There is plenty of argument over what caused the economic tailspin we are encompassed in, but there is no argument the Mortgage Backed Securities played a major role. If we look into the mechanics of the predicament rather than getting caught up in the emotional or paradigm reasoning, maybe we can come up with a cause that makes some sense.
The dollars and cents behind these specific securities are no mystery. Mortgage Backed Securities are simply collections of mortgages that make payments to the owner or group of owners of the security. They are house payments directed to the mortgage holders, just like a traditional mortgage, with a set time span and set or variable interest rates. The framework of the security itself has at times been described as "too complicated for any of us to understand" but this is usually uttered by someone trying to keep the mechanics from the public at large.
Banks that were involved in these transactions weren't doing anything different from their usual mode of operation. They never use their own money anyway; they utilize the depositor's money. The depositor is paid an interest rate below the interest rate levied on the mortgagor [borrower] and the bank collects the significant difference. In the case of Mortgage Backed Securities, the money is siphoned not from the depositor but from the investor[s] who purchased the mortgage securities.
Traditionally, the bank would hold a home mortgage for its duration, but with the advent of the MBS it became more profitable to sell the mortgage. Many corporations, such as Fannie Mae and Freddie Mac, but also investment firms like Goldman Sachs and eventually all the big buck players would purchase these mortgages and group or "bundle" them together into securities. The original bank itself could also perform this task if they desired and had the capability. The bank now became solely a "broker", collecting a fee for providing the borrower and processing the loan. This freed up their depositor's funds for other purposes, including fattening their reserves which widened their ability to undertake quantities of loans as opposed to quality.
Once bundled, the securities would be rated. As odd as it may seem, ratings companies such as Moody's, are contracted and paid by the corporation that is hoping to market the security. There is no need to expound on why this just doesn't work. The other weakness of the rating system is the "natural" monopolies that have occurred. Since a market needs a "trusted" company to perform the rating, there can never be true "competition". It is extremely difficult due to the need for a "trusted" rating, for a "new" rating organization to take hold. Who would value an opinion when it is the rating company's first? So we can conclude that there wasn't a failure with the rating system but that the rating system itself is inadequate and doesn't perform its function. The MBS is but one example of the failure.
The rating system did have a big effect when assets values began to decline. The Credit Default Swaps which were half insurance, half wager on the MBS's, have a clause in their contract that calls for posting collateral if the rating of the insurer declines. AIG, which had their "generous" accounting questioned before, were downgraded from top dog because of their declining assets and were called on by their clients to pony up collateral for their countless Swaps. They didn't have the funds and this is where the government stepped in with the first multi billion dollar bailout.
Once the security is rated there are throngs of investors, corporations, individuals and groups or mutual funds that long to purchase the MBS. At this point, it is important to ask why? What made the MBS and the mortgages contained within it more desirable to these investors than it was to the original banks? Economic logic tells us that they must pay more than they are worth to the bank; where can we find this value?
We have heard over and over that they were too difficult to understand and this caused the problem. That is total bull. If it were true, then fraud had to be widespread or everyone was nuts at the same time. It is impossible for all of these securities to be too difficult to understand and yet for all of them to arrive at the same end, investors longing for their risk and return. If they were not comprehensible, and because of this the risk and return was not what everyone believed it to be, then either everyone was crazy and performing crazy action at the same time, or someone was lying to everyone. Neither of these scenarios is probable.
One of the fundamental sources of the problem is the availability to the banks of below market rate money. The banks are a primary source of the Federal monetary releases. When new money is created it goes to the privileged banks and investment banks. What is experienced is inflation not of prices but of the money itself, or you could say the price of money. The money is worth less to the banks and the security creators than those next in line, the investors. The investors, rooted to monetary value of the recent past, perceive the securities as more valuable than those who created and marketed them, due solely to the issuing and direction of new money.
This is not to say that with sound money and real natural interest rates that banks would not act merely as "brokers" and sell the mortgages as they are finalized, but that banks would be making an economical choice based on all market conditions rather than on one condition; endless supply of cheap money.
Another money "source" to consider is the investors. Where did this money come from? Much of this also came from the Federal Reserve. Investment banks not only created these securities but gobbled them up. Primary receivers of federal funds need a good place to spend this cheap money, something with a high return. The Fed currency itself is a terrible investment, since it diminishes in value as the clock ticks. Every dollar the Fed imagines into the economy belittles the one before it, so the sooner they are transformed into something that appears to be more tangible the better.
Another fallacy that we are smothered with about this whole affair is that "great wealth has been created [by the "miracle" of Capitalism] in the developing nations [such as the Asian region] and this wealth needed a place to settle". Translated back into reality; "great amounts of fictitious paper wealth has been created by the world banks and governments, and the American consumer, who received a large portion of this paper creation, spent most of it on Asian products".
This provided Asian investors with massive quantities of dollars to invest, but why would they choose these bungled, I mean bundled securities?
In a natural economy, developing countries are strong magnets for capital. They are growing, have inexpensive labor and are always short on funds. Interest rates are high and should lure capital in, augmenting growth. But if you toss "fiat" currency into this soup, overseas interest rates are interwoven with currency production. If your nation is printing lots of dollars then interest rates have to increase proportionally to compensate for differences in foreign currency exchange. Earning ten percent over six months means little if the currency doubles every three months. Encourage every nation to print at will and you can imagine the investment mess that is created.
Apparently, Asian investors express greater "faith" in the American fantasy economics than their own. An emerging nation like China, with more than a billion citizens and so much need still chooses to "return to sender" much of the capital it received from the US consumer and invest in American securities. The MBS possessed not only good returns [especially in light of artificially suppressed central bank rates] but the promising collateral of American property. Very enticing!
Interest rates also played a dominant effect on the securities themselves. The MBS is most alluring when interest rates are at their lowest. When rates are high, banks tend to favor keeping the guaranteed high return of the mortgages and subsequently want a better commission if they are sold. The upfront costs then become prohibitive to the investor but the risk also increases. Homeowners with higher interest mortgages will refinance when rates drop. If the MBS contains high interest mortgages, it is probable many will be "pre paid" when rates drop as homeowners refinance. This represents a "loss" of interest and possibly principal to the investor, since each mortgage in the security originally cost the investor more than the principal value of the mortgage.
It is the artificially suppressed interest rate that prompts the bank to dump the long term mortgages and the investor to purchase them as bundled securities. Rising home values has the simple effect of limiting foreclosure, which as we are witnessing can so destroy the value of the MBS. The increased housing value, spurred by cheap money and low rates, is realized on paper by the homeowner and stimulates increased home ownership if cheap loans are available.
But eventually this artificially stimulated "value" grows too high. The list of potential homeowners, even with relaxed standards, runs low and the conclusion is reached that prices are inflated and must get back to reality.
Foreclosures ensue and the MBS loses its return. So what, certain investments are losing value, happens all the time, what is the big deal?
The plot thickens! The MBS is often "insured". Insurance paves the way for greater investment as risk is supposedly lessened. Giants like Fannie Mae or AIG backed the mortgages and the securities. The problem with this is not really lack of regulation, etc, but that the concept of insurance in our modern economy is quite convoluted.
Insurance firms offer to pay the balance when for instance, a borrower stops making house payments and foreclosure occurs. They do this by "pooling" the risk and calculating a percentage of the total value that they will need to meet the risk that will incur. This is referred to as the reserve; problem being, besides the complexity of the basic calculation, the reserve is unreserved. It is invested and subjected to risk itself through the same marketplace that is responsible for the original risk.
When the slide started not only did insurers not expect the risk that they were supposedly insuring, but the value of their reserves were being dumped by the markets. This is the point in which the government, the ultimate insurer, declared some of these corporations "too big to fail".
Now that we mention "corporation", their role must be taken into consideration. The phrase "too big to fail" can be translated, "corporations have limited liability but unlimited leverage and because of government protection have grown to such a size and interwoven their tentacles with themselves and everything else so much that in the event of insolvency the liability that would be socialized to government and the rest of the economy because of their failure might spoil things a bit!".
We also have the fact that the Corporate Socialist system itself was threatened and those in control weren't ready to let something else step in and fill the vacuum that would have resulted from corporate insolvency. We also heard "we are doing this for the good of all" which translates, "you all are going to pay for this!"
These securities now have little value and are referred to as "toxic". The Fed is feeding the banks and insurers hundreds of billions of dollars. This is simply using taxpayer funds to eliminate the risk of corporate investors. The government is also trying to rekindle the return of these toxic assets by dumping hundreds of billions into the economy any way possible. They are hoping reinflation will return things to where they were, an overheated economy built on overvalued assets.
In a way, the downturn was a lost opportunity. Although much hardship would have also been experienced by average folk, the demise of several swollen mega conglomerate monopolies could have been very beneficial in the long term. It's doubtful we were ever really facing total economic collapse but we certainly were on the verge of an economic realignment. With the actions taken, and similar actions that will continue to be taken, the possibility of real economic reform and better market equity grows dimmer by the billion.
Related Articles by Author:
The Land Value Fee, Why It Works
Non-Socialized Responsible Non-Investing
Theories of Value and the Recent Downturn
Banking Part Three: Investment
Deflation the Great Wealth Builder
©2009 Gene DeNardo, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Wednesday, March 11, 2009
Last modified: Wednesday, March 18, 2009
The views expressed in this article are those of Gene DeNardo only and do not represent the views of Nolan Chart, LLC or its affiliates. Gene DeNardo is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
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