How do MBS/CDO holders get paid when ARMs are involved?

[TheBreeze]

So I’ve been curious about something for a while and I haven’t been able to find an article that addresses it. Basically, I’m wondering how the holders of MBSs/CDOs get paid when there is an adjustable rate mortgage involved.

Let me throw out a concrete, very simplified example: Joe Idiot takes out a mortgage that has a two-year teaser rate (3%) with the rate exploding upwards after that (10%). The mortgage is sold to a third-party. At this point I’m not exactly sure what happens (I’ve read that ‘corporations’ on the Cayman Islands get involved, but that is not the point of this post). In any event, at some point the mortgage gets packaged as part of a CDO or a MBS or something and then Idiot2 buys it (Idiot2 possibly being the manager of the money market fund in my 401(k) retirement account). For the sake of this example, let’s say that only this one mortgage goes into the CDO/MBS. So now Idiot2 holds an instrument wherein the interest is paid out at 3% for two years and then 10% thereafter.

How does Idiot2 get his interest? Does he really get 3% for two years and then 10% after that? Or, does the creator of the MBS/CDO pay a flat rate of something like 8% for the life of the mortgage? What happens when Joe Idiot defaults? Does the creator of the MBS/CDO take back the house or does Idiot2 take the house?

[HLS]

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)

Long answer,

[HLS]

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)

Long answer,

[HLS]

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)

Long answer,

[bsrsharma]

TheBreeze,

I think you will find the posts at

http://calculatedrisk.blogspot.com/2007/07/compleat-ubernerd.html

pretty informative. The brief story is, there is no simple relationship between Joe’s mortgage and the CDO/CMO held by a fund. The mortgage is sliced into “Tranches” and reassembled with similar and dissimilar debt intruments. It is these new synthetic securities that are bought by the funds. As you can see, the risk computation on these synthetic securities is very complicated, and hence it is done based on computer simulations of various combinations of price appreciation, interest rate increases and (debt) default rates and other probabilities. The problem in the CDO industry now is that these models have been found to be incorrect and were based on a shallow horizon of past few years with increasing home prices, low interest rates and low defaults. Once those conditions are reversed, the models are collapsing and are basically telling that these CDOs are not valuable. That is the root cause of the whole mess now. In the absence of securitization and resultant market for them, there is no secondary market. Without secondary market, the only mortgages are those sellable to GSEs (Fannie/Freddie/Ginnie etc.,).

So, the final answer to your original question is that there is no direct correspodence between the interest rate the borrower pays at any time and what the CDO holder gets because they get decoupled during the securitization process. It is like your cow may eat some spoiled grain but you will still get drinkable milk. But that model fails if the cow dies due to food poisoning. We are seeing a lot of cows sick or dying because the dairy farmers got greedy and started to think cows can convert any thrash into milk and started feeding them more thrash and less grain. That is now causing a rise in milk prices.

[bsrsharma]

TheBreeze,

I think you will find the posts at

http://calculatedrisk.blogspot.com/2007/07/compleat-ubernerd.html

pretty informative. The brief story is, there is no simple relationship between Joe’s mortgage and the CDO/CMO held by a fund. The mortgage is sliced into “Tranches” and reassembled with similar and dissimilar debt intruments. It is these new synthetic securities that are bought by the funds. As you can see, the risk computation on these synthetic securities is very complicated, and hence it is done based on computer simulations of various combinations of price appreciation, interest rate increases and (debt) default rates and other probabilities. The problem in the CDO industry now is that these models have been found to be incorrect and were based on a shallow horizon of past few years with increasing home prices, low interest rates and low defaults. Once those conditions are reversed, the models are collapsing and are basically telling that these CDOs are not valuable. That is the root cause of the whole mess now. In the absence of securitization and resultant market for them, there is no secondary market. Without secondary market, the only mortgages are those sellable to GSEs (Fannie/Freddie/Ginnie etc.,).

So, the final answer to your original question is that there is no direct correspodence between the interest rate the borrower pays at any time and what the CDO holder gets because they get decoupled during the securitization process. It is like your cow may eat some spoiled grain but you will still get drinkable milk. But that model fails if the cow dies due to food poisoning. We are seeing a lot of cows sick or dying because the dairy farmers got greedy and started to think cows can convert any thrash into milk and started feeding them more thrash and less grain. That is now causing a rise in milk prices.

[bsrsharma]

TheBreeze,

I think you will find the posts at

http://calculatedrisk.blogspot.com/2007/07/compleat-ubernerd.html

pretty informative. The brief story is, there is no simple relationship between Joe’s mortgage and the CDO/CMO held by a fund. The mortgage is sliced into “Tranches” and reassembled with similar and dissimilar debt intruments. It is these new synthetic securities that are bought by the funds. As you can see, the risk computation on these synthetic securities is very complicated, and hence it is done based on computer simulations of various combinations of price appreciation, interest rate increases and (debt) default rates and other probabilities. The problem in the CDO industry now is that these models have been found to be incorrect and were based on a shallow horizon of past few years with increasing home prices, low interest rates and low defaults. Once those conditions are reversed, the models are collapsing and are basically telling that these CDOs are not valuable. That is the root cause of the whole mess now. In the absence of securitization and resultant market for them, there is no secondary market. Without secondary market, the only mortgages are those sellable to GSEs (Fannie/Freddie/Ginnie etc.,).

So, the final answer to your original question is that there is no direct correspodence between the interest rate the borrower pays at any time and what the CDO holder gets because they get decoupled during the securitization process. It is like your cow may eat some spoiled grain but you will still get drinkable milk. But that model fails if the cow dies due to food poisoning. We are seeing a lot of cows sick or dying because the dairy farmers got greedy and started to think cows can convert any thrash into milk and started feeding them more thrash and less grain. That is now causing a rise in milk prices.

[Author]

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