Securitization and the Housing Crisis
On the surface, securitization seems pretty simple and not nearly enough to screw over a multi-trillion dollar economy. It simply refers to mixing up many individual mortgages or loans into one security (a.k.a. something you can invest in).
In this case, though, something simple managed to become a huge, tangled mess.
Making Mortgages Less Secure
Ah, irony, we love you. Especially when we can define you.
Securitization and securities. You would expect with these words being thrown around that our mortgage system would be, ahem, secure. Here’s where the situational irony comes in: Securitization was meant to offer more security for mortgage holders, investors, and banks, but it was used and abused so much in the 1990s and beyond that it led to huge risks, instability, and eventually the housing crisis of 2008-2009.
Securitization of mortgages happens when brokers take a bunch of mortgages in a system like Fannie Mae, Freddie Mac, or others and divide them up into buckets. There are five of these imaginary buckets that brokers use (they’re stuck at the office all day, so imagining buckets is probably good for them):
(1) Mortgages that are almost sure to be paid off.
John Smith has a net worth of $10 million, a six-figure tenured job as a professor, a perfect credit score, a Tom Ford suit, flip flops, and a $300,000 mortgage. Even with the terrible choice in footwear, there’s very little that would happen that would make John unable to repay his loan. The $300,000 mortgage is probably equivalent to his toothpick budget.
(2) Mortgages that are likely to be paid off.
Jane and Jared Doe have good jobs: he’s a teacher and she’s worked in the same office for five years. They have a modest $250,000 mortgage and good (but not perfect) credit. They’ve plunked down $70,000 as a down payment and bought the loan officer a peach pie. They’re hard-working types and, while they may run into trouble, they are very likely to repay the loan.
(3) Mortgages that have a few question marks.
Sue Jane has moved around a lot, but always lands on her feet, whether she’s working at a radio station or travel resort. She had a few problems with credit a few years ago when she decided to throw her dog a birthday party in New Orleans, but she’s cleaned up her credit cards. Her credit’s not perfect, but maybe she’s ready for a home now.
(4) Mortgages that have a few question marks and maybe a few four-letter bombs.
The mortgage officer spilled a little coffee on the loan application after seeing the credit score— which happened after James Smith was fired twice and divorced three times. He’s missed a few mortgage payments on his last loan but eventually paid it off.
(5) Mortgages that have more red flags than a flag semaphore convention.
The loan application is filled out in green crayon and is enough to make a mortgage officer break a sweat. John Doe (and we’re not sure that’s his real name) has made late payments on his loans more than thirty times and has filed for bankruptcy twice. He lists his job as deodorant tester, but there’s no paperwork on that. The mortgage officer isn’t sure he wants to lend John his stapler, much less anything with George Washington’s face on it.
There are sellers selling these buckets of loans and investors buying them. Since mortgages in the first bucket have a low risk, buyers are less likely to lose their shirts; but these mortgages carry the best rates, so the investment might only produce 5% interest.
If you’re investing in mortgages like the one Sue Jane carries, there’s more risk, but if she (or enough people like her) pulls through, you might make 7-8% on your investment. But only about 10-15% of the people in that bucket might actually pay off the loan, and you don’t get any money on those mortgages where people just dig their heels in and don’t pay.
If you’re feeling very lucky—or, uh, reckless—you could invest in John Doe and his green crayon. You might get 20% on your investment…or 0% if no one among those mortgage holders pays off their loan.
Where it Went Wrong
When the system works, you can evaluate the risks and rewards so that you know what you’re getting into. What went wrong is that people lost sight of the buckets. Bankers wanted to sell and re-sell mortgages to make more money. After a few re-sales, it became harder to tell whether you were looking at a portfolio of people with great credit or people who should never have gotten a mortgage in the first place.
In some cases, people were promised a low-risk group of loans but were given high-risk mortgages where the risk of default was high. In some cases, bankers were offering loans to people they shouldn’t have been lending money to, and brokers quickly sold these loans for profit so they could become someone else’s problem.
It doesn’t even end there.
Investors sometimes use leverage to buy investments. Let’s say you’re a ramen-noodle-eating college student, but you have a few assets tucked away and some cash to invest. If you qualify for a loan, you can borrow money and invest it (plus your savings). If your loan interest rate is 5% but your investments yield or make 10%, you’re ahead of the game, and your loan has paid for itself and made you money. You can upgrade from ramen to dinner out every night at the local steak house.
But the opposite can happen, too.
Let’s say you borrow money at 5% to invest in mortgage-based securities. To make money, the actual people behind those mortgages have to pay their bills. And if they don’t? The whole package of mortgages you’ve bought drops in price. When that happens, other investors like you hit the panic button and try to sell their securities, which pushes the price even lower. Now you’ve got an investment that’s worth less than you paid for it and you’ve got a loan the bank’s calling about.
Shivering yet? You’ve just lost your shirt.
Between 2008 and 2009, investors across American lost their shirts, too. And they didn't look too good topless.
There’s no security system for securities. If you’re investing, you’re accepting the fact that there’s some risk, and unfortunately, you need to rely on what people tell you (and what you can read on the Internet) about the securities you buy. If the information is wrong, you could end up burned.
After 2008–2009, new laws were passed so that financial types have to disclose more information. That might help if you still want to invest—but…be careful.