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Mortgages, in theory, part 4 of N
Let's take a look at more complications on the scene.

Complication 3: Investors and Mortgage Backed Security.

So far, we've been talking about Harriette's mortgage loan being owned by Bob, a banker, possibly after being brokered by Mike, then sold. Bankers are used to dealing with mortgages and other similarly-sized loans. They've got a few tens to hundreds of millions of dollars to play with, and they'll make $5000 car loans, $1M housing loans, $50K business loans, etc. They know how to handle and service these loans, with all their complications.

Investors, on the other hand, don't work at that level. If bankers are retail money brokers, investors are wholesale. They may have a few hundred million to billions of dollars to play with. Where a banker might think that a loan under $1,000 is not worth the effort to issue, an investor might not consider anything under $1,000,000.

Investors traditionally don't like mortgages. They are small, they are complicated, and they are unpredictable. The $600/month income stream from Henriette's $100K loan could, at any time, turn into a pile of cash, not an income stream. And when you are dealing with $1B in assets, $600/month is tiny. You don't want to have to put a lot of effort into dealing with it. Besides, some investors, especially those who are playing with someone else's money (who also tend to have the most money), are contractually obligated to buy only "safe" investments -- they act in a predictable way based on their contract. Mortgages aren't "safe" in this way. So investors stay away from mortgages.

However, investors have a lot of money, and there are a lot of Harriette's out there. If someone could figure out a way to make mortgages appealing to investors, huge amounts of money could flow, and whomever acted as the middle-man could skim off a healthy profit in the process. In the 1980's, somebody figured out how to do exactly that. It doesn't matter who, really. Once one person did it, everybody else in a similar position started doing the same trick. Thus was invented the "Mortgage Backed Security" (MBS).

An MBS works like this: An individual mortgage is unpredictable -- no one can tell if, or when, Henriette will refinance her mortgage. But a collection of similar mortgages is. After 10 years, x% will have defaulted, y% will have refinanced; after 20 years, z% will have refinanced, etc. So to make an MBS, you take a bunch of individual mortgages, and sell bonds based on their collective behavior.

For instance, The mortgage we've been talking about with Harriette has a starting principal of $100K and an interest rate of 6%. If Tom (a MBS Trustee) takes a bunch of similar mortgages, he has (say) $2M of principal with an interest rate of 6%. So Tom promises to pay the Investors 5% (which is 6% less a servicing and guaranty fee) of the outstanding principal each month, and pass through to the Investors the scheduled principal payments plus any prepayments. Sure, people will still default, still prepay, still refinance, but overall the MBS is much more predictable than the original mortgage. (For an example of this, check out this April 2008 Prospectus from Fannie Mae, which discusses fairly readably how Fannie Mae MBSs work in 63 pages.)

The impact of MBSs is enormous: Investors have a lot of money, and a lot of sophistication to figure out how much an MBS is worth, and so are willing to invest in them. This, in turn, dumps money into the mortgage lending industry, making it easier for Harriette and others like her to get financing.

So here's the story of Harriette's loan so far: Harriette has $25K, good income and credit, and wants to buy a $125K house. She goes to Mike and gets a 6%, 30-year fixed-rate mortgage for $100K. Her mortgage payment is $600/month, serviced by Sam. Mike, in turn, trades Harriette's mortgage loan to Tom in exchange for $100K in certificates in the MBS Tom is putting together. The MBS pays 5% interest on the principal in the pool, which starts at $10M. Mike sells these certificates to Ivan for $110K. A month later, Ivan gets an interest payment of $417 and a principal payment of $100 (of which $4.17 and $1, respectively, come from Harriette's mortgage, as her mortgage is 1% of the pool) Over the next 10 years, the certificates have been traded a few times, and are now owned by Irene. Harriette refinances, and pays off the remaining $83K in principal. Irene's monthly check contains $3.49 in interest rate on Harriette's loan, plus $840 in principal repayment on Harriette's loan.

There's a lot more which can be done with MBS, and a lot more structures on how they can be arranged. One could get into tranches, for instance, or CDOs, or CDSs, etc all of which were involved (at this level) in the financial meltdown. But I won't.

In the next part, I'll tackle Fred and Fiona, who engage in fraud, and show how bad actors add their own complications.