Simple Explanation of Mortgage Backed Securities And How They Contributed to the Economic Crisis

As banks and revered financial institutions teeter and fall all around us, the newspapers and financial columnists are tossing around words that have very little meaning to people outside the world of finance and the stock markets. One of these terms is "mortgage-backed securities". Most of the people that I've spoken with about the whole crisis have no idea what that term actually means, or how it contributed to the current economic crisis. This is a simple explanation that I've used to help high school students understand how the concept of mortgage backed securities has affected us all.

Bringing it down to the personal level
Imagine that your friend Kathy comes to you and asks if she can borrow $100. You know that she can't pay that $100 back all at once, but she can manage to pay you some money every week. You agree to lend her $100, and she agrees to pay you back $20 a week for the next ten weeks. If she can't make the payments, she agrees that you can take her iPod and sell it to get your $100 back. That means that at the end of ten weeks, you'll have been repaid your $100 and made $100 profit. Your friend agrees, and signs a contract saying that she'll make the payments.

However, you don't want to wait ten weeks to get your money back. Instead, you go to your cousin Pete and offer to sell him your agreement with Kathy for $150. You walk away with the $100 that you lent Kathy, plus $50 profit. Pete walks away with the right to collect $200 from Kathy in payments of $20 per week. On paper, he has made $50 on the deal, too.

This works as long as Kathy can make the payments on her loan. If she can't, however, Pete can take her iPod and sell it for as much as he can get for it - which probably won't be the $150 he paid you for the right to collect on the loan you made to her, but will be something. In this equation, the only one who makes out is you - you got 50% return on your money - and cut out your risk by selling the loan and collecting half your projected interest up front.

Breaking it down to motivation
As long as your income depends on Kathy's repayment, you have a strong stake in making sure that Kathy has the ability to make those payments. When you sell that loan to Pete, though, your income no longer depends on Kathy's repayment of the loan you made her. You've detached your potential to make money from her ability to pay it back. You are now in a position where you don't lose anything by lending to people who can't pay it back. Under those circumstances, the more loans you make, the more money you make - and there is no risk or downside to making bad loans.

Imagine now that the only thing keeping you from making money that way is a rule that says you can either make loans or sell investments. You are not allowed to do both. With that rule in place, the only way for you to make money is to only lend money to people who can pay it back. With it gone, it no longer matters if the people to whom you lend money can repay it. And then - the rule gets changed and you suddenly have the potential to make a whole lot more money than you've ever been able to make before.

Bringing it back to the upper levels
That's the position that many lenders and mortgage brokers across the country found themselves in about ten years ago. Since their income didn't depend on the ability of the borrower to repay the loan, they started agreeing to lend money to people who might have trouble paying the money back. It really didn't matter, because they were going to sell the loan paper to someone else anyway.

Aunt Fannie and Uncle Freddie
Fannie Mae and Freddie Mac have also been getting a lot of the blame for allowing the economic crisis to happen. What was their role and how did it make things worse?

Fannie and Freddie are GSEs - government sponsored enterprises - that were created to help low-income people buy homes. They each have different mandates, but the general intent is the same. One of the ways that they did this was by buying mortgages from banks and lenders as long as those loans met specific conditions. The loans were meant to allow people who could afford mortgage payments, but couldn't afford to save for a down payment. They guaranteed the repayment of loans made with lower interest rates than the market rate to people who met specific income guidelines.

If we were to put Aunt Fannie into the example above, her job would have been to buy the loan from you and sell it to Pete, guaranteeing that if Kathy didn't pay off the loan, then she would cover it. That's called underwriting the mortgage. Essentially, Fannie was guaranteeing payments to lenders even if borrowers defaulted. Part of her job was to make sure that you were making good loans - not loans to people who wouldn't be able to pay back the money.

Unfortunately, Fannie and Freddie started looking the other way and loosening up their restrictions on who could qualify for an underwritten loan when housing prices started going through the roof. . The rise in prices was due to a combination of things, including lowered interest rates to stimulate the market and the sudden availability of mortgage money for people who couldn't buy homes before. That triggered a demand for more homes, which brought in contractors and investors who built more homes - far too many of them.

As even the most basic student of economics knows, when there's more demand than there is supply, prices rise. When supply outstrips demand, prices drop. And that's what happened. With more money available to buy houses, there was an increased demand for houses on the market. Prices rose, which encouraged more builders to get in on the rising prices. Eventually, though, those prices hit highs that could not be maintained, and the market slowed. At that point, prices should have dropped because there were fewer buyers who could afford a mortgage.

Unfortunately, that's not the way it went. Instead, bankers and the government chose to stimulate the market by making it easier for people to borrow money. Fannie and Freddie started lowering the income guidelines and assuming the risk on loans that were progressively more and more risky. As home prices rose, various people pushed to relax the standards even more.

Originating lenders - that would have been you in our little story - started pushing harder and harder to find people to take out loans. They stopped waiting for the Kathies to come to them and started going out and knocking on doors, trying to convince people that it was a good thing to borrow money - and they often succeeded. They made up new kinds of loans to make it easier for people who would have been turned down for a regular loan.

The most popular of those loans let borrowers pay very small payments for the first few years that they held the mortgage. After either two or five years, their monthly payment would jump back up to the market rate - or come due in full. The ability to pay those loans relied on the ability of the homeowner to refinance their home at lower interest rates and lower payments in 2-5 years. These creative loans looked good on paper, as long as you accepted the premise that home prices would continue to rise and loans would continue to be easy to get.

Unfortunately, both of those assumptions were flawed. With home sales stalling because of the number of houses on the market, home values dropped instead of rising. As those loans came due and payments increased, hundreds of thousands of people found themselves unable to refinance their homes for the full amount of their previous mortgages because the homes were no longer valued at the prices they had paid.

That brings us to our current situation, where the mortgage crisis has leached beyond our own borders to affect the entire world. Many of the investors that bought those mortgage backed securities are international investors and banks who expected that the mortgages would be secure, who expected that the U.S. had been overseeing the financial transactions to make sure that the money was really there. It puts the U.S. in the unfortunate position of having to protect the lenders and investors and the financiers who let their greed get in the way of ethical finances by paying off their bad debts.

It's tempting to try to pin the blame for the current economic crisis on one group of people, but it's far more complicated than that. As you can see in even this very simplified explanation, nearly everyone contributed to this mess in some way or other. Digging the U.S. out of it is going to take more than one group of people as well. Whether we are capable of working together to repair the damage done is something that remains to be seen.