Our economy is reeling because many borrowers are failing to make their mortgage payments. This undercuts the value of mortgage-backed securities, which, in turn, threatens the solvency of large financial institutions.
The irony is that the mortgage-related securities at the core of the crisis were designed to solve a very different problem, that of borrowers paying off their mortgages too soon rather than late or not at all.
A bit of history helps. For decades, local banks or savings and loan associations made mortgage loans. The usual requirements, including 20 percent down payments and 5-year terms, protected lenders.
Most borrowers could not pay off a house that quickly, so mortgages had big balloon payments at the end. All parties expected homeowners then would take out new 5-year mortgages to pay off what was left on their old ones. The effect was a system of mandatory refinancing at 5-year intervals.
The down payment protected the lender against loss of principal if the buyer defaulted. Foreclosed property usually could be sold for more than the balance due on the mortgage. Limiting the term to five years made a lender’s loan portfolio more liquid and protected it against unforeseen economic conditions like inflation. Prepayment penalties ensured a predictable stream of income to the lenders in case interest rates dropped and borrowers were tempted to refinance.
The problem was that historically the nation went through a pronounced business cycle. Whenever there was a bust, credit would be short. Honest, solvent borrowers who had never missed a payment would nevertheless find it impossible to refinance their loan. This led to foreclosures and hardships.
The problem was especially severe during the Great Depression. By some estimates, one fifth of all households were foreclosed on in the 1930s.
Congress established the Federal National Mortgage Administration to buy mortgages from depository institutions so they would have cash to make new loans. It also set up the Federal Housing Administration to insure home loans against default. The post-World War II GI Bill gave the Veterans’ Administration similar power. The Government National Mortgage Association and the Federal Home Loan Mortgage Corp. were set up with slightly different mandates to accomplish the same general goals.
These institutions pioneered the process of securitizing mortgages. “Pass-through mortgage securities” were the first model.
Banks and savings and loan institutions still made mortgage loans. One of the new government-sponsored agencies would then buy the loans and form a pool. It would then sell bonds to investors. Each bond gave the owner the right to a fractional share of the income from the pool of mortgages.
As principal and interest payments came in, the securitizing agency doled the money out to bondholders. If borrowers prepaid their mortgages or if anyone defaulted, all bondholders participated proportionately. But default losses were essentially zero since the mortgages were federally insured.
Early prepayment was the greater risk. Lenders prefer some certainty about the return they will get from a loan. If you loan $10,000 for 10 years at 8 percent interest, you want to be able to count on getting $800 in interest income for that period. If interest rates drop to 5 percent after a few years, and the loan is refinanced at the lower rate, you will only get $500 from re-lending the money.
Generally, if you buy a treasury, corporate or municipal bond (except for a few that can be “called”), you can count on getting the promised interest until the bond matures. If you make a mortgage loan and interest rates drop, borrowers will refinance. You will be left sitting with your money and no good place to put it.
Simple mortgage-backed bonds were thus riskier than traditional bonds. One way to solve this was to create more complex securities. Instead of a batch of identical bonds, all with the right to exactly the same share of mortgage payments, securitizers created a set of bonds with slightly different terms.
All paid periodic interest, although not the same rate, but the principal payments, including any prepayments from refinancing, went to one set of bondholders first. The bonds perceived to be the riskiest got the highest interest rate. If that group was all paid off, principal payments would then flow to each next group in turn. The last group to get paid was the safest group, the closest to a traditional bond.
By creating separate groups, or “tranches,” of bonds, issuers made these securities more competitive with other investments. Those most willing to take on prepayment risk could do so, and get paid for it. Those less willing could choose lower risk if they were willing to accept lower reward. It was a triumph of financial engineering. It was soon extended to other mortgages where the risk was that of default rather than prepayment. Although today’s mortgage securities are set up differently, that was the slippery slope that brought us to where we are now.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.