You decide to build a house and are looking for a 15 acre lot to build on. You find one you like but still want to look around a bit more before you commit. You give the land owner $500 and sign a contract that says you have 15 days to purchase the acreage for $5,000 an acre. If you don’t buy it within 15 days you lose the $500 and the $5,000 price will be renegotiated. The contract you signed is an option. Option contracts are derivatives. You’ve just securitized $5,000 per acre for 15 days for $500 using a 15 acre track as the underlying asset. You, Sir or Madam, just created a derivative.
90% of what “Wall Street” does is securitize time, money and assets. So. Are you now a greedy scumbag and a criminal?
You decide to buy the land, build a house on 5 acres and speculate that 10 acres will sell to a commercial developer in a year or two for $15,000 an acre.
While you wait you decide to farm that 10 acres, growing corn. Corn prices are volatile so in March … you figure you will harvest 1000 bushes in September … you sign a contract to sell 1000 bushels to General Mills for $14,500. You will do this in March so you’ll know how much you can spend to grow the crop and still make money in September. General Mills pays you $500 for the contract, and you are now committed to deliver 1000 bushels by September 30th come drought, hail or a plague of locusts; even if you have to buy corn in the open market to fulfill the deal. Wisely, you use the $500 to buy crop insurance, in case your crop fails. The contract you signed with General Mills is a future. Futures contracts are another kind of derivative. You’ve just securitized a $500 premium, 1000 bushels of corn, a strike price of $14.50 a bushel, and 6 months. You just created a derivative.
“Wall Street” brokers and underwrites millions of private contracts like this one to grease the movement of goods, services, credit, money and interest rates across the globe. So. Are you now a rapacious “bankster” and a monumental threat to the financial health and well-being of the nation?
You decide to build your house on that 5 acre plot during the spring and summer. You take out a construction loan at 1st National, a local commercial bank. It is a six month loan, drawn down as you complete the house. But the bank won’t make this loan unless there is a permanent mortgage “take out” in place. So you get a commitment from Farmer’s Mortgage Company in your town to fund your completed house in six months with a 30 year mortgage. You’ve created another future, another derivative, a funding commitment six months from now. Farmer’s charged you a fee of $1000 to secure this loan. The amount and rate are set. You’ve securitized money, time and an interest rate and created yet another futures contract, another derivative, this time as the buyer instead of the seller.
“Wall Street” creates funding “daisy chains” for buyers, sellers, borrowers and lenders, totaling trillions of dollars a year. So. Are you now a greedy, blood sucking finance mogul?
You’ve got your construction and final mortgage loans. You are good to go. But Farmer’s is just getting started, since they don’t want to hold your mortgage for 30 years. They just want to create it and then sell it, so they have money to fund the next loan that comes their way.
Farmer’s writes yet another futures contract with Wells Fargo, a wholesale mortgage ”aggregator”, to sell your mortgage to them in six months, after it’s closed. Money will flow from Wells Fargo to Farmers to 1st National to pay off the construction loan. But Wells Fargo isn’t the end of the line.
They don’t want to hold your loan “in portfolio”, either, so after they get the finished loan from Farmer’s, Wells Fargo will package up your mortgage with 4,999 others and sell this “bale” of 5,000 loans to Federal National Mortgage Association (Fannie Mae). Fannie Mae will in turn ”bale” 50,000 loans and slice them into well-defined, discrete pieces, selling each piece individually to institutions like pension funds and insurance companies, and to sophisticated investors in the open market.
Each piece of the mortgage “bale” is a derivative contract. The process of creating these derivatives is called securitization. The finance geeks who do this sort of large scale work refer to themselves … without the slightest embarrassment, I might add … as “financial engineers.”
Here’s what Fannie Mae and Freddie Mac do. One “bale” of 30 year loans might be sliced into 12 pieces, just as an example. There will be 6 five-year sections … years 1 thru 5, 6 thru 10, 11 through 15 and so on. Each section would be split in half again. Each half is tied to a specific stream of cash: one half for interest money you pay on the mortgage each month and the other for the principal money you pay each month. These streams of cash “pass through” with each mortgage check you write to Farmer’s Mortgage Company each month, going from Farmer’s Mortgage to Wells Fargo to Fannie Mae to the 12 investors who each bought one of the 12 slices of your mortgage. This is how mortgages work now.
Is this a criminal activity worthy only of “greedy Wall Street banksters”, do you think?
This is why it’s not. Each slice of the mortgage can be bought and sold independent of the others. They are traded just like any other stock or bond. A pension fund might buy the principal payments slice in years 26 through 30. They will pay a premium for this slice because this fits their need for money exactly 25 years from now, when the pension for a 40 year man begins to pay out. A money market mutual fund will buy the year 1 through 5 interest slice, because they deal strictly in shorter term debt, and they too will pay a premium.
The mortgage in slices is worth much more in the markets than the mortgage would be if it had to be sold whole. Studies show that if we could not securitize mortgages, if we could not gather all those premiums specialty buyers will pay, mortgage loan rates would have to be much higher than they are today, by as much as 3%.
Each slice is a derivative called a Mortgage Backed Security, or MBS. This doesn’t just work for housing loans but for credit cards, automobile loans and retail credit card (Sears, Kohl’s, Target) balances as well. They are all packaged, carved up and resold on the market. Investors will pay handsomely for high quality credits perfectly matching their needs. And the key words here are “high quality”, because if you think about it, MBS can only have the quality of the mortgage or credit card or auto loan from which its cash flows. Bad mortgage = bad MBS.
This is what happened in 2008. Millions of bad mortgages were written by order of the US Government, by the Democrats primarily. Bush43 tried three times to shut down the deteriorating credit standards that were being used by Fannie Mae and Freddie Mac to encourage ever weaker mortgages. 20 years ago 20% down was standard, and you had to have a job and decent income. 10 years ago 0% down was common, and you didn’t have to prove you had a job or an income. These two mega-loan banks, Fannie and Freddie, followed orders from Barney Frank and the Democrats to create “equality of credit access”, a kind of affirmative action for mortgages. Fannie and Freddie complied. Commercial banks and mortgage originators made loans using deteriorated Fan and Fred credit standards; banks made the loans exactly as Fan and Fred required, exactly as Barney Frank and the Democrats were demanding.
The result was people with poor credit or even no credit (the “no document” or “liar’s loans”) were given mortgages freely. These loans were called, in typical government euphemism, “sub-prime”. Very “sub” indeed. The sudden new demand for houses from millions of people who could never have qualified for a mortgage before created a housing rush that turned into a boom. Eventually, predictably, the poor credit resulted in massive delinquency and default, which in turn triggered the Great Recession of 2008.
The Democrats, to this day, blame the banks who originated the loans … in your case Farmer’s Mortgage … because they followed Fan and Fred’s requirements and Democrat’s demands for “affirmative action lending”; a demand, I remind, that George W Bush tried and failed thrice to stop. So. Were the bankers at fault because they didn’t refuse?
No. Had banks refused to make these sub-prime mortgages the Democrats would have sued them into bankruptcy for discriminatory lending practices … for “red lining” and violation of the Community Reinvestment Act. They’d have been fined billions of dollars.
Of course no politician who’s creates a disaster will ever take the blame for it. So after Wells Fargo and Bank of America and JP Morgan Chase made and aggregated these “sub-prime” loans as ordered, and they predictably fell into delinquency and foreclosure, it is these same banks the politicians are now crucifying. “Banksters” are paying billions of dollars for “fraud” and “deceptive lending practices” and for ”misleading borrowers” and a host of lesser crimes. Damned if you don’t and doubly damned if your do.
Ronald Reagan once said “If you get in bed with government you’ll get more than a good night’s rest.” Which pretty much nails it.
Securitization is not the Devil’s handiwork and isn’t inherently dangerous. Like any tool, though, it can be misused for financially ignorant, partisan political purposes. And if the securitization process is bastardized, then the MBS and other derivatives being created in that process will contain within them that very corruption. Derivatives are only as good or as bad as the quality of the loans they represent. Cynical politicians demanding bad credit standards will give you bad derivatives, every time.
Derivatives are an efficient way to fund civilization in the 21st Century. Without them it would 1955 all over again. Credit cards would be impossible. Car loans would still be what they were when I was a banker in the early 1970s: 8% add-on, 11% APR. Mortgage rates would be much higher and getting one much more difficult.
Here’s an idea. Keep securitization. Hang onto derivatives. Get rid of the bilious fools and ignorant pols in Congress who think “affirmative action lending” and ”equal access to credit” are really sound economic ideas. Clean out Congress and the rest will take care of itself.