The Miracle of Mortgage-Backed Securities
In the olden days, when savings and loans (and banks) made and held mortgages on their own books, they bore the entire cost when bad loans defaulted. There was a direct link between the loans they made and their profits.
The securitization system broke that link 3 or 4 times.
Mortgage-Backed Security System
Mortgage originators. It wasn’t the job of banks and mortgage brokers to determine “good” mortgages. Their job was to make sure the mortgages they originated met Fannie and Freddie guidelines so they could sell them immediately to Fannie and Freddie. If Fannie and Freddie bought it, it was a good mortgage.
Flash Forward: Most of the predatory and fraudulent lending that happened by loan officers during the boom wouldn’t have happened under the saving and loans model where the loan officers are direct employees of companies that would end up owning the loans and taking any losses.
Fannie and Freddie. It wasn’t the job of Fannie and Freddie to determine “good” mortgages. Their job was to buy mortgages they could resell to investors as mortgage-backed securities. If investors bought them, they were good mortgages.
Flash Forward: Fannie and Freddie lowered their lending standards a spoonful at a time but investors keep buying their mortgage-backed securities so Fannie and Freddie kept lowering their lending standards a spoonful at a time.
Ratings agencies. It wasn’t the job of the rating agencies to look at the individual mortgages in mortgage-backed securities. Their job was to take the information Fannie or Freddie gave them about a particular mortgage-backed security, run it through their mathematical models, give it a rating, and get paid by Fannie or Freddie. If the math said it was AAA, it was AAA.
Flash Forward: The ratings agency methods and “smartest guys in the room” mathematical models turned out to be complete crap.
Investors. It wasn’t the job of investors to analyze the quality of individual mortgage-backed securities. Their job was to buy and sell investments for their large institutional investors. If a rating agency said it was AAA, it was AAA.
Flash Forward: Investors bought the hell out of the “risk-free” AAA-rated mortgage-backed securities which made everyone else down the line want to create more and more of them.
It’s a Miracle!
A system that wasn’t making money for the S&Ls was somehow converted into a system that was making big bucks for banks, mortgage brokers, Fannie, Freddie, the ratings agencies and Wall Street investors.
It was a miracle of modern financial engineering and innovation to create big profits where few existed before.
They did it by hiding risk.
In the S&L system, default risk was always top of mind. In the mortgage-backed security system, people just did their jobs.
Default risk was hidden by the complexity and deniability of the mortgage-backed security system.
It didn’t spread risk, it hid risk.
Additional Notes
Federal Agencies. “It’s not my job.”
Politicians. “It’s not my job.”
