The role of U.S. securitized assets in the Global Financial Crisis: Part 1

Let’s start with a brief overview of securitization.

John Kerschner: Yeah, so securitization isn’t nearly as complex as or black-boxish as people make it out to be. It’s simply a process where you’re taking a portfolio of loans – think mortgage loans, think credit card loans, auto loans, etc. – and combining them. Putting them together, putting a framework around them that talks about the cash flows coming into the securitization and then the cash flows going out of the securitization and what happens when there are prepayments and defaults and things like that.

And the magic of securitization is, you can actually take the cash flows from this pool of loans and then divide them up into different layers of risk. So, if you think corporate bonds, you might like a particular company and you want to buy the bonds from that company – you are obligated to buy whatever rating the rating agencies put on that company.

If you like auto loans, for whatever reason, you can decide to go out and buy AAA rated auto loans all the way down to probably nonrated auto loans.

So that’s really it in a nutshell of how almost all securitization works.

What are the five main securitized subsectors?

Kerschner: The big one is obviously agency mortgages. Now when we say agency, we’re talking about the mortgages that are guaranteed by the government agencies Fannie Mae, Freddie Mac, and Ginnie Mae. Those loans are guaranteed by the government and then sold to investors, so they really have no credit risk. The U.S. is really the only country in the world whose mortgage finance is bedrock by a 30-year fixed rate mortgage.

Most countries have a fixed rate for a smaller period of time – one-year, two-year, three-year, five years, and then it floats. But because we have this government guarantee backstop in the U.S., we have 30-year fixed rate mortgages. So that’s the one. It’s a $9 trillion market that most people are aware of and familiar with because about 28% of agency mortgages are in the [Bloomberg U.S.] Aggregate Bond Index (Agg). And so most people, if they own an Agg fund, they will have some exposure to agency mortgages.

Then you have non-agency mortgages, probably the one we’ll talk about most today. Those are non-government guaranteed. A lot of bad press because of what happened during the GFC [Global Financial Crisis] with non-agency. There’s really nothing wrong with non-agency mortgages, as there are a lot of people that don’t qualify for an agency mortgage, sometimes because they’re self-employed, they don’t have a regular paycheck, they work on commission. Sometimes because their house is too big or too large, and their loan size is too high. Plenty of very high-quality borrowers in the non-agency bucket. The problem with the GFC is, we started giving loans to subprime borrowers, people that really probably didn’t have the financial wherewithal to be able to afford a lot of these homes. So agency, government guaranteed; non-agency, non-government guaranteed.

And then you have ABS, asset-backed securities. The big subsectors of ABS are autos, credit card, student loans.

And then we have CLOs, collateralized loan obligations. Those are taking corporate debt and securitizing those. The corporate debt is leveraged loans – or bank loans – two names for the same thing. Floating rate corporate debt, so CLOs are floating rate as well.

And then CMBS, which is commercial mortgage-backed securities. Those are principally commercial real estate: Think office buildings, malls, other type of retail, hotels, casinos, industrial properties, self-storage, manufactured housing, and multifamily as well.

What was the catalyst for the 2008 financial crisis?

Kerschner: Yeah, so like I mentioned, the GFC, the catalyst was mostly subprime mortgages. Back in the early 2000s they started making these loans to people of lower credit … they started giving loans to subprime borrowers.

A lot of also negative, what they call negative amortization loans. What that means is you’re not paying enough interest on the loan to make up for the rate. So, the principal balance every month actually gets higher instead of lower. On a normal mortgage, every payment you are paying off some interest and some principal. So, at the end of 30 years, the mortgage is completely paid off. A neg-am loan is just the opposite, where every month, because you’re not paying enough in interest, the principal balance goes up and up.

Obviously, if you can’t refinance that, or you can’t eventually start paying down principal, there’s going to be issues with that. The reason they did that is back in the early 2000s, affordability was being very stretched. And to get people into homes they would, they were given, these loans. So, a combination of loans to borrowers of lower quality plus some of these affordability products like neg-am loans was a little bit of a recipe for disaster.

But the problem is, people just kind of assumed that home price appreciation would continue to tick up, tick up, tick up. And that if you had a neg-am loan, or you were a borrower that was of lower credit quality, you could buy your house, after two or three years, you could refinance that loan. The price of the house would go up, and so you would gradually build equity.

Unfortunately, it really backfired in that a lot of people that got into homes ended up losing those homes during the GFC when the housing market kind of tanked. And they lost all the money they had put in that home and probably ended up much worse than if they had never gotten on that ladder. So, bottom line, GFC, subprime mortgages, affordability products, those do not exist any longer. It’s not a thing.

There are non-agency mortgages out there that are not guaranteed, but these are very high credit quality, very stringent underwriting guidelines. And if one good thing came out of the GFC, it was that the underwriting became so much better for mortgages in general.