Mortgage Securitization

Can someone explain offer some commentary on how securitizing mortgage debt eliminated lenders’ hesitence to lend and spread profits across more parties? So lenders issued mortgages to people who didn’t deserve them. Lenders pooled these mortgages into a security and sold pieces to different investors? When borrowers defaulted, the investors would not receive payment from the CDO isser, so they are at a loss and the original lender is at a loss? Sorry this is so basic, but I’m trying to understand how risk was transferred from the lender to the parties investing in the pooled mortgages. Also, did the lender lose money or just those parties invested in the CDO’s? If the lender lost money, how did that happen? Doesn’t the lender have the cash inflow from selling the pooled mortgages?

lenders sold 'em to fannie or investment banks. the investment banks pool 'em into mbs or whatever. this way the lenders have more money to lend, so rates stay low. whoever is involved in the process clips some fees, so it is now profitable good to keep issuing mortgages.

So where is the risk for the lender? Or, did they make off like bandits?

When they sold the mtg to the ibanks they received a PV of the cash flows. the risk is probably inherent in the discount rate used to calculate the PV. As a result not as profitable but enough to run their shop. well thats what i think could be wrong…

Yep, that’s the problem. The loan originator has no incentive to do appropriate due diligence because they’ll sell the loan to someone else right away. The originator keeps an origination fee, and the buyer bears the risk of default, and gets most of the cash returned from the sale to keep the process going. Now the buyer DOES have an incentive to do due diligence, but they are one step removed from the process, and so critical information can get garbled, like in the “telephone” game played by schoolchildren. Except that there is likely bias in what gets garbled. Anything that makes these loans look risky gets more garbled. So the buyers of these loans don’t have as good information, but they figure that they’re protected by diversification because, heck, these loans are unlikely to all go bad at once, and owning them pays a few basis points more than stuff they really can do some due diligence on.

the purchaser of the pool of mortgages can sue the lender for breach of representations and warranties under the purchase agreement. in the past year, investment banks have been taking lenders to court to force them to buy back mortgages that have defaulted in the first few months after the sale. but yes, during the good times the lenders went buck wild underwriting these suspect mortgages knowing that there will be eager buyers

bchadwick Wrote: ------------------------------------------------------- > Yep, that’s the problem. The loan originator has > no incentive to do appropriate due diligence > because they’ll sell the loan to someone else > right away. The originator keeps an origination > fee, and the buyer bears the risk of default, and > gets most of the cash returned from the sale to > keep the process going. > > Now the buyer DOES have an incentive to do due > diligence, but they are one step removed from the > process, and so critical information can get > garbled, like in the “telephone” game played by > schoolchildren. Except that there is likely bias > in what gets garbled. Anything that makes these > loans look risky gets more garbled. > > So the buyers of these loans don’t have as good > information, but they figure that they’re > protected by diversification because, heck, these > loans are unlikely to all go bad at once, and > owning them pays a few basis points more than > stuff they really can do some due diligence on. Excellent explanation, thank you. One more question… were the pooled mortgage securities rated by any rating agencies? Seems that if these securities were rated higher than they should’ve been (which sounds like it was happening), it would be easy for buyers to cut corners on the due diligence process.

in socal a couple years back everyone and their 3rd uncle was trying to get into the mortgage industry. Picture yourself as a broker in an environment where home px’s are rising 10% every year. 1. Between the RE agent and the Broker its easy to convince Joe Blow that he can afford a 600k house on a 80k salary because in a year or two when his neg-amortizing IO loan pmt balloons it will be worth over a mil and he can pull out equity while “investing in his future”. …And if you don’t buy now you’ll miss the boom and be priced out!! result>> loan agent “makes the #'s work” and get his commission free and clear. I’m not sure but I don’t think there’s anything analogous to the U-4 where a loan agent has his career threatened by a shady transaction. Additionally, most ppl were in it for the quick buck- not to make a career out of it so the more ppl they could get loans the better. Then there was the refinancing. My sister had fliers and calls daily about how she should refinance and pull an additional 500k out of her home @ 3%. Considering how many stupid/greedy ppl are out there I can see it happening. Again- lending agent pockets cash instantly. The one really taking on the risk has multiple degrees of separation and the due diligence is tough considering the massive amount of individual situations. I think all those who got themselves in this situation need to be held accountable and feel no guilt for those who will loose “their” (even though they’ve never really paid for them) homes. At the same time there really does need to be some sort of reform that will add regulations to lending that re-align the incentives to truly access the risk and complete the due diligence necessary by those who are in direct contact w/ home-buyers. It really was a lot of free money for the brokers who benefited directly by shady tactics and took on zero risk.

Yes the pooled securities were rated by rating agencies, who got a nice fee for rating them. The problem was that the valuation on that depends on a whole host of assumptions like prepayment rates, default rates, the correlation of default timings. A lot of ABSs have these “waterfall payments” so that some securities get paid before others do. So there were some obviously risky ones, and those paid higher rates to compensate. The real problem was that the securities that get paid first (senior securities) got AAA ratings (or thereabouts) because a lot of bad things had to happen simultaneously before they would default. Because they were AAA rated, and (for reasons I don’t entirely understand) paid better than comparable AAA stuff, lots of institutions bought them. That, in turn, created more money to originate more bad loans, and as the opportunities for good loans started to dry up, originators started issuing loans for lower and lower quality borrowers and using the same system. Now the institutions who bought them are sitting on lots and lots of these, and lots of pension funds and insurance companies’ and investment banks’ balance sheets (and hedge funds too) have them. The ratings people said “sure, these tranches have AAA ratings,” because we have smart guys who run simulations and they’re safe. But no one really knows how to model these things effectively. Now that the housing bubble starts to deflate and the economy seems to be questionable, all of a sudden people are starting to get worried about the most recent set of securities. There are some defaults, there are more than probably anticipated, but this is spooking everyone so that now people won’t trade the securities except at a huge discount. This makes a lot of the institutions holding AAA stuff nervous and they start to sell, pushing the price down. But now the variability in price seems to be way more than AAA ought to have, which means maybe they aren’t AAA after all. If things go to below investment grade, then many institutions MUST sell by law or because of their investment policy statements. So now the problem is they can’t find anyone to buy these, and so the price plummets downward. This makes more institutions more nervous, because AAA is supposed to hold its value well - price goes down further as more people panic. Probably, if you could buy a few of these things, you’d make some money, because fear is driving a lot of the discount more than fundamentals (fundamentals do play a role), and if you hold them a long time, they’d probably outperform. But there’s almost no one with pockets deep enough to buy enough of these to dissolve the fear that’s causing a discount. That’s why one version of the bailout is for the US government to set a floor price at which it will buy them. From the point of view of the government as an investor, it’s probably not a bad investment, but the purpose of government is not necessarily to make good financial investments with taxes (though you can argue that good government projects are a kind of investment in necessary public goods).

ah i c

bchadwick Wrote: ------------------------------------------------------- > Yes the pooled securities were rated by rating > agencies, who got a nice fee for rating them. The > problem was that the valuation on that depends on > a whole host of assumptions like prepayment rates, > default rates, the correlation of default timings. > > > A lot of ABSs have these “waterfall payments” so > that some securities get paid before others do. > So there were some obviously risky ones, and those > paid higher rates to compensate. The real problem > was that the securities that get paid first > (senior securities) got AAA ratings (or > thereabouts) because a lot of bad things had to > happen simultaneously before they would default. > > Because they were AAA rated, and (for reasons I > don’t entirely understand) paid better than > comparable AAA stuff, lots of institutions bought > them. That, in turn, created more money to > originate more bad loans, and as the opportunities > for good loans started to dry up, originators > started issuing loans for lower and lower quality > borrowers and using the same system. Now the > institutions who bought them are sitting on lots > and lots of these, and lots of pension funds and > insurance companies’ and investment banks’ balance > sheets (and hedge funds too) have them. > > The ratings people said “sure, these tranches have > AAA ratings,” because we have smart guys who run > simulations and they’re safe. But no one really > knows how to model these things effectively. > > Now that the housing bubble starts to deflate and > the economy seems to be questionable, all of a > sudden people are starting to get worried about > the most recent set of securities. There are some > defaults, there are more than probably > anticipated, but this is spooking everyone so that > now people won’t trade the securities except at a > huge discount. > > This makes a lot of the institutions holding AAA > stuff nervous and they start to sell, pushing the > price down. But now the variability in price > seems to be way more than AAA ought to have, which > means maybe they aren’t AAA after all. If things > go to below investment grade, then many > institutions MUST sell by law or because of their > investment policy statements. So now the problem > is they can’t find anyone to buy these, and so the > price plummets downward. This makes more > institutions more nervous, because AAA is supposed > to hold its value well - price goes down further > as more people panic. > > > Probably, if you could buy a few of these things, > you’d make some money, because fear is driving a > lot of the discount more than fundamentals > (fundamentals do play a role), and if you hold > them a long time, they’d probably outperform. But > there’s almost no one with pockets deep enough to > buy enough of these to dissolve the fear that’s > causing a discount. That’s why one version of the > bailout is for the US government to set a floor > price at which it will buy them. From the point > of view of the government as an investor, it’s > probably not a bad investment, but the purpose of > government is not necessarily to make good > financial investments with taxes (though you can > argue that good government projects are a kind of > investment in necessary public goods). Once again, thanks for an excellent explanation!

apcarlso Wrote: ------------------------------------------------------- > > Excellent explanation, thank you. One more > question… were the pooled mortgage securities > rated by any rating agencies? Seems that if these > securities were rated higher than they should’ve > been (which sounds like it was happening), it > would be easy for buyers to cut corners on the due > diligence process. http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo&refer=home

apcarlso Wrote: ------------------------------------------------------- > bchadwick Wrote: > -------------------------------------------------- > ----- > > Yes the pooled securities were rated by rating > > agencies, who got a nice fee for rating them. > The > > problem was that the valuation on that depends > on > > a whole host of assumptions like prepayment > rates, > > default rates, the correlation of default > timings. > > > > > > A lot of ABSs have these “waterfall payments” > so > > that some securities get paid before others do. > > > So there were some obviously risky ones, and > those > > paid higher rates to compensate. The real > problem > > was that the securities that get paid first > > (senior securities) got AAA ratings (or > > thereabouts) because a lot of bad things had to > > happen simultaneously before they would > default. > > > > Because they were AAA rated, and (for reasons I > > don’t entirely understand) paid better than > > comparable AAA stuff, lots of institutions > bought > > them. That, in turn, created more money to > > originate more bad loans, and as the > opportunities > > for good loans started to dry up, originators > > started issuing loans for lower and lower > quality > > borrowers and using the same system. Now the > > institutions who bought them are sitting on > lots > > and lots of these, and lots of pension funds > and > > insurance companies’ and investment banks’ > balance > > sheets (and hedge funds too) have them. > > > > The ratings people said “sure, these tranches > have > > AAA ratings,” because we have smart guys who > run > > simulations and they’re safe. But no one > really > > knows how to model these things effectively. > > > > Now that the housing bubble starts to deflate > and > > the economy seems to be questionable, all of a > > sudden people are starting to get worried about > > the most recent set of securities. There are > some > > defaults, there are more than probably > > anticipated, but this is spooking everyone so > that > > now people won’t trade the securities except at > a > > huge discount. > > > > This makes a lot of the institutions holding > AAA > > stuff nervous and they start to sell, pushing > the > > price down. But now the variability in price > > seems to be way more than AAA ought to have, > which > > means maybe they aren’t AAA after all. If > things > > go to below investment grade, then many > > institutions MUST sell by law or because of > their > > investment policy statements. So now the > problem > > is they can’t find anyone to buy these, and so > the > > price plummets downward. This makes more > > institutions more nervous, because AAA is > supposed > > to hold its value well - price goes down > further > > as more people panic. > > > > > > Probably, if you could buy a few of these > things, > > you’d make some money, because fear is driving > a > > lot of the discount more than fundamentals > > (fundamentals do play a role), and if you hold > > them a long time, they’d probably outperform. > But > > there’s almost no one with pockets deep enough > to > > buy enough of these to dissolve the fear that’s > > causing a discount. That’s why one version of > the > > bailout is for the US government to set a floor > > price at which it will buy them. From the > point > > of view of the government as an investor, it’s > > probably not a bad investment, but the purpose > of > > government is not necessarily to make good > > financial investments with taxes (though you > can > > argue that good government projects are a kind > of > > investment in necessary public goods). > > Once again, thanks for an excellent explanation! Largely, it isn’t hard to model these things. However, you need to good historical data, that resembles the pool being securitized. However, once you depart that, through changing underwriting policies (what happened), or using the same type of mortgages for different purposes (option arms were for high-quality credits with high bonus-type salaries, but then went down credit as affordability options). Alt-A liar loans were a big problem too. Combine that with the idea that housing prices will never go down, thus the idea that the obligor would just say “screw it, I’m not paying”, never entered the equation. Add to that the idea that more debt, in different forms, adds pressure (hard to model), you get a perfect storm of inaccurate modeling. Instead of being highly conservative, the Agencies were the i-bank’s bitches, and bent over accordingly.

bchad, didn’t the MBS’s pay monthly, which may be the reason they were preferred over comparable AAA’s? Also, weren’t some of the sold mortgages by the originators sold with recourse (I don’t know, I’m asking)? That is, the IB’s and others who bought the mortgages had some provisions in place should they not be able to collect payments.

I don’t know those details, since I’ve been staying away from that stuff like the plague. However, Warren Buffet’s analogy to Weapons of Mass Destruction is amazingly good. Anyone who was anywhere near the anthrax letters in 2001 knows that this stuff gets EVERYWHERE. Maybe someone who is a MBS specialist can tell us more about recourse and whether monthly payments were what gave it the AAA rating. I suspect it may have more to do with the fact that principal payments were coming in too (i.e. amortizing loans), and therefore there wasn’t some huge cash flow at the end that either came in or didn’t.

In general, other than reps and warranties, there is no recourse to the originators. The high rating has little to do with how often the payments are made. Assumptions are made about the expected cumulative loss in the pool and the prepayment speed. Throw in some assumptions about correlations across regions and thats the basic model. The main thing driving the ratings on the top tranches is the subordination and any diversion mechanisms in the waterfall of payments. Obviously the agencies were not conservative enough on the loss assumption but most of the banks made the same mistake. Why else do you think they ended up with so many AAA CDO tranches on their books? The real issue was the lack of historical data for subprime and option ARM mortgages.

bchadwick Wrote: ------------------------------------------------------- > Maybe someone who is a MBS specialist can tell us > more about recourse and whether monthly payments > were what gave it the AAA rating. I suspect it > may have more to do with the fact that principal > payments were coming in too (i.e. amortizing > loans), and therefore there wasn’t some huge cash > flow at the end that either came in or didn’t. I think the source of the cashflow and their respective FICO scores are what also helped give it a AAA rating…just a thought though, not 100% sure

spierce Wrote: ------------------------------------------------------- > > Largely, it isn’t hard to model these things. > However, you need to good historical data, that > resembles the pool being securitized. > I don’t know what you mean by that, but I’ve been to oodles of conferences and talks, read up on it a bunch, am a reasonably smart and educated guy and I think it’s a tremendous problem. Start with the problem of we don’t really know how to model interest rates, default probabilities, “correlation” of defaults and then add onto that complex structures with prepayments and tranching and it’s murderous. It’s easy to come up with a model, even 500 models. It’s just impossible to know if the model is any good.

JoeyDVivre Wrote: > I don’t know what you mean by that, but I’ve been > to oodles of conferences and talks, read up on it > a bunch, am a reasonably smart and educated guy > and I think it’s a tremendous problem. > > Start with the problem of we don’t really know how > to model interest rates, default probabilities, > “correlation” of defaults and then add onto that > complex structures with prepayments and tranching > and it’s murderous. It’s easy to come up with a > model, even 500 models. It’s just impossible to > know if the model is any good. And if I learned anything from passing all three levels of the CFA exam, it’s exactly this.

JoeyDVivre Wrote: ------------------------------------------------------- > spierce Wrote: > -------------------------------------------------- > ----- > > > > Largely, it isn’t hard to model these things. > > However, you need to good historical data, that > > resembles the pool being securitized. > > > I don’t know what you mean by that, but I’ve been > to oodles of conferences and talks, read up on it > a bunch, am a reasonably smart and educated guy > and I think it’s a tremendous problem. > > Start with the problem of we don’t really know how > to model interest rates, default probabilities, > “correlation” of defaults and then add onto that > complex structures with prepayments and tranching > and it’s murderous. It’s easy to come up with a > model, even 500 models. It’s just impossible to > know if the model is any good. One of the big issues is that the historical data going into the models to predict the future–I’m thinking about home prices specifically–never contained a down year in prices. People just straight-lined the past. Linear perception to the Nth degree.