Are Mortgage-Backed Securities Dead?

It can be argued that structured finance leads to more efficiency in our financial system because capital is freed up to pursue other goals. However, like Warren Buffett, it can also be argued that derivatives, the product of structured finance, are “financial weapons of mass destruction”. Both arguments are based on the same property of these securities: over-indebtedness.

When the loan that became part of the secured debt obligation was issued, that money was created out of thin air by the original lender. This is how all money is created in a fractional reserve banking system. As long as there is sufficient cash flow, debt accumulation is normal; However, when excessive debt arises and the available cash flow cannot service that debt, the system experiences the very serious problem of default, which can lead to currency deflation, the disappearance of lender-created money into the ether from which it was created.

If an individual investor wished to purchase a mortgage loan, the purchase would be made with equity rather than money created by the lender. However, once packaged into a collateralized debt obligation (CDO), the senior tranche is often purchased by an investment banker or other lender who also created that money out of thin air. Since the equity tranche does not raise capital, the mezzanine tranche may be the only money in the structure that was not created out of the air by a lender. With so little “real” money in the business, there is very little buffer between what would be a loss of invested capital and a banker’s loss of capital created. There is a tipping point where debt service exceeds cash flow, and when that tipping point is reached the entire debt structure can collapse in a deflationary spiral.

The structured financial products such as Collateralized Debt Obligations and their derivatives are highly leveraged instruments with a very sensitive turning point. These instruments are also very sensitive to short-term credit availability and lending rates. The long-term CDOs were often financed by continuously rolling up short-term debt. Rising costs of short-term debt would take a while to cause problems, but a sudden drop in the availability of credit, such as that seen during the credit crunch, meant desperate selling for those who owned the instruments. Currency deflation was a major concern for the Federal Reserve when the Great Housing Bubble began to deflate.

The use of structured finance techniques to syndicate collateral debt obligations was not in itself a problem that caused the Great Housing Bubble. This was part of the infrastructure to provide capital to the mortgage market that began with the creation of the secondary mortgage market. After the house price collapse, collateralized debt obligations got a bad rap as dangerous securities that didn’t deserve the safe “AAA” ratings they received from the companies that assess the creditworthiness of financial instruments.

The benefits of structured finance didn’t disappear because of problems with the market or the ill-advised ratings these securities received. Collateralized debt obligations as syndicators of mortgage-backed securities all but disappeared in 2008. They haven’t gone away, however, and they will continue to be an integral part of the capital delivery system that provides buyers with money to purchase residential property.