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This is a two part question:

1) I understand that there are certain mortgage loans that when originated by banks can be gathered up into pools and then "sold" to investors, and that these pools are backed by Ginnie Mae, in the sense that, if the borrowers are unable to make payments, and the banks that originated them are also unable to make payments, then Ginnie Mae would step in and make the payments.

My first question is about the banks. What incentive do they have to gather up the loans in pools and sell them to investors? Because the payments made are not ending up in their pockets, but that of the investors instead.

2) Secondly, I've read that, in this process, Ginnie Mae collects a fee (of a max of six basis points). Who is this "fee" levied upon?

I hope my questions aren't too naive and simple to understand. Thanks!

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    Recommend reading The Big Short. Fun to read, interesting people in it, also details the CDO debacle, which is related to your question. – Almo Feb 27 at 19:35
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    Didn't know The Big Short was a book. It's also a very entertaining and enlightening movie. – JoL Feb 27 at 20:51
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    The answer to "What incentive do banks have to... ?" is either "MOAR PROFITZ!!1!" or "Damn, the law says we gotta do this." – David Richerby Feb 28 at 10:39
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    @JoL The book is very good (among the best ones Micheal Lewis has written, in my opinion). – Peter - Reinstate Monica Feb 28 at 16:29
  • Ginnie Mae or not: Pooling averages the risk across many individual loans which makes the investment more predictable without the need to go into the dirty details of a loan. It's like buying an index fund as opposed to specific stock. But then (as The Big Short pointed out so brilliantly) nobody at all in the whole world looked at the details of the individual loans any longer, except for a single-digit number of guys, among them Michael Burry who actually enjoyed tables of numbers because it catered to his Asperger spectrum condition. Nobody else could be bothered. – Peter - Reinstate Monica Feb 28 at 16:35
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Say I can lend money at a 10% rate. I lend you $10,000 and the note is for $11,000 due in one year. But, the next day, I can sell the note for $10,100, the buyer willing to get a return of 8.9%. ($11K/$10.1K). Why would I lend that $10K for a year, when I can turn over the loan and make 1% in a day?

The mortgage is more complex, of course. But the concept is similar. Underwriting the loan and selling it into a package (CMOs or Collateralized Mortgage Obligations) lets a small bank help their customer get the mortgage, but not have their funds tied up for decades. At the other end, are investors who can get a return on their money closer to the rate on long term loans.

The concept itself is sound so long at ethical underwriting is maintained, i.e. 20% down, 28/36 debt to income limits, etc. The market blew up when this was ignored, not because the premise was faulty.

The 6 basis points are skimmed from the payments homeowners make for the money then paid to the CMO holders.

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    Yes, this works great for the banks if they can more than double the amount of loans they sell by making risky loans. – AbraCadaver Feb 27 at 20:05
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    @AbraCadaver And they can pass the risk off to others. – David Schwartz Feb 28 at 16:37
  • I can see this for Fannie Mae and Freddie Mac type loans, but doesn't the extremely low risk associated with Ginnie Mae loans change something? – StrongBad Feb 28 at 20:34
  • In theory, the lower risk of GNMA means an investor will bid the price of the debt up, i.e. pushing the yield (investment return) lower. – JTP - Apologise to Monica Mar 1 at 10:11
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Legal scamming, basically. That is speaking about the pooling part, not the "selling a debt" part. There are good reasons for doing that.

When you pool up mortgages, you also hide the details of individual ones. That way you can begin to play statistics games and present averages of the size, risks and other factors. Just picking your average (mean, medium, mode? and there are more...) carefully can make the bundle look better than it is. And once the pool has been repackaged a few times, risky loans that nobody would want on their portfolio can become entirely invisible. Now find someone stupid enough to buy into an opaque financial construction and ... profit.

That is not exaggeration, that is exactly how the financial crisis happened. Not much has changed since then.

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    It's easier to sell a bad apple if you package it into a fruit basket and put it in the bottom of it. – Viktor Mellgren Feb 28 at 11:41
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    @ViktorMellgren that's actually a great metaphor. I'd even expand it: You can sell an (unsellable) bad apple if you mix it with good apples, even without hiding. Buyers will value-judge the whole and consider it buyable. (there's a lot of psychology around this and how it affects the perceived value and all that). – Tom Feb 28 at 11:45
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    @Tom - yep, 2008 financial rigging was more a big bushel of worm infested apples with bombs intentionally planted, and a coating of perfectly hand picked apples on top. – paulj Feb 28 at 15:01
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    @Tom That was really only one part of the problem, though definitely one of the biggest. Another part of the problem was that the risk models that were used to evaluate the pools didn't take into account the possibility of a significant drop in the price of residential real estate over the entire country. – David Schwartz Feb 28 at 16:39
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    The basic idea of pooling is sound, it's similar to diversifying a portfolio -- a few bad mortgages would be offset by all the good mortgages. But this assumes that there's no correlation between the holdings, and that's where the error was in the mortgage crisis. It's more like diversifying your portfolio among mutual funds that all own the same underlying stocks. – Barmar Feb 28 at 20:54

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