Stuff You Should Know - How Mortgage-backed Securities Work

Episode Date: November 6, 2008

The 2008 US financial crisis has been blamed on the excessive use of mortgage-backed securities. But what exactly is a mortgage-backed security? Learn more about these securities and how they contributed to the crisis in this HowStuffWorks podcast. Learn more about your ad-choices at https://www.iheartpodcastnetwork.comSee omnystudio.com/listener for privacy information.

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I'm here to help. And a different hot sexy teen crush boy bander each week to guide you through life. Tell everybody, everybody about my new podcast and make sure to listen so we'll never, ever have to say bye-bye-bye. Listen to Frosted Tips with Lance Bass on the I Hard radio app, Apple podcast, or wherever you listen to podcasts. Brought to you by the reinvented 2012 Camry. It's ready. Are you? Welcome to Stuff You Should Know from HowStuffWorks.com. Welcome to the podcast located from deep within the bowels of HowStuffWorks.com headquarters. It's Josh and Chuck. Say hi, Chuck. That makes us sound really fancy and creepy or something. I don't know, I like it. I was going for creepy. Okay, I'll take it. Did it work? I'm creeped out, yeah. Okay, good. Chuck, did you

look out the window today at all? I have. Did you, did you notice that everything is spinning very quickly, clockwise? I have. You have, yeah. Do you know what that is? A downward spiral? It is. It's the U.S. economy circling the drain very quickly and taking the entire nation with it. It's pretty bad. Have you heard about this economic downturn? Yeah, I mean, you can't miss it, man. It's everywhere. It is. It is popping up everywhere. Huge investment banks that have weathered the depression are starting to go under. You know, there's all sorts of financial groups that are suffering as well. AIG, the largest insurance company in the United States, who ensures all these people is going under. Right. Well, now it's owned by the government

almost completely. Yeah. Well, 80% stake, 79.9% stake is owned by the federal government, owned by you and I. We own, we own part of that. I feel it. I feel it in my bones. I know that you feel richer. I noticed you're wearing your top hat and monocle today, very appropriately. So all this stuff is going on. Yeah, it's impossible to miss it. The crazy thing is that all of it can be traced back to a single thing, a single investment instrument that caused all of this problem. Right. And I was happy to learn this. You know what it is. Yeah, I'll go ahead and it's called a mortgage backed security. Yeah. And you're kind of the expert. I want to go ahead and preface this by saying that Josh wrote these articles and I'm an economic idiot, basically.

So I learned a lot by reading them and hopefully people will learn a lot by listening. Oh, I learned a lot by writing them. So if people, if people learn a lot listening, then it'll be a trifecta. Perfect. Everyone will have learned. So yeah, what we're talking about today are subprime mortgage backed securities. There's different kinds. Some mortgage backed securities are worse than others and the worst of the bunch are subprime mortgage backed securities. Right. Well, go ahead. I think the, the raw definition probably would get people interested. Get their juices flowing right off the bat. So basically what it is is a mortgage backed security is an investment tool that is based on a pool of mortgages. So you take Chuck's mortgage and our

producer Jerry's mortgage and, you know, everybody at house stuff works mortgages. You pull them together and then you divvy them up into basically shares of all this, this one single pool of mortgages. Right. And as long as everybody like Jerry and you Chuck are paying on your monthly, your monthly mortgage payment, sure, everything's fine. Right. They're like dividends. It gets distributed across the shareholders of this pool of mortgages and everybody's happy. Right. Well, who are the shareholders though? They're the people who bought these mortgage backed securities, which are banks larger than the banks. It can be anybody. It can be anybody. Yeah, what you're talking about is the process of how this works. Okay. So that what I just said,

that's a, that's a mortgage backed security. You could purchase a mortgage backed security. No, no way. You, if you wanted to, you could. Sure. And actually, ironically enough, because these mortgage backed securities are based on mortgages and because they've been so divided up and repackaged and repurposed, we'll get to that in a little bit. It's actually possible that if you have like a 401k or you invested a mutual fund or something like that, you may actually own a share of your own mortgage. Right. I couldn't, I read that in your article and I was blown away. Isn't that cool? Yeah, cool. I don't know. It depends. Weird. If the, if the economy's in the, in the tank, then yeah, it's not good, but yeah, it could be cool if you're making money

off of your own mortgage or paying it back yourself. Right. That's positive outlook. Kind of. Yeah. So what you just mentioned, Chuck, is, is how a mortgage becomes a mortgage backed security. Right. So say you go in and you, you get a mortgage, you go through all the, the rigmarole and they issue you a mortgage, the bank, when mortgage backed securities were hot, would turn around, put it together with, you know, several other of their mortgages that they'd issued that day and turn around and they sell it to an investment bank. Right. Okay. An investment bank takes your bank's mortgages and some other bank's mortgages and pulls them together even more. So now you have several hundred different mortgages and all of a sudden it's a single mortgage backed security.

Right. And then they start selling shares. The investment banks start selling shares and then the investors, your, your, your mutual fund manager or somebody at JP Morgan Chase who's looking for an investment, they buy these shares and they start collecting the dividends. So that's how it works. Right. Okay. It's actually a lot simpler than I thought. It's very, very simple. Like if you look at it just, it just, it's a very basic method of investing. Right. But it was completely and totally radical when it came about. I think it was the late nineties when they first really hit the scene, maybe early 21st century. And here's the thing. It's a really safe way to invest as long as, you know, the housing market's going well, the economy's doing well and people

are making their monthly mortgage payments. Right. There were rich times there for about a decade probably in the housing. And it was, it was based on that, that housing, that housing boom was keeping mortgage backed securities. It was making them perform well. Right. So because of that, because the interplay between the housing market and mortgage backed securities, mortgage backed securities become this hot commodity on Wall Street. Everybody's buying them. Everybody wants them. They're just great. It's money in the bank. Right. The problem is, is that demand created a situation where we needed more mortgages. Exactly. So I mean, basically say, you know, you're a good prime borrower. You're somebody who, you know, based on your credit rating, your credit history,

your employment history, that kind of thing, you pose little risk of defaulting on your loan. Right. There's a finite amount of prime borrowers in the United States. Right. And after a couple of years with, you know, with, with the mortgages being pulled together and put into mortgage backed securities, this pool of people dried up. And then I know what came next was the subprime market. Yes. Which is the big reason why the housing boom, the bubble burst. Exactly. Because subprime borrowers, a lot of people think that subprime is, has something to do with the rate, the interest rate. It's a below prime rate. That's what I always thought as well. But no, it refers to the borrowers. Exactly. People that don't have enough income or the right credit, basically they were just

writing things, you know, it's kind of like a blank check, a false market almost. Very much, very much so. But when banks change their lending practices to include subprime borrowers, all of a sudden there's this huge untapped pool of people who can create mortgage backed securities because you can't have mortgage backed securities without mortgages. Right. So basically to answer this clamoring for more mortgage backed securities on Wall Street, banks had to start issuing more mortgages. And the investment banks were more than willing to buy all these mortgages no matter what. Right. So your local bank that you go to, say you're a subprime borrower, and subprime has this really evil connotation here in 2008. Yeah, it does. But really if you think about it,

it's just somebody who has a credit score maybe below, I think right now it's 630. Right. It could be 629 when you're a subprime borrower. Or maybe you've even changed jobs in the last year that could make you a subprime borrower. There's a lot of factors. It doesn't mean like you're this, you know, nefarious drug dealing cat burglar. Right. You're not taking the bank drawing welfare checks and swindling houses out of banks. Exactly. Right. Necessarily. Some have, but for the most part, it's you can't really categorize these people beyond their credit score. Right. The war on drugs impacts everyone, whether or not you take drugs. America's public enemy number one is drug abuse. This podcast is going to show you the truth behind

the war on drugs. They told me that I would be charged for conspiracy to distribute a 2,200 pounds of marijuana. Yeah, and they can do that without any drugs on the table. Without any drugs, of course, yes, they can do that. And I'm the prime example of that. The war on drugs is the excuse our government uses to get away with absolutely insane stuff. Stuff that'll piss you off. The property is guilty. Exactly. And it starts as guilty. It starts as guilty. The cops, are they just like looting? Are they just like pillaging? They just have way better names for what they call like what we would call a jack move or being robbed. They call civil acid for it. Be sure to listen to the war on drugs on the iHeart radio app, Apple podcast,

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Most people in the ballet world are more interested in their experience of watching it than in a dancer's experience of executing it. Listen to The Turning Room of Mirrors on the iHeart radio app, Apple podcasts, or wherever you get your podcasts. So the banks, since they're no longer hanging on to the mortgage, you know, time was you went to a bank, you got a mortgage that sat in the bank's vault that Peace Paper did and you made monthly payments to the bank and they took it in and then after 30 years or whatever, you paid your last, you made your last payment and they sent you your mortgage.

Right. And they were, they did a lot of investigating into your history at that time because they were the ones, you know, that had the most to lose. They were carrying all the risks. Exactly. If you defaulted on your loan, that bank took the hit and that was it. It ended there. Yep. Right. With the subprime or with the mortgage back securities, that all changed. Banks no longer had any risk whatsoever. Right. They would almost literally issue you a mortgage and possibly that same day turn around and sell it. That really explains it. Yeah. Right there in a nutshell. So whoever ended up with this mortgage in whatever form, whether it was a mortgage

back security and it was divided among like 50 or 100 or 1000 people. Right. Whoever ended up with it in the end, assumed the risk. So these investment banks didn't necessarily carry the risk either. The risk of you not paying your loan went to the individual investors. Right. Since all of these mortgages started to become based on subprime mortgages, all the mortgage back securities became based on subprime mortgages. When the foreclosure started, the market almost immediately plummeted. Right. Because it was directly tied. Yeah. It wasn't a trickle down effect. They were directly linked. There is another instrument too that were based on mortgage back securities. Right. So think about this. You have a mortgage,

it's turned around, sold, packaged with some other mortgages and then divided into shares. Those shares can actually be divided further and repackaged into something called collateral debt obligations. Right. And some of these, these can be based on all sorts of different things. You can take just mortgage mortgages from a mortgage back security and that will all mature in five years or that are all interest only or that are all fixed interest. There's all sorts of ways to package it. But one of the hottest items on Wall Street for collateral debt obligations were these instruments that were made exclusively from subprime mortgage back securities. Because you're a subprime borrower, you get a higher interest rate. Right. So the security,

the investment on whether or not you're going to repay your loan, it's riskier, but the dividends are higher because the interest rate is higher. Sure. And not unlike a lot of just the regular Wall Street stock market stocks, great risk equals great reward. Right. And, and that, that pays off. But really, if you look at it a long enough arc, it never pays off. It always, it always goes under. So what you have now is, is a bunch of people playing, playing hot potato sure with these things. They were they short-sighted or were they, they're greedy, greedy. It's as simple as that. Was it a live for now type of thing? Did they plan on dumping these? I, I guess here's, that's, I would assume yes, that, that once people started realizing, wait a minute,

eventually when you follow these down the line, you're going to get to a house. And that house is basically its value is in this situation based on whether or not the person's making payments. Right. And we're, we're, we're betting on subprime borrowers making payments. And if they don't, this, this security tanks and we lose all of our money. Someone, somewhere down the line around, say 2006, figured out that these things were going to tank because of foreclosures. And that's exactly what happened. So it started this domino effect. Well, who's at fault here? Or is that even important? I mean, was it, or I guess everyone kind of shares in the plan because the homeowner that, that really doesn't have the money, it shouldn't go out and try to get the house. The,

the lender, certainly they were making the commissions, correct? The mortgage broker. Sure. So they were making money and then selling them immediately. Or actually, I think the mortgage lender, it immediately goes to the bank. So they're not even really tied to the bank necessarily. And then the bank sells them. And it's just, it seems like the more it gets spread out and split up, the more fractured it gets, it's really hard to even tell who's to blame anymore. It is. And I mean, ultimately, you know, finding the person to blame isn't going to help anything now. Exactly. But it kind of eases the pain a little bit. Or at the very least, you have someone to direct your eye or two. Well, I know in an election year though,

a lot of people look into point fingers. If this was not an election year, you're probably going down a little bit differently. I think, I think there's a lot of people to blame, as you said. And I don't think it's just the lending industry or the investment banking industry. And I don't think it's just the people who, who just got packed homeowner. Yeah. Or the hockey ones. Don't forget them. Right. I don't think it's, it's the average subprime borrower who took out a loan larger than they can afford. Right. Because they were sold to bill of goods oftentimes because I wrote an article on subprime mortgages and a lot of people didn't even know what they were signing. These mortgage lenders would kind of use tricky dialogue to get them

to sign on the dotted line so they could make their commissions. Yeah. There's, there was a lot of predatory lending going on big time. So regardless of who's to blame, these foreclosures start happening and they start happening big time, widespread, all over the place. Right. And like I said, it starts this domino effect. The weird thing is, is new houses that were being constructed stop, stop being sold as quickly because all of a sudden they had to compete with these foreclosed homes on the market. Exactly. That were maybe half price. Yeah. I bought my house in foreclosure. Yeah. I mean, this was even before the big, big foreclosure bust where they were all over the place. So we just got kind of lucky. But yeah, all of a sudden these new houses

are sitting empty because like you said, they can't compete with the house. It's 40% discounted. Right. So all these foreclosed homes have this effect on the market, the housing market. Right. Right. More new homes on them or more homes on the market means that the new homes aren't being sold because the foreclosures are going, it's like a fire sale out there in real estate in the US. But the presence of more homes on the market, the presence of more anything, the more supply, the lower the price. Right. So housing prices drop. So you've got people all of a sudden who are like, wait a minute, I'm in this huge, terrible, maybe hybrid arm adjustable rate mortgage. Right. And all of a sudden they owe more on their house than it's worth. Right. How long are you going

to stick around? When are you going to leave and start running? So foreclosures keep going and going and going. And as these, this wave of foreclosures takes over the US housing market, it also directly impacts the investment market as well. Right. Because everybody was, you know, so heavily invested in subprime mortgage-backed securities. Right. And then you have the construction companies who own all these houses that aren't selling. So they have to lay people off. And then it leads to unemployment. It's a huge domino effect. That's exactly right. Everything, pretty much in the modern economy and the global economy and the US economy, everything is interrelated, precariously so. Right. But it all goes back to mortgage-backed

securities in this case. That's exactly right. Whose idea was this to begin with? I don't know. I've never found that out. And I've actually looked. I think that they are laying low. There's got to be a dude. There's one guy who had this idea. Yeah. Well, there's a lot of financial instruments that are out there and they come out of places like Harvard Business or Wharton School and, you know, among other places and they're modeled, you know, that you can run them through an economic model. But it's really just a model. You can't really tell what kind of effect it's going to have until after it's introduced in the market. Right. In the real world, it's a little different sometimes. Right. And there's no, as far as I know,

there's no regulation over introducing a financial instrument to the market. You know, I mean, we regulate whether or not you can introduce a non-native fish into a lake. Right. But nobody's, you know, watching over the financial instruments that are being introduced to the market, right? Right. So I'm thinking basically, if we had regulation of that, things were tested out on a small scale first before being released en masse, that could be helpful. Sure. I think there's a whole lot of regulation that could take place. Well, maybe these guys should start listening to Josh Clark. Yeah, I guess. This is a pretty dense subject. Do you agree, Chuck? It's dense or I'm dense, one of the two. I don't think you're dense.

It is. It's a very dense subject. I would recommend anybody listening to this podcast going on to howstuffworks.com and typing in how can mortgage-backed securities bring down the U.S. economy and stick around to find out which four articles Chuck and I consider essential reading right now. So, Chuck, four articles, essential reading. Right. I'll say them because I know you're shy. They're all articles that you wrote and they're really great in-depth articles and they are about the four. The war on drugs impacts everyone, whether or not you take drugs. America's public enemy number one is drug abuse. This podcast is going to show you the truth behind the war on drugs. They told me that I would be charged for conspiracy to distribute 2200 pounds of marijuana.

Yeah, and they can do that without any drugs on the table. Without any drugs, of course, yes, they can do that and I'm a priming sample of tax. The war on drugs is the excuse our government uses to get away with absolutely insane stuff. Stuff that'll piss you off. The property is guilty. Exactly. And it starts as guilty. It starts as guilty. The cops, are they just like looting? Are they just like pillaging? They just have way better names for what they call like what we would call a jackmove or being robbed. They call civil asset for it. Be sure to listen to the war on drugs on the iHeart radio app, Apple podcast or wherever you get your podcast.

There is no need for the outside world because we are removed from it and apart from it and in our own universe. On the new podcast, The Turning, Room of Mirrors, we look beneath the delicate veneer of American ballet and the culture formed by its most influential figure, George Balanchine. There are not very many of us that actually grew up with Balanchine. It was like I grew up with Mozart. He could do no wrong. Like he was a god. But what was the cost for the dancers who brought these ballets to life? Were the lines between the professional and the personal were hazy and often crossed? He used to say, what are you looking at, dear? You can't see you, only I can see you. Most people in the ballet world are more interested in their experience of watching it

than in a dancer's experience of executing it. Listen to The Turning, Room of Mirrors on the iHeart radio app, Apple podcasts or wherever you get your podcasts. Candidates for president and vice president for this upcoming election. So we have how John McCain works, how Obama works, how Sarah Palin Palin Palin works, and how Joe Biden works. And I haven't read the Joe Biden one yet, but I'm hoping there's something in there about his teeth. Nothing about his teeth. A lot about his foot and mouth condition. Right. Well, if there's room in that mouth for a foot from all those teeth, then he does have amazing teeth. They're great. I need some choppers like that. You can check all four

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