I thought it might be helpful to summarize some of the background on how we got into our present mortgage mess.
Once upon a time, when you needed to borrow money to buy a house, you went to a bank (in the old days it was often called a “savings and loan”). The bank gave you the money you needed to purchase the house (indicated by the green arrow in the figure below), and you promised to repay the bank, with interest, over a certain length of time (red arrow).
Today, it is quite uncommon for the bank that originally made the loan to you to be the institution that actually receives your interest payments. Instead, those payments are likely going into a pool from which mortgage-backed securities were created by the government sponsored enterprises Fannie Mae or Freddie Mac, or, particularly in the last few years, arranged by large private institutions such as Countrywide Financial or Wells Fargo (the light blue “asset-backed securities issuers” in the graph below).
This process of securitization of household mortgages was associated with a tremendous increase in the total volume of U.S. mortgage debt, which grew three times as fast as GDP over the last decade.
I’ve created a schematic figure below to summarize the major flows that characterize the process whereby your monthly mortgage payments get turned into a security. The money with which you paid for your house came from a “mortgage originator”– ours came from Norwest Mortgage. The originator took your promise to make monthly payments and sold the rights to receive those payments to an “arranger”– probably Fannie or Freddie, if your mortgage qualified as one GSEs would buy, or to a private arranger if not.
But the arranger wasn’t interested in hanging on to the loan, either. In the case of many private arrangers, they in turn set up a separate legal entity (or “trust”) to which they sold the loan. And where did the trust get the money to pay the arranger? That money came from investors in the trust, who could have been anybody– pension funds, banks, or general investment funds. As a technical aside, these investors often let a separate fund manager make the actual decision of where their dollars got invested, a finer point that will make an appearance shortly when we get into what went wrong with this system. But before getting into any further details, you can get the big picture by following the money (green arrows) in the diagram below. When all is said and done, the cash you delivered to the seller of the house ultimately came from an investor at the far end of the chain.
In return, the trust is making payments to the investors not just out of the mortgage payments you make, but pools them with a large number of other borrowers. A given pool of mortgages was divided up into “tranches”. The way in which this is done can be fairly complicated, but the basic idea is pretty simple. Each tranche would make specified payments to investors over time according to a certain schedule, with every tranche meeting all its payments if all of the original mortgage borrowers make their payments on schedule. If some households in the pool default on their mortgage payment, the trust would be unable to make the full payments on all of the securities, and any shortfalls would be borne by the most junior tranches. For example, if the mortgages end up collecting 90% of the payments promised by borrowers, then the buyers of the securities in the top 90% of the tranches would receive 100% of what they were promised and those in the bottom tranche would get nothing.
Federal Reserve Bank of New York economists Adam Ashcraft and Til Schuermann have a very interesting new paper (hat tip: CR) in which they describe this process and what went wrong. Among other contributions, the paper investigates details of the securitization of a pool of about 4,000 subprime mortgage loans whose principal value came to a little under $900 million and which were originated by New Century Financial in the second quarter of 2006, a small part of the $51.6 billion in loans that the company originated in 2006 before declaring bankruptcy in early 2007.
A striking feature of this pool of loans is the magnitude of the increase in monthly payments to which borrowers were agreeing even if there had been no change in the LIBOR rates to which the “adjustable rate” mortgages were keyed. This increase would result from the 2/28 or 3/27 “teaser rate” feature of the vast majority of these mortgage contracts, according to which the borrower would be virtually certain to need to make a huge increase in the monthly payments within two or three years. Ashcraft and Schuermann calculate that the monthly payments that the recipient of the loan is supposed to pay were scheduled to increase by 26-45% (depending on other details) within 2-1/2 years of the loan being issued, even if LIBOR rates held steady at their values at the time the loan was originated, and by which time the total principal owed would have increased substantially relative to the sum that had originally been borrowed. One has to wonder what circumstances one would be counting on to expect such payments to be made on schedule from a pool of borrowers with a history of other credit problems.
A second remarkable feature of this pool is the high credit rating assigned to all but the most junior tranches. Out of the $881 million in original mortgage loans, there were created $699 million (or 79% of the total) in “senior-tranche” mortgage-backed securities that received the highest possible credit rating (AAA from Standard & Poor’s or Aaa from Moody’s). Only $58 million (or 6-1/2% of the total) received a rating as low as BBB or Baa. There is no reason to believe this is unrepresentative of the nearly half trillion dollars in subprime mortgages that were securitized in the U.S. in 2006.
It’s now clear to everybody that most of these loans should never have been made at the terms that they were, and that a good deal of money is going to be lost by a good number of people. As the multiple arrows in the above diagram attest, there were plenty of individuals who could (and did) make some serious mistakes in this whole process. Ashcraft and Schuermann catalog these and inquire how we might prevent these problems in the future. At the top of their list of “informational frictions” that contributed to the subprime debacle is the one that so far has received the most attention from the media and legislators, namely that between the originator and the borrower. To the extent that the originators just resold the loans before the problems came home to roost, the originator had an incentive to misrepresent overly complex instruments to financially unsophisticated borrowers. The authors’ proposed resolution of this problem is “federal, state, and local laws prohibiting certain lending practices, as
well as the recent regulatory guidance on subprime lending”.
Second on their list of the most important frictions is one we have long been emphasizing here, namely that between the investor and the fund manager. To the extent that fund managers are evaluated on the basis of recent performance subject only to ratings guidelines, there is an incentive for managers to invest the funds in the riskiest vehicles that somehow manage to get a AAA rating. Ashcraft and Schuermann recommend that the investment mandates of any managed funds be rewritten to note the distinction between the ratings on corporate debt and those on artificially structured securities.
Ashford and Schuermann discuss a great many other informational frictions in the whole process that have also been widely discussed elsewhere, including inadequate equity stakes on the part of the originator and arranger, and need for different guidelines and procedures for the rating process. The authors nevertheless note:
We suggest some improvements to the existing process, though it is not clear that any
additional regulation is warranted as the market is already taking remedial steps in the
Still, it’s useful to have Ashcraft and Schuermann’s careful summary of exactly what wrong, perhaps not so much in order to tell us to close the barn door as to understand just how all those cows got of the barn.