A mortgage bond is a bundle of mortgages packaged together and sold as a bond. The way it works is simple: A mortgage lender, usually a bank, lends money to an applicant to buy a home. They then sell the debt to an investment bank. The reason a bank sells their loans is that it takes them off their books, which enables them to lend again. The laws which govern banking practices require that the bank keep a sufficient amount of assets in reserve in case their loans go bad. Each loan would make more money for the bank if it went to maturity, but in passing the loan along the bank can now re-lend against the same assets that were held in reserve for the previous loan. Say for instance a bank has nine million dollars in reserve, by law, believe it or not, it can create up to one-hundred million dollars in new money for loans.[1] According to the Federal Reserve Bank, this generous ratio is enough to keep the banking system liquid as it is unlikely that all the banks loans would go bad at the same time. So if the bank has two, fifty- million dollar loans out, it cannot lend again until at least some portion of these loans are repaid. They net a smaller profit from selling the loans off, but it means they can lend again.
More often than not, the loans are purchased by Fannie Mae or Freddy Mac. Fannie was created by FDR as part of his New Deal banking reforms. It was a government agency, whose purpose was to buy debt from banks and allow them to re-lend. The program was extremely successful, so much so that it was privatized under Bush family protege, Richard Nixon. Today it, and Freddy Mac which came later, are Government Sponsored Enterprises ( GSE ), which means they are private corporations which are under a government mandate to serve a particular purpose in the public interest.
In the 1980s, Lew Ranieri of Salomon Brothers Wall Street investment bank came up with the idea of compiling bank debt and selling it as a bond. Hence the mortgage bond was born. The idea was simple: Buy a thousand or so mortgages, put them together, and sell them as a security. The bond-holders would get paid as the mortgages got repaid.
A great idea but there were problems unique to selling mortgage debt as bonds.
1, The bond which contained a thousand or more mortgages was going to be quite expensive, and would price most buyers out of the market.
2, Usually a bond is issued by a single institution, be it public or private, then given a rating by rating companies, then bought by the public at a price commensurate with the rating. The best bonds are rated AAA, these are the safest bonds one can buy, so the rate of interest offered by the issuer doesn't have to be so high. Lower rated bonds are riskier, consequently the rate of interest the bond pays has to be higher in order to induce the public to buy them. In the case of the mortgage bond, the risk incurred by the buyer was dependent on the ability of home-owners to pay off their debts. In some cases, as we shall see, such as when the loans were "prime," determining risk was quite easy. However, when these bonds contained sub-prime loans, the overall risk of buying such a bond was a tricky calculation based on the likelihood of a thousand individual mortgages being collected. The usual metrics the rating agencies used were not applicable to these new mortgage bonds, there was a lot of guesswork involved.
3, Another problem for the investment banks hoping to sell mortgage debt to the bond-buying public was the uncertainty of how long it would take for these bonds to mature. Typically, the term of the bond is known in advance. Their lengths vary greatly, and is taken into consideration by the prospective buyer. You buy what you want. In the case of the mortgage bond, some homeowners might pay off their mortgages early, which, from the point of view of the bond-holder, was undesirable.
If you buy a bond, you want to hold it for awhile. If your bond gets paid off early, you have made less from your investment than if it had gone to term. This is particularly problematic for a bond derived from mortgage debt as the mortgages were more likely to be paid off prematurely when bank interest rates were low. If a home-buyer takes a fixed-rate mortgage at five percent interest and rates subsequently drop to four or three percent, then he or she would do well to take out another loan to pay off the first and save thousands in interest. For the holder of a mortgage bond this means that one of the underlying loans has been paid off and part of your investment is now gone. To make matters worse, one cannot turn around and re-invest one's profits from the paid-off bond into a new one as the drop in interest rates which caused the premature pay-offs makes for a lousy bond market.
Why? If you are a business or government agency, and you want to raise some money, you can go to a bank and borrow, or you can issue a bond. If bank rates are low, borrowing makes more sense. If bank rates are high, and you think you can sell a bond with a lower rate of interest than you would have to pay a bank for a loan, then the bond is a better bet. Low bank rates kill the bond market as under those circumstances there's no reason to issue bonds. Homeowners refinance when rates are low, not a good thing if you are holding mortgage bonds.
Fortunately for Ranieri and Salomon Brothers, the rise of mutual funds provided the solution for the first problem, but created another.
Mutual funds are just that--mutual. Around the same time as Ranieri was contemplating the mortgage bond, investment banks began to offer mutual funds. These are pools of money into which anyone can invest. The funds themselves then buy stocks, bonds etc. This made it possible for people who were not rich to invest in a broad range of securities. It also made the purchase of fairly expensive items more feasible. Mortgage bonds could be bought by anyone who could afford them, but now they could be bought by investors who really couldn't afford them on their own.
Great news for Ranieri but there was still another hurdle: If mortgage bonds were to be collectively owned, how would redemption work? Say a mutual fund with a thousand investors in it buys a mortgage bond which included a thousand mortgages, would each mutual fund participant own a single mortgage within the bond? This wouldn't be feasible because these bonds would be owned by the fund collectively, not by individuals within the fund, otherwise it wouldn't be a mutual fund. If the bond was collectively owned, how would it be determined whose investment would be ended first if and when a mortgage was paid prematurely? The obvious answer would be for all the fund's participants to bear the loss equally but this would make it hard for funds to buy mortgage bonds as investors might not be willing to accept the depreciation of the bond in this manner. Some would want greater protection or would see these bonds as not a good investment vis a vis non-mortgage bonds.
Cleverly, Ranieri came up with a solution: Mortgage bonds would be sold in "tranches" ( French for "slices" ), and each one would be backed by just a handful of mortgages within the bond. Mike Lewis'[2] analogy is that of a sky-scraper in a flood plain. Buying the first tranche of a mortgage bond was like buying a condo on the first floor, you were more likely to be flooded--having your investment end due to prepayment of the underlying mortgages--so the rate of interest paid on the first tranche was a little higher. You were exposed to more risk, but had a greater reward. As the tranches progressed--being higher in the building--your risk of being flooded out declined and so did your potential pay-off.
In addition, it was determined that the flow of money that would result from homeowner prepayment of mortgages would be distributed in a pay-as-you-go manner. The owner(s) of the first tranche would receive payment when all of the mortgages which comprised the tranche were paid by the homeowners. In such cases where only some of these mortgages were prepaid, the the holder(s) would receive payment on that percentage of the loans which were prepaid and the rest of the investment would continue until all of the mortgages were paid. This offered investors the opportunity to be part of the riskier, higher pay-out tranches, or, for those more conservative, they could buy into a safer tranche.
It worked brilliantly, Mortgage bonds became very popular with bond investors. At this initial stage all the loans underlying these bonds were prime. These were the kinds of loans bought from mortgage buyers by Fannie Mae. As such, the loans were guaranteed by the GSE. If somebody actually defaulted, Fannie would take possession of the property and pay off the loan. This being the case, these mortgage bonds were as close to a sure thing as a bond can be. They were better than AAA, and quickly gained the reputation of being the safest investment one could make.
This would change with the advent of sub-prime lending. Which will be the subject of the next article in this series.
[1] For a more detailed explanation, please watch the video entitled Money as Debt linked on the right column of this blog.
[2] From his book The Big Short
