How To Fill a Box of Stocks with Air . . . (Updated) 1

Bonddad explains “securitization”:

This is where securitization comes into play. Instead of making one big pool of mortgages we “carve up the cash flows” – meaning, we make a series of bonds that pay people at different times. For example, one bond will pay principal and interest to a specific bond holder for three years beginning 3 years from now and ending 5 years from. Another bond holder will get principal and interest payments for 7-10 years from etc…. That’s all that securitization is – pooling a group of mortgages with similar characteristic (interest rate, length of maturity) and directing the various cash flows to different people at different times. That’s all.

This process has been going on for the better part of 25-30 years now without much incident. So – what went wrong this time?

The biggest problem with securitization is no one has a vested interest performing due diligence on the borrowers – the people taking out the mortgage loans. The mortgage brokers write the loan and sell it to a large investment bank. The investment bank pools the mortgage and carves it up into different bonds. The bond holders don’t hold all the collateral, only pieces of it. As a result, no one really owns all the mortgages for an extended period of time. Instead, the most they own is a piece of a larger pool of mortgages.

Let’s go back to the first few paragraphs. Remember – we’re using collateral composed of residential mortgages. What if we’re writing a lot of mortgages to people who aren’t credit worthy? That’s the central problem with the mortgage securities market right now – mortgage brokers wrote a lot of loans to people who couldn’t afford them. In other words, the collateral used as the basis for mortgage backed bonds was bad collateral. No matter how you carve the cash flows, you’re still using collateral that will eventually default.

Addendum, That Evening:

Mithras thinks Bonddad isn’t clear on what is the cart and what is the horse.

Frankly, I think that Bonddad pretty much nailed the mechanics of the process; that’s what I was interested in when I put up the post this morning.

As to where it went wrong, well, we can argue over the mechanics of what went wrong, and everyone can be right and everyone can be wrong all at the same time.

Whether it started to go wrong on Main Street, with the mortgage lenders, or on Wall Street, with self-designated Masters of the Universe, is really not the issue.

It went wrong when financial types convinced themselves and their regulators that the “invisible hand of the market” (whatever that is) was somehow inherently moral.

It doesn’t matter whether the initial mistakes were made by lenders or by Wall Street.

For all practical purposes, they colluded. Main Street signalled it was willing to make junk loans. Wall Street signalled that it was willing to “securitize,” well, just about anything, as long as it could find marks buyers. Hell, they would have “securitized” free paper matches if they thought they could find buyers.

Chicken or egg? Egg or chicken?

Doesn’t matter.

What matters is that, when greed takes control, good sense and judgement and moral sense go out the window. The “invisible hand of the market” knows not morality, but worships wealth.

I must say, though, that, as far as I am concerned, Mithras has a better handle on a solution: Make sure that the box of stocks Wall Street is trying to sell is not a box of air.

That breaks the fraud.

All that matters for a solution is breaking the fraud at the most efficient possible location.