Are Mortgage-Backed Securities Dead?

One can argue that structured finance creates greater efficiency in our financial system because capital is freed to pursue other objectives. Although, it can also be argued, as Warren Buffet has, that derivatives, the product of structured finance, are “financial weapons of mass destruction.” Both arguments stem from the same characteristic of these securities: excessive debt.

When the loan that became part of the collateralized debt obligation was originated, this money was created out of nothing by the originating lender. This is how all money is created in a fractional reserve banking system. As long as there is sufficient cash flow, debt creation is normal; however, when excessive debt is created and available cash flow cannot service this debt, the system experiences the very serious problem of insolvency which can lead to monetary deflation, the disappearance of lender-created money into the ether from which it was created.

If an individual investor wanted to buy a mortgage loan, the purchase would proceed with equity rather than lender-created money. However, once packaged into a Collateralized Debt Obligation (CDO), the senior tranche is often purchased by an investment banker or another lender which also created this money from nothing. Since the equity tranche raises no capital, the mezzanine tranche may be the only money in the structure not created by a lender out of the ether. With so little “real” money in the deal, there is very little buffer between what would be a loss of invested capital and a banking loss of created capital. There is a tipping point where the debt service exceeds the cash flow, and when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral.

The structured finance products such as collateralized debt obligations and their derivatives are highly leveraged instruments with a very sensitive tipping point. These instruments are also highly sensitive to short term credit availability and lending rates. The long-term CDOs were often financed by continually rolling over short term debt. Rising cost of short-term debt would take a while to cause problems, but a sudden withdrawal of credit availability, as was witnessed during the credit crunch, meant desperate sales for those who owned these instruments. Monetary deflation was a major concern to the Federal Reserve as the Great Housing Bubble began to deflate.

The use of structured finance techniques in the syndication of collateral debt obligations was not by itself a problem causing the Great Housing Bubble. This was part of the infrastructure for delivering capital to the mortgage market which began with the creation of the secondary mortgage market. In the aftermath of the crash of house prices, collateralized debt obligations received a bad reputation as dangerous securities unworthy of the safe, “AAA” ratings they received from the companies that evaluate the creditworthiness of financial instruments.

The advantages of structured finance did not disappear because of problems with the market or the ill-advised ratings these securities received. Collateralized Debt Obligations as syndicators of mortgage-backed securities nearly disappeared in 2008. However, they did not go away, and they will continue to be an integral part of the capital delivery system providing money for buyers to purchase residential real estate.