Thursday, December 1, 2011

repackaged loans

A tiny attempt to clarify one common source of confusion / ignorance: what are repackaged loans (e.g. mortgage-backed securities) and why were they created?

Say there are two types of people in the world, those with high and low credit worthiness. If you loan a high type money, he will always pay you back. If you loan a low type money, he will pay you back only 90% the time.

Banks might be willing to give a high type a $100 loan with a 5% interest rate, knowing that they will definitely get back $105. In order to be willing to loan money to a low type, the interest rate has to be higher to compensate for the risk: loaning $100 to a low type with an interest rate of 17% will on average get back the same $105 as loaning it to a high type (10% of the time you get nothing back, 90% of the time you get $117 back).

This $105 quantity, in either case, is the expected value of the loan. That is, this is the average amount of money you can expect to get back in payments for the loan.

Despite the fact that the expected value of each loan is the same, banks would obviously rather make the loan to the high type, since there is no risk involved. So, if banks for some reason can't charge a high enough interest rate to compensate for the risk of lending to low types (for legal reasons, or because no one wants to take the loan on those terms, or whatever other reason), there are people or businesses out there who are on average good loan prospects who can't get loans. This is a bad thing because if someone can turn $100 cash into $105 of expected value, society in sum is better off if they can get the financing to do that.

This is where securitization (repackaging the loans) comes in. If a hundred banks make a hundred loans to low types, and then split up the repayments equally, no single bank will be burdened by a defaulted loan and each will have the same amount of money on the line as if they each made a single loan as usual. The risk is disappears (in the limit), and any loan with a positive expected profit can be financed.

A mortgage-backed security is a slice of this big pie of loans. It gives you the right to keep a certain fraction of the payments made by a whole bunch of people who took out mortgages. You get back, with a very small amount of risk compared to the riskiness of the underlying loans, the expected value of the loan.

This is a great idea. Risk sharing allows society to undertake worthwhile things that are too risky for individuals to finance on their own, be it home ownership or startup tech firms or pharmaceutical research. And since there is money to be made once the risk is taken care of, this can simply happen through the market. Wins all around.

The problem, as with so many things, isn't with the thing itself, it's with the stupid use of it. Seatbelts and antibiotics are clearly wonderful inventions. But people who drive recklessly or contribute to the evolution of resistant superbugs, thereby hurting themselves and others, need to be held accountable. Likewise, people who blindly purchased mortgage backed securities, thinking they were riskless investments, and then lost a lot of money when it turned out that the expected profit was actually negative, can't blame the securitization process itself. They can only blame themselves for not doing due diligence (which, yes, is very hard when you're dealing with huge pools of loans, and with contracts that are, in actuality, extremely complicated).

(It goes without saying that deliberate misinformation is another matter. But still not something you can get upset at the loan packaging mechanism about.)

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