Analysis of current economic conditions and policy

January 11, 2008

Mortgage securitization

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Today, it is quite uncommon for the bank that originally made the loan to you to be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).
Fraction of U.S. mortgage debt held by institutions of various types. Source: Green and Wachter (2007).

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.

Ratio of total mortgage debt (from Table L.2 of Flow of Funds Accounts) to nominal
GDP (from BEA Table 1.1.5).
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
right direction.

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.