How Mortgage-backed Securities Work


Announcer: Welcome to Stuff You Should Know from HowStuffWorks.com.

Josh Clark: Welcome to the podcast, located from deep within bowels of HowStuffWorks.com headquarters. This is Josh and Chuck. Say Hi Chuck.

Chuck Bryant: That makes us sound really fancy or creepy or something. I don't know. I like it.

Josh Clark: I was going for creepy.

Chuck Bryant: Okay. I'll take it.

Josh Clark: Did it work?

Chuck Bryant: I'm creeped out, yeah.

Josh Clark: Okay, good. Chuck, did you look out the window today, at all?

Chuck Bryant: I have.

Josh Clark: Did you notice that everything is spinning very quickly, clockwise?

Chuck Bryant: I have noticed that.

Josh Clark: You have. Do you know what that is?

Chuck Bryant: A downward spiral?

Josh Clark: It is. It's the U.S. economy, circling the drain, very quickly and taking the entire nation with it.

Chuck Bryant: It's pretty bad.

Josh Clark: Have you heard about this economic downturn?

Chuck Bryant: Yeah, I mean you can't miss it man. It's everywhere.

Josh Clark: It is. It is popping up everywhere. Huge investment banks that had weathered the depression are starting to go under. There's all sorts of financial groups that are suffering, as well. AIG, the largest insurance company in the United States, who insures all these people, is going under.

Chuck Bryant: Right. Well, now it's owned by the government, almost completely, correct?

Josh Clark: Yeah. Well, 80 percent stake, 79.9 percent stake is owned by the Federal Government, owned by you and I. We own part of that.

Chuck Bryant: I feel it. I feel it in my bones.

Josh Clark: I know. Don't you feel richer? I noticed you're wearing your top hat and monocle today.

Chuck Bryant: Right.

Josh Clark: Very appropriately. So all 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 this problem.

Chuck Bryant: Right and I was happy to learn this.

Josh Clark: You know what it is.

Chuck Bryant: Yeah, I'll go ahead. It's called a mortgage-backed security.

Josh Clark: Yeah, yeah.

Chuck Bryant: You're kind of the expert. I want to go ahead and preface this by saying that Josh wrote these articles. I'm an economic idiot, basically. So I learned a lot by reading them, and hopefully people will learn a lot by listening.

Josh Clark: Oh, I learned a lot by writing them. If people learn a lot listening, then it will be a trifecta.

Chuck Bryant: Perfect.

Josh Clark: Everyone will have learned, so yeah. What we're talking about today are subprime mortgage-backed securities. There's different kinds. Some mortgage-backed securities are worse than others. And the worst of the bunch are subprime mortgage-backed securities.

Chuck Bryant: Right. Well, go ahead. I think the raw definition probably would get people interested.

Josh Clark: Okay, get their juices flowing?

Chuck Bryant: Yeah, right off the bat.

Josh Clark: 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, Jeri's mortgage and everybody at How Stuff Works mortgages. You pool them together and then you divvy them up into basically shares of all this one single pool of mortgages.

Chuck Bryant: Right.

Josh Clark: And as long as everybody, like Jeri and you, Chuck, are paying on your monthly mortgage payments, everything is fine.

Chuck Bryant: Right.

Josh Clark: They're like dividends. It gets distributed across the shareholders of this pool of mortgages and everybody's happy.

Chuck Bryant: Right. Well who are the shareholders, though?

Josh Clark: They're the people who bought these mortgage-backed securities.

Chuck Bryant: Which are banks larger than the banks, correct?

Josh Clark: It can be anybody. I can be anybody. Yeah, what you're talking about is the process of how this works.

Chuck Bryant: Okay.

Josh Clark: So what I just said, that's a mortgage-backed security. You could purchase a mortgage-backed security.

Chuck Bryant: No, no way.

Josh Clark: If you wanted to, you could.

Chuck Bryant: Sure.

Josh Clark: And actually, ironically enough, because these mortgage-backed securities are based on mortgages and because they've been so divided up and re packaged and repurposed, we'll get to that in a little bit, it's actually possible that if you have a 401k or you invest in a mutual fund or something like that, you may actually own a share of your own mortgage.

Chuck Bryant: Right. I couldn't - I read that in your article and I was blown away.

Josh Clark: Isn't that cool?

Chuck Bryant: Cool, I don't know. Weird!

Josh Clark: It depends. If the economy is 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.

Chuck Bryant: Right, true.

Josh Clark: Paying back yourself.

Chuck Bryant: That's a positive outlook.

Josh Clark: Kind of, yeah. So what you just mentioned, Chuck, is how a mortgage becomes a mortgage-backed securities.

Chuck Bryant: Right.

Josh Clark: So say you go in and you get a mortgage. You go through all the rigmarole and they issue you a mortgage. The bank, when mortgage-backed securities were hot, would turn around, put it together with several other of their mortgages that they'd issued that day and turn around and they sell it to an investment bank.

Chuck Bryant: Right.

Josh Clark: Okay. An investment bank takes your banks mortgages and some other bank's mortgages and pools them together even more. So now you have several hundred different mortgages. And all of a sudden, it's a single mortgage-backed security.

Chuck Bryant: Right.

Josh Clark: And then they start selling shares. The investment bank starts selling shares. And then the investors, your mutual fund manager or somebody at JP Morgan Chase who is looking for an investment, they buy these shares and they start collecting the dividends. So that's how it works, right? Okay.

Chuck Bryant: It's actually a lot simpler than I thought.

Josh Clark: It's very, very simple. If you look at it, it's a very basic method of investing.

Chuck Bryant: Right.

Josh Clark: But it was completely and totally radical when it came about.

Chuck Bryant: Sure.

Josh Clark: I think it was the late 90s when they first really hit the scene, maybe early 21st Century. And here's the thing. It's a really safe way to invest, as long as the housing market is going well, the economy is doing well and people are making their monthly mortgage payments.

Chuck Bryant: Right, there were rich times there for about a decade, probably.

Josh Clark: Right.

Chuck Bryant: In the housing business.

Josh Clark: And it was based on that that housing boom was keeping mortgage-backed securities, it was making them perform well.

Chuck Bryant: Right.

Josh Clark: So because of that, because of that interplay between the housing market and mortgage-backed securities, mortgage-backed securities become this hot commodity on Wall Street. Everybody's buying them. Everybody wants them. They're just great. It's money in the bank. Right? The problem is that that demand created a situation where we needed more mortgages.

Chuck Bryant: Exactly.

Josh Clark: So basically, you're a good prime borrower. You're somebody who, based on your credit rating, your credit history, your employment history, that kind of thing, you pose little risk of defaulting on your loan.

Chuck Bryant: Right.

Josh Clark: There's a finite amount of prime borrowers in the United States.

Chuck Bryant: Right.

Josh Clark: And after a couple years, with the mortgages being pooled together and put into mortgage-backed securities, this pool of people dried up.

Chuck Bryant: And then I know what came next was the subprime market.

Josh Clark: Yes.

Chuck Bryant: Which is the big reason why the housing boom, the bubble burst.

Josh Clark: Exactly.

Chuck Bryant: Because subprime borrowers, a lot of people think that subprime has something to do with the rate, the interest rate, below prime rate.

Josh Clark: That's what I always thought as well, but no. It refers to the borrower.

Chuck Bryant: Exactly, people that don't have enough income or the right credit. Basically they were just writing things. It was kind of like a blank check, a false market, almost.

Josh Clark: Very much, very much. 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.

Chuck Bryant: Right.

Josh Clark: So basically, to answer this clamoring for more mortgage-backed securities on Wall Street, banks had to start issuing more mortgages. And the investment banks were more than willing to buy all these mortgages, no matter what.

Chuck Bryant: Right.

Josh Clark: So your local bank that you go to, say you're a subprime borrower. And subprime has the really evil connotation here in 2008.

Chuck Bryant: Yeah, it does.

Josh Clark: But really, if you think about it, it's just somebody who has a credit score maybe below; I think right now it's 630.

Chuck Bryant: Right.

Josh Clark: It could be 629 and you're a subprime borrower. Or maybe you've even changed jobs in the last year. That could make you a subprime borrower. There's a lot of factors. It doesn't mean you're this nefarious drug dealing cat burglar.

Chuck Bryant: Right.

Josh Clark: Who is taking the bank for a ride?

Chuck Bryant: You're not drawing a welfare check and swindling houses out of banks, necessarily.

Josh Clark: Necessarily. Some have, but for the most part, you can't really categorize these people beyond their credit score.

Chuck Bryant: Right.

Josh Clark: So the banks, since they're no longer hanging on to the mortgage - time was, you went to a bank. You got a mortgage. That sat in the bank's vault, that piece of paper did. And you made monthly payments to the bank.

Chuck Bryant: Right.

Josh Clark: And they took it in and then after 30 years or whatever, you paid your last - you made your last payment and they sent you your mortgage.

Chuck Bryant: Right and they did a lot of investigating into your history at that time.

Josh Clark: Sure.

Chuck Bryant: Because they were the ones that had the most to lose.

Josh Clark: They were carrying all the risk.

Chuck Bryant: Exactly.

Josh Clark: If you defaulted on your loan, that bank took the hit and that was it. It ended there.

Chuck Bryant: Yeah.

Josh Clark: Right? 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.

Chuck Bryant: That really explains it, right there in a nutshell.

Josh Clark: So whoever ended up with this mortgage, in whatever form, whether it was a mortgage-backed securities and it was divided among 50 or 100 or 1000 people, 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?

Chuck Bryant: Right.

Josh Clark: Since all of these mortgages started to become based on subprime mortgages, all the mortgage-backed securities became based on subprime mortgages, when the foreclosures started, the market almost immediately plummeted.

Chuck Bryant: Right, because it was directly tied.

Josh Clark: Yeah.

Chuck Bryant: It wasn't a trickle down effect. They were directly link ed.

Josh Clark: There was another instrument too, that were based on mortgage-backed securities. 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.

Chuck Bryant: Right.

Josh Clark: And some of these, these can be based on all sorts of different things. You can take just mortgages from mortgage-backed securities that will all mature in five years or that are all interest only or that are all fixed interest. There's all sorts of ways to package it. But one of the hottest items on Wall Street, for collateral debt obligations were these instruments that were made, exclusively from subprime mortgage-backed securities. Because you're a subprime borrower, you get a higher interest rate.

Chuck Bryant: Right.

Josh Clark: So the security, the investment on whether or not you're going to pay your loan, it's riskier. But the dividends are higher because the interest rate is higher.

Chuck Bryant: Sure, and not unlike a lot of just the regular Wall Street stock market stocks, great risk equals great reward.

Josh Clark: Right. And that pays off. But really, if you look at it on a long enough arc, it never pays off. It always goes under. So what you have now is a bunch of people playing hot potato with these things.

Chuck Bryant: Now were they short-sided or were they -

Josh Clark: They were greedy.

Chuck Bryant: Greedy.

Josh Clark: It's as simple as that.

Chuck Bryant: Was it a live for now type of thing?

Josh Clark: Yes.

Chuck Bryant: Were they planning on dumping these?

Josh Clark: I guess. I would assume, yes, 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, basically its value, is, in this situation, based on whether or not the person is making payments.

Chuck Bryant: Right.

Josh Clark: And we're betting on subprime borrowers making payments. And if they don't, this security tanks and we lose all of our money. Someone, somewhere down the line, around say 2006, figured out that these things were going to tank because of foreclosures. And that's exactly what happened.

Chuck Bryant: Right.

Josh Clark: So it started this domino effect.

Chuck Bryant: Well who's at fault here? Or is that even important? I mean was it - I guess everyone kind of shares in the blame because the homeowner 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.

Josh Clark: Sure.

Chuck Bryant: So they were making money and then selling them immediately. Or actually, I think the mortgage lender immediately goes t o the bank. So they're not even really tied to the bank, necessarily. And then the bank sells them and it 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 any more.

Josh Clark: It is. And ultimately, finding the person to blame isn't going to help anything now. But it kind of eases the pain a little bit, or at the very least, you have someone to direct your ire to.

Chuck Bryant: I know in an election year, though, a lot of people are looking to point fingers.

Josh Clark: Sure.

Chuck Bryant: If this was not an election year, it would probably be going down a little bit differently.

Josh Clark: 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 took out huge -

Chuck Bryant: Joe, six-pack, homeowner.

Josh Clark: Yeah. Or the hockey moms don't forget them.

Chuck Bryant: Right.

Josh Clark: I don't think it's the average subprime borrower who took out a loan larger than they can afford.

Chuck Bryant: Right, because they were sold a bill of goods, often times, 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 line so they could make their commissions.

Josh Clark: Yeah, there was a lot of predatory lending going on, big time. So regardless of who's to blame, 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 new houses that were being constructed stopped being sold as quickly because all of a sudden, they had to compete with these foreclosed homes on the market.

Chuck Bryant: Exactly.

Josh Clark: That were maybe half price.

Chuck Bryant: I bought my house in foreclosure. And this was even before the big, big foreclosure bust where they were all over the place. 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 a house that's 40 percent discounted.

Josh Clark: Right. So all these foreclosed homes have this effect on the market, the housing market, right. 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 U.S. But the presence of more homes on the market, the presence of more anything, the more supply, the lower the price.

Chuck Bryant: Right.

Josh Clark: So housing prices drop. So you've got people, all of a sudden, who are like wait a minute. I'm in this huge, terrible, 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 going to stick around? When are you going to leave and start renting? So foreclosures keep going and going and going. And as this wave of foreclosures takes over the U.S. housing market, it also directly impacts the investment market as well.

Chuck Bryant: Right.

Josh Clark: Because everybody was so heavily invested in subprime mortgage-backed securities.

Chuck Bryant: Right, and then you h ave the construction companies who own all these houses that aren't selling, so they have to lay people off. And then it leads to unemployment. It's a huge domino effect.

Josh Clark: That's exactly right. Everything pretty much in the modern economy, in the global economy, in the U.S. economy, everything is interrelated, precariously so.

Chuck Bryant: Right, but it all goes back to mortgage-backed securities in this case.

Josh Clark: That's exactly right.

Chuck Bryant: Whose idea was this to begin with?

Josh Clark: I don't know. I've never found that out and I've actually looked. I think they are laying low.

Chuck Bryant: There's got to be a dude. There's one guy who had this idea.

Josh Clark: 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, among other places. And they're modeled. You can run them through an economic model, but it's really just a model. You can't really tell what kind of effect it's going to have until after it's introduced in the market.

Chuck Bryant: Right and the real world is a little different sometimes.

Josh Clark: Right and there's no, as far as I know, there's no regulation over introducing a financial instrument to the market. I mean we regulate whether or not you can introduce a non-native fish into a lake, but nobody's watching over the financial instruments that are being introduced to the market, right.

Chuck Bryant: Right.

Josh Clark: So, I'm thinking, basically, if we had regulation of that, if things were tested out on a small scale first before being released en masse that could be helpful.

Chuck Bryant: Sure.

Josh Clark: I think there's a whole lot of regulation that could take place.

Chuck Bryant: Well maybe these guys should start listening to Josh Clark.

Josh Clark: Yeah, I guess. This is a pretty dense subject. Do you agree, Chuck?

Chuck Bryant: It's dense or I'm dense, one of the two.

Josh Clark: I don't think you're dense. It is. It's a very dense subject. I would recommend anybody listening to this podcast going on to HowStuffWorks.com and typing in how can mortgage-backed securities bring down the U.S. economy. And stick around to find out which four articles Chuck and I consider essential reading right now. So Chuck, four articles, essential reading!

Chuck Bryant: Right. I'll say them because I know you're shy. They're all articles that you wrote and they're really great in depth articles. And they are about the four candidates for President and Vice-President for this upcoming election. So we have How John McCain Works, How Obama Works, How Sarah Palin Works and How Joe Biden Works. And I haven't read the Joe Biden one yet, but I'm hoping there's something in there about his teeth because those are fantastic.

Josh Clark: Nothing about his teeth, a lot about his foot in mouth condition.

Chuck Bryant: Right, well if there's room in that mouth for a foot, from all those teeth, then that's awesome.

Josh Clark: He does have amazing teeth.

Chuck Bryant: They're great. I need some choppers like that.

Josh Clark: You can check all four of those out by typing in Joe Biden, Sarah Palin, Barrack Obama, John McCain, any of them in our wonderful search bar on HowStuffWorks.com.Announcer: For more on this and thousands of other topics, visit HowStuffWorks.com. Let us know what you think. Send an e-mail to Podcast@HowStuffWorks.com.