This quarter for the Family Finance Book Club pick, we read The Big Short by Michael Lewis, giving many of you a front-row seat and eye-opening read about how the mortgage industry nearly collapsed the entirety of Wall Street, taking Main Street down with it… but it also left you with lots of questions. Like, what are all those financial acronyms? How did all those mortgages become bonds? And how do mortgages work, really?
How Do Mortgages Work
From your perspective as a potential homebuyer, the way a traditional mortgage works is fairly straightforward and standardized. The troubles that led us into The Great Recession, bankrupted two major Wall Street investment banks, and led to double-digit declines in home prices that it would take more than a decade to recover from all came about from what happened on the lender side of the equation.
So let’s walk through the basics of how mortgages work on each side of the transaction, and how the industry changed in the late 1990s to set the stage for what happened 20 years later.
How Do Mortgages Work for the Borrower
As a borrower, when you go to get a mortgage, the lender does a few basic things:
- Checks your credit to make sure you have a history of paying your debts
- Checks your income to make sure you make enough to pay for your mortgage every month
- Appraises the home you are attempting to buy to make sure it is worth what you are paying for it and represents adequate collateral for the mortgage
- Based on all of the above, sets an interest rate they are willing to accept to loan you the money for your mortgage
Related Post: How to Calculate How Much House I Can Afford
While there is more to the cost of home ownership than just your monthly mortgage payment, calculating your mortgage payment is a fairly simple formula that takes into account 1) the value of the your mortgage, 2) the interest rate, and 3) the term of the loan. An amortization calculator uses those inputs to calculate a fixed, monthly payment you pay for the life of your loan.
However, over the life of your loan, the breakdown of your payment changes. In the early years of your mortgage, most of it is interest on the high remaining balance of your loan. Over time, as small principal payments whittle down that balance, more and more of the monthly payment is put towards reducing principal. As an example, here’s what that payment breakdown looks like for a $240,000 mortgage, at 3.25% interest with a 30 year term.
For borrowers, with the exception of some crazy options that were offered during the height of the real estate bubble in the early 2000s like interest-only ARMs, mortgages have worked in this fairly straightforward manner for decades. Seems simple enough, right?
How Do Mortgages Work for the Lender
So what changed to lay the groundwork for the Great Recession of 2008? How mortgages worked for lenders.
Historically, when you borrowed money from a bank, they held that loan on their balance sheet as an asset, collecting your payments for the life of your loan. This made banks pay careful attention to who they lended money to – since they were relying on you to pay it back for the next 30 years!
Debt securitization totally changed the mortgage industry. While securitizing loans had existed in the early 1700s in Britain, they hadn’t again for nearly 200 years. Then, in the 1970s, the first mortgage backed securities were issued.
Before that, banks might buy and sell loans from each other… but they were not standardized in any way, making them more difficult to trade and limiting the investors who might buy them essentially to other banks.
In the 1970s, Ginnie Mae (the Government National Mortgage Association) guaranteed the first mortgage-backed securities. A bank could put together a large number, or pool, of mortgages, sell them off as individual, $1,000 bonds to investors, and pass-through the payments as they were collected. And so long as the loans met Ginnie Mae’s standards, they guaranteed the bonds would be repaid, even if the mortgage borrowers defaulted. So investors saw these bonds as government-backed, risk-less securities.
Banks could remove these loans off their balance sheets, collecting payment upfront as the bonds were sold, and make more loans, collecting all the origination and other related fees in the process. They now also had removed the credit risk of borrowers from their balance sheet and transferred it to a whole pool of investors… who also weren’t worried about it since Ginnie Mae guaranteed repayment. So what do you think happened to the creditworthiness of mortgage borrowers?
By the 1980s, there were two more Government Sponsored Enterprises, Fannie Mae and Freddie Mac, backing mortgage-backed securities. And in order to create more credit for less creditworthy borrowers, they got fancier… creating Collateralized Mortgage Obligations. These took the pooled mortgages and sorted them into groups, or tranches, based on varying risk levels investors were comfortable with. The highest-rated tranches would get paid off first and experience the least number of defaults. Lower tranches were higher risk, had lower credit ratings, and would experience the greatest risk of default.
This allowed more subprime mortgages to be issued, loans a bank would never have made and held on their balance sheet before, and borrowers who might never have been able to borrow or own a home before were buying homes in droves. Homeownership rates increased significantly. Which would have been great news… if it wasn’t saddling borrowers with loans they could never actually afford.
By 2000, mortgage-backed securities had become a $6 trillion market. As the market continued to grow throughout the early 2000s, and as more and more subprime mortgages were extended, MBS investors started to worry about the creditworthiness of their investments. They started buying Credit Default Swaps (CDS) to hedge that risk.
A CDS is like an insurance policy against default risk. You buy a CDS from another investor, they collect quarterly payments as a premium for assuming the default risk, and they agree to pay you if your bond defaults… sort of like the PMI you pay for when you borrow more than 80% of the value of your home. As an investor, you’ve offset the default risk, for a small payment, and you feel comfortable buying even more MBS. But you are also relying on the creditworthiness of the CDS underwriter.
The problem in 2008-2009? Banks and major insurers, like AIG, underwrote a whole lot of CDS on MBS… and defaults were way more than anyone expected. If the CDS underwriter went under, there was no one to collect from if your investment defaults too. And those MBS investors? A lot of them were the major Wall Street banks who pooled the mortgages and sold them as bonds to begin with, holding a lot on their own balance sheets. And as the mortgage defaults started happening, the house of cards started to fall.
So, the super abbreviated version? Lenders made loans to people less and less able to pay them because they no longer had to worry about them defaulting as long as someone else, investors, bought them as MBS. Investors bought more and more MBS because they were either government-guaranteed or they thought they could effectively offset the default risk by buying CDS. And everyone underestimated the risk and level of defaults there would be.
12+ Mortgage Industry Terms Defined
To fully understand the story told in The Big Short, and exactly how the mortgage industry became so over-extended, you have to understand A LOT of financial jargon and acronyms. Some I’ve already alluded to above – but below they are fully explained in greater detail to help you better understand the story.
What is a Mortgage Backed Security (MBS)?
A bond-like instrument backed by a bundle of home mortgages. Investors in MBS receive periodic coupon payments, just as bond investors receive interest payments on bonds. They also assume the risk of default of the underlying home mortgage borrowers, and risk of being repaid early.
What is a Credit Default Swap (CDS)?
A credit default swap is a financial agreement between two parties for protection in the event of a debt default or other credit event (can also be used to fix floating rate debt) by a specific credit instrument or borrower. The protection buyer pays a quarterly premium to the protection seller, and in the event the credit instrument or borrower defaults, the buyer gets paid, typically the face value of the loan or bond instrument, and the protection seller assumes ownership of the loan or bond.
What is a CDO?
CDO stands for Collateralized Debt Obligation. I will explain these in more detail as a specific type of CDO, Collateralized Mortgage Oblications, below.
What is a CMO?
CMO stands for Collateralized Mortgage Obligations. Initial MBS were packaged as pass-through securities, where all bond investors were paid off evenly as the pool of mortgages collected interest and principal.
As the MBS market matured, some investors didn’t like when say people repaid their mortgage early, and now their bond was paid back and they had to reinvest sooner than planned. Other investors didn’t have the same appetite for risk, and wanted higher credit quality, while others were willing to take on more subprime risk.
And so, to offer something to all investors while also increasing liquidity in the mortgage market for more and more subprime borrowers, banks started collateralizing the pools of mortgage obligations.
A CMO is a pool of mortgages but the payments from those mortgages, instead of being passed through evenly to all investors in the pool, get distributed differently across different groups, or tranches, of investors who buy the securities. These different securities in the CMO were designed to meet different investors’ investment objectives and appetites for risk. And each tranche could have different coupon rates, prepayment risks, default risk and maturity dates.
What is DTI?
DTI stands for Debt-to-Income ratio. It is a measure lenders use to guage your ability to borrow debt and repay it given your existing levels of debt and income.
It is calculated by adding up all your monthly debt payments and dividing it by your gross monthly income. Typically, this ratio must be less than 43% to get a Qualifying Mortgage (see below).
Who are Ginnie, Fannie and Freddie?
The mortgage backed securities industry wouldn’t have been possible without some government support, specifically, via Ginnie Mae, and GSE’s: Fannie Mae and Freddie Mac.
- Government National Mortgage Association (aka Ginnie Mae): Ginnie Mae guarantees investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans, primarily those insured by the Federal Housing Administration (FHA) or Veterans Affairs (VA). This guarantee makes affordable housing and mortgages more available to low and moderate-income households by allowing mortgage lenders to sell the loans at a better rate in the secondary market, and use those proceeds to make more loans. It was created in 1968 as part of the US Department of Housing and Urban Development to promote homeownership. Ginnie Mae-insured bonds are the only MBS to explicitly be backed by the federal government.
- Federal National Mortgage Association (FNMA, aka Fannie Mae): Fannie Mae is a government-sponsored enterprise (GSE) created by Congress in 1938 during the Great Depression as part of the New Deal Unlike Ginnie Mae, Fannie Mae not only guarantees mortgage loans made by lenders, they also purchase them and then issue mortgage-backed securities from the pools of mortgages they purchase.
- Federal Home Loan Mortgage Corp (FHLMC, aka Freddie Mac): Freddie Mac is a government-sponsored enterprise (GSE) created by Congress as part of the Emergency Home Finance Act in 1970. Like Fannie Mae, Freddie Mac also guarantees, purchases and securitized mortgages into MBS.
When lenders talk about a Conforming or a Qualifying Mortgage, it means it meets the terms laid out by Ginnie, Fannie or Freddie to be guaranteed or bought and re-packaged as MBS. This makes those mortgages available at a lower interest rate than they otherwise would be offered to you at.
It is important to note that ONLY Ginnie Mae-insured bonds are actually backed and guaranteed by the federal government. While Fannie and Freddie were entities originally set up by the government, they are now publicly traded companies owned by their own shareholders.
However, Fannie and Freddie have become so large and vital to the mortgage market, most assume (and in 2008 this was proven to be true), that the government would bail them out if they got into trouble. In 2008, the US Treasury was authorized to purchase preferred stock of Fannie and Freddie, as well as distressed MBS assets off their balance sheets, and put into conservatorship by the Federal Housing Finance Agency.
It cost US taxpayers nearly $200 billion to keep them afloat at the time. The US government has since more then re-cooped that investment, and collected almost $100 billion more. There is current ongoing litigation about the payments made to the government by shareholders, and debate in Congress about eliminating the remaining preferred stock ownership stake of the government.
What is a HELOC?
You will be approved a set amount of credit based on the appraised value of your home and your outstanding mortgage balance. You can draw down as much or as little of the credit as you need, and you will make interest and principal payments based on how much you borrow.
Interest rates for HELOC’s are typcially floating, or at an adjustable rate. It will typically be charged based on an underlying reference rate, like Prime, plus an additional spread, so Prime + 2%.
What is LIBOR?
LIBOR stands for the London Interbank Offered Rate. It is the benchmark interest rate that major banks lend to one another at globally. The rate is calculated and published each day by the Intercontinental Exchange (ICE), and is based on five currencies: US Dollar, Euro, British Pound, Japanese Yen, and Swiss Franc. It is typically used for short-term loans, ranging from overnight to 12 month terms.
While it is the rate for lending between global banks, it is also used a reference rate for consumer and corporate loans globally as well, with loans often priced at a spread to LIBOR.
What are LEAPs?
LEAP stands for Long-Term Equity Anticipation Securities. It’s a fancy way of saying that it’s a publicly traded option contract with an expiration date longer than one year.
An option contact gives a buyer the option to buy (call) or sell (put) at a given price in the future up to and until the expiration date. You pay a small premium upfront in exchange for that option.
In The Big Short, LEAPs are discussed as an example of how derivative contracts are frequently mispriced because they are overly weighted by an assets recent volatility, and underestimates the potential for extreme moves in prices in the future. This fundamental point is critical to what happened in the CDS market… if buying default protection had been more expensive, and the risk properly calculated, the financial fall out would likely have been much smaller and more contained.
What is LTV?
LTV stands for loan to value. How much is your mortgage relative to the appraised value of your home. For most traditional mortgages, lenders expect you to make a 20% down payment so your loan to value does not exceed 80%.
When your loan to value exceeds 80%, many lenders will require you to pay PMI (private mortgage insurance) to protect them against the risk you default.
What is Subprime?
Subprime is a a category of mortgage loans made to lenders with below average, or subprime, credit ratings. These borrowers are likely to have higher default risks, and therefore, their mortgages carry higher interest rates to compensate for that risk.
The significant growth and expansion of the subprime mortgage market, made possible by the growth in securitizing loans into MBS, is largely viewed as the most significant contributors to the 2008 financial crisis.
What is a Tranche?
A tranche is a segment of a pooled collection of loans within a CMO. In French, tranche literally means slice. The pool is typically grouped into different tranches based on different risk characteristics to make it marketable to different investors.
In a CMO, tranches could be grouped based on default risk, credit ratings, or likelihood of early repayment.
What is a Qualified Mortgage?
A Qualified Mortgage is one that meets specific requirements laid out by various agencies so that they can be securitized. These requirement both set rules the borrower must meet, as well as rules the lender must follow.
These requiremenet include:
- Cannot have negative amortization, interest-only payments or balloon payments
- Total points and fees cannot exceed 3% of the loan amount
- Mortgage term must be 30 years or less
- Must meet at least one of the following 3 requirements:
- Borrower’s DTI ratio is 43% or less
- Loan must be eligible for purchase by Fannie, Freddie or insured by the FHA, VA or USDA
- Loan must be originated by a small bank (less than $10 billion in assets) but only if held by the bank
It is important to note that many of these requirements came about as a result of the 2008 financial crisis.
Now that I’ve answered how do mortgages work, both for you as a borrower and for banks as your lender, and de-mystified lots of the financial jargon, hopefully, that helps clarify how what used to be a simple transaction between you and your bank, grew to something far more complex that nearly imploded financial markets back in 2008. To join in on more discussion about The Big Short, be sure to follow #FFMBookClub on Instagram. Learn more about the FFM Book Club and find our next read here.
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