Mortgage backed bonds have a problem. No one is willing to buy them except at a huge discount to their intrinsic value. This is often referred to as a liquidity problem. The liquidity problem is partly the result of being unable to determine the value of modern mortgage backed securities.
Mortgage backed securities are bonds that are backed by a pool of mortgages, and there are trillions of dollars in mortgages.
We never know ahead of time exactly how many people who buy a house will fail to pay the mortgage, but we have a statistical history that tells us that under ordinary circumstances, in times past a certain percentage - call that “x%” - will go into default and the house will have to be repossessed and resold.
The problems began when lending standards were abandoned due to a combination of greed, stupidity and the ability of mortgage originators to sell the mortgages instead do holding them. If a mortgage company like Countrywide can create mortgages and sell them to someone else who bears the brunt of defaults, they can poison the entire mortgage market. And they did. They were aided and abetted by crooked politicians like Barney Frank and Chris Dodd, mortgage packagers like Fannie and Freddie, investment banks that demanded more and more of these profitable bonds, rating agencies that fell down on the job, and the liars who took out mortgages they could not afford.
So now what? What’s a defaulted mortgage worth?
Instead of getting technical, let’s get practical. If I had a mortgage on my property of $500,000 and its assessed value was $400,000 what would a mortgage backed security that includes my mortgage be worth? That’s a guesstimate, isn’t it? Let’s say I am part of a pool of mortgages and I can’t afford to pay the mortgage. What is the pool worth?
There are several moving parts: the number of homes that will have to be repossessed and the resale prices of the foreclosed homes are two of the major factors. What could a vulture recover? To use real numbers, let’s say my mortgage is $500,000 and the market value is $400,000. Look at your own assessment. In my case, the value of the lot is about 30% of the total assessed value of my home. So if someone took over my mortgage and burned my home to the ground, they could probably sell the empty lot for about $120,000 ($400,000 x 30%). So that’s the bottom line on the value of the repossessed home, a recovery rate of 24% ($120,000 is 24% of the $500,000 mortgage)…. just for the land.
The current rate of people who are late or in default on mortgages is 12%. For purposes of this discussion, let’s assume that this figure rises to 50%.
So a random pool of mortgages with a 50% default rate where the homes in default get burned to the ground and the empty lost is sold would have a value of 62% of face value (.5 x100% + .5 x 24%). PIMCO, the huge bond manager is offering 60%. Do you think they know something that some people who are scared out of their wits - and can’t do math - don’t?
The problems began when lending standards were abandoned due to a combination of greed, stupidity and the ability of mortgage originators to sell the mortgages instead do holding them. If a mortgage company like Countrywide can create mortgages and sell them to someone else who bears the brunt of defaults, they can poison the entire mortgage market. And they did. They were aided and abetted by crooked politicians like Barney Frank and Chris Dodd, mortgage packagers like Fannie and Freddie, investment banks that demanded more and more of these profitable bonds, rating agencies that fell down on the job, and the liars who took out mortgages they could not afford.
So now what? What’s a defaulted mortgage worth?
Instead of getting technical, let’s get practical. If I had a mortgage on my property of $500,000 and its assessed value was $400,000 what would a mortgage backed security that includes my mortgage be worth? That’s a guesstimate, isn’t it? Let’s say I am part of a pool of mortgages and I can’t afford to pay the mortgage. What is the pool worth?
There are several moving parts: the number of homes that will have to be repossessed and the resale prices of the foreclosed homes are two of the major factors. What could a vulture recover? To use real numbers, let’s say my mortgage is $500,000 and the market value is $400,000. Look at your own assessment. In my case, the value of the lot is about 30% of the total assessed value of my home. So if someone took over my mortgage and burned my home to the ground, they could probably sell the empty lot for about $120,000 ($400,000 x 30%). So that’s the bottom line on the value of the repossessed home, a recovery rate of 24% ($120,000 is 24% of the $500,000 mortgage)…. just for the land.
The current rate of people who are late or in default on mortgages is 12%. For purposes of this discussion, let’s assume that this figure rises to 50%.
So a random pool of mortgages with a 50% default rate where the homes in default get burned to the ground and the empty lost is sold would have a value of 62% of face value (.5 x100% + .5 x 24%). PIMCO, the huge bond manager is offering 60%. Do you think they know something that some people who are scared out of their wits - and can’t do math - don’t?
2 comments:
Most of these products are leveraged within their structures. Otherwise their yields would have been most unattractive (think mortgage rate minus servicing charges and marked up at each level). To get any decent rates, these products were highly leveraged.
Some were, some were not. The typical financial engineering was done by creating a number of tranches with the riskiest ones getting the highest yields in return for taking the first losses. The highest tranches were even more secure than a mortgage backed bond that was not sliced and diced this way since it had the lower tranches protecting it. The reason these bonds were bought was because they had higher yields than comparable treasuries giving pension funds, for example, ways of getting a better return. For an even better explanation go here.
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