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Wednesday, October 3, 2012

The Boom (and Bust) That Your Mortgage Bonds Built


Mortgage-backed securities are in the news again this week now that the Justice Department has sued a JPMorgan Chase unit accusing it of various improprieties during the housing boom and subsequent collapse.

In this excerpt from his new book, “Man vs. Markets,” Paddy Hirsch, senior producer for personal finance at American Public Media's business radio program production house, Marketplace, explains the history of asset-backed securities and how they ended up causing so much trouble.

Mr. Hirsch, perhaps best known for his series of whiteboard drawings and videos, leads the team of Marketplace staffers that co-produces two special newspaper sections and two hourlong radio shows each year with The New York Times.

In the 1980s, old-fashioned banks wanted big money. The kind of big money that the investment banks were making with all their fee­-based business. Commercial banks began asking themselves how they could get their hands on that fee money, without taking on risk. Interest income is great but it comes with an ever­-present risk that the borrower might default. The fee that a borrower pays on first signing for a loan, on the other hand, comes without any risk.

So one way lenders can make more money is to extend loans to borrowers, collect the fees, and then sell the loans to a third party, someone who's neither the borrower nor the lender. The risk of default is now assumed by the new owner of the loan, and the original lender simply pockets the fee and walks away.

The first mortgage­-backed security, which was assembled in this fashion from plain-old home mortgages, was created in 1970. It was called a pass-through, because the interest an d principal on all the loans in the pool were simply passed straight through to the bondholders (after the people running the trust were paid a fee, of course).

Securitization was a boon for homeowners, for the government, and for the banks who lent these mortgages. When investors asked for even more loans, with higher potential returns, Salomon Brothers and First Boston teamed up to give the idea a try. In 1983, they created a new securitization for Freddie Mac that offered a range of bonds based on a pool of private mortgages. Each class of bond had a different tenor and a different interest rate. Just like in a corporation, the safest, shortest-­duration investments were at the top and the riskiest and longest were at the bottom. It was a mortgage­-backed security with a twist, so it needed a new name. They called it a collateralized mortgage obligation.

It might help to think about a collateralized mortgage obligation as a pyramid of glasses, piled up in se veral tiers on a silver tray. Each tier represents a class of investor, the senior bondholders at the top, then the mid­level or mezzanine bondholders in the middle, and the junior bond­holders at the bottom. The tray is where the equity holders stand.

Now we pop the bottle of Champagne. The bottle is the bundle of mort­gages. At the end of the month, all the mortgage borrowers make their interest payments and the cash flows, like Champagne pouring out of the bottle. It flows out over the pyramid, filling the top tier of bondholders first, then the mezzanine tier, then the bottom and finally it fills the silver tray. And the same thing happens month after month after month.

If some of the mortgage borrowers get into trouble and fail to make their interest payments, or if they prepay or refinance their mortgages, less money will spout out of the mortgage pool and cascade over the pyramid. The top tier will likely still be filled, so those bondholders get paid, and maybe the mezzanine, too. But the chances of the bottom­-tier lenders and the equity investors being left dry become very real. That's why the junior bondholders get the biggest interest payments, while the payouts to the senior lenders are the smallest.

The collateralized mortgage obligation was a stroke of genius. It cre­ated a range of risk profiles and investment durations, and thereby appealed to many more investors. Now conservative banks could buy bonds that gave them a small, steady, and all­-but­-certain income, while speculators could gamble big with their bond investments, hoping for a fat payout each month.

And just like that, the genie was out of the bottle. Lenders realized that anything that generated cash flow or a steady stream of money each month could be securitized. Whether it was a mortgage, an aircraft lease, a student loan, or a book royalty payment, if it had cash flow, it was called an asset, which meant it could be turned into a so­-called asset-backed security, or A.B.S.

Now a single investor could put money into mortgages, credit cards, and car loans, rather than focusing on just one area. Investors liked the idea of being able to diversify this way, so they asked for more of these types of bonds.
That demand in turn fueled demand for more car loans, mortgages, and credit cards to put into the securitizations, which meant banks were pressured into going out and making more loans.

Suddenly it became a lot easier to get a loan. And that was great news for the economy. At the consumer level, it gave individuals access to money to buy goods and services in volumes that businesses had never seen before. That income allowed those businesses to grow, to hire more people, who in turn consumed more. At the corporate level, it gave companies access to the kind of money that gave them the freedom to do the kinds of things that companies could only have dreamed of in the past. Now they could expand into other parts of the globe, create new markets for their goods, even buy out their competitors.

In the late 1990s and early 2000s, the banks were happy, because they were making lots of fee money without taking much of a long­-term risk. American consumers and companies were happy because more money in the system and the banks' dwindling concern about credit quality (since it was bondholders who were now on the hook in the event of nonpayment) made it easier for them to borrow. But investors were happiest of all. Asset­-backed securities, whether they were based on mortgages, corporate bonds, or student loans, were enormously profitable. America was growing rapidly, unemployment was falling, and incomes were rising. Investors noticed that most people were making their interest payments, and the default rate of companies and individuals was way, way down. Many figured the riskiest bonds sold by an asset­-backed security were less risky than they seemed. So they demanded more.

And the lenders were happy to oblige. As the 1990s wore on, they doled out mortgages, car loans, and credit cards to people who would never have qualified for a loan twenty years before. Those borrowers of­ten paid painfully high interest rates on their loans, which reflected the possibility that they wouldn't be able to make their payments. But the investors who bought bonds backed by bundles of mortgages or car loans didn't mind: the more the borrowers had to pay, the higher the interest payments went on the bonds, and the more cash went into their pockets.

In the early 2000s, an unprecedented amount of debt was being lent to subprime borrowers, who opened credit card accounts, bought cars, boats, and, of course, houses. We now know that many lenders were giv­ing mortgages to people without asking for any collateral, or even proof of earnings. The lenders didn't care about the borrowers, because they could simply sell the mortgages on to a securitization trust. If the borrower defaulted, it was no longer the lender's problem.

The trusts didn't think it was their problem, either. The economy was booming, so that enough subprime borrowers were making their payments to funnel money to most of the investors who bought the bonds in these securitization vehicles. Most of the glasses in the pyramid were filling up, as it were. These bonds did so well that some enterprising financiers decided to take those bonds and securitize them, too! They called these new vehicles collateralized debt obligations, or C.D.O.'s, and they marketed them as completely safe.

But on Oct. 31, 2007, a stock analyst named Meredith Whitney shocked the banking world with a report that said Citigroup, one of the biggest banks in the nation, had too many bad home loans and was barely making enough money to operate.

The statement seemed absurd. Citi was the recipient of stamps of approval from analysts at all three ratings age ncies and the best investment banks. The bank insisted it had plenty of money and that Whitney was plain wrong.

But Whitney was right. She had ignored her peers, dug deep into Citi's balance sheet, and gone through its operations with a clear, hard eye. Other analysts rushed to do their own due diligence a little more diligently. Many downgraded Citi, and a week later, the bank's chief executive resigned.

Debt was the engine of the massive boom in the economy from 2002 onward, and the shadow banking system was the grimy stoker shoveling the fuel. Everyone benefited from debt: the people from all walks of life who could buy huge houses and max out their credit cards filling those houses up with flat­-screen TVs and leather recliners; the companies who could set up operations in far­-flung corners of the world one day and then gobble up a neighbor the next; the investors who rode the soaring stock market, and used asset­-backed securities to turn a billion dolla rs into a hundred billion on paper in less than a year; the politicians who could point to the buildings rising in their districts and the unemployment numbers falling all over the nation; the president who could boast about the country's stunning growth rate and announce the forces of terror had failed to suppress the American way of life.

Occasionally some egghead or analyst like Ms. Whitney would try to spoil the party by muttering darkly about the overextension of credit, or the lack of regulation in the banking sector, or the dangerous and poorly understood interconnected­-ness of the financial system. But most Americans had no idea what the eggheads were burbling about. And most of those who did understand the warnings dismissed them, saying they didn't acknowledge the benefits of a truly free and unregulated market.

Unfortunately, however, the eggheads were right. Debt, and consumer debt in particular, was the fuel that the stokers of the financial indust ry shoveled into the engine of the 1990â€"2007 economic boom. The trouble with fuel is that someone has to pay for it. A borrower can play the game of paying one loan off with another for so long, but one day the bill comes due and the debt must finally be paid. And in 2007, the bills started coming due, all over America.

Excerpted from “Man vs. Markets: Economics Explained (Plain and Simple),” published by Harper Business. Copyright © Paddy Hirsch, 2012. Reprinted with permission.