Okay, the title is either gibberish to you or it's just not really funny...
Sorry, but I'm not erasing it.
MBSs. This is where the problems begin. They are Mortgage Backed Securities. Think of yourself as a small bank. You've taken a bunch of deposits from people in your town or city and you lend those deposits out to a bunch of other people in your town or city. Let's just say you are a Savings & Loan (S&L). As an S&L you are limited to making mortgage loans and taking deposits. So you make your loans and those loans become the bulk of your assets.
[When a bank lends money, the loan is an asset. The borrower promises to make steady payments on their mortgage, so the bank (or S&L) sees this steady, predictable (mostly, except for defaults) stream of income coming in from all the mortgages they have made.]
Here's the basic model of banking:
So let's say you are an S&L in a small town and you have $1,000,000 in deposits. Banks (and S&Ls) have reserve requirements, so let's assume that you are required to hold 10% reserves or $100,000. If this is news to you, then think about it for a minute. The banks don't ever have all of their depositors asking for the full value of their accounts to be transferred, in fact they rarely see depositors withdraw more than the $100,000 in any given day. So this fractional-reserve system allows for the bank to make loans on 90% of their deposits, or $900,000 worth. So you make 9 mortgages for $100,000 each, taking full advantage of banking regulations because you make money on the mortgages (origination fees, plus mortgage interest to keep this simple).
Okay so at this point you have $100,000 in the bank vault, $1,000,000 in deposits (where you are paying a low rate of interest, say 3%), and a portfolio of mortgages worth $900,000 (where you are collecting a relatively high rate of interest of 7%, on average). You earn profits on fees and the difference between the interest rate you pay, 3%, and the interest rate you earn, 7%.
Again, this is how banking used to function.
Now we introduce MBSs. Instead of just sitting on those deposits and loans, you decide to sell the portfolio of loans to another bank. The other bank has investors that see the steady income coming from the portfolio, so to them it is just like a bond (a financial instrument that pays a steady amount over a specified period of time.) If your portfolio consists of all 30 year mortgages with everyone that you've lent to representing the lowest risk of default (all the people that borrowed from you have credit scores of 750 and no prior credit problems), then the investors expect a lower return, but very limited risk of losing money.
On the other hand, if your portfolio consists entirely of sub-prime borrowers, then the risk that some of the people will not make their mortgage payments for the entire 30 years is greater and the investors would expect a higher return.
So you, the S&L, decide to bundle these mortgages and sell them off. Now you put the money you got from the other bank into your assets and the loans go away. You suddenly have the incentive to make a lot more loans, since your assets are all cash and you can make more money by lending out that cash. So you make more loans, package them as a bundle and sell them and continue on this path.
But why would you want to keep doing this, are you making any more money by selling the mortgages off? Yes, you earn fees on all of these transactions, but the reason you sell all your loans is to offload the risk of default. With the loans on your balance sheet, you lose when borrowers lose their job and can't pay their mortgages. Once you sell them, it's the investers that have to deal with that problem. Of course that's not really a problem when housing prices only go up. If any borrowers can't make their mortgage payments, they can just sell (for a profit) and exit the market.
However, when prices are declining this becomes a big problem.
To summarize, mortgage-backed securities (MBSs) are pools of mortgages with varying levels of risk (likelihood of "performing" - will borrowers be able to pay their mortgages or not?) that trade like bonds. This is key because of the role that the credit rating agencies had in this mess.
Please ask questions if this doesn't make sense. Tomorrow I'll move on to the ratings agencies, and then we'll discuss the more complex CDSs and other securities that are at the core of this crisis.
UPDATE: More here if you would like a slightly different perspective (with visuals).
[When a bank lends money, the loan is an asset. The borrower promises to make steady payments on their mortgage, so the bank (or S&L) sees this steady, predictable (mostly, except for defaults) stream of income coming in from all the mortgages they have made.]
Here's the basic model of banking:
So let's say you are an S&L in a small town and you have $1,000,000 in deposits. Banks (and S&Ls) have reserve requirements, so let's assume that you are required to hold 10% reserves or $100,000. If this is news to you, then think about it for a minute. The banks don't ever have all of their depositors asking for the full value of their accounts to be transferred, in fact they rarely see depositors withdraw more than the $100,000 in any given day. So this fractional-reserve system allows for the bank to make loans on 90% of their deposits, or $900,000 worth. So you make 9 mortgages for $100,000 each, taking full advantage of banking regulations because you make money on the mortgages (origination fees, plus mortgage interest to keep this simple).
Okay so at this point you have $100,000 in the bank vault, $1,000,000 in deposits (where you are paying a low rate of interest, say 3%), and a portfolio of mortgages worth $900,000 (where you are collecting a relatively high rate of interest of 7%, on average). You earn profits on fees and the difference between the interest rate you pay, 3%, and the interest rate you earn, 7%.
Again, this is how banking used to function.
Now we introduce MBSs. Instead of just sitting on those deposits and loans, you decide to sell the portfolio of loans to another bank. The other bank has investors that see the steady income coming from the portfolio, so to them it is just like a bond (a financial instrument that pays a steady amount over a specified period of time.) If your portfolio consists of all 30 year mortgages with everyone that you've lent to representing the lowest risk of default (all the people that borrowed from you have credit scores of 750 and no prior credit problems), then the investors expect a lower return, but very limited risk of losing money.
On the other hand, if your portfolio consists entirely of sub-prime borrowers, then the risk that some of the people will not make their mortgage payments for the entire 30 years is greater and the investors would expect a higher return.
So you, the S&L, decide to bundle these mortgages and sell them off. Now you put the money you got from the other bank into your assets and the loans go away. You suddenly have the incentive to make a lot more loans, since your assets are all cash and you can make more money by lending out that cash. So you make more loans, package them as a bundle and sell them and continue on this path.
But why would you want to keep doing this, are you making any more money by selling the mortgages off? Yes, you earn fees on all of these transactions, but the reason you sell all your loans is to offload the risk of default. With the loans on your balance sheet, you lose when borrowers lose their job and can't pay their mortgages. Once you sell them, it's the investers that have to deal with that problem. Of course that's not really a problem when housing prices only go up. If any borrowers can't make their mortgage payments, they can just sell (for a profit) and exit the market.
However, when prices are declining this becomes a big problem.
To summarize, mortgage-backed securities (MBSs) are pools of mortgages with varying levels of risk (likelihood of "performing" - will borrowers be able to pay their mortgages or not?) that trade like bonds. This is key because of the role that the credit rating agencies had in this mess.
Please ask questions if this doesn't make sense. Tomorrow I'll move on to the ratings agencies, and then we'll discuss the more complex CDSs and other securities that are at the core of this crisis.
UPDATE: More here if you would like a slightly different perspective (with visuals).
3 comments:
I'm reading it - but I'm probably not your "intended" audience. The descriptions you provide seem easy enough to understand, but then again I might have a little better base to work from given my background.
I actually get it...
Thanks for the comments, I'll try to get to the ratings agencies and maybe CDOs tonight. I think the hardest part is trying to think from the perspective of the bank, if you haven't done it before that is...
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