How Mortgage-backed Securities Work

Did you did you notice that everything is spinning very quickly clockwise? I have? Yeah. Do you know what that is? A downward spiral? It is. It's the US economy circling the drain very quickly and taking the entire nation with it. It's pretty bad. Have you heard about this economic downturn? Yeah? I mean you can't miss it, man, It's everywhere it is. It is popping up everywhere. Um. Huge investment banks that

did whether the depression are starting to go under. Um. You know, there's there's all sorts of financial groups that are suffering as well. A i G. The largest insurance company in the United States who ensures all these people is going under right, Well, now it's owned by the government almost completely. Yeah, we well, uh, eight percent stake seventy nine point nine percent stake is owned by the federal government, owned by you and I we own we own part of that. I feel it. I feel it inout.

I know, did you feel richer? I know if you're wearing your top hat and monocle today very appropriately. Um, So all of this stuff is going on. Yeah, it's impossible to miss it. The crazy thing is that all of it can be traced back to a single thing, a single investment instrument that caused all of this problem. And I was happy to learn this. Do you you know what it is? Yeah, I'll go ahead, and it's called a mortgage backed security. And you're kind of the expert.

I want to go ahead and preface this by saying that Josh wrote these articles, and uh, I'm an economic idiot basically. So I learned a lot by reading them, and hopefully people will learn a lot by listening. Oh, I learned a lot by writing them. So if people if people learn a lot listening, then it will be a trifecta. Everyone will have learned. So yeah, what we're talking about today are subprime mortgage backed securities. There's different kinds.

Some more mortgage backed securities are are worse than others, and the worst of the bunch or subprime mortgage backed security, Well, go ahead, and I think the the raw definition probably would get people interest right off the bat. So basically what it is is a mortgage backed security is an investment tool that is based on a pool of mortgages.

So you take Chuck's mortgage and our producer Jerry's mortgage, and you know, everybody at how stuff works mortgages, you pull them together and then you divvy them up into basically shares of all this this one single pool of mortgages. And as long as everybody like Jerry and you, Chuck are are paying UH on your monthly your monthly mortgage payments, everything's fine right there. Like dividends, it gets distributed across

the shareholders of this pool of mortgages and everybody's happy, right. Well, who are the shareholders though, they're the people who bought uh these mortgage backed securities which are banks larger than the banks. It can be anybody, it can be anyvidy, Yeah, what you're talking about is the process of how this works. So that what I just said, that's a that's a

mortgage backed security. You could purchase a mortgage backed security, no way you if you wanted to, you could, and actually, ironically enough, um, because these mortgage backed securities are based on mortgages, and because they've been so divided up and repackaged and repurposed. Will get to that in a little bit. Um, it's actually possible that if you have like a four oh one K, or you invest in a mutual fund or something like that, you may actually own a share

of your own mortgage. Right. I couldn't at that in your article and I was blown away. Isn't they cool? That cool? I don't know if the if the economies in in the in the tank, then yeah, it's not good, but yeah it could be cool if you're making money off of your own mortgage, paying back yourself. It's positive about luck kind of. Yeah. So what you just mentioned, Chuck, is is how a mortgage becomes a mortgage backed security.

So say you go in and you you get a mortgage, you go through all the rigamar role and they issue you a mortgage. The bank when mortgage backed securities were hot, would turn around, put it together with you know, several other of their mortgages that they'd issued that day, and turn around and they sell it to UM an investment bank. Right, Okay, an investment bank takes the your bank's mortgages and some

other banks mortages and pulls them together. Even more so, now you have several hundred different mortgages and all of a sudden, it's a single UM mortgage back security. Right. And then they start selling shares. The investment banks starts selling shares, and then the investors, your your your mutual fund manager or somebody at JP Morgan Chase who who's looking for an investment, they buy these shares and they start collecting the dividends. So that's how it works, right, Okay.

It's actually a lot simpler than I thought. It's very very simple, Like if you look at it, just uh just it's a very basic method of investing. But it was completely totally radical when it came about. I think it was the late nineties when they first really hit the scene, maybe early twenty first century. And here's the thing. It's a really safe way to invest as long as you know the housing markets going well. Uh, the economy is doing well, and people are making their monthly mortgage payment.

There were rich times there for about a decade, probably right in the housing and it was it was based on that that housing Uh, that housing boom was keeping mortgage backed securities. Uh, it was making them perform well. So because of that, because the interplay between the housing market and mortgage backed securities, mortgage backed security has become this hot commodity on Wall Street. Everybody's buying, everybody wants them.

They're just great. It's money in the bank, right. The problem is is that demand created a situation where we needed more mortgages. So I mean basically, say you know you're a good prime borrower. Uh, you're somebody who you know, based on your credit rating, your credit history, your employment history, that kind of thing, you pose little risk of defaulting on your loan. There's a finite amount of prime borrowers

in the United States. And after a couple of years with you know, with the mortgages being pulled together and put into mortgage backed securities, UM, this pool of people dried up. And then I know what came next was the sub prime market, which is the big reason why the housing boom, uh, the bubble burst exactly because subprime borrowers. A lot of people think that subprime is uh has something to do with the rate, the interest rate. It's a below prime rate, That's what I always thought as well.

But no, it refers to the barrow exactly, as people that don't have enough income or the right credit. Basically, they were just writing things. Uh. You know, it's kind of like a blank check, a false market almost very much, very much so. But when banks change their lending practices to include subprime borrowers, all of a sudden, there's this huge untapped pool of people who can create mortgage backed securities because you can't have mortgage backed securities without mortgages.

So basically, to answer this clamoring for more mortgage backed securities on Wall Street, UH, banks had to uh start issuing more mortgages, and the investment banks were more than willing to buy all these mortgages no matter what. Right, So your local bank you go to say you're a sub prime barrowerk. And subprime has this really evil connotation here in two thousand and eight, but but really, if you think about it's just somebody who has a credit

score maybe below. I think right now it's six thirty. It could be six nine. When you're a subprime barrower, or maybe you've even changed jobs in the last year, they could make you a subprime bar There's there's a lot of factors. It doesn't mean like you're this um you know, nefarious drug dealing cat burglar. You're not taking the bank, drawing the welfare checks and swindling houses out

of banks, exactly right. Um, necessarily, some some have, but for the most part, it's you can't really categorize these people beyond their credit score. UM, so the banks since they're no longer hanging onto the mortgage. You know, time was you went to a bank. You've got a mortgage that sat in the bank's vault, that piece of paper did and you made monthly payments to the bank and

they took it in. And then after thirty years or whatever, you paid your last you made your last payment and they sent your mortgage and they were they did a lot of investigating into your history at that time because they were the ones, you know, that had the most to lose. They were carrying all the risks. If you defaulted on your loan, that bank took the hit and that was it ended there right. Um, with with the subprime or with the mortgage backed securities, that all changed.

Banks no longer had any risk whatsoever. They would almost literally issue you a mortgage and possibly that same day, turn around and sell it. That really explains it right there in a nutshell. So whoever ended up with this mortgage in whatever form, whether it was a mortgage backed security and it was divided among like fifty or a hundred or a thousand people, um, whoever ended up with it in the end assumed the risk. So these investment

banks didn't necessarily carry the risk either. The risk of you not paying your loan went to the individual investors. Right, Since all all these mortgages started to become based on subprime mortgages, all all the mortgage backed securities became based on subprime mortgages. When the foreclosure started, the market almost immediately plummeted, right because it was directly tied. Yeah, it wasn't a trickle down effect. That were directly linked. There

is another instrument too that we're based on mortgage backed securities. Right, So think about this. You have a mortgage, it's turned around and sold packaged with some other mortgages and then divided into shares. Those shares can actually be divided further and repackaged into something called collateral debt obligations. And some of these these can be based on all sorts of

different things. You can take just mortgage mortgages from a mortgage backed security and that will all mature in five years, or that are all interest only, or that are all fixed interests. There's all sorts of ways to package it. But one of the hottest items on Wall Street for collateral debt obligations were these, uh these instruments that were

made exclusively from subprime mortgage backed securities. Because you're a subprime borrow where you get a higher interest rate, So the security the investment on whether or not you're gonna pay your loan. It's riskier, but the dividends are higher because the interest rate is high. Sure and not unlike a lot of just the regular Wall Street stock market stocks, great risk equals great rewards and and that that pays off. But really, if you look at it long enough, arc

it never pays off. It always it always goes under. So what you have now is is a bunch of people playing playing hot potato with these things. They were they short excited, They're greedy, greedy, It's as simple as that. Was it a live for now type of thing that

they plan on dumping knees? I guess here's that's I would assume, yes, that that once people started realizing, wait a minute, eventually, when you follow these down the line, you're going to get to a house, and that house is basically its value is in this situation based on whether or not the person is making payments, and we're we're betting on subprime borrowers making payments, and if they don't, this this security tanks and we lose all of our money.

Someone somewhere down the line, around say two thousand six figured out that these things were going to tank because of foreclosures, and that's exactly what happened. So it started this domino effect. Well, who's it fault here? Or is that even important? I mean, was it? Or? I guess everyone kind of shares in the plane because the homeowner that that really doesn't have the money shouldn't go out

and try to get the house. The lender certainly they were making the commissions correct the mortgage brokers, so they were making money and then selling them immediately, or actually I think the mortgage lender it immediately goes to the bank, so they're not even really tied to the bank necessarily, and then the bank sells them. And it's just seems like the more it gets spread out and split up, the more fractured it gets. It's really hard to even

tell who's to blame anymore. It is. And I mean, ultimately, you know, finding the person to blame isn't gonna help anything now exactly, but it kind of eases the pain a little bit, or at the very least you have someone to direct your I or two. Well, I know, in an election here though a lot of people are looking at point fingers. If this is not an election year,

probably going down a little bit differently. I think, Um, I think there's a lot of people to blame, as you said, And I don't think it's just the lending industry or the investment banking industry. And I don't think it's just the people who who yeah, or the hockey

moms don't forget them right. I don't think it's it's the average subprime barrower who took out a loan larger than they can because they were sold a bill of goods, oftentimes because I wrote an article on subprime mortgages and a lot of people didn't even know what they were signing. These mortgage lenders would kind of use tricky dialogue to get them to sign on the dotted lines so they could make their commissions. Yeah, there's there was a lot

of predatory lending going up big time. Um so regard list of who's to blatant. These foreclosures start happening, and they start happening big time, widespread, all over the place, right, and like I said, it starts this domino effect. The weird thing is is new houses that were being constructed stop stop being sold as quickly because all of a sudden they had to compete with these four closed homes on the market exactly that were maybe half price. Yeah,

I bought my house and foreclosure. Yeah. I mean this was even before the big, big foreclosure bust where they're all over the place, So we just got kind of lucky. But yeah, all of a sudden, these new houses are sitting empty because, like you said, they can't compete with the house that's discounted. So all these four closed homes have this effect on the market the housing market, right, more new homes on them or more homes on the market means that the new homes aren't being sold because

the foreclosures are going. It's like a fire sale out there in real estate in the US. UM but the presence of more homes on the market, the presence of more anything, the more supply, the lower the price. Housing prices dropped. So you've got people all of a sudden who are like, wait a minute, I'm in this huge terrible UM maybe hybrid arm adjustable rate mortgage, and all of a sudden they owe more on their house than it's worth. How long are you gonna stick around? When

are you gonna leave and start renting? So, foreclosures keep going and going and going. And as these this wave of foreclosures takes over in the US housing market, it also directly impacts the the investment market as well, because everybody was, you know, so heavily invested in subprime mortgage backed security. And then you have the construction companies who own all these houses that aren't selling, so they have to lay people off, and then it leads unemployment. It's

it's a huge domino effect. That's exactly right. Everything, Uh, pretty much in the modern economy and the global economy and the US economy, everything is in a related precariously so, but it all goes back to mortgage back securities in this case. That's exactly right. Whose idea was this to begin with? I don't know, I've I've never found that out and I've actually looked. I think that they are laying low. There's got to be a dude, there's one

guy who had this idea. Yeah. Well, there's a lot of financial instruments that are out there, and they come out of places like Harvard Business or Wharton School and you know, among other places, and they're modeled. You know that you can run them through an an economic model, but it's really just a model and you can't really tell what kind of effect it's going to have until

after it's introduced in the market. In the real world is a little different sometimes, right, And there's no as far as I know, there's no regulation over introducing a financial instrument to the market, you know. I mean, we we regulate whether or not you can introduce a non native fish into a lake, but nobody's you know, watching over the financial instruments that are being introduced to the

to the the market right right. So I'm thinking basically, if we had regulation of that, if things were tested out on a small scale first before being released on mass that could be helpful. I think there's a whole lot of regulation that that could that could you know, take place. Well, maybe these guys should start listening to Josh Clark. Yeah, I guess this is a pretty dense subject to agree, Chuck. It's dense or I'm dense, one of the two. I don't think. I don't think you're dense.

It is. It's a very dense subject that I would recommend, uh, anybody listening to this podcast going on to how stuff works dot com and typing in how can mortgage back securities bring down the US economy? And stick around to find out which four articles Chuck and I consider essential reading right now? So, Chuck, four articles essential reading, right,

I'll say them because I know you're shy. Uh. They're all articles that you wrote, and they're really great in depth articles, and they are about the four uh candidates for president and vice president for this upcoming election. So we have how John McCain works, how Obama works, how Sarah H. Palin Palin Palin works, and how Joe Biden works. And I don't haven't read the Joe Biden one yet, but I'm hoping there's something in there about his teeth. Nothing about his teeth, a lot about his um foot

in mouth condition. Right, Well, if there's room in that mouth for a foot from all those teeth, then past does have amazing teeth. They're great beans and choppers like that. You can check all four of those out by typing in Joe Biden, Sarah Palin, Barack Obama, John McCain, any of them in our wonderful search bar on how stuff works dot com for more on this and thousands of other topics. Is it how stuff works dot com. Let us know what you think. Send an email to podcast

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