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Mortgage-backed securities 101

Kai Ryssdal Aug 13, 2007

TEXT OF INTERVIEW

Kai Ryssdal: We’ll grant you that this stuff is all mind-numbingly complicated. From however the heck a quant fund works to why some funds have had to stop allowing withdrawals because they can’t do something called mark to market. And at the bottom of the whole mess is something that sounds fairly self-explanatory, but somehow isn’t. The mortgage-backed security.

We’ve asked Mike Hatley to come in to give us a tutorial. Mike, good to see you.

Mike Hatley Thank you, Kai, nice to be here.

Ryssdal: Maybe the best place to start is my mortgage. Who owns my mortgage?

Hatley: That’s a good question . . .

Ryssdal: And that’s why we started there.

Hatley: And nobody knows for sure, really, who holds your mortgage. Because in the old days, when your parents and my parents were buying their first homes, they went to their local savings and loan or their local bank. They arranged the mortgage, and that bank or savings and loan held the mortgage, and that’s who owned the loan.

Ryssdal: Today, though, that loan is within hours, I understand it, sold to somebody else.

Hatley: That is correct.

Ryssdal: Who is it sold to?

Hatley: Well, investors. There was a great innovation a number of years ago, the invention of these mortgage-backed securities. And so what that means is you take a pool of a number of loans and they put them into a new vehicle, a trust. And that trust issues securities.

Ryssdal: Securities, that is, something that can be bought or sold on the open market.

Hatley: Exactly.

Ryssdal: Obviously, different investors have different tolerances for risks. So as I understand it, what these guys do is they take those securities and they slice them up by risk profile.

Hatley: That’s right. And in the securities market in general, one of the factors that’s important is the ratings for the securities, and the highest possible rating is a triple-A. And that means that the risk of loss is very minimal — in theory, at least. Then when you get down to triple-B, there’s more risk, and down to triple-C and below there’s a lot of risk.

Ryssdal: How am I gonna make money if I buy somebody else’s mortgage — whether I buy a slice of the security or a slice of the institution that offers those securities?

Hatley: Historically, the interest rate that they pay is a little bit higher than an interest rate for the same credit rating from a corporate borrower. So if you were going to buy an investment in a triple-A rated bond from General Electric, that might pay a certain interest rate. But the triple-A rated, mortgage-backed security would pay a little bit higher interest rate for the same triple-A rating.

Ryssdal: Just ’cause there’s that touch of risk that is now sort of coming home to roost, right.

Hatley: That’s right.

Ryssdal: How does it get to where we are today? Is the hiccup that starts these dominoes falling, is it somebody not making a payment on a mortgage?

Hatley: That is the hiccup. In the subprime case, which is the biggest problem today, a number of those loans were made to borrowers that probably shouldn’t have gotten money in the first place. And the default rates on those loans have spiked dramatically — particularly over the loans originated in 2006 and 2007. When those start defaulting, the securities that are issued based on those mortgages, those have issues as well, and the values of those securities go down when the defaults are rising.

Ryssdal: Is this circle irretrievably broken now, or is there a way to sort of fix it so that the system can start working again?

Hatley: Well, that may be a better question for Ben Bernanke than for me.

Ryssdal: Well, I mean, something like an interest rate cut or something like that. I mean, what would it take to fix this whole mess?

Hatley: I think an interest rate cut might be helpful in that it would make the payments more affordable. But I think the main thing is it’s just gonna take time for these defaults to cycle through, for the recoveries to cycle through. And it could take several years before the mortgage-backed securities markets return to where they were a year ago.

Ryssdal: Mike Hatley is the president of WestGate Horizons Advisors here in Los Angeles. Mike, thanks a lot.

Hatley: Thank you, Kai.

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