The bank or other lender that issued a mortgage showed it on its books as an asset of $100K that would be producing a string of income payments (principle and interest) over time, the length of the mortgage. Banks and lenders tried to make loans secured by solid property values and a borrower who could and would make the payments month in, month out. This was traditional mortgage lending.

Banks and Lenders become Clever
Over the past 10 to 20 years, things changed. (See Part II on Deregulation & Derivatives.) Some, not all, banks and other lenders found a new way to make (lots of) money off of stuffy old mortgage loans to homeowners.

A Mortgage-Backed Security (MBS) was introduced to Main Street by the wizards of Wall Street. A MBS is a bond sold to investors, just like other bonds issued by American Airlines, Coca Cola, or McDonalds. However, a bundle of mortgage loans backs a specific MBS. So the value of a MBS is, ultimately, dependent on the quality of the mortgages underlying it.

Here is how the game was played the last ten years.
1. A bank or mortgage company extended a loan to a homebuyer.
2. The bank or mortgage company then sold the loan, often to one of several U.S. government-sponsored agencies, e.g., Fannie Mae or Freddie Mac.
3. The agency (or private entity, in some cases), then took a pile of individual mortgages it had bought and bundled them into a package, which became a Mortgage-Backed Security bond. A given package could contain 100 mortgages or many hundreds. The combined value of the mortgages determined the size of the bond.
4. The agency then sold the package as a security, like a share of stock or a corporate bond, to investors.

Why would investors buy a MBS? Because they believed it would give them a continuing string of monthly payments from all the underlying mortgages in the package. And the MBSs were generally considered attractive investments for several specific reasons.

One was that “home values always go up.” This is what everyone said. So the MBSs seemed like sure-fire investments. Two, financial industry executives and sales people made a lot of money selling MBSs, so they really pushed them—around the world. Three, the U.S. government guaranteed many of the MBSs. And four, once a MBS was sold for the first time to an investor, thereafter the MBS traded on the open market, just like a share of Apple Computer or G.E. So the investment was pretty liquid; investors could sell (or buy) at will.

5. In the early years the mortgage payments made by individual homeowners—principal and interest—did pass up through the chain of financial enterprises to the bond (MBS) holders; everyone was happy.
6. The participating banks and other lenders that originally created (sold) the loans to homeowners were particularly happy. These mortgage issuers no longer had to worry about the mortgages being repaid by homeowners. The issuers simply sold the mortgages they issued! The banks and other lenders made a fee (“points”) when they initiated the mortgage; then they made a profit when they sold the mortgage to a packager.

Bingo, participating banks and other primary lenders were quite profitable AND off the hook for collections. Is it little wonder that “a mortgage loan for anyone and everyone,” became the mantra of the financial world. Easy credit swept the U.S.A., with real estate in the lead. Boom times.

In addition to easing the requirements to get a loan, participating banks and lenders also became extremely creative with loan terms. Homebuyers could pay nothing down, no interest for a while, take out loans that featured very low rates for several years before jumping (way) up, and so on. There was plenty of fine print in the “subprime” loans that are making headlines today. The U.S. Comptroller of the Currency estimates that 20% of the new mortgages originated in the past two years were subprime, another word for high-risk.

It is important, too, to note that many members of the U.S. Congress encouraged, even required, banks to make a certain number or percentage of high-risk, sub-prime loans. These loans helped fuel the housing boom and boost home ownership. The unspoken, underlying concept, however, was still that homeowners would repay the loans out of their monthly incomes.

The financial and home building industries loved what was going on, and—no surprise—they funded the campaigns of many congressmen and congresswomen. (See Part III on Money in D.C.)

In summary, participating banks and lenders made a nice profit and passed any mortgage risk up the chain to investment bankers (e.g., Lehman Bros.) and other packagers as well as to government agencies. A look at the huge bonuses paid executives all along the way, including the government agencies, is a nice indicator of how the system operated. But the foundation for the whole “system” was a bunch of homeowners paying their principal and interest.

7. A sizeable portion of the risk in the system was taken on by government agencies, i.e., unknowing taxpayers. GNMA (Ginnie Mae), FNMA (Fannie Mae), and FHLMC (Freddie Mac) are congress-sponsored entities that guaranteed MBSs issued by approved private institutions, namely, many banks and mortgage lenders. This means the government put the full faith and credit of the United States, the same guarantee afforded U.S. Treasury bonds, behind a significant percentage of MBSs. This guarantee, or in some cases, implied guarantee, gave MBS investors certain assurances of the timely re-payment of mortgages by homeowners.

It is easy to see why MBSs became so popular around the world. MBSs, in fact, infected the world.

Who bought the MBSs? Pension funds, banks themselves, insurance companies, countries, cities across America, mutual funds behind 401Ks, individuals. The list is very long. In mid-2007, there was $6.9 trillion in mortgage-related debt outstanding in the U.S. bond market. This made it the largest segment of the bond market with 24% of all debt outstanding. For comparison, U.S. Treasury debt accounted for 15%; corporate bonds were about 20% of the total market.

In addition, MBSs were among the most actively traded securities in the U.S. bond market. Primary dealers, i.e., large banks authorized to deal directly with the Federal Reserve, traded on average more than $300 billion per day of agency-supported MBSs in 2007.

The Weakest Link
So what went wrong? Late in 2007, subprime mortgage holders started defaulting on their payments at a higher-than-expected rate. Many holders became delinquent in their first three months of payments. This was caused by the plain inability of the borrowers to make payments and the fact that housing prices had started to fall in many places. Foreclosures started to increase and some people with low, or no, down-payments on their homes simply walked away. This put more houses on the market and further depressed prices—something that is still going on.

In the last six months, long-napping regulators started asking lenders to tighten their loan standards, and companies that rate MBSs (and didn't understand them) started downgrading the worthiness of MBSs as investment instruments. This made investors nervous and the demand for MBSs shrunk. It also made financial institutions holding MBSs nervous (or bankrupt, e.g., Bear Stearns) as the value of their MBS assets declined. Almost over night, lending institutions stopped lending. This sudden credit drought triggered the stock market crash and is currently, along with fear, draining the life out of the economy in general, worldwide. It's a quagmire and viruses love it.

To keep the whole financial industry from caving in on itself, Congress has put up $700 billion so far. The first $250 billion will be used to shore up weakened banks. Here is the headline and start of a front-page story on CNNMoney.com on October 20, 2008:
BROAD GROUP OF BANKS WANT BAILOUT MONEY.
“Banks of all sizes are interested in a piece of the federal government’s $250 billion fund to recapitalize financial institutions, Treasury Secretary Henry Paulson said Monday.”

At the same time, "insurance firms, auto makers, state governments, and transit agencies" are lining up to request that the U.S. government buy equity stakes in the companies with part of the $700 billion, according to the Wall Street Journal of October 25. The line forms at the rear.

Meanwhile there is also a scramble going on in governments around the world to find an acceptable formula to aid some homeowners facing foreclosure.

So who gets hit by this fiasco? Ultimately, everyone: lenders in general, subprime lenders and their shareholders, owners of MBSs, investment banks that packaged the mortgages and often continued to own many of them, firms that insured the MBSs…and individuals with shrunken investments or savings who will have to pay the enormous bills as taxpayers. Everyone—for many years to come.

Editor's Note: Steve Brandt is Senior Lecturer in Management, Emeritus at the Stanford Graduate School of Business where he was a faculty member for 21 years.


Author’s Note: This short series, by a non-economist, non-banker, is written to try to help readers get their arms around the current, economic mess. A general understanding may provide a whiff of relief. The series highlights some of the major peaks of the problem; the series does not attempt to describe the entire mountain range in detail, a task far beyond the author’s ability. Parts II in the series is about Deregulation & Derivatives; Part III is about Money (lobbying) in D.C.