Wall Street's Mortgage Business: How It Works

The 2008 US mortgage crisis was largely attributed to Wall Street's involvement in the non-prime mortgage industry. Wall Street lenders acted as conduit lenders, borrowing money to lend out as mortgages, and profiting from the sale and closing costs. These mortgages were then packaged into bonds and sold as mortgage-backed securities (MBS) to investors. The MBS market was huge, with investors such as foreign governments, pension funds, insurance companies, banks, and hedge funds. The MBS market was also complex, with several institutions consuming a slice of the mortgage pie. The 2008 crisis was catalysed by an influx of money from the private sector, banks entering the mortgage bond market, government policies, speculation by home buyers, and predatory lending practices.

The role of Wall Street lenders

Wall Street lenders play a significant role in the mortgage industry, particularly in the secondary mortgage market. They act as conduit lenders, facilitating connections between borrowers and investors. The investments offered by these lenders are known as Commercial Mortgage-Backed Securities (CMBS) or mortgage-backed bonds.

The process typically involves Wall Street lenders obtaining and then selling loans to make a profit. They lend substantial sums, often borrowed money, across various property types, including multifamily, industrial, office, and retail. These loans are then pooled and rated based on factors such as tenant mix, property type, and average loan-to-value. The pool is rated as a whole, with the highest-rated loans typically constituting a significant portion of it.

Wall Street firms then sell these mortgage-backed securities to investors, such as foreign governments, pension funds, insurance companies, banks, and hedge funds. By doing so, they generate fees and profits while transferring the risk of the loans to the investors. This practice allows Wall Street lenders to get their money back quickly and reuse it for multiple loans during a single loan term, increasing their overall profits.

How mortgages are sold to investors

Banks and lenders sell mortgages to investors to free up funds to offer more loans. This is known as the secondary mortgage market, where lenders sell loans they've originated to investors. This market allows for a continuous flow of funds in the housing and financing markets.

Mortgages are financial instruments, much like bonds, that can be bought and sold between investors. Mortgage-backed securities (MBS) are created when mortgages are pooled together and sold as securities. MBS investors get income from mortgage payments, and mortgage lenders get cash to extend loans to new borrowers. The end goal is to sell them as securities to investors. Foreign governments, pension funds, insurance companies, banks, GSEs, and hedge funds are all big investors in mortgages.

Wall Street lenders lend money to different borrowers for mortgage-backed loans. They then sell these loans to investors, turning a profit from the sale and any closing costs. Investors buy the ownership of the loans from Wall Street lenders so they can collect the interest or foreclose on the properties. The first-tranche investors are in the last-loss position, while the last-tranche investors are in the first-loss position.

Mortgages are often sold without the borrower's knowledge, but the terms of the loan, such as the interest rate, monthly payment, and remaining balance, remain the same. The mortgage servicer may change, but this typically has a minimal effect on the borrower. Homeowners have rights under the Real Estate Settlement Procedures Act (RESPA) to receive information about the transfer of their mortgage.

Mortgage-backed securities

MBS are investments like bonds. Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them. Investors in MBS receive periodic payments like bond coupon payments. MBS can be issued by government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae, and are considered to be of the highest credit, given government backing. Non-agency MBS are issued by private entities and carry higher risk and potentially higher yields since they are not government-guaranteed.

MBS are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization. Most MBS have the backing of the US government and are called agency MBS.

MBS are sold to a trust, a GSE like Fannie Mae, Freddie Mac, a government agency like Ginnie Mae, or a private financial institution. The trust then structures these loans into MBS and issues them to investors. A mortgage-backed security (MBS) contains a pool of mortgage loans and pays fixed-interest payments to investors. The secondary mortgage market is huge and very liquid, with several institutions eager to consume a slice of the mortgage pie. The end goal is to sell them as securities to investors.

The subprime mortgage crisis

• An influx of money from the private sector, with banks entering the mortgage bond market.
• Government policies aimed at expanding homeownership, leading to lax lending standards and unsustainable housing price increases.
• Speculation by many homebuyers, driving up demand and prices.
• Predatory lending practices, such as adjustable-rate mortgages and 2–28 loans, sold via mortgage brokers.
• High personal and corporate debt levels, with record levels of household debt accumulated in the years preceding the crisis.
• Inappropriate government regulation and weak underwriting standards.
• Excessive use of leverage and derivatives by financial institutions to take on more risk.

The crisis had a significant impact on Wall Street, with the failure of many banks and financial institutions. The securitization market "seized up", with investors no longer willing to lend, and the value of mortgage-backed securities (MBS) plummeted, leading to significant financial losses. The precarious financial position of major investment banks and the collapse of the United States housing bubble further exacerbated the crisis.

The role of Wall Street firms and traders also came under scrutiny. The incentive structure for traders was focused on generating fees from assembling financial products rather than their long-term performance, with bonuses heavily skewed towards cash. This encouraged short-term risk-taking behaviour and a lack of understanding of the complex financial products being traded.

The crisis led to a wave of foreclosures, devaluation of housing-related securities, and a downward spiral in house prices. It also contributed to the recession of 2007-2009, impacting construction, consumer spending, and the ability of financial firms to lend and raise funds.

The impact of the stock market on mortgage rates

The stock market does not directly impact mortgage rates. However, both are influenced by the fundamental movement of the economy. When the economy is doing well, stock prices and mortgage rates tend to increase. Conversely, when the economy falters, they usually decrease. This relationship is due to investors' behaviour during economic booms and downturns. When the economy is strong, investors are more confident in taking risks and investing in the stock market. Conversely, when the economy is weak, investors tend to move their money to safer investment products, such as bonds, which offer guaranteed repayment and interest from government entities. As a result, demand for stocks decreases, leading to a decline in stock prices.

Mortgage rates are influenced by the demand for mortgage bonds in the secondary mortgage market. Mortgage lenders often sell their loans to this market, where they are bundled into mortgage-backed securities (MBS). When the supply of mortgage bonds is high, demand decreases, leading to lower interest rates. Conversely, when demand for mortgage bonds is high and supply is limited, interest rates tend to increase.

Additionally, mortgage rates are influenced by the federal funds rate set by the Federal Reserve. When the Federal Reserve raises the federal funds rate to manage inflation, other rates, including mortgage rates, tend to increase as well. Conversely, when the Federal Reserve lowers its rate to stimulate economic activity during stagnant inflation, mortgage rates may decrease.

It is important to note that the relationship between the stock market and mortgage rates is complex and influenced by various factors. While they tend to move in opposite directions, this relationship is not absolute, and other economic indicators, such as unemployment rates, inflation, and wage growth, also play a role in determining mortgage rates.

Furthermore, the behaviour of Wall Street lenders and investors influences the availability and cost of mortgage loans. Wall Street lenders obtain loans from investors and then lend this money to borrowers, such as those seeking mortgages. By selling these loans, Wall Street lenders profit from the sale and closing costs while also getting their money back quickly, allowing them to lend the same funds multiple times during a single loan term. This practice increases the liquidity of the secondary mortgage market and contributes to the complex dynamics between the stock market and mortgage rates.

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