India-First-Global-Insights-Analysis -Sharing-PlatformIndia-First-Global-Insights-Analysis -Sharing-Platform

Disaster in Making: Role of Monetary contracts in creating mortgage crisis

, May 24, 2019, 0 Comments

mortgage-crisisMortgages purchased by Fannie Mae and Freddie Mac were sold in the market through Securitization – a financial mechanism under which various contractual debts/loans like home loans, auto loans, credit card debt/loan obligations, etc. are pooled together into a single contractual debt by a securitizer and converted into financial securities like bonds carrying a rate of interest, at face value, duration etc., and sold in the market to various investors. This mechanism was developed to promote liquidity in the marketplace.

Read: Disaster in making: Financial crisis, Excessive borrowings & distorted financial modelling

In the second part of the series, we will understand how the complex financial instruments whose objective was to reduce the risk to the banks were created, and which later on became objects of greed and ultimately the reasons for the fall of the banks giving birth to the crisis.

Mortgage-backed Securities (MBS) was created out of a pool of only mortgage/home loans and sold to investors in the form of mortgage pass-through security or participation certificate. From 1970 until 1983, Fannie Mae and Freddie Mac issued only pass-through certificates guaranteed by Ginnie Mae.

But this structure has limitations – Ginnie Mae guarantee was available to relatively few mortgages, like the FHA (federal home agency, a US govt. Agency like National Housing Board in India) and VA (a US govt. Agency for veterans – ex-servicemen and their spouses, etc.), mortgages and the mortgage pool, thus formed should be homogeneous – same principal amount, interest rate, maturity period, same credit quality, etc. Also, there was a risk of prepayment – borrowers repaying the loan amount before maturity. This, prepayment risk was instrumental in developing more sophisticated types of MBS.
In June 1983, two investment bankers – Salomon Brothers and First Boston, helped Freddie Mac to introduce a new kind of sophisticated MBS – Collateralized Mortgage Obligation (CMO). CMO allowed the heterogeneous mortgages to be pooled together – different interest rates (adjustable or fixed), different maturities, different qualities (prime, sub-prime, Alt-A, etc.), etc. The cash flows from the pool – interest and principal –were sliced into various “tranches” based on the seniority, typically divided into three tranches: Senior, Mezzanine, Equity or Toxic. The payments – interest and principal are paid seniority-wise.

Once the senior most tranche securities are paid-off, and then its the turn of next junior one will start, and so on. However, each ‘tranche’ security should be first rated by a credit rating agency like S&P. Senior tranches consist of securities with a credit rating of AAA to A, Mezzanine with BBB to be, Equity with much lower rating or no ratings. Senior tranche being a AAA to A rated, it is  considered to be much safer as they signify low default risk, so this tranche carries a less rate of interest compared to other tranches, while equity or toxic tranche has high default risks, so this toxic tranche securities carry a high rate of interest.

Since 1980s, after the growth of MBS and CDOs, the securitization of the mortgage market increased considerably. At most of the mortgage companies, the mortgages were originated with the intention of selling them to Securitizers (Originate-to-Distribute (OTD) model). The majority of the securitization was done by the three GSEs. The contribution of the GSEs to securitization of mortgages is astonishing: in early 1908s, agency MBS represented approximately 50 percent of the mortgage market, went up to 64 percent by 1992 and a 73 percent by 2002.

However, after 2002, the mortgage as well as securitization market changes dramatically, with non-agency MBSs representing 15 percent in 2003, 23 percent in 2004, 31 percent in 2005, 32 percent in 2006, and overcoming agency MBSs – 56 percent in 2006. A large portion of this issuance consisted of subprime and Alt-A loans. Non-prime mortgages were only 14 percent of the total mortgages in 2001 and it jumped to 48 percent of the total in 2006. Many of these subprime loans were of adjustable rate loans, due to be reset in the period 2007-2009, which played a part in the advent of the financial crisis of our time.

The actual cause of the financial crisis was the expansion and build up of unregulated financial instruments during the crisis. These are complex financial products whose value are derived from an underlying asset or index. A good example of it is a mortgage-backed security.