No Ordinary Fool

Prologue

To be honest, I started writing a completely different post on confidence in the money markets, when I thought that it probably makes sense to explain what a Mortgage-Backed Security is firstly. Not that I have any remarkable insights, but I have been reading up on it enough to have a decent grasp of how it works.

Why Mortgage-Backed Securities are interesting is that they lie at the heart of a tale that tells how some of the poorest people in America precipitated the fall from grace of some of the country’s richest and how the world may yet end up in an economic depression because of it all.

The Dutch tulips mania of the 1630s has nothing on this one!

The Homeowner’s Tale

Our multi-faceted tale begins with you, dear reader, wishing to buy a home for you and yours. Naturally, you head straight for your local bank Longman’s Lascivious Lounge of Loans-A-Go-Go to obtain the necessary financing. Longman, being a generous sort, readily agrees to advance you a mortgage and you now get to buy the house of your dreams – something you once thought would never be possible.

So now you are happy!

The Mortgage Lender’s Tale

Now, while Longman is a big-hearted fellow when it comes to doing business with his customers, he does harbour some concerns over the wisdom of having lent that money to you.

Namely, when he combines your career as a poker player with those of the professional Big Brother contestant, the knife thrower’s assistant, and the partially decomposed corpse to whom he has also lent money, he feels that the risk is getting rather large that he may not get all of his money back again afterwards. Given that his wife lives for the latest designer shoes and handbags, this is not a pleasant position to be in.

However, all is far from lost, for Longman has entered into an arrangment with an investment bank called Oz’s Ostentatiously Ornate Offerings-A-Bling-Bling. What this means is that out of the goodness of his heart, Oz has already agreed to buy such loans from Longman. The upshot of this is that while you will continue to repay your mortgage directly to Longman each month, he now passes this money along to Oz.

The net result for Longman is that he no longer has to worry about these loans defaulting. Not only that, he has earned some fee income in the process and now has freed up his capital once more to lend to new mortgage applicants.

So he is happy too - especially because his wife is happy!

The Investment Banker’s Tale

Now, as charitable a person as Oz most surely is, he also happens to be a wily old investment banker. More particularly, he has a clever way of making money from these less-than-stellar loans that he has just purchased from Longman. This is done by using these loans to create a brand new product called a mortgage-backed security that he can then sell to investors all around the world.

This is how it works. Oz transfers these loans into a company that he has created especially for this purpose. Next he needs to find the investors who will provide enough funding to this company that he no longer has to.

However, why should some other investor wish to pay for something that both Longman and Oz think is too risky to keep for themselves? Well, get ready, because here comes the really clever part!

Oz has built a fancy financial model, which shows that the more of these loans that he can pool together, the lower the impact becomes of any one of them defaulting. At its most elemental, his idea is that if you lend $100,000 to one homeowner, you may lose all of your money if this homeowner subsequently cannot pay you back. However, if you invest the same $100,000 in a portfolio of mortgages worth $10,000,000 and that same hapless homeowner defaults, you now only lose 1% of your investment instead of 100%!

In other words, by pooling these “sub-prime” mortgages together and spreading the funding of these mortgages out amongst many different investors, the overall investment becomes much less risky for everyone. Brilliant, even if Oz says so himself!

However, Oz does not stop there. He has even more elaborate ways of structuring this investment so that different types of investors can take different types of risk and earn different types of return as a result. This would mean that the investors who like risk the least would lose nothing at all if just one $100,000 loan within the portfolio defaulted.

Now, these investments are called securities and because they have collateral underpinning them in the form of people’s houses, these securities are considered to be mortgage-backed. Hence, the term mortgage-backed security was born. In truth, they are just like a bond – you lend it for a fixed amount of time for a fixed rate of interest and you receive your money back in fixed installments.

When Oz sells these securities to other investors, he can expect to make an extraordinarily handsome profit from being the middle-man on loans that the homeowner pays a high amount of interest on and the ultimate investor receives a lower rate of interest on because his risks are reduced thanks to the protection that the portfolio structure affords him.

As you may have guessed, it is this ability to earn vast amounts of money for himself from such financial engineering that makes an investment banker like Oz so universally loved.

Naturally, we have one very happy person here indeed!

The Insuer’s & Rating Agency’s Tale

One of Oz’s elaborate ways of structuring this investment is to call upon the services of a major insurance company. This major insurance company provides a form of guarantee to the class of investors who wants the least risk. This means that even if there are a large number of defaults within the portfolio, this class of investor can still claim its money back afterwards from the insurer.

Furthermore, Oz is still rather sensitive about the time that Longman jokingly called him a second-hand car salesman. He remembers it as the night when he took a number of these hick mortgage bankers, including that lecherous old drunk Longman, to a gentleman’s club, having marketed his idea to them during the day.

So, Oz, stung by the remark and being the model of utmost probity that all investment bankers are, goes and hires a reputable international ratings agency to provide an independent assessment of his calculations and to then assign a risk rating to the different types of investment that can be made in his company. Such a rating then gives investors much greater confidence in terms of what they are buying.

Because there are many of these deals on the go, both the major insurance company and the reputable international ratings agency are being kept quite busy doing this sort of work. Needless to say, neither of their services comes cheap.

Because of this, they are happy too!

The Investor’s Tale

Based on this independent assessment, investors from all over the world, who like the sound of lower risks, are willing to contribute millions of dollars each to the financing of this company. Indeed, quite a number of these investors happen to be other mortage banks looking to diversify their risks by purchasing investments in other countries. Just as importantly, such investments usually allow them to earn a higher return than they would from other investment opportunities with the same risk rating.

Wow, now everyone, it seems, is happy!

Epilogue

This, my friends, is the magic of the mortgage-backed security.

It is the perfect tool to encourage normally conservative local banks to lend to people who were traditionally seen as being too risky to give a mortgage to. These people now get to be house-owners too! The government also benefits from this outcome, needless to say, in terms of the money that it receives from houses being bought and sold.

Meanwhile, back in the world of high finance, there are plenty of people there too making serious money from this arrangement. The higher profits of their firms help to drive up stock exchange values, which is then good for pension funds and day investors alike. The subsequent feel-good factor encourages greater economic activity and a virtuous circle of economic expansion commences. Peace and love soon breaks out across the planet and humanity prospers forever more. Manchester United and Chelsea even let Liverpool win a league title again, such is the bonhomie that now exists.

Well, either that outcome or the damn things bring about financial Armageddon. However, more on that very soon!