Saturday, November 15, 2008

Understanding the financial crisis - Risky Assets

In order to achieve returns, financial firms have to take risks. Over the last several years, securities firms and hedge funds have traded heavily in investments known as mortgage-backed securities. Let us try and understand how these instruments work.

Mortgages are familiar to people the world over. Buyers take a loan in order to buy a home and pledge the home as collateral. They also agree to make regular payments of interest and/or principal on the loan. If they fail to make payments, they are considered to be in default and the lender can repossess the home. Now look at this transaction from the point of view of the lender. A loan is an asset for a lender, because it yields periodic cash flows. Just as other assets can be bought and sold, loans can be bought and sold as well. The widespread availability of home loans in the US has been facilitated by the existence of an excellent secondary market for loans.

The secondary market in the US had its beginnings in the setting up of the Federal National Mortgage Association (FNMA or “Fannie Mae”), the Government National Mortgage Association (GNMA or “Ginnie Mae”), and the Federal Home Loan Corporation (“Freddie Mac”). These organizations have functioned quite well for decades, providing a secondary market for mortgage loans originated by banks and other depository institutions.

The secondary markets have worked well due to the securitization of loans. The concept of securitization is quite clever. A pool of mortgage loans is assembled and claims to the cash flows generated by the pool are sold. These claims, or securities, are like bonds: there is a promised interest paid on the principal amount. Buyers of these securities are protected from losses by guarantees provided by the agencies, Ginnie Mae, Fannie Mae and Freddie Mac. To understand the mechanism in some detail, let us borrow the following example from the Wikipedia article on Ginnie Mae:

For example, a mortgage lender may sign up 100 home mortgages in which each buyer agreed to pay a fixed interest rate of 6% for a 30-year term. The lender (who must be an approved issuer of GNMA certificates) obtains a guarantee from the GNMA and then sells the entire pool of mortgages to a bond dealer in the form of a "GNMA certificate". The bond dealer then sells GNMA mortgage-backed securities, paying 5.5% in this case, and backed by these mortgages, to investors. The original lender continues to collect payments from the home buyers, and forwards the money to a paying agent who pays the holders of the bonds. As these payments come in, the paying agent pays the principal which the home owners pay (or the amount that they are scheduled to pay, if some home owners fail to make the scheduled payment), and the 5.5% bond coupon payments to the investors. The difference between the 6% interest rate paid by the home owner and the 5.5% interest rate received by the investors consists of two components. Part of it is a guarantee fee (which GNMA gets) and part is a "servicing" fee, meaning a fee for collecting the monthly payments and dealing with the homeowner. If a home buyer defaults on payments, GNMA pays the bond coupon, as well as the scheduled principal payment each month, until the property is foreclosed. If (as is often the case) there is a shortfall (meaning a loss) after a foreclosure, GNMA still makes a full payment to the investor. If a home buyer prematurely pays off all or part of his loan, that portion of the bond is retired, or "called", the investor is paid accordingly, and no longer earns interest on that proportion of his bond.

The GNMA said in its 2003 annual report that over its history, it had guaranteed securities on the mortgages for over 30 million homes totaling over $2 trillion. It guaranteed $215.8 billion in these securities for the purchase or refinance of 2.4 million homes in 2003.

These arrangements, especially the guarantees provided by the agencies, allowed a vast market in mortgage-backed securities to develop. In fact, Fannie Mae guaranteed securities were bought even by foreign governments such as China.

Before loans could be packaged into pools and obtain a guarantee from the agencies such as Fannie Mae, they had to meet certain criteria set by the agencies. These were basically designed to limit potential defaults and ranged from a limit on loan size, a minimum credit score for the borrower, documentation of income, a maximum loan-to-property-value ratio etc. There were always some loans that did not meet the criteria laid down by the agencies. These loans were securitized by private companies. The resulting securities are known as non-agency or private-label mortgage-backed securities or as residential asset-backed securities. These securities are based on pools of loans which had
  • high loan amounts, such as the ones common in California (known as jumbo loans),
  • were issued to borrowers who had good credit scores, but did not meet other criteria such as verifiable steady income levels (known as Alt-A or Alternative-A loans),
  • were issued to borrowers who had low credit scores (“subprime” loans).
[In the US, creditworthiness for individuals is measured by a score which is calculated by consumer credit measuring companies. A “prime” borrower is generally one who has a credit score of 660 or higher and usually is able to borrow at the lowest prevailing interest rate at a given time. Hence the terminology of “subprime” borrowers and “subprime” mortgages].

Starting in the early years of this decade, interest rates in the US have been at historic lows. In 2003 and 2004, individuals with good credit scores could get home loans for an annual interest rate of about 4.5%. Since many buyers tend to look at home buying purely in terms of the affordability of monthly payments rather than in terms of the size of the loan, the low interest rates meant that they could get bigger loans and bid up the prices of the houses in the market. What followed was a remarkable real estate boom.

The boom was fuelled by the easy availability of credit, and it in turn justified further lending by the financial firms. Many people were able to obtain several loans in order to buy second and third homes as investments. Some of the most astounding loans made were the so-called “stated income” or the “no documentation” loans. This meant that in order to meet whatever minimal lending standards the lenders required, the borrower could invent any income level and claim any assets. This practice was rubber-stamped by mortgage brokers and lending institutions alike. Because securitization allowed lenders to offload loans, they had little incentive to make sure that good lending practices were being followed.

You might justifiably ask why the buyers of mortgage-backed securities were not insisting on stricter lending standards. One major factor was that non-agency securities (the ones based on pools of Alt-A or subprime loans) were given good ratings by credit-rating agencies such as S&P, Moody's and Fitch. This was in turn possible because the non-agency sponsor would provide credit enhancements or buy insurance to guarantee that the principal would be paid back. In other words, inherently risky investments were dressed up to look acceptable by referring to dubious guarantees.

This kind of game, if played by a few players at a low level, can go on for a while. However, when many firms start doing this, it sets up the system for a major failure.


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