Why Buy a House? — 2

In the previous part we observed that something strange was in play that led to absurdly loose credit standards. In this part we’ll understand more about the market conditions, stakeholders and tools that led to such a situation, check this out if you need a refresher (https://medium.com/business-club-iit-bhu-varanasi/why-buy-a-house-b12293c4692).

Why such standards?

As we went through the previous part, an obvious question arose,
“Why did financing kept getting easier and easier?”
To answer this question, we need to look at what traditionally happens when a person goes to the bank for a loan.

If I want a loan, I will go to my bank. And the loan officer at the bank would be giving me the bank’s money for the house in the hope of earning the interest; thus, the bank really cares about not losing money on the transaction. If he’s giving me out a million dollars, then he wants to make sure I pay him back no matter what happens; even if I lose my job, get arrested or skip town, he still wants his million dollars because that bank officer had his bonus based upon how good the loans he gave held up.
That’s why a few decades back, they made sure people put 25% as down payment, had a good steady income and had a good credit rating.

What started to happen in the mid-90s, especially in California, and then in the entire US in 2001 is what we call Securitization of the Mortgage market.

Securitization means the conversion of an asset, especially a loan, into marketable securities, typically for the purpose of raising cash by selling them to other investors.

But before we go further, let’s look at the tool which led to this securitization :

Mortgage-backed Securities:

Let’s consider the previous example where I took a million dollar loan and for the sake of simplicity, let’s assume that this is an interest-only loan; thereby meaning at each subsequent interval I’ll pay the bank the mutually agreed interest, say 10% (100k), and at the end of the term, I’ll pay the interest + principle. The money I received came from some depositors who were promised a return, say 5%, from the bank and the bank made money through this difference in interest. The key point being that my payment is directed towards the bank to whom I owe the mortgage, that’s how the loans worked before the securitization.

Then there was the innovation of ‘Mortgage-backed Securities’. With the introduction of MBS, banks did not need to wait for deposits in order to keep lending loans. They said: “Why don’t we sell these loans to a third party and let them do something with it?”

But how do we sell loans? Well, let’s say there are a thousand people who are borrowing money from the bank and they have collectively borrowed $1 billion. Also, let’s say they’re collectively paying an interest of 10% on that i.e. $100 million.
Now the bank has these assets worth $1 billion that give pretty good returns. They can say to an investment bank: “Why don’t you give me a billion dollars + some commission and take over the ‘rights of the interest and principal payments’ ?”.
So, instead of thousands of us paying money to the bank, our payments are now delivered to this new party, the investment bank.
But why would the banks do it in the first place?
Well, there could be multiple reasons like fear of default, the commission fee for mortgage rights transfer, etc. but I hope we have now understood the notion of actually transferring the loans.

So now the investment bank would set up a special purpose entity and they’ll transfer their rights of the payments to this entity. This entity (or corporation) gets $100 million per year (interest payments) and at the end of the lending term, say 10 years, they’ll also get the principal of $1 billion as well.

But since this is a corporation, the investment bank can issue shares in it.

For simplicity let’s say it issues 1 million shares, thus each share is entitled to receive a millionth (1/1,000,000) of the cash flow stream of this entity. Therefore, each share gets $100 per year for 10 years and at the end of the term, it’ll also get an additional $1000.

So the bank will take these shares and sell them to the general public may be via an IPO and tons of people including pension funds, mutual funds, bond investors, and hedge funds will buy them.

Essentially these investors hope that there’ll be a lot of demand for such types of products and they’ll get more than that ‘$100 per year + the $1000 at the 10th year’ by reselling it to other investors. So if the investment bank sold the shares at $1.1 billion then they earned somewhere in the ballpark of $100 million before paying the brokerage to the consumer banks on its initial purchase of the right to payments on these mortgages.

All these million shares are a mortgage-backed security i.e. the value of the shares are dependent upon the health of the underlying mortgage payments and if by chance the owners can’t pay their mortgages then the special purpose entity and thereby the shareholders would have the right to the owner’s property. Thus the entity can auction the property and distribute the compensation to the shareholders.

This securitization also created an opportunity for a whole industry outside of the government-sponsored ones, and this is essentially me going to my local “mortgage broker” (ex: Countrywide Financial Corporation)**for a loan, instead of my local bank**.

Mortgage Broker: A mortgage broker is an intermediary who brings mortgage borrowers and mortgage lenders together but does not use their own funds to originate mortgages. A mortgage broker helps borrowers connect with lenders(Individuals, Investment banks, trusts, etc.) and seeks out the best fit in terms of the borrower’s financial situation and interest-rate needs. The mortgage broker also gathers paperwork from the borrower and passes that paperwork along to a mortgage lender for underwriting and approval purposes. The broker earns a commission from either the borrower, the lender, or both at closing.

So I would go Countrywide, and essentially I would get a million dollars from them as a home loan, and I’d agree to pay interest to Countrywide. But then Countrywide would do this a million times for different people, put all these loans together, and then sell them to investment banks like Bear Sterns or Lehman Brothers, who in turn package a bunch of these loans together to create an MBS and sell those to investors.

So instead of Countrywide being responsible for my loan, my payments essentially go to these investors. The bottom line is that because of this process Countrywide is just serving as a transactional entity (no skin in the game); they are just doing paperwork for my loan and are temporarily holding the IOUs (a signed document acknowledging a debt, literally an ‘I Owe U’) ‘**thus only showing little bit due diligence**' in verification.

And in return, Countrywide (the ‘mortgage broker’) will still get a ‘fixed fee’ for doing this transaction and now Bear Sterns will package a bunch of such loans which are now in billions and then repackage them to sell them to the investors.

In the whole process, Bear Sterns also gets a cut (probably multiple billions) considering that they are dealing with millions of such packages and finally the investors would gain my interest payments.

Let’s say that hypothetically the collective interest rate on the mortgage is 7% then the investors would be making 7% on their money, and that seems like a pretty reasonable proposition.

The below cycle perfectly sums up our above discussion :

The only reason investors would give their money is that they have a lot of confidence that these are really really good loans (because the mortgage interest is their return), but they don’t know who the person borrowing the loan might be, they might not have any idea about his credit score, job stability, etc. so the investors have to rely on someone to tell them that they are “good loans”. But who do they rely on?

Rating Agencies

Institutions like Standard and Poor’s, Moody’s provide the trust factor to those loans, and they rate these mortgage-backed securities. They take a look at these oversized packages of mortgages that Bear Sterns patched together, And they’ll look at the historical default rate and say, “Wow, you know these mortgages haven’t really been defaulting, there’s a very high chance you’re going to be able to get all your money back and make more” and accordingly rate those securities ‘AAA/AA/BBB/BB/D(default) ratings’ based upon different risk parameters, such that the AAA is the safest investment and would ideally give more ‘secured’ payoffs (Not necessarily more rewarding) and any tradable security rated below BBB is considered as non-investment grade i.e. there is a very high chance of losing the investment.

Therefore, although investors didn’t know about the actual creditworthiness of the underlying mortgage borrowers, they took a leap of faith. They said, “Well, Standard and Poor’s or Moody’s did the work, and they are telling me this is AAA or A”, thus consequently they just took their word for it and invested their money and got a superior return as compared to other investment instruments. Therefore, in short, they were happy.

But there could only be so many MBS contracts as the brokers were already giving money to all those who qualified, so to find more people who want mortgages, they reasoned that they could “lower” the lending standards a bit. So as more people qualified for mortgages, we had more MBS packages, consequently more investment through the firm established by the investment bank and ultimately more ‘brokerage’ to both Countrywide and Bear Sterns;

At that moment, the investors seemed pretty happy because they kept giving money to the system and kept getting consistent returns. Even though lending standards were going down, these investments were considered very low risk. This was because the defaults were very low in this period (2000–2003) and not due to the underlying ‘strength’ of the securities*.*

But why were the default rates low during the early boom (2000–2005) and how do these affect the investment returns?
Let’s say that I buy a million-dollar house and the bank gives me the loan to finance it. Let’s say that due to the unstable nature of my job, I end up unemployed a year later and can’t pay the mortgage anymore.

So I have a couple of options, I can either sell the house and pay the debt off or I can say that I can’t pay any mortgages and the bank will foreclose my home but that’ll ruin my credit score and I would lose all my Equity on the house.
But suppose a third option arises due to the ongoing boom in the housing market: a situation arises such that I could sell my property for 1.1 million and make a profit of 100k !!

So the only reason this worked out even though I was a credit risk was that the housing prices went up. Thus if we have rising prices then the banks won’t lose money lending to me because even if I can’t pay the mortgages I can still sell the house and pay them off.

Thus the only situation where one would foreclose is if the market price goes less than my loan say 900k then the bank would be taking a loss of 100k and once this delinquency (default) rate starts climbing up, it eventually turns into a catastrophe.

That’s exactly what happened in the 2008 financial crisis.

Therefore the reason the housing prices went up in 2000–2006 was not that people could pay ‘more’ but because financing got easier, thereby driving the prices up through increased aggregate demand, and thus the defaults rate went down; consequently, the perceived lending risk went down, and that makes more people willing to lend which implies financing standards go down.

We had this whole cycle occurring from the late 90s, and it especially got a lot more momentum during 2001–2003; Due to how interconnected the entire system was, the moment the delinquency/default rates went up, this house of cards came crashing down.

The article dealt with how the tragedy was staged but as an ending note I’ll leave you with a few recommendations which may help in understanding the aftermath this whole fiasco had:

• The Big Short
• Inside Job
• Too Big to fail
• Margin call
• The china hustle

Raghuram Rajan’s ‘Skewed incentives for investment managers may be adding to global financial risk’

https://www.imf.org/external/pubs/ft/fandd/2005/09/straight.htm

And yes the above article was published well before the crisis actually came in light : )