Mortgage Backed Securities

I got this off of the Housing Bubble 2 posted Yeasterday

I thought this was a great post

zed said... "
I thought I'd comment on some of the posts I'm seeing here. There are some good comments, some bad/misinformed ones, and some in between. Let me try and shed some light on some issues here, to the best of my ability.

First, a bit about me: I work for a Wall Street firm. We securitize mortgages of all sorts, Option ARMs included. As an example, we will buy the loans from the bank, package them into bonds whose payments are backed by the loans, and sell those bonds to investors (hedge funds, mutual funds, pension funds, etc.).The typical structure of a deal might be as follows:

Class A Bond: 700 million
Class B Bond: 200 million
Class C Bond: 50 Million
Class D Bond: 50 Million

I am simplifying, but bear with me. The way these bonds get paid is sequentially. Every month when borrowers make their mortgage payments, the A bonds get interest first. When they are paid, then the B bonds get interest, and so on. After the interest then the principal gets paid, once again in order.

What this does is effectively shield the higher class bonds from suffering losses. They are safer, and the lower classes are riskier. As a result when these deals are done, the lower classes will pay higher interest rates (to compensate investors for additional risk), and these classes will be rated lower by the rating agencies (S&P, Moody's, Fitch).

The job of the agencies is to rate the security of each bond so that investor can roughly gauge what they are in for. The deals are stressed enough in terms of prepayments/defaults/losses than the Class A Bonds are extremely well covered from losses. The lower classes suffer most should things go wrong. So a statement such as:"My alarm was that these mortagages were now being used to back securities up by 40%! They're not secure for a mortgage in my opinion...along the same track...Do some reading on pension funds etc..They are all invested. You may not even have near what you think you had coming when this unravels..

Heck you don't need your pension or SS you have your home equity right? By this fiasco being encouraged all will be affected...Maybe their point? Blow it all up so noones' liable..."

is incorrect. Pension funds will typically invest in these higher classes, and even if the shit hits the fan they will be relatively well off. I am not a pension fund manager but I believe they are usually restricted in the types of rated bonds they can purchase (read: only the highest rated types).Moving on to another comment:

"My ex-friend is using Option ARMs to flip. Even more crazy."

Well...it depends. This product is certainly unique, and certainly carries risks. But it was designed for borrowers with a certain risk tolerance. You pay more up front (in interest) for a 30 year fixed rate loan because you are paying for that extra security (your rate never changes). Hybrid ARM loans (fixed for a certain period, then floating) carry additional risk (floating rate later on). As a result, you will pay less in fixed rate costs initially. Mom and Dad buying a house they will live in for years and years and years to come would go with the 30 year fixed, or maybe a 10/1 hybrid arm to save a little interest initially. But let's say I'm someone who knows he'll be moving in 2-3 years (planning on graduate school) and am buying a place. The 30 year fixed is a bad idea. Why pay more in interest for those 2-3 years when I could maybe do a 3/1 hybrid arm instead. Before the loan converts to a floating rate I will already have sold my place and paid off the loan.

The Option ARM is good for a borrower who 1) is willing to take on risk, and 2) is looking to manage cash flow. #2 does *not* mean "I can't afford the loan any other way, so I will make this minimum payment and stay current." Anyone who takes out this loan with that line of thought is going to get raped when their payment adjusts after a year. #2 *does* mean someone who has income that is relatively discrete over the course of the year. Maybe you own your own business. Or (in my case), the majority of your income shows up once a year in your bonus. In that situation the Option ARM could make sense...if you are willing to accept the risk involved.

I should also note that just because you have the OPTION to make a minimum payment does not mean you HAVE TO. If I were to take out this loan (which I haven't), I'd probably use the minimum payment feature for a few months until my bonus arrived. At that point I'd pay down a chunk of principal at once. And if I felt like paying my loan normally and amortizing on a normal schedule, I could do that as well.If you are flipping in a 3-4 month time frame, and KNOW you will sell at that point, then this loan is perfect for your needs. A 1.5% teaser rate for 3 months is impossible to find anywhere else...in that case the only risk you run is having housing prices collapse in that timeframe (which is a valid concern, but a separate one from the mortgage risk being discussed here)

If this product blows up (and I suspect that some originators will and others won't, depending on the types of guidelines they are using to make these loans), the only people to blame will be the originators for offering loans to borrowers they shouldn't have, and the borrowers for taking on a mountain of debt they couldn't have afforded. Just because someone offers you something doesn't mean it a good idea. The blame down the line, if there is any, should be shared by both sides.

Who will lose money? The owners of the riskier bond classes backed by these loans, the borrowers when they go delinquent and potentially default. "
7:56 PM