I love me some Roman Mars, and his “99% Invisible” show, so I have to pay attention when he delves into finance. I recently tried to introduce the idea of the mortgage bond ‘when-issued’ market, which is a form of futures trading that I used to be involved in. If you have no idea about what futures are, or what ‘selling short’ is, you might try to this episode of “99% Invisible”
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On the 2008 mortgage crisis, from my perspective
Ok friends, are you ready? I’m about to piss you off.
Contrary to the dominant journalistic narrative of the 2008 Crisis – that greedy bankers and their Wall Street enablers tricked the poor and gullible into predatory loans on their homes which led to foreclosures and economic misery – I think borrowers mostly caused the mortgage crisis.
Obviously this is a deeply unpopular thing to say, and cuts against the grain of “little guy = good” and “big bank = bad,” and it appears at first blush that I’m blaming the victim. I sympathize with homeowners who lost their jobs and then possibly their homes and clearly many were victims of forces beyond their control. But I’m still gonna piss you off.
Borrower as “innocent victim” myth
I really just mean to point out that a whole lot of borrowers were not innocent victims, but rather perpetrators of mortgage fraud. Many of these folks were investors, speculators, flippers, and just Hail-Mary passers hoping short-term real estate inflation could cover their terrible financial positions.
I mean to call out the people who knew they didn’t really have a chance at paying back their loans under ordinary circumstances, except maybe extraordinary price appreciation. I mean people who got “no income, no asset” loans knowing that income and asset disclosure would tank their chance to borrow a lot of money. I mean people who, with almost no money down, bought an option to ride the upside of real estate appreciation but who risked no real equity when the market went sideways and then south.
I don’t believe I’m an extremist in this view, I am a realist.
Bankers getting stoopid
Yes, mortgage underwriting standards slipped from “loose” to “stoopid” somewhere between 2004 and 2007, with ARMS, sub-prime loans, interest-only loans, and liar-loans expanding from niche products for niche situations to dominant products crowding out sensible mortgage loans, eventually clogging up the sewage pipelines of global finance. One of my earliest podcast interviews for this site was with a mortgage underwriter who got out of the business just as the ridiculousness started to take over.
But despite this, and contrary to the dominant journalistic narrative, banks do not make money when they lend money to people who will not, or cannot, pay them back. Lending to a borrower who cannot pay back the loan is not a profitable strategy. I’ve never met a banker who wanted to take back someone’s home. It’s a ticket straight to financial destruction for the bank.[1]
Yes, bankers are profit-oriented, and yes they got briefly stoopid, but banks generally get only a few years to make these kinds of terrible underwriting and financial modeling decisions, after which, the inexorable gravity of finance pulls them down, punishes them, and makes them pay.[2]
Borrowers too acted from a combination of greed and stupidity, taking out loans they should never have taken.
Homeownership is not a fundamental right of citizenship. It’s a choice that’s right for some people, but financially catastrophic for others, because home ownership is risky. A mortgage contract confers opportunity, but also demands responsibility.
And yes, I get it, it’s harder to blame the individual borrower who lost her job, her credit and then her home, than it is to blame the overpaid financiers and their banking institutions. Obviously the underwater and foreclosed borrower is a far more sympathetic character than the slick mortgage bond investor or the bank. But just because we feel for the little guy or gal doesn’t mean we should misunderstand shared responsibility for the mortgage crisis of 2008.
I understand better than most the terrible mistakes and greed of Wall Street. I was there, and I’ve written about some of it here. I’ll be the first to say I think the ongoing coddling of Wall Street and unsolved TBTF problem remains a black mark on the Obama administration. But if we don’t acknowledge the shared responsibility of predatory borrowers then we don’t learn the right lessons from the mortgage crisis.
Although I disagree with much of his politics, Edward Conard in his Unintended Consequences debunks – better than anything else I’ve read – the flawed journalistic narrative on the mortgage crisis of 2008.
I know I’m going to piss people off when I write this, because it’s impolite to lay responsibility on the individual homeowner who had the most to lose.
Selling mortgages from bank to bank
What about the fact that mortgages get sold and reassigned to banks that didn’t even underwrite the loans?
Recently a neighbor told me a story – with a straight face – that an acquaintance of hers received notice from a bank of imminent foreclosure on her house. The acquaintance claimed to have made all of her mortgage payments, but the mortgage had been sold to another bank, which hadn’t received her monthly payments. My neighbor was shocked about the mortgage having been sold to another bank, and wholly believed her friend would lose her home.
I remained outwardly sympathetic and pleasant, but let me tell you what I was really thinking.
To dispose of the last point first, the fact that the mortgage was sold to another bank is irrelevant. You know why? Because practically every single mortgage in this country is sold from one bank to another.
Unless you got a mortgage from one of four banks – Wells Fargo, Bank of America, Citibank, or JP Morgan Chase – you can be absolutely certain your mortgage will either be sold or serviced by a different bank.[3] Look at your mortgage statements. Is that the bank that gave you your mortgage? Probably not.
But but but – I hear the objections to the original point – what about all those mortgage bank robo-signers in the foreclosure mills? What about foreclosure mistakes, in which people lose their homes due to bank error?
Ah, yes, the myth of foreclosure mistakes.
The myth of mistaken foreclosure
I just do not believe in the myth of mistaken foreclosure.
I say this with confidence for a couple of reasons.
Through my business I’ve invested in many mortgages myself, a great number of which became delinquent.[4]
It takes between 6 months and a few years to enforce unpaid debts. Thousands of dollars in attorney fees are followed by months of notices, certified mail, and disclosures to homeowners in arrears. Unlike a Hobbesian life, mortgage foreclosure is nasty, brutish, and long. If the lender pressing foreclosure misses any steps along the way, you pass directly to Go, do not collect $200, and the foreclosure process can be held up indefinitely.
Look, we live in an extremely litigious society. There are thousands of consumer rights’ lawyers ready to take on a big juicy target like a bank for mistakenly foreclosing on a homeowner who has faithfully made mortgage payments but who lost his home due to bank error. Any homeowner who got mistakenly foreclosed upon by a bank is not a homeless loser but holds a golden ticket to financial paradise.
A mistaken foreclosure is a Golden Ticket for the homeowner?
Has this ex-banker forgotten his meds?
No.
If Bankers-Anonymous readers can refer me to a homeowner tricked out of her home, or mistakenly foreclosed upon who remained current on her mortgage,[5] I will find a lawyer who will win millions of dollars for that homeowner from the bank. If you can find me more than one instance nationwide – let’s just say a few dozen – we will all retire just on the referral fees to the class action lawyers alone.
How much can we make the banks pay? $100 million? $200 million? Maybe more. Some percentage of that would be fine by me.
But it’s never going to happen, because it’s a big fat myth.
Mortgage settlements with big banks
But wait, what about the hundreds of millions of dollars in penalties Wall Street banks have paid in the past 5 years to attorneys general for mortgage underwriting errors or fraud? Doesn’t that prove Wall Street and the mortgage banks were cheating and predatory?
No. It proves only that securities firms cannot afford to get crossways with securities regulators. Not a single mortgage case filed by the government against the big banks in the past 5 years has ever gone to trial.
The banks’ attorneys immediately ask for a settlement, put aside a big chunk of money, and try to move on.
Being sued by the government for securities fraud is such a business-quashing situation that no bank can remain there for long. Their lawyers just reach for the corporate wallet and ask the regulators what it’s going to take, and then they move on.
Conclusion
I’m not trying to be the mean jerk here by blaming the borrowers. Clearly homeowners suffered, and they suffered individually more than the bankers. But we need a clearer-headed analysis of the cause of the mortgage crisis – or at least a more balanced view of where to place the blame.[6]
I think we’ve bought into an imbalanced journalistic narrative, and we draw the wrong lessons for the future as a result.
Postscript to the Conclusion
On this same issue of ‘who to blame?’ the mortgage crisis strongly resembles the internet crash of 2000 and then-Attorney General Spitzer’s campaign to blame internet analysts. As always, Michael Lewis said it best, in this classic New York Times Magazine article. If you choose the politically convenient target – mean, nasty, banks and their forked-tongue research analysts – rather than the fact that investors are greedy, working with imperfect information, and should be held responsible for their own investment decisions, then you learn the wrong lessons. And you end up with a bullying hypocrite for a New York Governor, among other consequences.[7]
In the case of the mortgage crisis, exclusively blaming the banks for loose lending standards leads to, among other things:
So let’s consider the whole picture of responsibility, however unpalatable it may seem.
Also, see previous posts on Mortgages:
Part I – I refinanced my mortgage and today I’m a Golden God
Part II – Should I pay my mortgage early?
Part III – Why are 15-year mortgages cheaper than 30-year mortgages?
Part IV – What are Mortgage Points? Are they good, bad or indifferent?
Part V – Is mortgage debt ‘good debt’ A dangerous drug? Or Both?
Part VI – Mortgage bond creation on Wall Street
Part VII – Mortgage Derivatives
[1] When they don’t get paid back, banks have to start a foreclosure process, which is long, costly, and uncertain. Then when they do obtain the property, more often than not the bank sells it for a loss. It’s a terrible situation. Banks don’t like to own properties. They want Tuppence.
[2] And then they call up daddy Paulson, and say ‘Daddy, start writing checks!’ Yes, I realize banks got unfairly bailed out. That too drives me nuts. But I’m talking right now about the causes of the crisis, not the consequences.
[3] And even if you did get your mortgage underwritten by one of those four, it’s highly likely your mortgage will be reassigned into a mortgage bond structure, often with a different servicer. For more on the way the mortgage bond sausage is made, I recommend this primer.
[4] In a related piece of news, I’m no longer a hedge fund manager. Rather, I’m stacking mad chips as a blogger.
[5] “Remained current on her mortgage” is the key clause of this whole thing. I define a foreclosure mistake as a situation in which the homeowner who actually paid the mortgage, but lost the home. Yes, lots of people lost their home after not paying on the mortgage, and that’s tragic all around. But that’s not the bank taking advantage of people, that’s the bank following through on its signed, written contract, which contract has been thrown into default for non-payment.
[6] On this same issue of ‘who to blame?’ the mortgage crisis strongly resembles the internet crash of 2000 and then-Attorney General Spitzer’s campaign to blame internet analysts. As always, Michael Lewis said it best, in this classic New York Times Magazine article. If you choose the politically convenient target – mean banks and their forked tongue research analysts – rather than the fact that investors are greedy and working with imperfect information and should be held responsible for their own investment decisions, then you learn the wrong lessons. And you end up with a bullying hypocrite for a New York Governor, among other consequences.
[7] And then after he’s exposed for what he is, you get him back, as Comptroller of New York City.
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Below are my reactions to the US Securities and Exchange Commission fraud suit that began yesterday against “Fabulous Fab” Fabrice Tourre, a Vice President at Goldman Sachs for structured products.
From what I gather in the press, the Feds are suing Fabulous Fab for the following reasons:
Listening to the news last night I realized that people might actually think Fab is to blame here. That is a travesty. The SEC’s suit is a joke, albeit a really unfunny one if you’re Fab.
Fab is no more to blame for investors’ losses in a CDO known as the Abacus 2007-AC1 than any broker who sold you shares in any publicly traded stock in the year 2007 which subsequently halved in value by the end of 2008.
The SEC prosecution appears to rest primarily on the idea that Goldman brought together clients with opposite views of the mortgage derivative market, and then didn’t tell all sides of the trade who everyone was.
Factor #1
What?!! You mean to tell me Goldman brought together clients with opposite views on the market?
One of the disappointing aspects of William Cohan’s Money and Power: How Goldman Sachs Came to Rule the World is Cohan’s seeming misunderstanding of how a broker-dealer works. Cohan seems shocked, as the SEC attorneys in the Fab trial want the jury to be shocked, that Goldman could match up clients with diametrically opposed views on the mortgage derivative market.
Hey guys? Let me give you pro tip: That’s how a broker-dealer works.
It’s the job of a broker to find willing buyers and willing sellers, all day long, to take diametrically opposed views on the future direction of securities and markets. It’s also the broker’s job to generally protect and make anonymous the counterparties to a trade.
[NB: Cohan clearly does know how a broker-dealer works and he has an excellent review of the Fab case here on Bloomberg. My jab at him is about his book in which he doesn’t clarify just how ridiculous Sen. Carl Levin, and by extension the SEC’s theory is, on potential conflicts of interest within a broker-dealer]
So the fact that Paulson and ACA had different views on mortgages means that Goldman did its job. The fact that Goldman didn’t overly advertise the central role of Paulson in the CDO structuring is not evidence of a crime.
The level of expected disclosure in CDO structuring will be a combination of
1. law, and
2. informally agreed-to market standards.
I spent enough time around the persnickety legal compliance folks at Goldman to have confidence that Fab’s team complied with the letter of the law over counterparty disclosure, or what is called in the business ‘name give-up.’
Some types of trades require it, some types of trades forbid it, and some types of trades will rely on market standards to determine the correct level of disclosure.
At the moment of structuring the Abacus CDO it’s less clear to me, from a distance, whether Fab’s team reached a less formal level of ‘market standard’ when it came to disclosing Paulson’s role. But market standard is a kind of nebulous concept for which I can’t believe Fab can be found guilty by the SEC
Factor #2
Why go after Fab and not bigger fish? Because he’s the only one against whom you could find embarrassing emails to his girlfriend? (Give him a break. He’s French.)
Fab was a relative nobody. Like Greg Smith (of Muppets fame), or like me, Vice Presidents are in charge of very little at a Wall Street firm. From his ill-advised emails we gather he was an over-worked, under-sexed, anxious, and narcissistic guy, but what 31 year-old on Wall Street isn’t all of those things? If that’s a crime, then lock ‘em all up.
I’m not a fan of the Eliot Spitzer- trademarked prosecution-and-trial by embarrassing email.[2] That appears to be why Goldman settled for $550 million with the SEC a year ago, because of Fab’s anxious, flirty emails to his girlfriend.[3] Goldman, as is typical in these situations, did not admit guilt, they just paid the money in order to move on.
I’m not saying the SEC shouldn’t bother to prosecute bad actors even if they are low on the totem pole, but I am saying two things:
1. Fab was a small cog in a big machine doing exactly what he was paid by his bosses to do, and
2. There’s nothing bad about what he did except try to sell squirrely investments to willing, professional, sophisticated buyers. And that’s his job! CDOs are squirrely. Everybody knows that. CDOs, we used to say on the desk, are “sold, not bought.” Meaning, once you’ve placed them in a client’s portfolio, pray they never ask to sell them back to you. You do not want to buy them back. They’re too squirrely.
Factor #3
ACA was no innocent victim
ACA was not an ‘innocent victim’ of mean, nasty brokers tricking them into buying destined-to-soon-fail derivatives. These were highly compensated, professional, CDO investors. ACA charged their customers millions of dollars in fees, and collectively paid themselves millions of dollars in compensation, to provide their “unique insight” into buying complex financial products.
As Michael Lewis pointed out before in The Big Short, if any fraud or crime was being perpetuated, it was by ACA on their own customers, for pretending they knew how to separate the profitable from the unprofitable, the gold from the dross, the good from the garbage. If you can’t do that, you’re just tricking your own customers. If you lose money buying a terrible product in the way ACA did, you should only blame yourself.
Factor #4
But ACA was on the wrong side of John Paulson without knowing it. Paulson’s a genius! It’s so unfair!
John Paulson in 2007 was not John Paulson. He was just another contrarian hedge fund guy taking a swing at the overly frothy mortgage and housing market. Everybody who had done this type of trade previously – betting big against mortgage credit and housing in the run-up – from 2001 to 2007 – had lost their shirt, as the market moved against them.
Everybody who took Paulson’s side of the trade before things broke in 2007 was an idiot and a money loser. What’s obvious now in retrospect was not obvious then. The ACAs of the world – buying the stupid, illiquid, highly-levered subprime, garbage CDOs – had made much more money in the previous years than the John Paulsons of the world.
That’s why Paulson was so damned successful. Because there were only a few Paulsons around to take the other side of the mortgage derivative trade in 2007.
Being on the short-side, like Paulson dared to be, appeared to be for suckers.
ACA must have been laughing all the way to the bank.
If Fab is guilty, then I’m the big bad wolf.
Bloomberg News wrote that
U.S. District Judge Katherine Forrest, who will oversee the trial in Manhattan, summed up the SEC’s allegations this way in a June 4 opinion: “Tourre handed Little Red Riding Hood an invitation to grandmother’s house while concealing the fact that it was written by the Big Bad Wolf.
The SEC’s version of the case is so absurd it’s hard for me to believe they’re pursuing it. It’s a fairy tale.
[1] In my opinion, this is the only valid reason of the three.
[2] For more on this, as well as a great primer on why Spitzer should never, ever, be elected dog-catcher, I recommend this blast-from-the-past article.
[3] Broker-dealers always, always, always settle with regulators because the cost of fighting regulators in court is that you’re out of business.
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Please see my earlier post, on the creation of a Mortgage bond
which reviewed 3 parts of the mortgage bond market.
This post will cover subsequent features of mortgage bond trading and structuring
Mortgage Trading – All about the prepayment risk
So how do mortgage bonds trade on Wall Street? How do investors think about the product?
Contrary to popular reports, plain-vanilla mortgage bond trading and investing remains among the safest type of investing from a ‘credit’ perspective. Investors can always expect their full principal and interest returned to them.[1]
Our simple FN 8720331 4% bond issued in October 2013 offers investors AAA-risk comparable to US Government bond risk and extreme liquidity, meaning an investor can sell the bond at any time and not pay much in transaction costs.
The main and only significant difference between our FN 4% bond and a similar US Treasury bond is the uncertainty of the timing of principal payments. Meaning, the US Treasury does not generally pay back its bond principal early, but a mortgage bond, by contrast, pays a little bit of principal, every single month. In addition, if any of the 2,000 underlying homeowners decides to sell or refinance his house, an unexpected principal repayment flows through to the bondholder.
Not if, but when
The risk to the bond-holder, therefore, is not if he’ll get paid back, but when. Since in our example 2,000 individual homeowners have the choice over when, anytime in the next 30 years, their individual mortgage gets paid back, the mortgage bond holder is subject to other people’s choices, which the investor cannot control.
The mortgage bond holder, by purchasing the bond, has implicitly sold 2,000 little 30-year options to homeowners.
In financial terms, when you sell an option you get paid a premium for that option. That premium shows up in the form of extra ‘yield,’ or investment return over comparable US Treasury bonds. This makes plain vanilla mortgage bonds ‘yield’ more than other AAA-rated bonds, but it also burdens the bond holder with ‘prepayment risk.’ Mortgage investors and mortgage traders spend all of their waking hours stressing about prepayment risk.
NSA-sized computer servers, and the greatest minds of our generation are dedicated right now, as I write this, to modeling prepayment risk in mortgage bonds. I didn’t say they were tapping the phones of those 2,000 homeowners to get a sense of when they will refinance, but I mean seriously, do you doubt it? There’s a lot of money at stake here, after all.
The problem of being a mortgage bond holder, just to dig a bit further into the prepayment problem, is that homeowners always exercise their option to refinance their home at the precisely wrong time, for bond investors. What do I mean by that?
Always on the losing end of volatile markets
I mean mortgage bond holders get paid early just when they don’t want to, and they don’t get paid back early when they would like to be paid early.
When rates drop strongly, for example, many more of our 2,000 homeowners will choose to refinance early to take advantage of the new interest rate savings. That uptick in refinancings will send early payments to the bond holder and amortize his 4% bond more quickly than expected. Unfortunately for the dedicated mortgage bond investor, however, he has to own mortgage bonds, that’s what he does for a living. So he needs to invest in new mortgage bonds to keep his money earning money. He will have to reinvest his cash at the new lower rate, which might only earn him 3%, since rates dropped strongly.
Rate hikes can be even more deadly. If mortgage rates jump to 6%, for example, many fewer of our 2,000 homeowners than usual will opt for refinancing. In fact, only people who move houses (or get foreclosed on) will pay off their mortgage early.
Few homeowners elect to refinance into higher interest rate mortgages. Hardly any prepayments flow to the bondholders to amortize the bond. Our bondholder anticipated a certain amount of prepayments and hoped to invest his proceeds at the new higher rates. He can’t. In the new 6% interest rate world, new mortgage bonds pay close to 6% but our mortgage bond investor still holds our dumb old 4% bond, with less-than-anticipated cash to put into the higher yielding bonds.[2]
The more that interest rates move, the worse off the mortgage bond holder fares, in both directions, because he’s short the prepayment option.
In times of volatile interest rate moves, the homeowner holds this very valuable option, and the bond holder suffers as a result.
Everything about mortgage trading and investing flows from this fundamental problem – the problem of prepayment risk.
Mortgage Servicing and Mortgage Derivatives – attempts to solve prepayment risk
The 2,000 individual homeowners paying their monthly mortgages underneath our theoretical $750 million Fannie 4% bond are really raw financial clay with which Wall Street artistes create financial sculptures.
If prepayment risk is the ultimate heavy burden of mortgages, the point of the financial sculpture of mortgage derivatives is to shift risk in ways to defy gravity, ultimately matching investor appetite for prepayment risk.
The mortgage servicer who separately pays interest and principal payments to bond-holders plays a key role in making these works of art possible
Simple mortgage derivatives
CMO – A Collateralized Mortgage Obligation is a generic term for relatively simple mortgage derivatives, first created 30 years ago, that typically shift prepayment risk forward or backward in time over the life of a mortgage bond.
A Wall Street bank may decide to sculpt our FNMA 4% bond into a CMO structure to split the timing of mortgage prepayments.
As a simple example, let’s assume three different investors want three different types of investments.
What a savings and loan bank wants
A traditional savings and loan bank might be looking for a place to park its cash for up to 2 years and is happy to earn a safe 2% return on its money. Our theoretical bank investor needs everything it is investing in a mortgage bond returned over the next 2 years to make its budget, and it cannot risk tying up its capital much past the next 2 years. Our savings and loan bank needs a CMO structured to receive lots of mortgage prepayments.
What an insurance company wants
An insurance company, by contrast, typically seeks long-term bond investments to match its need to meet its long-term liabilities, like life insurance payouts. The insurance company seeks a way to invest its capital for 10 years, but needs something more than a bank for that long term investment – it seeks a 4.5% return. In addition, the insurance company really does not want to receive early principal payments. The point is to keep its capital earning the 4.5% rate for as long as possible, so the insurance company really wants a CMO structured to help it avoid prepayments.
What a hedge fund wants[3]
Finally, a hedge fund has a flexible view of yield and the timing of return of capital, but thinks it has a better sense than the rest of the market on the true likely prepayment speed of this FNMA 4% October 2013 cohort. The hedge fund wants to earn extra yield and is willing to stomach the risk of a wider range of bond payment timing outcomes. In financial lingo we’d say the hedge fund earns the extra premium by being “short” a volatile pre-payment option. By buying the CMO with the most volatile outcome, the hedge fund has done the financial equivalent of selling many call and put options to homeowners, and it hopes to profit from this implied sale, if the interest rate environment turns out to be less volatile than expected.
Our clever Wall Street firm can assign our FNMA 4% bond to a CMO structure and instruct the mortgage servicer to follow a set algorithm as prepayments arrive over the next 30 years.
All principal payments first go to pay the bank’s CMO until that bond is completely paid off, followed by the hedge fund CMO, followed finally by the insurance company’s CMO.
For the bank’s CMO all principal payments – both the scheduled principal amortization and the unscheduled prepayments – get forwarded to this short-term bank CMO. As a result, this bond pays down extremely quickly and will likely return all capital to its holder within the 2 year time frame. There is some uncertainty about timing, but the fact that the bank CMO gets every single principal payment really limits the prepayment timing to within a nice, tight, short range.
The bank’s CMO structure also makes the next two CMOs created from the same FNMA 4% bond possible.
The hedge fund CMO only receives principal prepayments after the bank CMO has been fully paid off. As a result, the hedge fund knows it will not be subject to prepayments for some period of time in the very near future. As it is second in line for principal payments, this CMO acts kind of like a shock absorber for the other two bonds, and will be quite sensitive to changes in interest rates and therefore prepayment speeds. The investor in this type of bond, like a hedge fund, will likely believe it has a better read on prepayment risk than others in the market. Because it takes on the most prepayment risk of the three bond structures, the hedge fund will demand the most yield enhancement over comparable AAA bonds to compensate for this increased risk and uncertainty.
The insurance company’s CMO, as third in line for prepayments, has two layers of prepayment ‘protection.’ Although the timing of principal payments may ultimately differ significantly from the insurance company’s expectations, the two layers of protection cushion the prepayment risk and keep it within a tighter range than would be otherwise available from a plain-vanilla 4% FNMA bond.
By slicing up our mortgage bond pool to meet the demand of three separate investors, the Wall Street firm can, ideally, sell the entire pool at a higher implied price than would be otherwise available in a plain vanilla format. Happy customers, and higher fees, follow.
Interest only bonds and principal only bonds – another simple CMO structure
Because interest and principal payments for our $750 Million 4% FNMA bond can be easily separated by the mortgage servicer, Wall Street desks quickly figured out that some investors want interest only bonds, while others prefer to receive only principal.
Who would want an interest-only bond?
The first feature of an interest-only bond is its potentially volatile and leveraged nature – it fluctuates widely in value if you get the bet right. The second feature is that it moves in the opposite direction of most bonds due to changes in interest rates.
Most bonds go down in value as interest rates rise. But interest-only bonds created by mortgage pools will increase in value as rates rise. That’s because we expect prepayments will drop with a rise in rates, which means that you will receive interest payments on the 2,000 underlying pools for a much longer time, as fewer homeowners extinguish their mortgage through refinancing.
The price of an interest only bond will shoot upwards if interest rates unexpectedly shoot upwards and prepayment expectations drop accordingly.
If I as a mortgage investor need to hedge my mortgage portfolio against an unexpected rise in rates, I might shop for interest only bonds. If my entire portfolio is likely to lose value when rates rise, I benefit from the hedge of owning bonds that rise in value when rates rise.
Conversely, a bet on a principal only mortgage bond may be a type of bet on a decline in interest rates. Principal only mortgage derivatives will be especially sensitive to changes in rates.
Principal only mortgages trade at a discount to face value. If prepayments arrive more quickly than expected (due to, say, an unexpected increase in refinancing activity) the principal-only mortgage holder wins. Every principal payment is made at ‘par,’ causing an investment gain versus the discounted price at which the investor bought the entire principal-only mortgage derivative.
If for example I bought my principal only bond at 80 cents on the dollar, but 10% of my 2,000 underlying mortgages prepay early this month, I’ll get 10% of my investment returned to me at 100 cents on the dollar. That’s a win.
Funkier structures – More CMOs
Traditionally, mortgage structuring desks attracted some of the brainiest folks on Wall Street.[4]
With the raw material of a home mortgages, the creativity of these artistes knows few limits. Some CMOs provide precise prepayment certainty to risk-averse investors, as long as other ‘companion bonds’ serve as shock absorbers for unpredictable prepayment risk. Companion bonds will be retained by Wall Street mortgage desks comfortable with the risk, or may be bought by hedge funds with a higher risk appetite or a strong conviction about future prepayment risk.
Some CMOs offer floating interest rate structures to investors seeking to eliminate interest-rate risk exposure, while creating ever-more algorithmically complex ‘companion bonds.’
For those curious about the ever-awesomer financial sculptures the smartest minds of our generation can create, I recommend this Wikepedia page.
Recent market moves must have been ugly
Interest rates shot up more than 0.5% in May and June. For mortgage bond holders, interest-rate volatility generally hurts, and rising rates provide a double whammy to the problem.
There is no doubt this kind of movement is career-making and career-ending for Wall Street folks. Rates have been so low, for so long, that some mortgage desks will be positioned right, and many more will prove in retrospect to have been positioned wrong.
If you held a preponderance of IOs, or some extraordinary floating rate structures, or got massively short interest rates in April 2013, you’re probably ok.
For a great number of mortgage investors and traders, however, I suspect they didn’t save themselves from huge losses.
Also, see previous posts on Mortgages:
Part I – I refinanced my mortgage and today I’m a Golden God
Part II – Should I pay my mortgage early?
Part III – Why are 15-year mortgages cheaper than 30-year mortgages?
Part IV – What are Mortgage Points? Are they good, bad or indifferent?
Part V – Is mortgage debt ‘good debt’ A dangerous drug? Or Both?
Part VI – Mortgage bond creation on Wall Street
Part VIII – The Cause of the 2008 Crisis
[1] Before you get smart-assed about all the scary bond losses you read about once in a Gretchen Morgenson article, let me reiterate that I said plain-vanilla mortgage bonds, not risky portions of mortgage-backed CDOs or sub-prime structured products.
[2] Adding insult to injury, if it’s an un-hedged mortgage bond position, his bond also trades significantly below par. So if he decides to sell the 4% bond to buy a 6%, he’ll take a loss. Rate hikes are hard on all bond investors, but especially mortgage bond investors.
[3] If you were born around the same time as me, it’s what you want Joel. Its what every white boy off the lake wants.
[4] Plenty of raw idiocy and barbaric types too, of course, like any testosterone-fueled environment, anywhere. For a humorous depiction of the brutal origins of the market, look no further than the original Michael Lewis classic, Liar’s Poker.
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A friend asked me recently for investment advice. I sent her my thoughts by email but couldn’t resist making it into an “Ask an Ex-Banker” post.
Question: My daughter got caught in the housing downturn and finally has sold her condo in NY but is too poor in this economy to buy a bag of chips, let alone a house in LA. So she is trying to figure out what to do with the $90,000 left over after paying off student loans and replacing a broken car. Do you have any suggestions for earning more interest? K__ and I could use a suggestion as well, but none of us can stick it away for 3 years because as optimists, we are always hoping things will change. Thanks. Paula H., Sarasota, FL
Hi Paula,
It’s nice to hear from you. Thanks for reaching out!
Sorry to hear about your daughter D’s housing condo mess, but, from a distance, my first thought is that it could have been worse.
Despite getting caught in the housing downturn, she came out $90,000 ahead – after student loans and a broken car – a victory. It gives her a positive net worth, something most people in this country don’t have.
In my opinion, the first and only difficult thing about a pile of money like this is deciding whether you should put it in the ‘Risk’ or ‘No Risk’ investment bucket.
‘No Risk’ includes things like cash, a bank account, money markets, and annuities, while ‘Risk’ encompasses just about anything else, typically stocks, as well as real estate, and funkier investments as well. We tend to assume lots of different flavors of ‘Risk’ investments, but I’m increasingly convinced all ‘Risk’ investments are fundamentally the same. You can make money, you can lose money, but there’s no guarantee you’ll get all your money back when you need it.
If you decide on ‘No Risk’ then you should expect virtually no return, just the same amount of money available to you when you need it next. If you decide ‘Risk’ then the investment could go up or it could go down in value, but, in the short run at least, there’s no way to know where you’ll end up. The key advantage to dividing up the world this way – into these two buckets – is that it forces you to realize the illusion of having both safety and a good return in the same investment. You can’t. Anyone who offers you both absolute safety and a good return is lying. Run away from them.
In your question you’ve already hit on the key answer/problem in your question: Timing. If D might need the money within 3 years there’s no chance to earn a decent investment return, while also entirely protecting principal.
Earning a reasonable return right now, without taking risk, is impossible. If you choose the safe approach, you earn nearly nothing – $900 per year, or 1% on $90,000 – which won’t buy much. It’s hardly worth the effort of opening up the bank savings account. Interest rates are on the rise now, but from such a historically low base that they’ve got a way to rise before return on traditional savings will be “worth it.”
On the other hand, investing it ‘in the market’ or in another risky asset like real estate means that your $90,000 could be a lot smaller by the time you try to actually get it back. It very well might be larger too, but that’s just one possibility, not a guarantee. If you have to have at least $90,000 when you want it back, then ‘Risk’ isn’t the right place to put the money.
So, now, to D’s particular situation.
If she’s a starving artist in LA, without a steady income right now, then it’s likely she’ll need to access at least some of that $90,000 in the short run, in less than 5 years. To the extent she might need this money for living expenses anytime in the next 5 years, it needs to be in ‘No Risk.’ The return will be terrible, somewhere between 0% and 2%, but that’s just where we’re at. It probably doesn’t matter where you invest. Just stick it in a stupid bank savings account, earn the 0.9%, and be content. Don’t even bother tying it up in a 2 year CD offering 1.9%, because it just doesn’t matter. Another $900 per year won’t compensate for the fact that she can’t access all the money if she really needs it.
When would it make sense to invest in something Risky? It depends on her time horizon for accessing the money.
Less than 3 years, no way. ‘No Risk’ bucket only.
Over 5 years, start to lean towards Risky.
Over 10 years, put all of it in Risky.
If D’s music royalties or other income can reasonably cover her monthly expenses for the next 5 years, so she knows she doesn’t have to access the money, then it seems fine to pick something risky. Put it in a low-cost, all-stock mutual fund and watch it grow. Or use your real estate savvy to get involved in a rental building.
I wouldn’t bother with sexier higher-risk situations like oil royalties, film-financing, hedge funds, start-up businesses, or art unless she can blow the whole wad without missing it. It might make 10X your money. But it probably won’t.
Is there a course in between ‘Risk’ and ‘No Risk’ buckets?
Yes, for example, D may know she’ll only need a maximum of $30,000 to cover emergencies over the next 5 years. In that scenario, make two allocations – $30,000 into the stupid ‘No Risk’ bank account earning bupkis, and up to $60,000 in something that might earn a positive return over the long haul, like stocks or real estate.
The longer her $60,000 has to stay tied up in that Risky bucket, the higher the probability that the money will be larger when she needs it. The key here, though – the really essential point – is to know ahead of time which money she can’t afford to lose because she’ll need it, and which money she can afford to risk, because she won’t need it, ideally until retirement.
For you and your husband K, the equation might be different. I’m presuming you’re much more likely to have your monthly expenses covered in the next few years, so you can afford to make much riskier choices. If you lost some of your $90,000 in a risky situation that didn’t work, you’re still less likely to depend on the principal for daily living.
Your time horizon for choosing risky investments is probably better than D’s. For K and you, putting the money ‘in the market,’ or in a real estate opportunity seems perfectly reasonable to me, if you can weather the volatility. It makes sense to me that you’d invest the $90,000 differently than D should.
I know I’m not giving creative investment ideas that offer both safety and good return, but the fact is that usually – and certainly now – we can get safety or good return, not both.
I hope this helps.
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How do mortgages make it to Wall Street anyway?
None of the following is essential to understanding mortgages from a personal finance standpoint, I just thought the details of mortgage securitization and mortgage bond trading and structuring would be interesting for some people.
I sold mortgage bonds at Goldman for a few years in the early 2000s, so this sausage-making was my daily life. Below, and in a subsequent post, I introduce some Wall Street concepts of the mortgage bond market.
In this post, I’m going to describe points 1 through 3.
Subsequent posts will describe points 4 through 7.
Conforming mortgages, the forward trade
In July 2013, Wall Street is now “forward trading” the October 2013 30-year 4.0% mortgage bonds. October 2013 mortgages are part of the ‘When Issued” market, which is kind of like a grain farmer selling wheat on the commodities exchange 3 months before his harvest. The farmer has an approximate idea of what yield he’ll get soon, but he may trade on a commodities exchange as his estimate changes, and as his sense for the attractiveness of prices changes.[1]
As the largest originator in the US, Well Fargo, in recent times, originates over $100 Billion in mortgages per quarter.
That means that on any day in July, and in fact for the next two months, mortgage traders at a big mortgage originator like Wells Fargo will call up their salesman at Goldman Sachs and ask Goldman to purchase some amount of their mortgages that will be originated by October 2013.
This “When Issued” mortgage market is just about the most liquid market in the world, and a $1 billion trade happens in seconds.
“Hello, this is Goldman,” said in a shouty but efficient voice
“Bid 750 Fannie 4s in October!” *
“22+” **
“Done” ***
“Done. GS buys $750 million Fannie 4s in October at 100-22+. Thanks for the trade.” Click.
****
[And…let’s translate:
* Wells Fargo today, in July 2013, is selling $750 million worth of future mortgage supply, which it will ultimately originate in October 2013. Wells has an idea of its future October volume, however, because of the recent amount of customers who have locked in their current interest rates. Many of these will end up as loans eligible for inclusion in a Fannie Mae securitization of similar mortgages.
**The mortgage salesman’s price is a fractional short-hand for how many 64ths Goldman will pay, in this case the 22+ means 22 and a half/32nds, or 45/64ths, or .703125. This quote assume everyone knows on the buying and selling side knows the ‘handle,’ which is the main price, near par, that the bond will trade at during origination. Newly issued mortgage bonds, like most newly issued bond generally, will trade somewhat near 100, but during periods of rapid interest rate changes this handle could be in the 95 to 105 range. The Well Fargo trader and Goldman salesman will now ahead of time and won’t waste time reviewing this info, until after the trade is done.
***I agree to your price. Not only that, but I agreed to your price so quickly (within a second or so) that you as broker are held to the price even if the market moves against you in the subsequent 10 seconds, or minutes, or days. Goldman is now at risk as a future owner of $750 million in bonds
****Ok, I bought your bonds.
Now back to your regularly-scheduled description of mortgage origination and hedging.]
As Wells Fargo’s mortgage origination supply fluctuates between July and October, Wells may find itself needing to sell more ‘When Issued’ mortgages, or it may buy some back if its mortgage origination supply drops. If mortgages expected to close in October instead actually close in November, then Wells may end up selling fewer mortgages in October and will instead do a trade so that it can deliver them in November.
Delivery, again, is like the futures market for wheat.[2] The farmer, in this case Wells Fargo, anticipates his yield, and manages and hedges his future production by selling his ‘When Issued’ mortgages to Wall Street.
Delivery and Securitization
When October arrives, Wells Fargo delivers its $750 million in conforming[3] mortgages to Goldman. Goldman may then choose to turn over this inventory of raw mortgages to Fannie Mae for securitization as a 4% Fannie Mae bond.
Securitization, the process by which a few thousand similar-vintage mortgages become a tradable bond, is the process that occurs to most home mortgages, further separating the home owner from the bank. Not incidentally, it’s part of what makes our home mortgage rates so affordable.
Let’s say for simplicity’s sake that 2,000 different mortgage loans underlie the $750 million securitization, for an average loan balance of $375,000. They will cluster in interest rate, to the 2,000 homeowners, around 4.375% to 4.5%, and all will generally have ‘closed’ in October 2013. Astute readers will notice the extra 0.375% to 0.5% difference between the homeowner rate and the bond rate. This difference largely gets paid in monthly fees to two different entities, the mortgage bond servicer, and the mortgage insurer. I’ll next explain these two roles in the mortgage securitization market.
The plain-vanilla Mortgage bond
Once the 2,000 underlying mortgages get grouped together and assigned to a structure, and assigned to a mortgage servicer, and guaranteed by the mortgage insurer – Fannie Mae – it becomes a tradable bond. The bond will get registered, with a Cusip and ISIN[4], loaded into Bloomberg for ease of tracking, and assigned a Fannie Mae number. I’ll call this one “FN 8720331.”
Let’s say Goldman next sells this particular FN 8720331 to a Vanguard Fund dedicated to purchasing new mortgage bonds. For the next few years, the Vanguard Fund will receive a combination of principal and interest from FN 8720331.
FN 8720331 is a AAA-rated, safe security. Vanguard will earn 4% on its investment – I’m assuming that’s the coupon of the bond and that it was purchased at par – although the timing of payments is uncertain. If interest rates decline from here, many of the 2,000 homeowners will refinance before 30 years, shortening the ‘average life’ of FN 8720331 to something in the 3 to 7 year range. If instead interest rates rise – as seems more likely – homeowners may realize their 4.5% mortgages is a great rate, and they may not refinance for many years. FN 8720331 may end up as a 10+ year average life bond. Vanguard takes that risk, known as pre-payment risk.
Mortgage Servicer
The mortgage bond servicer earns its fee – a portion of the 0.375% to 0.5% difference between homeowner interest and bond-holder interest – making sure that the monthly mortgage payments of 2,000 homeowners get routed correctly through the structure that pays out monthly to Vanguard. Our theoretical $750 million bond pays a monthly portion of the 4% annual interest plus principal on a mortgage bond.
Just as an individual mortgage paid by a homeowner slowly amortizes – decreases in principal amount owed each month – so too does the servicer of the mortgage bond disburse a portion of underlying principal to Vanguard every month.
This means that 3 years from now our $750 million bond will have partly amortized, let’s say to 70% of its original face amount. Wall Street, if it trades this bond in the future, will still quote the original face amount, but mechanically only 0.7 of money will change hands at the time of a trade between Vanguard and its Wall Street broker. In other words If you want to buy $100 million of this bond – and it still trades at par – you’ll only need to pay $70 million to Vanguard for it, since it trades at a ‘factor’ of 0.7.
Each month the factor gets a little smaller, as each month more of the mortgage bond principal gets paid down. Toward the end of the life of a mortgage bond, you get to a sort of absurd factoring situation, in which only 10% of the bond face value is left, meaning a $1 million bond only has $100,000 principal left.
The mortgage servicer’s process is mostly automated, directing a precise amount toward the interest and principal, but the separation of the principal from the interest is essential.
If a homeowner pays off his mortgage early, or a foreclosure forces a sale of the home and repayment of a mortgage, that larger-than-expected payment shows up for Vanguard as a larger principal payment the next month. The mortgage servicer pre-pays a portion of the principal, reducing the bond factor faster than the original amortization schedule.
For the purposes of creating mortgage derivatives – the technology that makes mortgage lending even more efficient – the mortgage bond servicer separates the interest and principal amounts precisely before passing that on to bond holders. I’ll explain a bit more of that further down, after introducing the role of the mortgage insurer.
Mortgage Insurer
The mortgage insurer, in my example Fannie Mae, also earns a fee every month (a portion of that 0.375% to 0.5%) for guaranteeing loan defaults and loan losses within the portfolio. If a few of the 2,000 loans underlying the bond ‘go bad’ in any given month, Fannie Mae makes up the difference to bond holders owed a fixed amount, their 4% plus principal, every month.
Losses may occur because of delinquency – for example, some of the 2,000 homeowners stop paying on their mortgage for a few months. Fannie Mae makes up the temporary shortfall in funds, guaranteeing no diminishment of payment.
Losses may also occur because of foreclosure – some of the 2,000 homeowners lose their home. A special servicer will work to recover the proceeds of the foreclosure sale and apply that recovered money as an early payment of principal to Vanguard.
Under ordinary times, temporary losses from the 2,000 mortgages in non-payment remain relatively light. At any given time only a few homeowners are delinquent on their payments, and many of these resume payment as the homeowners stabilize their finances, or the house gets sold. In addition, bond holder losses due to foreclosure are typically not catastrophic, given that a 20% down-payment cushions bond holders from taking a loss, even when the house gets foreclosed upon.
Fannie Mae, and its close cousin Freddie Mac found this mortgage insurance business extremely profitable, for many years, leading up to the Crisis of 2008.
Under ordinary times, Fannie and Freddie were like insurance companies offering health insurance for 20-30 year-olds. Hardly anyone got sick. The occasional kid decided to ride a motorcycle and amassed huge fees after cracking his head open, but the majority of people never even saw a doctor. Fannie and Freddie collected fees for doing next to nothing.
Obviously, this comfortable arrangement all changed in 2008.
See upcoming posts on:
The Mortgage Insurance Crisis of 2008
and
An introduction to Mortgage Derivatives
Also, see previous posts on Mortgages:
Part I – I refinanced my mortgage and today I’m a Golden God
Part II – Should I pay my mortgage early?
Part III – Why are 15-year mortgages cheaper than 30-year mortgages?
Part IV – What are Mortgage Points? Are they good, bad or indifferent?
Part V – Is mortgage debt ‘good debt’ A dangerous drug? Or Both?
[1] My managing editor (aka wife) points out that nobody outside of Wall Street or farmers knows what commodity futures are either, so my analogy is about as useful as a bicycle is to a fish. But since that is an analogy everyone remembers from that U2 song, at least we have some pop culture reference in here somewhere. Right then, so, we cool?
[2] Which, again, I can’t really explain if you still have no idea what I’m talking about. But remember the orange juice plot line in Trading Places? That was the futures market for another commodity, recently explained here. The price of the future bond fluctuates in anticipation of future supply and demand. Like the most active part of the mortgage bond market.
[3] “Conforming” is distinguished from “Jumbo” mortgages by size. In most cases the current conforming loan needs to be smaller than a set limit, currently somewhere between $417K and $625,500 depending on local real estate prices.
[4] All securities get assigned these registration numbers for tracking purposes.
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