The textbook talks a lot about mortgage securities. I expect you to read this out of Fabozzi. I actually got complaints in past years. Students found this the least enjoyable part of the readings for this course, but you should know about these things.
We have securities called Collateralized Mortgage Obligations. These are mortgage securities that are sold off to investors and they hold mortgages, but as is explained in Fabozzi, they will divide them into separate tranches or separate securities in terms in prepayment risk. That is, there’s a risk that the mortgages will be paid off early in times when it’s adverse to the investors interests. So, they would divide up the risks into different classes of securities. And some of them were rated triple A by the rating agencies because they thought there was almost no risk to those securities, and others were rated differently. And these CMOs were sold to investors all over the world.
Another kind of security which the textbook talks about is a CDO, which is a Collateralized Debt Obligation. These are issued to investors and they typically hold mortgage securities as their assets. Many of them held subprime mortgages in recent years, mortgages that were issued against subprime borrowers. A lot of these securities that were rated very highly by the rating agencies rated triple A, ended up defaulting and losing money for their investors. And the investors were all over the world.
The United States is a leader in mortgage finance and it was issuing companies in the United States, not just Fannie and Freddie, but lots of companies were issuing mortgage securities that had triple A ratings, which meant that Moody’s and Standard and Poor’s and the other rating agencies were telling you basically there’s no risk to them. And so, people in Europe, in Asia were investing in these and they thought they were perfectly safe, and then they went under.
Part of it was bad faith dealings by some of the issuers. Some of the issuers themselves doubted that these mortgages were so safe.
But what do I care? This is what happened. It’s gotten to be a complicated set of steps. Somebody originates the mortgage. That means I talk to the homeowner. I have the homeowner fill out the papers. Then after they’ve originated the mortgage, they sell it to an investor, like Fannie and Freddie or some private mortgage securitizer and the mortgage securitizer finds a mortgage servicer, it may be the originator, who will then service the mortgage.
What does it mean to service the mortgage? It means to call you on the phone if you’ve missed your payment, for example. Or if you have questions about the mortgage, there should be someone you call. So, the mortgage service does that. That’s a separate entity. And then we have the CMO originator, then we have the CDO originator. It’s gotten to be a very complicated financial system. And then the whole thing collapsed.
So, there’s been a lot of reform to try to see what can we do to prevent this kind of collapse? Some people would say, let’s end the whole thing. Let’s go back to 1778, let’s not have mortgage securitizers. But that’s not the steps that been taken. I think we are making a progress, but I want to just conclude with just a little reference to one important change that was made in both Europe and the United States.
The European Parliament passed a new directive that requires or incentivizes mortgage originators to keep 5 percent of the mortgage balance in their own portfolio. That means, if you originate mortgages, you can sell off 95 percent of the mortgages to investors, but you have to keep 5 percent. So, this 5 percent limit was then incorporated into the Dodd-Frank Act in the United States. So, we again have the same requirement. And this is supposed to reduce the moral hazard problem that created the crisis and retain the mortgage securitization process. So, the idea is this – I know I heard people tell me, mortgage originators sometimes got cynical. They thought, okay, I’m helping this family fill out a mortgage. What do I care? I think this family doesn’t look like they’re not going to pay this back. But what do I care? I’ll fill it out, I’ll sell the mortgage to someone else and I’m out of here.
In fact, it got bad in some cases with some more mortgage brokers. A family would come in wanting to buy a house and the mortgage broker would say, what is you income anyway? And they will tell him the income. And he’d say, you’re trying to buy a $300,000 house on that income? I don’t know if I can do this. But then he’d say, wait a minute. Think about this again, is that really your income? You told me your income is $40,000 a year. Are you sure? Why don’t we say $50,000 thousand a year or say $ 60,000 a year and the couple would look at him in disbelief and say, no, we only have $40,000. He would say, well, think about it. You have other sources, don’t you? Everybody does this, you know. So, okay, we have $60,000. He says fine. And they thought, well, the mortgage broker gave me permission to do this. And he doesn’t care because he’s not going to take the loss.
So, the new law is supposed to discourage that kind of thing. And there are lots of new laws that are trying to tighten up. For example, mortgage brokers in the United States now have to be licensed. It used to be just five years ago, you could be an ex-con, fresh out of jail, and you could take up a business as mortgage broker. You can’t anymore. So, what’s happening all over the world is learned from this experience, but we’re retaining this basic system if mortgage securitization. Mortgage lenders that are professional. The basic industry has been retained. And we’re hoping and thinking that maybe we have a better system.
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This course was recorded in Spring 2011