What the hell happened?
When you buy a house, you take out a mortgage. A mortgage is, in essence, a loan. For this type of loan, you are using that house that you bought as collateral. If you do not make your mortgage payments when they are due, you are defaulting on that loan, and you will lose your home.
What is the correct way to assess risk?
If you were going to lend money to, say, a friend of yours, you had better wake up to his or her financial makeup. There are some friends who I am sure you wouldn't even think about lending money to ... we all have friends like this. Then there are others who you know are neurotic who will pay you back relatively fast and will thank you forever for doing them the favor. This is called creditworthiness.
In other words, what is the likelihood that you will actually get your money back?
Other questions could be:
When will you get your money back?
What are others out there willing to pay you to borrow that same money? In other words, what is the value of the interest that you receive relative to what others are paying to use money?
Securitization is a relatively new phenomenon. Securitization basically takes different types of loans and turns them into different types of securities. Get it? They include student loans, car loans, and yes, you guessed it, mortgages, as well.
When mortgages get “securitized”, they are called MBS (Mortgage-Backed Securities).
The different types of MBS get sliced and diced up into different bond-like investments called "tranches". Tranche is a French word that means "slice". If we look at mortgages, for example, these could be sliced up into different tranche classes based on risk, maturity, etc.
These securities are traded like other bonds, so people all over the world end up owning them (e.g. Germany). They trade like any other security. It's kind of like eating meat (weird analogy, Jason. Yeah, I know.) We buy meat in the supermarket all packaged up. We don't want to know where it came from. We don't want to know how it got to our plate, just that it is there. If we saw what it took to get it to our plate (e.g. the cow getting slaughtered), I am sure that most of us would be vegetarians, and fast.
Just like any other loan, these securities also carry risk. The risks are default risk, prepayment risk, interest rate risk, etc. Let's say that you own a bond from a certain class of tranches that is paying you, say, 6%. If interest rates drop down to, say, 4%, the people who own those mortgages will want to refinance this debt, and you may lose that nice above-market interest rate that you are currently receiving; that is called prepayment risk.
Default risk is obviously the risk that the borrowers won't make their mortgage payments. Interest rate risk is, of course, if interest rates go higher. If interest rates go higher, then your bond will look less attractive. The price will go lower because it is now worth less in the marketplace.
Houses, stocks, and you
The financial companies loaned out money like crazy to Americans who wanted to buy houses. They incorrectly assessed the risk. They incorrectly assessed the ability of many to pay back their loans (mortgages). Or did they?
Did they lend to people just because they wanted to please their shareholders for that quarter? How short-sighted is that?
Unscrupulous mortgage brokers and other financial institutions got many buyers involved with mortgages that had low teaser rates knowing that they would reset at a much higher rate in the future and that these new homeowners were in over their heads.
These financial companies are now getting hit and have begun to see the error of their ways. YOU DON'T LEND MONEY TO PEOPLE WHO CAN'T PAY YOU BACK!
The pendulum now swings the other way. These foreclosures have affected everyone, and the financial companies have tightened their belts and have increased their lending standards, big time. This has led to the credit crunch in which we now find ourselves. This, of course, negatively affects the economy. In fact, it negatively affects everyone.
Why didn't they do it right from the beginning? Why did this have to happen?
Ladies and gentlemen, welcome to the land of Wall Street. Welcome to the land of greed. Greed led the charge then, and fear leads the charge now. Stay tuned.
Until the next time, folks, spend your hard-earned money wisely.
The Tycoon Report