The mortgage market used to be a segregated, regional, illiquid and low margin but simple business. Local banks, acted as originators, and used to lend money to home buyers, hold the titles of their houses as collateral, and profit from the spread between higher mortgage rate received vs. lower interest rate paid to depositors.
In the good old days, mortgage lending officers were more careful to review and approve mortgages from homeowners. They evaluated the financial situation of mortgage applicants carefully on things such as household income, job security, total debt, net worth, and monthly obligations. Banks were more stringent in their lending practices, kept a close eye for local and regional real estate trends, and ensured enough cushion if there was an unexpected downturn.
The reason is that banks acted as both originators as well as life-long holders of these mortgages. Even though, from time to time, delinquencies and foreclosures were unavoidable, they wanted to avoid losses large enough to put them out of business. If losses happened, banks would be covered first by their spread (profit), and if that was still not enough, they would dip into their own capital and reserves. For mortgage officers, their current jobs and future careers were on the line if they were responsible for making careless loans. At that time, the home mortgage business was definitely not a lucrative one, but was a low margin and simple business like commercial banking.
However, for the last 10 years or so, the rise of home mortgage packaging, securitization and collectivization has thrown many good old practices out of the window. Local banks and mortgage companies nowadays are acting as agents, closing deals as originators, then selling the loans to large investment banks in order to earn a quick fees. Their role has changed from a loan quality controller to a salesman, doing as many deals as possible in order to earn higher commissions.
Then the structured finance groups at large investment banks collect thousands of mortgages from around the country, put them into a pool, package and securitize them, slice and dice them into many tranches (products with various credit ratings), then sell them to investors. The incentive profile has totally changed in this mortgage alchemy process. Who cares if a couple years later the loan is delinquent? Maybe I am the originator, but it is your problem.
This has created some very innovative and aggressive practices in mortgage lending, since the key to earn a fee here is volume, not loan quality anymore. This is similar to house flipping during the real estate bubble. When house price goes up 10% a year with no payment down, who doesn’t want to buy a multimillion house which can be flipped for a quick profit? Same motivation for the originators. The faster they finance and flip to sell a loan, the more money they can earn.
One day, a few smart people came up with a revolutionary idea called "subprime"; basically anyone with no income, no credit, no down payment, no nothing, has no problem to buy a house at almost any price. Or even better, anyone can get a loan for 110% equity of the house's appraisal value (since housing prices are going up 10% a year anyway). Not only is there no down payment, there is actually "free" money to be made by buying a house. It is such an ideal society, better than anything Karl Marx could have ever imagined.
More importantly, this securitization revolution has also brought many more players and their capital into the mortgage market. Instead of only local and traditional banks, which have a very limited capital base, lending money, we now have investors with large capital bases coming into this casino to make large bets. They are insurance companies, hedge funds, corporate and state pension funds, endowment funds, foundations, fixed income mutual funds, foreign central banks, foreign large commercial banks, the so-called 144A “sophisticated” (now we know how sophisticated they are!) financial institutions which are "qualified" to bypass any regulatory requirement and oversight.
Suddenly the pool of available capital is 100 times bigger than before. Coupled with next to no mortgage lending requirements, how could house price not go up? Since the 1970s, the median home price/median family income stayed at 2.8 most of the time, until 1999 when securitization just started and the figure has suddenly taken off all the way to almost 4 in 2005 to 6 a year's time: over 3 standard deviations.
As I mentioned earlier, this used to be a low margin and simple business in the good old days. But lately, before the collapse of real estate, every seller in the process of flipping mortgages got a cut, with the largest cut going to the structured finance group at Wall Street. Suddenly the home mortgage business became a lucrative and highly profitable business. Where did all this "free" money and high margins come from? I have seen many articles discussing subprime and MBS, even the very questionable lending practices, but I have read few articles explaining how and where this large profit was created. I want to provide a couple of my thoughts here.
- Value was "added" or rather mispriced by pooling many mortgages across the country together in the securitization alchemy process. This is based on the argument that the sum of the portfolio is larger than its parts.
I use the S&P as an analogy here. To obtain the fair value of the S&P500, there are two ways to do this. One way, which I refer to as the correct way, is to evaluate each company separately by studying their financial statements, talking to management, attending earning calls, trade shows and industry symposiums, and building NPV models to come up with the fair values of all these 500 companies, then capital weight them to derive the fair value of S&P 500 Index. Even there are errors and biases here and there, but hopefully they offset each other and are canceled out at the end of the day.
Another way is to build a complex macro econometric computer model, download all the historical financial data, make assumptions on macroeconomic factors such as business cycle, interest rate, profit margin, earning increase, GDP growth, job market, payroll, inflation, etc. A lot of the modeling is to calibrate or forcefully fit historical data and trend into the model. This is what Abby Cohen at Goldman had done to forecast S&P earning and price target every year. This is not bad in bullish years since it is basically a trend following approach, but it would create bad calls during major economic turning points when future economic behavior is out of sync with historical data.
It is the same story, but with a much worse result, at the home mortgage securitization desk due to the lack of transparency and due diligence process (unlike the stock market.) When the structured finance group dumps many mortgages across the country into a pool, its aggregate price becomes more subject to the US real estate market assumptions including time frame models, historical data of delinquency, and default and payment patterns.
It is a big question of whether even the original mortgage data is correct due to questionable or fraudulent lending practices. In the model, I bet the delinquency and foreclosure rates were very low, and interest rate assumption was low so refinancing would never be a problem. They probably also assumed that US real estate had always been on an uptrend, never a down year for US as a whole since the Great Depression (this common myth was not true either, unless the data had been smoothed), and this uptrend would go on forever. Well, until 2007. Good times always end.
In the subprime area, it could not be worse. Without even getting into the fraudulent lending practices, there was no subprime 10 years ago. There is little historical data except from the last several years. How would the structured finance group at Wall Street come up with a reasonable estimate of default rate and payment pattern for the next twenty years? By assuming real estate will be up 10% every year forever? Or just grabbing a number in the thin air? These distorted assumptions dramatically amplify the nonlinear behavior on the pricing of the aggregate mortgage pool.
All this would not have happened in the good old days, when a loan officer did due diligence one borrower and one house at a time, similar to many stock analysts doing research on 500 S&P companies. This new alchemy process of mortgage securitization offers no transparency, no due diligence and makes no common sense at all. Investors basically let them twist the computer model to come up with whatever they think the future should look like, always resulting in higher aggregate price than the sum of its parts.
Another argument used repeatedly is the benefit of owning a diversified mortgage pool, so investors should pay a higher premium. A pool does offer lower risk, since mortgage investors are diversified from specific local and regional real estate markets but are subject only to general US real estate risk. This is similar to the fact that stock investors who invest in over 25 diversified stocks have diversified away most company-specific risk but are subject only to general market risk. However, why should investors pay a higher price for the pool? When stock investors buy more companies to construct a diversified portfolio, why would they have to pay higher price for each company per share, just because they are buying more than one company? This doesn’t make sense either.
II.. When structured finance groups slice and dice mortgages into many tranches in order to sell them, each tranch (product with a specific credit rating) is manipulated to create a price higher than it is actually worth, and thus further squeezes additional profits. This is based on the argument of charging a higher price premium by customizing products for customers with different risk profiles.
Through the magic hands of Wall Street banks, there are so many tranches being created, sometimes it is stripping out embedded options, another time it is a derivative on top of another derivative, called whatever squared or cubed, in order to squeeze more fees out of the pool. The more products, especially the more exotic products the banks can create and sell, the more profits for them.
Let us just look at the two most common derivatives of MBS: IO (interest only) and PO (principal only). Investors of IO vs. PO would only have rights to the interest payments vs. principal repayments paid by borrowers. IO will fall if the rate goes down, since more borrowers will be refinancing (no more interest payment to the original loans anymore), so called negative duration. PO is totally the opposite that borrowers will pay them back so quickly when the rate falls and they will have a free fall of cash, or positive duration.
A small deviation of default rate, interest rate movement and especially their timing assumption on payments would dramatically change the price for them. What is the right price? Only God knows. It is basically whatever the price the computer model says, and we will trust the computer and buy their products. Who wants and has time to dig behind the hundreds of thousands of lines of programming codes to figure that out? If you feel both IO and PO are way overpriced, that is too bad, since they are not like calls and puts of stock options which are governed by put-call parity and provide investors with arbitrage opportunity. There is no way to short IO and PO and long the original pool. Talking about market efficiency!
Because of exotic and complex products like this, investors have gotten totally lost, were unable to understand the behavior and do any due diligence on the products they were buying. As a result, they have to rely on the opinion of the rating agencies and bond insurers. However, they never realized the rating agencies and bond insurers were actually in bed with Wall Street banks; not only they were paid by the banks with their revenue growth mainly from increasingly complex mortgage derivatives, but also they were all using the same computer models and assumptions, so structured finance groups could twist the models to push yield to the ultimate threshold for a particular credit rating.
No wonder mortgage derivatives could always pay higher yields than other bonds for the same rating. This alone has guaranteed that there would be no lack of yield-hungry investors from insurance firms, hedge funds (using leverage by borrowing short term repos to generate double digit return), pension funds (need to reduce their pension deficit and liability), foreign banks (too sophisticated to know what they were getting into).
At the end of the day, mortgage securitization is a sales business, and pricing of mortgage products is driven by making yields higher and more attractive for a particular credit rating. As Wall Street says, it doesn’t matter what the product really is, it is always how it is structured to make it look good in order to be sold. Now you know why the cosmetic industry has such a high profit margin by making some low cost powders and creams, since they make people look good. Home mortgage securitization makes yield hungry financial institutions and investors look good.
In order to guarantee their future profits, many investment banks bought mortgage originators to secure future sources of their fees, now they are guaranteed to secure future losses, write-offs, litigations and liabilities. The WSJ has several articles about the ongoing investigation on UBS about a Dillon Read mortgage trader being fired because he was trying to assign a more accurate price to an inflated mortgage product. Come on, be realistic, mortgage trader, if you tell people the truth, how would you still be able to sell them?
As Warren Buffett quoted a banker saying: “Why banks have to find new ways to lose money when the old way had worked just fine?” The problem is without new “creative” ways of losing money, where are all the lucrative fees, top salaries and yearend bonuses for investment banks coming from?
