New Age Financial Securities – Mortgage Backed Securities & Credit Default Swaps

The new age mortgage market was extremely unlike the old one. The old one used to work based on a simple mortgage contract between the borrower and the lender. However, in the previous few articles, we read about how the system has completely changed. Instead of the bank holding the loan for its entire tenure, mortgage debt is now traded in open markets like shares and bonds. These secondary markets and the open trading of these debts requires the use of new age financial securities.

The 1990’s and the 2000’s saw the invention of many such securities. In this article, we will discuss the two most important types of these securities i.e. mortgage backed securities and credit default swaps.

Mortgage Backed Securities

We already know that in the new age world, banks do not actually fund mortgages. Rather they are intermediaries who originate loans and then sell it in the secondary mortgage market. This is enabled by a security known as mortgage backed security (MBS).

A mortgage backed security is a security that is backed by a mortgage or a pool of mortgages. Now, this may sound like confusing financial jargon.

However, in essence it is very simple. When the bank makes a loan it sells it someone in the secondary market. These people in the secondary market collect a wide variety of such loans and create a “pool” of such loans. This pool therefore derives its cash flow from the mortgage payments it receives on a monthly basis. The pool is therefore nothing but a large mortgage which is a collection of many small mortgages.

Now, they sell the rights to own small pieces of these cash flows to investors via securities called mortgage backed securities.

Let’s say that at the end of every month there are $100 accumulated in the mortgage pool and there are 100 securities outstanding then they will pay each of them $1 each. Thus, mortgage backed securities derive its cash flows from the mortgage pool.

Since they are “backed” by mortgages i.e. derive their cash flow from mortgages, they are called mortgage backed securities.

The mortgage backed security is therefore often referred to as a “pass through” structure. The job of the mortgage backed securities is to allow the cash flow of the mortgages to be redirected to the holders of these securities i.e. it allows the cash to pass through.

There are several kinds of mortgage backed securities available in the market.

The most important distinction lies between agency mortgage backed securities and private label mortgage backed securities. The mortgage backed securities are issued by quasi government agencies like Freddie Mac, Fannie Mae and Ginnie Mar.

On the other hand, the private label securities are issued by special purpose entities created by investment banks. The agency mortgage backed securities usually sell at a premium because they are considered to be more secure since they are guaranteed by the quasi government agencies.

Any debt guaranteed by these agencies is implicitly guaranteed by the taxpayers of the United States. Private label mortgage backed securities on the other hand have private guarantees which may be valuable depending upon their credit ratings.

Credit Default Swaps

Another instrument used in the new age financial markets is called credit default swaps. Although this instrument is not directly related to the mortgages, they were often used to bet against investment banks issuing mortgages. This is complex derivative structure and needs to be understood with caution.

A credit default swap is a kind of insurance. Let’s say that I have a belief that Lehman Brother’s bank is issuing bad quality debt and that they are going to default on their debt. In this case, I can go to a company issuing credit default swaps, (say AIG) and pay AIG a premium every month. In the event of a default by Lehman Brother’s AIG will make good my losses.

This is exactly like insurance except for one major difference. I do not hold the debt issued by Lehman Brothers in the first place! It is like me buying insurance on my neighbor’s car. I do not own the car. However, I pay insurance premiums on it and in the event of a default I get reimbursed for the loss of his car! I hope you see the difference. If we remove the principle of insurable interest from the insurance contract it turns into pure speculation and that is exactly what happened in the event of a credit default swap.

In the aftermath of the financial crisis of 2008, credit default swaps faced critical reviews and public outrage. The reason behind this was the fact that these contracts were highly unregulated. These contracts were mostly sold by regulated agencies i.e. banks and insurance agencies.

However, they were so new to the market that the regulation had not caught up with them i.e. there were no laws requiring reserve requirements for these contracts.

Hence, banks and insurance agencies could go on selling these contracts without keeping any money in the bank for a rainy day fund in case they all came due.

The first catastrophe of the credit default swaps was the insurance company AIG. The company literally faced a run on their assets as claims piled up after the housing market went bust and almost all the issuers of debt defaulted.

Since then, credit default swaps have been brought under the purview of legislation. The government is making it mandatory for the data regarding credit default swaps to be published so that it can be compared with the rating given by the rating agency and the true risk of the investment can be ascertained.