How derivatives could have saved the mortgage market

What went wrong with the subprime mortgage market? In a nutshell, a lot of the problem was that it wasn’t as sophisticated, in terms of derivatives, as the rest of the bond market.

Let me explain. Investors demanded vast amounts of subprime mortgages in the form of MBSs, and Wall Street did everything it could to meet that demand. Unfortunately, Wall Street met the demand by happily securitizing anything and everything sent to it by originators using ever-laxer underwriting standards. Think of it as the mother of all reverse inquiries: CDOs and other investors essentially went to the originators and told them they would love it if they could originate vastly more in the way of subprime MBSs than they ever had in the past. And so the originators did just that — by writing mortgages which turn out, in restrospect, to have been very bad ideas for the homebuyers, for the originators, and for the investors.

How could all this have been avoided? Quite simply, in theory: Wall Street could simply have started issuing synthetic MBSs. Total subprime originations would not have risen nearly as much, underwriting standards could have remained relatively strict, and the investors would be much happier today. There would also have been less of a housing bubble, as individuals would have found it much harder to buy houses they couldn’t afford.

But financial technology never really got as far as synthetic MBSs. And so we find ourselves in the situation we’re in today.

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15 Responses to How derivatives could have saved the mortgage market

  1. brad setser says:

    dude — you now have a new line of work. synthetic MBS are the next big thing!

    one question? who are the natural buyers and sellers. An example from eM land.

    as the supply of $ bonds dried up, the old EM long only fund managers started selling a fair amount of CDS protection (i.e. basically another way of betting there won’t be a default and collecting the spread).

    and demand for EM CDS came in part from folks looking to hedge local currency debt and local currency equity exposure, since in the past, there was a good correlation between rising risk premium on the $ debt and moves in the local currency market, so it worked as a cheap proxy hedge …

  2. josh reich says:

    I think you have just inspired me to dust off my copy of Culp’s “Art of Risk Management”. But if anyone can give me any hints as to what structure might fit inside a synthetic MBS, I’d be greatly appreciative.

  3. murray says:

    This is a silly argument. You make it sound like those poor lenders and borrowers were merely the puppets on the strings pulled by MBS structurers and investors. If it weren’t for these greedy investors, all would be just swell!

    Baloney. Everyone in the food chain got greedy, or was at best complacent about risks. Borrowers wanted to own houses, regardless of their ability to pay the mortgage. Lenders wanted the fees from sourcing the loans and then selling the on to Wall Street. That gain on sale is a nice juicy part of the business.

    And don’t forget, lenders had built up large fixed costs they had to pay for. The only way to do that when rates are rising is to continue lending to people with poor credit using ever sillier products.

    In any event, synthetic MBS do exist, to a degree. ABS CDOs have been gobbling up single-name defauult swaps of triple-B MBS paper since 2005. By the end of last year a $10m triple-B bond might have as much as $300m in notional outstandings owned by investors through the CDO market.

    Wouldn’t stop the lending, though – investors still love owning the paper when they can. And lenders still love making a packet in the good times from gain on sale.

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