Although the global economic crisis has many causes, mortgage securitization in the 2000s is certainly one culprit, so we begin with it.
The Globalization of Mortgage Market Securitization:
A national TV program ran a documentary on the travails of Norwegian retirees resulting from defaults on Florida mortgages. Your first reaction might be to wonder how Norwegian retirees became financially involved with risky Florida mortgages.
We will break the answer to that question into two parts. First, we will identify the different links in the financial chain between the retirees and mortgagees.
Second, we will explain why there were so many weak links. In the movie Jerry Maguire, Tom Cruise said: “Show me the money!” That’s a good way to start identifying the financial links, starting with a single home purchase in Florida.
1. Home Purchase. In exchange for cash, a seller in Florida turned over ownership of a house to a buyer.
2. Mortgage Origination. To get the cash used to purchase the house, the home buyer signed a mortgage loan agreement and gave it to an “originator.” Years ago the originator would probably have been an S&L or a bank, but more recently the originators have been specialized mortgage brokers, which was true in this case. The broker gathered and examined the borrower’s credit information, arranged for an independent appraisal of the house’s value, handled the paperwork, and received a fee for these services.
3. Securitization and Resecuritization. In exchange for cash, the originator sold the mortgage to a securitizing firm. For example, Merrill Lynch’s investment banking operation was a major player in securitizing loans. It would bundle large numbers of mortgages into pools and then create new securities that had claims on the pools’ cash flows. Some claims were simple, such as a proportional share of a pool, and some claims were more complex, such as a claim on all interest payments during the first five years or a claim on only principal payments. More complicated claims were
entitled to a fixed payment, while other claims would receive payments only after the “senior” claimants had been paid. These slices of the pool were called “tranches,” which comes from a French word for slice.Some of the trenches were themselves re-combined and then redivided into securities
called “collateralized debt obligations (CDOs)”, some of which were themselves combined and subdivided into other securities, commonly called CDOs-squared. For example, Lehman Brothers often bought different tranches, split them into CDOs of differing risk, and then had the different CDOs rated by an agency like Moody’s or Standard & Poor's
There are two very important points to notice. First, the process didn’t change the total amount of risk embedded in the mortgages, but it did make it possible to create
some securities that were less risky than average and some that were more risky. Second, each time a new security was created or rated, fees were being earned by the investment banks and rating agencies.
4. The Investors. In exchange for cash, the securitizing firms sold the newly created securities to individual investors, hedge funds, college endowments, insurance companies, and other financial institutions, including a pension fund in Norway.
Keep in mind that financial institutions are themselves funded by individuals, so cash begins with individuals and flows through the system until it is eventually received by the seller of the home. If all goes according to plan, payments on the mortgages eventually return to the individuals who originally provided the cash. But in
this case, the chain was broken by a wave of mortgage defaults, resulting in problems for Norwegian retirees.
Students and managers often ask us, “What happened to all the money?” The short answer is “It went from investors to home sellers, with fees being skimmed off all along the way.” Although the process is complex, in theory, there is nothing inherently wrong with it. In fact, it should, in theory, provide more funding for U.S. home purchasers, and it should allow risk to be shifted to those best able to bear it. Unfortunately, this isn’t the end of the story.
Look next article for continuation: Global Crisis part 2
