I want to re-tell a story from Frank Partnoy’s F.I.A.S.C.O., but a bit of background on Collatoralized Mortgage Obligations is first in order. CMOs, and their generalized cousin Collatoralized Debt Obligations (CDOs) are the current culprits in the sub-prime meltdown, so this is probably useful to know practically as it is to know theoretically. Also, I’m participating in a conference on Crisis, Emergency, and Global Processes, and I’m thinking about incorporating some of this thinking into that. This is a long post, and kind of technical, but probably not too much. There is a nice visual at Portfolio Magazine, so if this whole primer doesn’t help, perhaps that will.
Where to begin? Well, begin at the beginning. Banks make home loans. But they would prefer (or have been convinced that they prefer) not taking the risk of holding on to those loans. It ties up capital, and individual loans run the risk of non-repayment. Banks tend to be fee-happy and risk-averse, so if they can take fees without incurring risk, they would like to do so.
Mortgages are odd ducks, finance-wise, because the US government decided long ago that there is social value in supporting home ownership. As such, interest paid on a primary home mortgage is tax deductible. At least one analysis notes that this is the third highest tax expenditure for the federal government from 2005-2009. Let me repeat this, though it is an aside here – the tax deduction for interest on mortgage payments is the third highest tax expenditure, behind exclusions for employer contributions to health care and employer contributions to retirement plans.
The way a (fixed) mortgage works is that early payments are mostly interest, with a sliver of principal; while later payments are mostly principal, with a sliver of interest. In addition, homeowners have the option of pre-paying their principal, by making an extra payment per month, for example – this reduces future interest payments, and reduces the overall cost of a loan.
What a pain for a bank! Uncertainty over how much the total loan amount will be, uncertainty over the timing of the loan. And sensitivity to changes in interest rates, since when rates go down, homeowners can take out a new loan at a lower rate, pay off the entirety of their existing loan, and ‘take equity’ out of their homes.
So, how can a bank off-load this risk, and instead of sitting on the uncertainty of existing loans, take some fees and reduce their exposure? Securitization! Taking a bunch of loans, packaging them into a single income stream, and then re-selling that income stream off to investors is one way for commercial banks to take fees from mortgages but also to get them ‘off the books’ by selling them immediately to investment banks. But how to do this financial alchemy?
By grouping a bunch of loans, it is possible to create a common income stream of monthly payments. This stream can then be packaged and sold (this is, in principle, how municipal bonds are turned into investment vehicles as well). An investment bank can transform these individual loans into streams of payments. But housing is special! Fannie Mae, a quasi-governmental institution that insures many home loans, does this work for mortgages. Here’s how it works:
As Fannie Mae describes it:
The mortgage-backed security process begins with a mortgage loan. The loan is made by a financial institution or other lender to a borrower to finance or refinance the purchase of a home or other property. These loans are made to borrowers under varying terms (e.g., 15-year, 30-year, fixed-rate, adjustable-rate, etc.); during the life of the loan, the balance is generally amortized, or reduced, until it is paid off. The borrower usually repays the loan in monthly installments that typically include both principal and interest.
Because mortgage loans may take years to pay off, lenders must find ways to replenish their funds in order to make more mortgage loans. To do this, lenders sell groups of mortgages with similar characteristics into the secondary mortgage market to issuers or guarantors of mortgage-backed securities, including Fannie Mae.
It is possible to create an income stream from one person’s mortgage, but n=1 is a bit of a problem. Even if the person seems like a good risk, what if they flake? What if they sell their home tomorrow and repay the loan immediately? Refinance? Go broke? There are too many variables with any given individual to securitize their loan. But a gaggle of owners, that’s something else. If you could pool homeowners (or mortgages, rather) into clusters with similar characteristics, then you have some degree of certainty. It is a process not unlike stratified sampling – 3br homes, similar demographics, with a dog, and we can guess that as a whole this group becomes somewhat more predictable.
Now, this stream of payments can then be turned into something with bond-like qualities.
Normally, Fannie Mae will issue a security in exchange for the underlying pool of mortgages. This is the ‘collateral’ part of the collateralized mortgage obligation. Fannie Mae will swap the underlying loans in exchange for a bundled payment obligation based on those loans – and then, Fannie Mae will distribute disparate payments into my new corporate entity. Let’s call it Peter’s Pool of Payments. PPP is the securitized version of the underlying pool of mortgages. My stream of mortgage payments has now been packaged.
For instance, I can split this security into 1000 equal shares, and sell the shares. Or I can separate payments into ‘classes’, with the first class getting paid fully before the second class, before the third, etc. Or I can split the interest and principal payments. These different kinds of mortgage-backed securities go by such names as: Grantor Trusts, REMICs, and SMBs, all designating the appropriate ways they have been classed or ‘tiered’ into payments.
This is all based on how well and to whom you could sell these shares. If you have investors who are sensitive to interest rate risk, you can have one class pay out interest from the pool of mortgages, while another class pays out principal. In theory, this means that the interest payments are more front-loaded, and more sensitive to interest rate changes. Another way to go is to tier (or tranche) the shares by default risk, so that class one gets fully paid before class 2, before class 3.
Ok, that’s it. I want to tell a story about how Merrill Lynch used CMOs – and in particular a vehicle that split a pool of mortgages into Interest-only and Principal-only financial instruments – to facilitate totally screwing some folks over. Who knows, maybe those folks are you!
(As a side-note, which has received much ink, and deservedly so, much of the sub-prime lending problems are coming because these CMOs are being used for more complicated derivative transactions** at the same time that: (a) the pool of mortgages has grown dramatically; and (b) the payment of underlying mortgages has become dependent on continually rising housing prices combined with continually falling interest rates. Since (b) has not continued, and (a) is institutionalized in our financial system, the system breaks down. This probably needs its own post. Maybe with different graphics.)
**For instance, how much should one of these CMOs, which is a 15-year pseudo-bond, be worth today? And then, how much should a future on this pseudo-bond be worth? That is, how much is the future obligation on this 15-year pseudo-bond be worth today? Derivatives on these instruments gets tricksy very quickly. At the end of 2007, Citibank had something like $50 billion in CDO exposure, UBS had $20-something billion, Merrill Lynch disclosed $27 billion.