Mortgage-backed securities (MSB) refer to the process of “securitization” or packaging mortgages and selling them to investors. In 2006, Fannie Mae and Freddie Mac purchased an estimated 40% percent of residential mortgage loans and issued them as mortgage-backed securities (MBS.) Regulations imposed guidelines on the quality and size of the loans Fannie and Freddie could buy. Large builders, commercial and investment banks, including Countrywide, Wells Fargo, Goldman Sachs, and Lehman Brothers, controlled the other 60% of the residential securitization market.
Beneficiaries of Securitization?
Several participants profit from the sale of mortgage-backed securities. In theory, securitization makes more funds available to homeowners at better terms. By moving loans off their books, loan originators reduce reserve requirements mandated by regulations. Reserves insure lenders have the necessary funds if homeowners default. MSB issuers combine mortgages in a pool. Issuers segment the pool into smaller units called tranches. Issuers classify tranches according to the potential for homeowners to default.
Bond rating agencies, such as Moody, Standard, and Poor's, rate MBSs based on bond quality. The highest rated class - bonds with the lowest risk, receives an AAA rating, which usually pay a lower interest rate. Lower rated instruments - bonds with the highest risk, receive a B rating and paid a higher interest rate.
Issuers sell mortgage bonds to investors who would not otherwise have the resources to purchase larger pools. Loan servicers receive fees from servicing loans purchased by issuers. Investment bank earns underwriting and sales fees from other issuers. Some investment bank issued their own MBSs. Issuers sold MBSs to institutional investors, such as hedge funds, insurance companies, and pension funds. Historically, MBSs offered a high degree of safety of principal and reliable interest returns.
When homeowners make their mortgage payments, loan servicers allocate the interest portion to pay interest due on all the bonds in the pool. Servicers post 100 percent of mortgage principal towards the reduction of the principal on the highest rated MSB until paid in full. Future principal payments go to the next highest rated bond, and so on, until full payment of the principal for all bonds.
Re-Securitization: Collateralized Debt Obligations
In 2006, the total market for mortgage-backed securities equaled $28 trillion, according to The Economist. Investment banks had 60 percent of the mortgage market. This same year, the daily trade volume of mortgage-backed securities issued by government-sponsored enterprises averaged $250 billion dollars, compared to $60 billion at the beginning of the decade. (See: Gretchen Morgenson, Crisis Looms in Market for Mortgages, N.Y. Times, Mar. 11, 2007.) Subprime loans ballooned from 13% of MSBs in 2003 to 34% in 2006.
A significant portion of the new subprime loans consisted of new mortgage products called “affordability products.” A Deutsche Bank report revealed that 40 percent of subprime loans issued in 2006 were affordability products, which offered low “teaser” interest rates. These interest rates escalated over time. In addition, subprime loans provided borrowers with 40 and 50-year terms to make them "affordable.” Many loans did not require income verification. The Mortgage Asset Research Institute said that 60 of 100 subprime loans analyze by their organization showed borrowers inflated their incomes by more than 50 percent.
The Appetite for CDOs
Beginning in 2006, CDO issuers aggressively purchased subprime mortgage-backed securities and resecuritized them. In a process similar to classifying mortgage loans into mortgage-backed securities, issuers pooled subprime MBSs and divided them into tranches. Attractive interest rates fueled the demand for collateralized debt obligations among institutional investors. Many of these CDO issuers decided they could make even more money by buying CDO tranches and securitized them to create more product backed by the original CDO. Many issuers repeated this resecuritization process to complete multiple levels of CDOs. Most issuers market these CDOs as safe, desirable triple AAA rated investments.
Structured Investment Vehicles
Another type of investment, known as Structured Investment Vehicles (SIV), also fueled the demand for the resecuritization of mortgage-backed securities and collateralized debt obligations. Consisting of commercial paper and medium-term notes issued by commercial and investment banks, SIVs pay the principal and interest due on other SIVs as they matured. Many SIVs include CDOs backed by risky subprime mortgages. Therefore, when homeowners defaulted on their mortgage payments, it had a domino effect. The value of CDOs, supported by the referenced mortgage-backed securities, declined. This led to a plunge in the credit rating and worth of many SIVs.
The effect of securitization on the housing and mortgage markets do not end with SIVs. Another instrument rolled out by investment banks in this seeming unending process of creating convoluted financial products -- “synthetic securitization.” Most people are more familiar with the term “credit derivatives.” These products allow banks to package its credit risks as securities. Credit Default Swaps (CDS) were the most well known credit derivative. A CDS functions as a type of insurance policy. CDO buyers pay an “insurance” premium and receive a guaranteed promise of payment in the event of a default. Speculators could also purchase credit default swaps to bet that a particular company would default on its debt obligations or file for bankruptcy.