What is: A Mortgage-Backed Security

My last post was on mortgages, and focused on the home-owner (see here). If you'll recall:

1. The Home-Owner has a mortgage liability, which is the obligation to pay back the instalments over the mortgage term; and
2. The Bank has a mortgage asset, which is the right to receive instalments over the mortgage term.

Now this situation can create a slight problem for the Bank. Firstly, banks are political hot potatoes - if a bank goes down, there are going to be a lot of unhappy voters. And because they have such high political risk (I'm a cynic), they are highly-regulated. That regulation will extend down to the type and ratio of assets that a bank can have on their Balance Sheet. 

And this has a lot to do with liquidity risk. 

• Liquidity Risk: is the risk that an institution/individual will not have enough cash to settle its debts. For example, let's say I spend all my savings on a porsche worth $30,000, but owe my friend $1,000. Even though I can theoretically afford to pay my friend back (I can always sell the car), I have high liquidity risk because it will take me time to sell the car. If he asks for the money tomorrow, I'm not going to be able to pay him.

Banks face the following liquidity risk conundrum:

1. Their liabilities tend to be current (ie. they can require payment in cash on very short notice);
2. Their assets tend to be non-current (ie. the cash inflows are expected to happen over a period of time).

Note: a bank's liabilities would include my savings deposit. From the bank's perspective, they owe me my money - and it is therefore their liability. As I can withdraw my savings on very short notice, the liabilities would be current for the bank.

Therefore, most countries will regulate the amount of long-term assets that a bank can have on its books. If a bank wants to give out more mortgages (and make more money), it has to find some way of removing long-term assets from its books, and replacing them with cash (a short-term or current asset). At the same time, some governments (especially the US government) actually want there to be more mortgages out there. The American Dream, after all, is two kids, a wife and a mortgage. So there is immense pressure from many sides to ease credit in the mortgage market.

Enter: the Mortgage-Backed Security. Or MBS for short. Also known as a CMO (Collateralised Mortgage Obligation - as the debt is collateralised by property).

For a typical mortgage, the original cash-flows are between the Lender and the Home-owner:

Cash Flows between the Home-Owner and the Bank/Mortgage-Lender

In a Mortgage-Based Security transaction, the Bank "sells" the cash-flows it receives from the Home-owner to a third-party investor. The cash-flows now look like this:

The Repackaging of Mortgage Cash Flows as Mortgage-Backed Securities

The net effect is that the bank has become an intermediary. It has removed the mortgage asset from its books and replaced it with the cash that it received from the sale of the securities. At the same time, I should probably point out that the Investor gets the principal and interest after fees. Which makes sense: a Bank must earn on the way in and on the way out.

Some points:

1. The bank will never sell an investor one mortgage. Rather, they will sell a "book" of mortgages - which is generally referred to as a "Mortgage Pool". This diversifies risk; because it is extremely unlikely that all the mortgages in the pool will default, or prepay, or anything else that disrupts the schedule of cash flows.
2. However, it is likely that a portion of the pool will default, or prepay, or otherwise disrupt the flow of cash. This historically created a problem with mortgage-backed securities, as the cash flows were considered too unreliable to be securitised. 
3. But the uncertainty of the cash flows can be addressed to some extent, because when it comes down to the difference between principal and interest - the interest is clearly more of a problem. The principal is set. But the interest is dependent on interest rate changes (people could refinance), prepayments and curtailments (early repayments of principal). 
4. So the solution is to split the cash flows. Some investors only want the principal cash flows, some only want the interest cash flows (the risk-loving bastards), and some are more versatile:

The Mortgage Pool being broken up into CMO with different risk exposures

And obviously, the riskier the CMO type, the cheaper its selling price (which is the same as saying that it earns a higher return). 

Once the Banks started differentiating between types of cash flow, everyone went crazy on this risk category business. They took the Principal + Interest section, and started decomposing it into who gets paid first, who gets paid last, who is the first to lose out if the underlying mortgage holders default, and so on. The mortgage pool was therefore separated into "tranches" based on the type of cash-flow and the variety of risk. 

These tranches would then be rated from AAA all the way down to junk status by the Ratings Agencies - and the investment grade stuff could then be bought by the regulated institutional investors like pension funds.

And the junk stuff?

Well this is where it really starts to get interesting. 

In the next post. 

What is: A Mortgage

Given the recent news around the US Housing Market and the Freddie Mac, I thought that I should start tackling the Subprime Mortgage crisis, the Debt Ceiling Crisis, the America-in-General crisis, and all the fun stuff that goes with it.

But before I can get to that, I think I may have to back-track a little to discuss mortgages, and mortgage-backed securities. Like I've said before, we all know that having a mortgage is related to owning a house. In America, it's also related to living the dream. But for many people my age, a mortgage is something to think about:

1. When you're getting married; and
2. Once you've found a real job (that pays real money).

And my age group is just about there. At least, we're getting married. The real job is more of a hit-and-miss situation.

Definition: 

• Mortgage: the official name for a hire-purchase arrangement attached to buying a house. The purchase price of the house is borrowed upfront, and then repaid over a specified period of time in regular instalments. Each instalment comprises a portion of principal (the original purchase price/capital amount) and a portion of interest (the cost of borrowing the capital).

It generally works as follows:

1. You find the house you want. 
2. You find out how much it costs 
3. You then approach a bank in search of finance. 
4. You fill out a large number of forms which look a lot like a stylised version of your facebook profile, except with more emphasis on your payslip, your monthly debit orders, and your expensive and frequent taste in restaurants. Unlike facebook, there is also a frantic search for supporting documentation. Photoshopping - unfortunately, not encouraged.
5. You wait.
6. The bank then comes back to you with a mortgage proposal that is significantly lower than the cost of the house that you'd like to buy. 
7. You sign anyway, and find another house in your price range. There's no ways that you're going through that again.

Once you've found the house you can actually afford, the bank pays the purchase price. You then repay the bank in monthly instalments for however long a mortgage period we're talking about (the mortgage period is known as the term). The important thing to note is that your instalments include two things:

1. Principal - which is the capital amount you borrowed upfront; and
2. Interest - which is the cost of borrowing the money from the bank.

As the interest is being calculated on the principal outstanding, the interest cost is highest at the beginning of the mortgage period, and gradually reduces as you pay back more principal. But this is all factored into the monthly instalment. So your first instalment will consist mostly of interest, with only a little principal being repaid. And over time, this ratio will shift in the other direction, as illustrated:

Mortgage Repayments Over Time

The above implies that you cannot get into a situation where your interest owing on the principal outstanding is greater than your mortgage instalment. If that were the case, the unpaid interest portion would also accrue interest, and you would enter into a "death warrant" situation, where you would never be able to pay off the debt (on the contrary, you would just go deeper into debt as time goes by!). That situation is a form of financial slavery. Many countries have made it illegal - in South Africa, we have the National Credit Act which prevents it from happening.

The other fact to point out is that a mortgage loan is collateralised by the house itself: which means that the bank will either get your mortgage repayments, or the house. When a home-loaner misses a mortgage repayment, the bank has the right to foreclose on the mortgage loan - which basically means that it takes ownership of the house and sells it to recoup (claim back) its loan.

So that's the basic form of a mortgage. To recap:

1. The home-owner has a mortgage liability where he/she is obliged to pay monthly instalments to the bank;
2. The bank has a mortgage asset, where it is entitled to receive monthly instalments from the home-owner.

At this point, I'd like to bring in a few technicalities that will become more relevant when I post about the Subprime Crisis. Firstly, there are often variations in the type of interest rate specified in a mortgage contract:

1. Fixed Rate Mortgages: are mortgages where the rate of interest is fixed in the contract (ie. the monthly instalments will be explicitly quantified in the loan contract). These are the common form of mortgages in the United States. 
2. Variable Rate Mortgages: are mortgages where the rate of interest is defined in the contract in relation to a published rate of interest (for example, in South Africa, we have the prime rate of interest - so the contract could specify "interest at Prime plus 1 per cent"). The mortgage repayments will therefore fluctuate with movements in prime. These are also known as "Floating Rate Mortgages".

Now this is interesting to me because I think it demonstrates the relative empowerment of a population. Fixed Rate mortgages force the Bank to carry the interest rate risk; Variable Rate mortgages force the home-owner to carry the interest rate risk.

• Interest Rate Risk: the risk that you will have to pay more when interest rates go up (in the case of the home-owner), or the risk that you will receive less when interest rates go down (in the case of the bank). 

Clearly, where Fixed Rate Mortgages are in place, the bank will lose out if interest rates go up - as they could have earned more interest if they had a Variable Rate Mortgage.

But the bank will still benefit if the rates go down, right? Because the home-owner has committed to a fixed rate mortgage with the higher rate of interest?

No. If you've ever heard the phrase "refinance the mortgage" - this is where it comes into play. When interest rates go down, the home-loaner simply refinances. While I'm not sure of the exact way that it happens in the US banks, it makes sense to me because, if I were a home-owner, I would:

1. Approach a new bank and take out a mortgage on my house at the low interest rate; and then
2. Use the mortgage loan to pay off the original mortgage.
3. Now I have a fixed rate mortgage at the low rate.

This leaves the banks fully exposed to the downside of interest rate risk, with none of the upside. Because no home owner is going to refinance when interest rates go up!

Two final terms that I'd like to introduce here are a "prepayment" and a "curtailment".

A prepayment is a repayment of principal over and above the mortgage instalment. It effectively means that you will pay less interest over the mortgage term, thereby either reducing your monthly instalments, or shortening the mortgage term (if you continue to pay the original instalment amounts). Interestingly, prepayments are not encouraged by the bank - and there are often prepayment penalties imposed by the mortgage loan contract.

A prepayment usually refers to the settlement of the full outstanding capital amount, where a curtailment refers to a partial settlement.

In the next mortgage-related post, I will talk about Mortgage-Backed Securities. And after that, I can get to the really interesting part: the Subprime Crisis.

Daily News Roundup 2012: Wednesday 1 February

So, the news that I'm reading:

The Eurozone Debt Crisis

• Greece one step away from Debt Deal (Associated Press via CNBC) link: http://www.cnbc.com/id/46205601 
• Europe's Central Bank can't fix "dysfunctional" EU (CNBC) link: http://www.cnbc.com/id/46205597
• What happens if Greece defaults? (CNBC) Link: http://www.cnbc.com/id/43425042?slide=1 Slide 11 is frankly unnecessary. 
• Portugal Pressures ECB to Halt Contagion (Bloomberg) Link: http://www.bloomberg.com/news/2012-01-31/portugal-as-greece-pressures-ecb-to-halt-contagion-prompting-nascent-bulls.html

The key points:

1. Everything mostly continues unchanged. Greece is still close to a deal, but not there yet.
2. The Greek deal will not be enough to make her debt sustainable. Even if there is a 70% haircut.
3. Germany is still irritated.
4. France is still telling everyone that they'll only ratify the new Fiscal Treaty after elections (ie. once Sarkozy has been replaced - that seems to be the general idea...)
5. Journalists still keep writing misleading headlines like "Greek Debt talks continue as EU signs new treaty". From what I can tell, that treaty is still unsigned and unratified. The best we can talk about is general agreement to agree.
6. Portugal is the new Greece. 
7. People (important ones) think that the EU is dysfunctional: the Southern countries (and, for some reason, Ireland) have one code of fiscal discipline (debatable use of the word "discipline") where the Northern countries have another (less debatable use). No big surprises there.
8. I found an interesting slide show on CNBC: "What happens if Greece defaults?". Although I felt that Slide 11 was frankly unnecessary. Link:  http://www.cnbc.com/id/43425042?slide=1 

The Golden Cross

• Stocks form "Golden Cross" (CNBC) link: http://www.cnbc.com/id/46203721 When the 50-day moving average crosses the 200-day moving average - considered a bullish signal. Issue with technical chartists.

The key point:

1. The Golden Cross is a trend observed by technical chartists: when the 50-day moving average crosses above the 200-day moving average. It's considered to be a bullish signal, mainly because it means that the average share price (that's more or less what an index is) over the last 50 days is now higher than the average over the last 200 days. Higher short-term averages over long-term averages sounds like the markets are picking up.
2. I'm just not sure why everyone is so excited. Generally speaking, technical chartists are dismissed as not having predictive power. 
3. It's interesting that the markets seems to be recovering, but the technical chartists then take it a step further and say that we can now reasonably expect a bullish market (an 81% chance) because that's what has happened historically.
4. Many academics consider this an incorrect assumption for a number of reasons (including a number of quantitative academic studies). But mostly, in my mind, the problem is the oranges and apples story. There is a mismatch between the underlyings: the historic data was generated in a period that had definitively different economic characteristics to today's. We are not the same fruit anymore.

The Republican Nomination

• Mitt Romney wins Florida Primary (Associated Press via CNBC) link: http://www.cnbc.com/id/46212222

I'll admit that I don't really understand the nomination process. Everyone runs around collecting delegates in various states, all in the lead-up to a convention. Anyway - I read it because I like the word "caucuses" - and I'm interested to see if the Republicans will nominate a candidate with a name like Newt Gingrich. He sounds like a character out of Harry Potter. But I suppose it worked for the Democrats with Obama. 

If politics had technical chartists, they would be predicting Newt Gingrich for the win on that basis alone.

Sorry - that was a bit mean. 

The US Housing Market Saga

• Treasury Investigates Freddie Mac Investment (The New York Times via CNBC) link: http://www.cnbc.com/id/46201587 Freddie Mac is a mortgage giant. Pressure from the Obama administration to forgive some of the principal for mortgage-holders whose principal exceeds the value of the underlying house (election year) - ease refinancing, and participate in debt forgiveness programs. Under investigation for investing in "inverse floaters" in 2010 - effectively giving them exposure to the interest component of mortgages. At the same time, Freddie Mac has barriers in place to prevent refinancing. 
• Foreclosures draw Private Equity as US sells homes (Bloomberg) Link: http://www.bloomberg.com/news/2012-01-31/foreclosures-draw-private-equity-as-u-s-selling-200-000-homes-mortgages.html

The key points:

1. Firstly, this is hugely interesting. I'm going to have to write a series of posts on the US Housing Market because it's both fascinating and important on a number of levels (it did, after all, trigger a crisis).
2. The Freddie Mac (the Federal Home Loan Mortgage Corporation) is a US government-sponsored enterprise that is intended to expand the credit available to home-owners (the topic of a future post).
3. The Freddie Mac has been under pressure recently from the Obama administration to ease refinancing for mortgage-holders, and participate in debt forgiveness programs. It is, after all, an election year. 
4. The background to this story is that after the housing market crashed, some investors were left with principal amounts to repay that exceeded the value of their properties (to be honest, for many, this was the case before the crash as well). So the Obama administration would like to forgive some of the principal for these home-owners; and also to permit them to refinance the mortgages at the new lower interest rates being pushed by the Treasury. ("Refinancing a mortgage" essentially means that you can take out a new mortgage at the lower rates of interest, and use those proceeds to pay off the old mortgage at the higher rates of interest, with the net effect that you pay less interest).
5. Freddie Mac has been actively resisting both the refinancing and the principal forgiveness - arguing that it does not make economic sense.
6. It turns out, however, that Freddie Mac has been investing in "inverse floaters". Basically, an "inverse floater" is a financial instrument that has higher values when mortgage-holders pay higher rates of interest (ie. when they're not permitted to refinance). 
7. It all smells a little like vested interest.

The US Credit Rating

• S&P warns of cuts; Another US downgrade coming? (CNBC) link: http://www.cnbc.com/id/46202656 

The key points:

1. The issue is health-care costs. As these go up, so the spending pressure increases.
2. The interesting question being raised is whether a US downgrade will make a difference. After all, the dollar was still a safe haven after its downgrade in August 2011. It actually strengthened.
3. According to the economist interviewed in the article, it seems that Ratings Agencies have a very short term view. If you project out any healthcare and pension costs, there should be no AAAs at all.

Dodd-Frank

• Citigroup opposes applying Dodd-Frank to Municipal Bond Market (Bloomberg) Link: http://www.bloomberg.com/news/2012-01-31/citigroup-joins-msrb-to-oppose-applying-dodd-frank-law-to-muni-bond-market.html

The key points:

1. The Dodd-Frank is to the Subprime Crisis what Sarbanes-Oxley was to the Enron crisis.
2. We should all know more about it. 

Other

• CNBC has a special "coverage" section on the Porn Convention 2012. Link: http://www.cnbc.com/id/45292339/

The key points:

1. The Adult Entertainment industry is a $14 billion industry, despite being under threat from piracy and legislation.
2. Like the Tobacco industry, most users repeat.
3. Would you invest in a listed Adult Entertainment conglomerate? Ethically, maybe not. But morals aside? Forgive the pun - but yes, you'd probably want to have a closer look...