The Mess in the US - Part I

Falling home values, growing unemployment, plunging stock prices; how did we get into this mess? Well, in order to fully understand our current economic funk, we need to go back and examine the roots of what has now been coined the credit crisis. So take a walk with me down memory lane while we explore the origins of securitized loans and unregulated swap contracts in a fascinating tail of innovation, riches, stupidity, and good ol' fashion greed.

Our story begins in an era know as the 1980's...Ronald Regan has declared war on the evil empire, Michael Jackson is better know for his music than his sleepovers, rock bands wear more makeup and hairspray than supermodels, and the S&P 500 sits at a lofty 150 points. With the stock market yielding little to no returns over the last decade and a half, the "hot money" is not in equities (stocks). The place to be if you are a big shot on Wall Street is in bonds and other fixed income products. One such product is a mortgage backed security (MBS). These securities, along with their slightly sexier cousin CMO (collateralized mortgage obligations), became the belle of the 1980's ball on trading floors across Wall Street.

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Before the dawn of securitized loans (MBS, CMO, etc.), banks and brokerages would just trade individual home loans, know as whole loans. The process of trading whole loans is cumbersome and involves a large amount of paperwork in order to transfer ownership (anyone who has ever refinanced a loan can attest to this). The MBS was designed to combat this issue by creating a tradeable security that was backed by a group of individual whole loans. The originator of the MBS typically purchases whole loans, bundles them together, provides credit for the new security (guarantees the principal and interest payments of the underlying mortgages), has the security rated by a rating agency, and then brings the new security to market where it can be traded. In addition to the liquidity benefit (being able to purchase a sell the new security with easy), securitized loans also provide a diversification benefit by spreading the risk of default over a wide group of whole loans (as opposed to buying a single whole loan and hoping for the best).

The very first MBS arrived on the scene back in the 70's when the Government National Mortgage Association (GNMA or Ginnie Mae) started bundling home loans that were being originated by various government branches within the U.S. Department of Housing and Urban Development (HUD). These branches were set up to help lower income families realize the "American dream" of owning a home by using the "full faith and credit" of the US government to back the riskier loans. The advantage of securitizing these loans from the lender's (the US government in this case) perspective is that it frees up capital, which allows the lender to go out and make more loans. As an example, let's say that I lend my friend $1,000 and she agrees to pay me back $1,100 a year from now. Assuming this is all the money I have to lend out, if someone else came to me for a loan, I would have to turn them away. As an alternative, if I could sell my loan to another investor for say $1,010, I would realize an immediate $10 profit and have my principal back to lend out all over again.

Although the invention of the MBS was an innovative way for banks to free up capital and invest in the US housing market, they still weren't a huge hit for many fixed income investors for one reason -- prepayment risk. Anyone who takes out a mortgage has the option of paying it off before it comes due. Loans can get paid off for a variety of reasons, but the most likely scenarios are a refinance when interest rates drop or a home sale. Taking a look at the first scenario, if a bank has an outstanding loan at 7% interest and interest rates drop to 5.5%, the last thing they want to happen is for the person with the 7% loan to pay it off, but this is typically the case in this scenario. If the loan does get paid off, the bank will then have to turn around and invest (by making another loan) the proceeds at the current, lower interest rate of 5.5%. What I've just described is known as prepayment risk and it is the primary drawback for investing in mortgage backed securities versus other fixed income investments with a standard, predetermined timeline for interest and principal payments. To fix this problem, the innovative minds on Wall Street came up with a more appealing securitized loan known as a CMO (collateralized mortgage obligation).

The only major difference between a CMO and a MBS is that a CMO includes different tranches to help control prepayment risk. A pecking order is established for each tranche within the CMO and investors can choose the tranche that best fits their investment objective. The tranches at the bottom of the pecking order are the first to absorb any prepayments. The highest tranche in the pecking order known as the "senior tranche" will not see any prepayments until after all the supporting or subordinate tranches have been completely paid off. Subordinate tranches are typically offered at a higher interest rate than the senior tranche because of the increased level of prepayment risk. Basically, if an investor is willing to take on more risk, they will potentially reap a higher reward (higher interest rate = higher return on investment).

The creation of the CMO security greatly pleased Wall Street bond traders as they were now able to tap the giant, relatively untraded US mortgage market with a variety of securities that closely represented a typical bond with a stated interest rate, credit rating, and predictable cash flow. The new securitized loan market combined with the equally new and exciting junk bond market gave rise to a whole new fixed income culture on Wall Street. A culture that once was reserved for old, stodgy investors had now become a Wall Street gold mine. Financial legends such as Michael Milken and John Gutfreund, both of whom were immortalized in Michael Lewis' book Liar's Poker (an entertaining and highly recommended read), saw their star's and fortunes rise to astronomical heights during this hot decade for fixed income.

So the stage is set with the roaring 80's in full swing and securitized loans growing like wild fires. In the next installment we'll take a look at Wall Street's fallout during the Savings & Loan crisis of the early 90's along with the invention of a dangerous little gem known as a credit default swap.

Frugal Franco

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