MBS/CDO are sold off based on their perceived returns, and the risk associated. Brokerage houses (i.e. Bear Sterns etc)
were large buyers.
In your above example, There were no 3% loans that were not Option Arm loans. (NEG AM) The pay rate was low, but the actual interest rate was probably 8%+.
The market rate at the time of origination was probably 6%, so an 8% return may have carried a premium when sold. Even though the payment was low, the loan balance would grow and the gravy train was a prepayment penalty of 6 months interest at 8% if the loan was paid off within the first 2 or 3 years, or a higher principal balance.
Loans that were not option arms were closer to market rate at the time of origination for 2-3 years.
Idiot2 only wants a return on investment. Influenced by ratings agencies, they decide what risk they would take.
A servicing company handles all the payments (late charges, customer service, etc) for a fee. Companies like Aurora, Litton, etc. even Countrywide might service loans for Idiot2. The servicer will handle (or sub out) legal proceedings, foreclosures etc. Missed payments result in no return to Idiot2.
Increase in rate results in higher return to Idiot2.
MBS/CDO and Idiot2 aren’t experienced in dealing with foreclosures, the servicer is.
2nds were always riskier. Even at 10%-12%, a 2nd might not have brought much premium.
The MBS are traded like bonds. 100% being par, a strong portfolio might bring 100.50% or 101% (or higher) for high returns.
The brokerage houses probably reserved the right to return loans that didn’t perform within the first 90 days +/-(BUYBACKS)
There were cases where people refi’d, took cash out, and never made a payment, or didn’t make their 2nd or 3rd payment. (Defaults)
This is where the troubles started. The originator (Like New Century) only made a small amount on each loan.
Underwriting fee was around $1000 whether it was a $100K loan or $1,000,000 loan. Additional profit came from the premium that may have been received when the loan was sold.
Earlier this year, the subprime defaults got ugly.
The brokerage would go back to the originator and say here’s $500 million of crappy loans that you sold us, we want our money back NOW. The originator says we don’t have the money, give us a week, or we’ll just go out of business…. They might drag it out for a few days, but in a nutshell, that’s why so many companies went out so quickly. No access to cash.
SO Wall Street starts to get scared, and doesn’t want to buy loans unless they have larger premiums. What was a premium loan at 101%, became a 98% (or less) which represents a loss to the originator. That was earlier this year. 98% went lower and lower. No sense in originating loans if they can’t be sold at a profit.
There are probably some risky loans that are selling for 20%, representing an 80% loss from origination.
The downward spiral happened quickly. Over 125 wholesale lending companies have gone out of biz in less than a year, leaving thousands of people unemployed.
This is a brief overview, it gets more complicated.
The higher the perceived yield on each loan, the more was paid out in commissions to everone involved (up front)
The folks on Wall Street collected fees up front also.
It was house of cards that has collapsed, leading to virtually no loans being sold off right now, and the problems with jumbo loans (above $417K)