Derivatives Based on Real Property Loans

A few days ago, I published a post stating that interests in timeshares based on point, essentially were no different from derivatives based on mortgage loans.  I have had a few questions about derivatives based on mortgage loans, so I am posting this discussion.

I  like to begin by defining terms.  I found the following definition in an online dictionary:

”  an arrangement or instrument(such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset”.  It is important to note that the value is not in the underlying asset or mortgage but is merely derived from the underlying mortgage – more on that later in this post.

When applied to real estate loans secured by mortgages a definition would be A Financial Contract whose value is dependent on the value of the underlying mortgage loan.

Seems simple enough, so how did derivates help create the current economic mess.  Therein lies the tale.

In the old days when people wanted to buy a house and didn’t have enough cash to pay for it they would go to a bank and get a loan.  The bank would provide the difference between the buyer’s cash down payment and the purchase price plus any closing costs.  That difference would be an asset on the bank’s financial statement.  The bank had a legal interest in the buyer’s house until the loan was paid off.  The bank’s legal interest was secured by a Mortgage Contract that gave the Bank certain rights to seize the property if the homeowner failed to make payments when due and under other defined circumstances.

As the number of people looking for mortgages increased (e.g., post World War II baby boomers entered the housing market), a shortage of funds available for investing in mortgages developed.  The reason for this is that the mortgage market was generally limited to businesses having the ability to make mortgage loans and manage  loan portfolios (generally referred to as Servicing the mortgages (collecting and recording the payments of principal and interest, handling escrow accounts, and foreclosing when necessary, and to handling loan payoffs and delivery of free and clear titles.).  Simply stated the banks had all of their capital tied up in mortgages and other loans and were limited in their ability to make net new mortgage loans.

A very bright person came up with a solution.  The banks would sell their existing loans to new investors that were not in the business of making mortgage loans.  Since these new investors did not have the ability to Service the loans, the investors would form a new legal entity in which to assemble or Pool a group of mortgages (e.g. a form of trust or partnership) to hold legal title to the mortgage loans and the bank that originally owned the loan would continue servicing the loans.  The new investors would put their money into the new legal entity  which we will refer to as the Pool.  The Pool would use the investors money to buy the loans from the Bank, generating new cash for the Bank.  The result was that the money from the new investors created new money that could be used by the banks to make new mortgage loans.  Importantly, in the early days, when the banks sold the loans to the new legal entities, they did so with Recourse, i.e., if the borrower didn’t make payments when due, the bank had to reimburse the Pool for the shortfall.

Investors in the Pools did not generally have legal title to the loans, legal title was held in the name of the Pool.  What the investors owned was the beneficial interest, the assets were theirs but they could not manage the mortgages, that was done by employees of the Pool and/or the Servicer.  It is vital to understand that the Pools were not investing in Derivatives, they were investing in real mortgages and had a secured interest in the mortgage loans.

This solution provided ample funds for mortgage loans for a number of years but when interest rates and bank earnings began declining and investors began clamoring for higher yielding investments, the geniuses on Wall Street found ways to create high yield financial contracts and the fun began.

What essentially happened was that Derivative Contracts were developed for mortgage loans.  A typical situation might unfold as follows:  An Investment Bank would show investors representatives a list of real existing mortgages.  The investors representatives would be told that their clients could buy a financial contract entitling them to receive all principal and interest payments  Derived from the mortgages shown on the list; e.g, when the borrower made principal and interest payments the investor would receive the payments.  When the borrower paid off the loan, the investor would receive the payoff amounts.  The amount the investor paid for the mortgages was based generally on the estimated net present value of the mortgages on the list, plus commissions for the Bankers initiating and selling the Derivative Contract.  For ease of management, the investors held the Derivates Contracts in a separate legal entity (e.g, trust or partnership), generally referred to as a Pool. A very significant difference between the Derivative Contract Pools and the Mortgage Loan Pools was that the investor in the Derivative Contract Pool did not have a secured interest in real property assets.

So why did people buy these unsecured things?  For one thing, they wanted the higher yield and the Investment Bankers told them that the Derivative Contract Pools would be rated by one or more of the large debt Ratings Agencies.  When the bubble burst, unhappy investors alleged that the Rating Agencies had improperly and knowingly overstated the credit quality of the Pools because they had a conflict of interest:  the  Investment Bankers selling the Pools and making huge commissions were paying the Rating Agencies fees.

As the demand from Pension Funds and other yield-seeking investors grew and the fees earned by Wall Street multiplied, greed came to the fore.  This is where the geeks running the financial models in the back rooms come in.  They began devising increasingly complex ways to put together pools of loans.  The developed financial models showing that  the Investment Bankers could sell the rights to the loan principle payments to one group of investors and sell the rights to the interest payments to others.  They found that they could sell loans made to poor credit risks to aggressive investors.  Eventually loan brokers began qualifying anyone breathing (currently living) for a mortgage loan and we were off  to the races.  This was the new Alchemy, they could create new assets out of thin air ( the Derivatives), sell them to investors at a profit and earn big fees.  They had found the New Jerusalem of Investment Banking.

Well, as my alter ego the Grey Peregrinator likes to say, “Guano happens.”  We had a Great Recession and people began defaulting on their mortgages.  According to some commentators, more than 90% of the liquidity created by Derivative Contracts was wiped out.  Who lost?  Pension Funds and Institutional Investors, homeowners that bought houses whose prices were artificially inflated by the excess liquidity in the market.  Wall Street initially lost, but the Bankers were bailed out by us Taxpayers.  What’s worse is that the Banks used a substantial amount of the capital loaned them by the government to buy up Derivative Contracts assets at pennies on the dollar and are, as the market slowly improves, selling the Contracts at a profit; thereby increasing the banks’ earnings and CEO’s bonuses.  Wall Street has a lot to like about that.

GP helped research this topic: finding a much more entertaining treatment of the subject called Derivates Explained as Only a Bartender Can, you can find it at http://politicsandfinance.blogspot.com/2011/02/financial-derivatives-explained-as-only.html.

GP and I will appreciate comments from people more knowledgeable than we – or from people who just want to vent.