No matter how many times it's explained to me, I'm not sure I actually get it.
September 26, 2008 10:39 AM Subscribe
I could use a better, clearer explanation than I've found so far of: What is a mortgage-backed security, and how does it (in theory) work? What does a "cash injection" by the Fed literally mean? And when a bank "buys bad debt," does that literally mean it just buys the contract that said debt was written on & tries to chase it down itself?
I've been doing a lot of reading-up, and I think I understand these concepts, but I've found the explanations full a lot of terminology that I'm not positive I understand. I understand that MBS's were a really bad deal that led us where we are now, and so on, but...
I took Econ in college, but it was my weakest "social studies" course, and seeing as I'm a social studies teacher, I should probably have access to some very plain-spoken explanations on what's going on...
I've been doing a lot of reading-up, and I think I understand these concepts, but I've found the explanations full a lot of terminology that I'm not positive I understand. I understand that MBS's were a really bad deal that led us where we are now, and so on, but...
I took Econ in college, but it was my weakest "social studies" course, and seeing as I'm a social studies teacher, I should probably have access to some very plain-spoken explanations on what's going on...
Response by poster: Another question: We know that the value of all these homes is totally inflated, right? And these defaulted mortgage bills then go to... who?
What's to stop the banks from repo'ing the "$500k house" that's probably really worth $200k, and simply selling it for... well... $200k? I mean, at that point, are they really out anything? They seem to be treating every foreclosure like a total loss.
Or are we just assuming that nobody is going to buy a home for the foreseeable future?
posted by scaryblackdeath at 11:21 AM on September 26, 2008
What's to stop the banks from repo'ing the "$500k house" that's probably really worth $200k, and simply selling it for... well... $200k? I mean, at that point, are they really out anything? They seem to be treating every foreclosure like a total loss.
Or are we just assuming that nobody is going to buy a home for the foreseeable future?
posted by scaryblackdeath at 11:21 AM on September 26, 2008
From Slate:
Mortgage-backed securities resemble bonds, instruments issued by governments and corporations that promise to pay a fixed amount of interest for a defined period of time.
Mortgage-backed securities are created when a company such as Bear Stearns buys a bunch of mortgages from a primary lender—that is, from the company you actually got your mortgage from—and then uses your monthly payments, and those of thousands of others, as the revenue stream to pay investors who have bought chunks of the offering. They allow lenders to sell the mortgages they make, thus replenishing their coffers and allowing them to lend again. For their part, buyers of mortgage-backed securities take security in the knowledge that the value of the bond doesn't just rest on the creditworthiness of one borrower, but on the collective creditworthiness of a group of borrowers.
When the housing market is doing well and interest rates are low, investing in a mortgage-backed security is a fairly safe bet. So long as homeowners stay current with their payments, holders of mortgage-backed securities receive a stream of payments.
But when the housing market goes south, or if interest rates rise, even the safest of these investments are in serious jeopardy. Rising interest rates reduce the value of securities that pay a fixed rate of interest. When borrowers default on mortgages, the stream of payments available to holders of mortgage-backed securities declines. And when a firm has borrowed heavily to finance the purchase and trading of such securities, it doesn't take much of a fall in value to trigger serious problems.
posted by magstheaxe at 11:30 AM on September 26, 2008
What's to stop the banks from repo'ing the "$500k house" that's probably really worth $200k, and simply selling it for... well... $200k? I mean, at that point, are they really out anything? They seem to be treating every foreclosure like a total loss.
3 things -- 1) Banks aren't in the business of selling homes. That's not what they're built to do, particularly if the volume of houses a bank has rises like it has in some areas, and the way a lot of these foreclosed houses have been trashed (if news reports are to be believed). 2) They're not necessarily treating it like a total loss, but they have no idea what the "value" really is, be it $200K or $100K or $300K. 3) Getting mortgages right now is tough.
posted by inigo2 at 11:46 AM on September 26, 2008
3 things -- 1) Banks aren't in the business of selling homes. That's not what they're built to do, particularly if the volume of houses a bank has rises like it has in some areas, and the way a lot of these foreclosed houses have been trashed (if news reports are to be believed). 2) They're not necessarily treating it like a total loss, but they have no idea what the "value" really is, be it $200K or $100K or $300K. 3) Getting mortgages right now is tough.
posted by inigo2 at 11:46 AM on September 26, 2008
The problem is when the bank lent the owner $500k to buy it, they defaulted because they couldn't afford to pay it any more, and the bank foreclosed. They might get back $200k on it's current value, but they're still out $300k (that went to the original seller) that they won't get back. That's assuming they can even sell it. Unoccupied unmaintained houses rapidly lose value, especially when the housing market is collapsing anyway.
The other problem is, simplifying greatly, the banks sold shares of the future profit from the repayments to brokers, who then packaged them all up, classified it as 'low risk, high profit' bundles, and sold it to well, everybody. These bundled shares are mortgage backed securities.
The problem is, when the loan taker defaults, the mortgage lender loses money, but everyone who had those dibs on part of the future profit from the repayments are also stuffed. Too many of these bad loans and the mixed share packages become effectively worthless, because nobody wants to pay something to buy them with all those bad worthless bad mortgages mixed in. Problem is, other investors bought a lot of this stuff, which people are afraid is now worthless, and they can't sell it - so they spent a lot of money on something expecting a profit, which they can't sell making it defacto worthless - for now. Those assets - things they bought - have to be written off, meaning large amounts of money just disappear from a bank's asset sheet. Too much of that, and they don't have enough money to run a bank any more.
Even worse, the banks are a) not lending directly to people any more, because they've been losing lots of money, and haven't got enough to work with
b) not lending money to each other, because they're afraid they won't get it back when said bank goes bust. Banks rely heavily on short term lending amongst themselves, as well as using the currency markets for money, so when these sources dry up, they can simply run out of money to do day to day business even if their illiquid assets (i.e. assets that can't be sold in a hurry for cash) means they're still solvent.
Even worse than that, a lot of this stuff was insured, in case it did go bad. The problem is, the insurance companies shared out the insurance amongst themselves, so it has a bit of a domino effect - failures in one bank, cause failures in others. The US government propped up AIG, because if they'd fallen over it would have spread big problems to everybody else.
The Us government bailout would buy up a lot of these currently worthless securities from banks, clearing the air. The banks could go back to normal, having got rid of all the crap that they couldn't move and was stopping anybody trusting anybody else. The problem is, the government can't just print money to pay the banks with, or all the other dollars become worth a lot less, which causes all sorts of other problems - this is inflation.
So they take the money from taxpayers. Or rather, future tax payers who will face future taxes to pay off all this debt the government is getting into by giving money to the banks.
The happy plan is that all these securities based on mortgages that aren't being paid will eventually be worth something in the future. Most people think this won't happen, so the end result of the bailout will be a massive big chunk of taxpayers money going permanently to the banks for taking stupid risks with their investments.
The downside of not having a bailout is more banks will collapse, and it's quite possible one too big to save will collapse, and drag down vast amounts of the rest of the banking system with it. Or, even without a really big bank failure, the problems with credit flow will causes normal companies to fall over in large numbers, causing big job losses, more mortgage defaults, and cause a really really big depression. Nobody really knows how bad it will get, because it's mostly caused in the first place by uncertainty, doubt of others, and greed.
posted by ArkhanJG at 11:52 AM on September 26, 2008 [2 favorites]
The other problem is, simplifying greatly, the banks sold shares of the future profit from the repayments to brokers, who then packaged them all up, classified it as 'low risk, high profit' bundles, and sold it to well, everybody. These bundled shares are mortgage backed securities.
The problem is, when the loan taker defaults, the mortgage lender loses money, but everyone who had those dibs on part of the future profit from the repayments are also stuffed. Too many of these bad loans and the mixed share packages become effectively worthless, because nobody wants to pay something to buy them with all those bad worthless bad mortgages mixed in. Problem is, other investors bought a lot of this stuff, which people are afraid is now worthless, and they can't sell it - so they spent a lot of money on something expecting a profit, which they can't sell making it defacto worthless - for now. Those assets - things they bought - have to be written off, meaning large amounts of money just disappear from a bank's asset sheet. Too much of that, and they don't have enough money to run a bank any more.
Even worse, the banks are a) not lending directly to people any more, because they've been losing lots of money, and haven't got enough to work with
b) not lending money to each other, because they're afraid they won't get it back when said bank goes bust. Banks rely heavily on short term lending amongst themselves, as well as using the currency markets for money, so when these sources dry up, they can simply run out of money to do day to day business even if their illiquid assets (i.e. assets that can't be sold in a hurry for cash) means they're still solvent.
Even worse than that, a lot of this stuff was insured, in case it did go bad. The problem is, the insurance companies shared out the insurance amongst themselves, so it has a bit of a domino effect - failures in one bank, cause failures in others. The US government propped up AIG, because if they'd fallen over it would have spread big problems to everybody else.
The Us government bailout would buy up a lot of these currently worthless securities from banks, clearing the air. The banks could go back to normal, having got rid of all the crap that they couldn't move and was stopping anybody trusting anybody else. The problem is, the government can't just print money to pay the banks with, or all the other dollars become worth a lot less, which causes all sorts of other problems - this is inflation.
So they take the money from taxpayers. Or rather, future tax payers who will face future taxes to pay off all this debt the government is getting into by giving money to the banks.
The happy plan is that all these securities based on mortgages that aren't being paid will eventually be worth something in the future. Most people think this won't happen, so the end result of the bailout will be a massive big chunk of taxpayers money going permanently to the banks for taking stupid risks with their investments.
The downside of not having a bailout is more banks will collapse, and it's quite possible one too big to save will collapse, and drag down vast amounts of the rest of the banking system with it. Or, even without a really big bank failure, the problems with credit flow will causes normal companies to fall over in large numbers, causing big job losses, more mortgage defaults, and cause a really really big depression. Nobody really knows how bad it will get, because it's mostly caused in the first place by uncertainty, doubt of others, and greed.
posted by ArkhanJG at 11:52 AM on September 26, 2008 [2 favorites]
Think of a MBS as a package, like a pack of steaks in the supermarket. A package of ten mortgages, each earning 5% interest, and each for $200,000, would be sold and would be expected to be worth $2 million and to generate a stream of income that would be amortized over 30 years.
Now suppose a couple of the steaks go bad. Eight of nine of them are still good, and there is still a lot of value there, but the spoilage tends to ruin the product for the prospective purchaser.
posted by yclipse at 2:28 PM on September 26, 2008
Now suppose a couple of the steaks go bad. Eight of nine of them are still good, and there is still a lot of value there, but the spoilage tends to ruin the product for the prospective purchaser.
posted by yclipse at 2:28 PM on September 26, 2008
i'm on my phone so i can't link you but i just heard an excellent "this american life" that explained the whole situation very clearly
posted by lannanh at 3:27 PM on September 26, 2008
posted by lannanh at 3:27 PM on September 26, 2008
Seconding iannanh: This American Life's Giant Pool of Money is the best explanation I've heard.
posted by media_itoku at 7:46 PM on September 26, 2008 [2 favorites]
posted by media_itoku at 7:46 PM on September 26, 2008 [2 favorites]
Mortgage backed securities 101:
1- Our banking system is called a "fractional reserve" system. That means that banks take in money, and they are allowed to reinvest a portion of that money.
2- Now the bank has money to invest. They decide to invest it by making mortgages on houses. So they lend people money to buy homes. The bank makes money by charging interest on the loan. The same way you make interest off the bank by putting money in a savings account. Think of interest as the fee for renting money.
3- So now the bank has loaned out all its money. As people make their mortgage payments, the bank gets some of their money back, and can then make more mortgages.
4- That's a slow, but sure, way to make money.
5- Now, a mortgage is an asset. A thing with value. An IOU, if you will. And, key to this whole thing, that IOU can be sold.
6- So the bank decides that it wants to make more money more quickly. Nothing wrong with that. So, they start calling around to other banks and say "hey, I have these mortgages, would you like to buy them?" And depending on how things are, those other banks might take them up on the offer.
7- But that excludes a lot of potential buyers. After all, your customers for these mortgages you are selling are limited to the people who have the cash to buy a whole mortgage.
8- So, you decide to securitize them. You take 10 really nice mortgages from your pile of mortgages you own, and you split them off into their own "thing". Think of that "thing" as a separate company that you formed, whose only job is to collect the mortgage payments from the homeowners and flow that money back to the owner, your bank. To securitize them, you break the ownership of those assets up. Same thing, in theory, as taking on an equal partner in a business. You both own 50% of the business, and reap 50% of the rewards. Except in this case, the business is making money from the mortgages, and you are sharing it with 1000 partners. And further, what makes these shares into securities is that the people who buy these shares can buy and sell them at will. Just like stocks in the stock market.
Now, the theory is great- the original bank gives up their stake in the future profits of those investments, in exchange for getting their original investment back, plus a little profit.
It works just like those commercials during Judge Judy on TV- "we'll buy your lawsuit award! Cash now!" These people with the lawsuit awards are getting $100 a month for 10 years or whatever. But some of those people might need cash right now. So instead of taking the whole $12,000 in tiny increments, the lawsuit buying people give them, say, $5000 bucks to sign over their right to those payments. Holding a mortgage is the same thing. The bank gave some guy $100,000, and that guy is going to pay them back plus interest. Sure, with interest, it will be $300,000, but 30 years is a long time. So instead, the bank sells it off for $120,000. The bank just made a fast $20,000, and the buyer just bought $300,000 for $120,000. The buyer just has to wait.
Among the things that made this situation bad is that the banks weren't doing a good enough of a job correctly estimating how much money these securities were going to generate. And the credit rating agencies didn't do their job either. Because housing prices were rising so fast, buyers didn't really care what the reason was, they just knew that these things were making tons of money and wanted their piece.
posted by gjc at 8:39 PM on September 26, 2008 [2 favorites]
1- Our banking system is called a "fractional reserve" system. That means that banks take in money, and they are allowed to reinvest a portion of that money.
2- Now the bank has money to invest. They decide to invest it by making mortgages on houses. So they lend people money to buy homes. The bank makes money by charging interest on the loan. The same way you make interest off the bank by putting money in a savings account. Think of interest as the fee for renting money.
3- So now the bank has loaned out all its money. As people make their mortgage payments, the bank gets some of their money back, and can then make more mortgages.
4- That's a slow, but sure, way to make money.
5- Now, a mortgage is an asset. A thing with value. An IOU, if you will. And, key to this whole thing, that IOU can be sold.
6- So the bank decides that it wants to make more money more quickly. Nothing wrong with that. So, they start calling around to other banks and say "hey, I have these mortgages, would you like to buy them?" And depending on how things are, those other banks might take them up on the offer.
7- But that excludes a lot of potential buyers. After all, your customers for these mortgages you are selling are limited to the people who have the cash to buy a whole mortgage.
8- So, you decide to securitize them. You take 10 really nice mortgages from your pile of mortgages you own, and you split them off into their own "thing". Think of that "thing" as a separate company that you formed, whose only job is to collect the mortgage payments from the homeowners and flow that money back to the owner, your bank. To securitize them, you break the ownership of those assets up. Same thing, in theory, as taking on an equal partner in a business. You both own 50% of the business, and reap 50% of the rewards. Except in this case, the business is making money from the mortgages, and you are sharing it with 1000 partners. And further, what makes these shares into securities is that the people who buy these shares can buy and sell them at will. Just like stocks in the stock market.
Now, the theory is great- the original bank gives up their stake in the future profits of those investments, in exchange for getting their original investment back, plus a little profit.
It works just like those commercials during Judge Judy on TV- "we'll buy your lawsuit award! Cash now!" These people with the lawsuit awards are getting $100 a month for 10 years or whatever. But some of those people might need cash right now. So instead of taking the whole $12,000 in tiny increments, the lawsuit buying people give them, say, $5000 bucks to sign over their right to those payments. Holding a mortgage is the same thing. The bank gave some guy $100,000, and that guy is going to pay them back plus interest. Sure, with interest, it will be $300,000, but 30 years is a long time. So instead, the bank sells it off for $120,000. The bank just made a fast $20,000, and the buyer just bought $300,000 for $120,000. The buyer just has to wait.
Among the things that made this situation bad is that the banks weren't doing a good enough of a job correctly estimating how much money these securities were going to generate. And the credit rating agencies didn't do their job either. Because housing prices were rising so fast, buyers didn't really care what the reason was, they just knew that these things were making tons of money and wanted their piece.
posted by gjc at 8:39 PM on September 26, 2008 [2 favorites]
I just read the Global Pool of Money show. It is an excellent piece. But it does not mention a key point.
A character named Clarence was introduced. He had three part-time jobs paying a total of $45,000 per year and a house. He was able to borrow $540,000 from a bank which did not check his income or his assets - sometimes called a liar's loan.
What was not mentioned was the key point. Why would a bank lend him that much money when it was sure to be a bad loan? Because the bank was not using its own money. It would turn around and sell the loan to someone else. That someone else (or his successors down the line) are stuck with the risk of non-payment, etc., while the original lender has the money in hand to lend again. It has none of its own money at risk and thus has no motivation to ensure that the loan is a good one.
posted by yclipse at 5:41 AM on September 27, 2008
A character named Clarence was introduced. He had three part-time jobs paying a total of $45,000 per year and a house. He was able to borrow $540,000 from a bank which did not check his income or his assets - sometimes called a liar's loan.
What was not mentioned was the key point. Why would a bank lend him that much money when it was sure to be a bad loan? Because the bank was not using its own money. It would turn around and sell the loan to someone else. That someone else (or his successors down the line) are stuck with the risk of non-payment, etc., while the original lender has the money in hand to lend again. It has none of its own money at risk and thus has no motivation to ensure that the loan is a good one.
posted by yclipse at 5:41 AM on September 27, 2008
(Actually, it was mentioned, a little later. Looks like I read it too fast.)
posted by yclipse at 5:47 AM on September 27, 2008
posted by yclipse at 5:47 AM on September 27, 2008
« Older Locking down firefox in fedora | VMWare: Web server on guest OS, accessed from Host... Newer »
This thread is closed to new comments.
Bad Debt is still secured by the property in question. The bank is able to purchase the mortgage note and foreclose on the property with intent to auction it off for profit.
Cash injection by the Feds can mean two things. #1 A loan or gift to the company in trouble. (Think the automotive industry.) #2 The government purchases the company in trouble and "we", the US citizens, then own the company. (One of the talking points of Senator Obama is that "we" should share in any future profits.)
posted by TauLepton at 11:09 AM on September 26, 2008