My last post was on mortgages, and focused on the home-owner (see here). If you’ll recall:

  1. The Home-Owner has a mortgage liability, which is the obligation to pay back the instalments over the mortgage term; and
  2. The Bank has a mortgage asset, which is the right to receive instalments over the mortgage term.

Now this situation can create a slight problem for the Bank. Firstly, banks are political hot potatoes – if a bank goes down, there are going to be a lot of unhappy voters. And because they have such high political risk (I’m a cynic), they are highly-regulated. That regulation will extend down to the type and ratio of assets that a bank can have on their Balance Sheet.

And this has a lot to do with liquidity risk.

  • Liquidity Risk: is the risk that an institution/individual will not have enough cash to settle its debts. For example, let’s say I spend all my savings on a porsche worth $30,000, but owe my friend $1,000. Even though I can theoretically afford to pay my friend back (I can always sell the car), I have high liquidity risk because it will take me time to sell the car. If he asks for the money tomorrow, I’m not going to be able to pay him.

Banks face the following liquidity risk conundrum:

  1. Their liabilities tend to be current (ie. they can require payment in cash on very short notice);
  2. Their assets tend to be non-current (ie. the cash inflows are expected to happen over a period of time).

Note: a bank’s liabilities would include my savings deposit. From the bank’s perspective, they owe me my money – and it is therefore their liability. As I can withdraw my savings on very short notice, the liabilities would be current for the bank.

Therefore, most countries will regulate the amount of long-term assets that a bank can have on its books. If a bank wants to give out more mortgages (and make more money), it has to find some way of removing long-term assets from its books, and replacing them with cash (a short-term or current asset). At the same time, some governments (especially the US government) actually want there to be more mortgages out there. The American Dream, after all, is two kids, a wife and a mortgage. So there is immense pressure from many sides to ease credit in the mortgage market.

Enter: the Mortgage-Backed Security. Or MBS for short. Also known as a CMO (Collateralised Mortgage Obligation – as the debt is collateralised by property).

For a typical mortgage, the original cash-flows are between the Lender and the Home-owner:

Cash Flows between the Home-Owner and the Bank/Mortgage-Lender

In a Mortgage-Based Security transaction, the Bank “sells” the cash-flows it receives from the Home-owner to a third-party investor. The cash-flows now look like this:

The Repackaging of Mortgage Cash Flows as Mortgage-Backed Securities

The net effect is that the bank has become an intermediary. It has removed the mortgage asset from its books and replaced it with the cash that it received from the sale of the securities. At the same time, I should probably point out that the Investor gets the principal and interest after fees. Which makes sense: a Bank must earn on the way in and on the way out.

Some points:

  1. The bank will never sell an investor one mortgage. Rather, they will sell a “book” of mortgages – which is generally referred to as a “Mortgage Pool”. This diversifies risk; because it is extremely unlikely that all the mortgages in the pool will default, or prepay, or anything else that disrupts the schedule of cash flows.
  2. However, it is likely that a portion of the pool will default, or prepay, or otherwise disrupt the flow of cash. This historically created a problem with mortgage-backed securities, as the cash flows were considered too unreliable to be securitised.
  3. But the uncertainty of the cash flows can be addressed to some extent, because when it comes down to the difference between principal and interest – the interest is clearly more of a problem. The principal is set. But the interest is dependent on interest rate changes (people could refinance), prepayments and curtailments (early repayments of principal).
  4. So the solution is to split the cash flows. Some investors only want the principal cash flows, some only want the interest cash flows (the risk-loving bastards), and some are more versatile:
The Mortgage Pool being broken up into CMO with different risk exposures

And obviously, the riskier the CMO type, the cheaper its selling price (which is the same as saying that it earns a higher return).

Once the Banks started differentiating between types of cash flow, everyone went crazy on this risk category business. They took the Principal + Interest section, and started decomposing it into who gets paid first, who gets paid last, who is the first to lose out if the underlying mortgage holders default, and so on. The mortgage pool was therefore separated into “tranches” based on the type of cash-flow and the variety of risk.

These tranches would then be rated from AAA all the way down to junk status by the Ratings Agencies – and the investment grade stuff could then be bought by the regulated institutional investors like pension funds.

And the junk stuff?

Well this is where it really starts to get interesting.

In the next post.