emerges sooner or later. It's gotten to the point where that observation is almost plain as day such as "water is wet" or "the sky is blue."

[Elspeth]

34. That makes sense

The term "manufacturing mortgages" is really an interesting one.

[Dreamer Tatum]

30. Yes, the world is an imperfect place

In the meanwhile, it occasionally provides capital for people to buy homes.

Thought experiment...how would the following headlines have looked before 2008:

"Experts say too much credit extended to those with poor borrowing histories"

"Loans to minorities at unacceptable levels"

"Lenders tighten underwriting criteria for those with poor credit histories; require massive down payments"

"Increases in home values encourage irresponsible borrowing, say bankers"


Hindsight...like LASIK for the present.

[AP]

37. Sometimes making something easier isn't a good thing.

If you want to give a lot of people who really can't afford houses the ability to own a house, then you create a lot of risk in the real estate markets and you end up undermining the stability of economies around the globe.

[Eurobabe]

39. Because Bear Stearns said so. n/t