Mortgage Securitization Part II

In a previous post on mortgage securitization, I argued that mortgage securitization – or any other debt securitization for that matter – was nothing more than a fraudulent scheme in which money is made through fees (and comissions) but that the scheme is sure to blow up at some point, but thanks to securitization not in the faces of the ones who reaped the benefits.

Here is some more evidence that supports that argument.

Let’s start – again, because it is one of the great sources – with Barry Ritholtz’s Big Picture, who hosts a post from ABS Investor Advocate. You’ll find quite a few other good posts there.

In his post ASF and NERA Rearrange the Deck Chairs, David J. Grais, a lawyer with 30 years experience in trials of complex financial and technical disputes, makes the following point:

There is only one question worth asking about securitization: why did securitization become the seedbed of the broadest and costliest epidemic of fraud in history? Until we face that question squarely and answer it honestly, securitization will remain in its coma. Unfortunately, the Obama Administration missed a chance to address that question in its plan to regulate the securitization market. (See the post immediately below.) ASF’s sponsorship of the NERA report is more insidious. By a combination of forbidding mathematics and emollient prose (“Recent experience appears to demonstrate readily that securitization is not inherently ‘good’ or ‘bad.’”), ASF tries to whisk us past that looming question and past the one measure that will best restore confidence in securitization: effective redress for investors against those that turned securitization from a useful financial tool into an orgy of misconduct.

The ASF report referenced in his post makes a few other interesting points, not at all positive for securitization (or the ASF). In fact, the report argues that securitization was a major contributor to the financial crisis (p. 10):

Our empirical analysis shows that increases in secondary market purchases have a positive and significant impact on the amount of mortgages credit per capita, with the non-agency sector displaying  a stronger impact in recent years. For example, the model suggests that a 10% increase in the secondary market purchase rate would increase mortgage loans per capita by 6.43% for a given Treasury rate of 4.5%. Higher incomes, lower unemployment rates, older borrowers, higher shares of borrowers from underserved areas, and strong price growth all correspond to higher loan amounts per capita. The results suggest that secondary market activities help increase credit availablitity to a greater extent in lower interest rate environments.

Or in other words, in environments where a loan issuer can borrow money cheaply, loans are doled out to people who normally could not get one or not one of that amount – presumably because they can’t afford it – and the rate of securitization increases (p. 10):

In addition, we document the increase in both the share of loans originated in underserved areas and the share of underserved loans sold to the secondary market. Both the dollar volume of originations in underserve dareas, as well as the share have increased since 1990 from $47 billion (16% of total originations) to as high as $609 billion in 2004 (26% of all originations).

Thus, no cheap funds and no securitization, no bubble. Please note that ‘underserved areas’ means low-income, high-minority census areas. On p. 12:

Mortgage Securitization

What’s wrong with Securitization?

Consider the following example. A bank has 10-year mortgages for 100 mln on their books, which generate a yearly cash-flow of 4%, i.e. 4 mln p.a.,  as people service their mortgage debt.

Of course, there is a risk to the bank from having 100 mortgages on their books – people could fall behind in paying them or simply default. Besides 4% is not a very exciting return in the world of masters of the universe.
So the bank, or rather the executives of the bank, might want to sell these mortgages so they can make a more lucrative use of the bank’s money. Selling the mortgages will probably generate less than 100 mln and the bank would forgo the cash-flow income of 4 mln p.a. Therefore there must be a better solution.

There is indeed one. It is called special purpose entity (SPE) or special purpose vehicle (SPV). It is a legal entity, much like a corporation, but not entirely like a corporation. It is more like the legal hull of a corporation containing almost only financial assets.
Since it is a separte entity, it is no longer represented on the banks books, the fianacial and legal risk is thus off-loaded.

So our bank, let’s call it Bank A, goes on and establishes this SPE, which we call SPE1, and intends to sell to it the mortgages for 100mln.
The SPE1, however, does not have cash yet, so it needs a loan, which luckily, Bank A, being a bank, is able and willing to provide – however, at 6% interest p.a. Bank A doesn’t want to be commited for 10 years for 6% only (interest rate risk. Besides SPE1 is risky, we’ll see below why), so it makes the loan 5 years only. This could also be two years, but let’s make the example with 5 years.

Having received the cash, SPE1 now buys the mortgages from Bank A for 100 mln. Bank A  has now 100 mln cash back in its accounts, a loan at 6% p.a. to SPE1 outstanding (interest, i.e. an income of 6.76 mln p.a.) and the loan will now be available for re-investing in 5 years instead of 10. In fact, 26.76mln will be available for re-investing after the first year already.

Best of all, the 100 mln in cash received for the sale of the mortgages are immediately available for issuing new mortgages. So that the game can start anew with an SPE2.

The clever bank executives get a bonus for increasing profits by more than 50% in one year (just by rearanging the balance sheet, but of course they won’t say so, they are clever). Bonuses are necessary, say the executives, to retain such talent that comes up with brilliant solutions like this. Of course, when they talk about ‘talent’ that must be retained, they are really talking about themselves.

Balance sheet Bank A before and after off-loading mortgages to SPE1

Now, SPE1 needs to generate an income of at least $26.76 mln p.a. over 5 years in order to repay the loan with interest to A. How does it do that, after all the mortgages still do only pay 4%, or 4 mln p.a.?

SPE1 could issue shares or bonds. Lets assume bonds.  SPE1 issues 1 mln bonds (e.g. CMOs), $30 each at 2% p.a., but that would just postpone the day of reckoning.
The 30mln generated in year one can be used to service the loan (with 26.76mln for year one), and the bondholders (o.6mln for year one) and we haven’t even factored in that SPE1 also has talent that wants to be retained.
However, for year two already, SPE1 will need a new source of funds, which it has to find for example by issuing new bonds/shares, or other types of debt, etc.

There is a whole host of such debt instruments with names like CDOs, CMOs, CLOs, CFOs,RMBS,CMBS and more. There are even CDOs based on CDSs. This bullshit is called financial ‘innovation’.

My conclusion then is that, over a longer period of time, this is as sure to crash as the usual pyramid scheme. Why? Well, because it IS a pyramid scheme.
The only real thing in this game are the fees and the bonuses, the rest is just smoke and mirrors used to hide the true state of affairs.

In fact, mortgage securitization is another example of the mechanism I described in a previous post.