Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.
The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.
The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.
Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.
Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.
This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.
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