The Mortgage Crisis in the Tranches

cross-posted at Dagblog

I've posted about the housing and mortgage crisis, and the impending dangers, here and here, but there's one additional problem that I hadn't got my head around when I wrote those posts. That's the tranche problem, which is likely to lead to all kinds of perverse incentives and unforeseen difficulties.

Most of the bad mortgages, by which I mean both the loans which should never have been made and the mortgages that have that have become part of the banks' routine fraud, were bundled into so-called pools that supported the infamous mortgage backed securities. Those securities then split up the revenues from each mortgage pool a bunch of different ways. So instead of your mortgage having one owner, it's part of a big lot of mortgages with let's say ten different owners, the holders of the various bonds issued on the pool of mortgages your home loan is in. So far, so good.

Here's where it gets tricky: not all of those owners are equal, even if they own equally large percentages of your house, because the bonds are organized into "senior" and "junior" tranches, which get paid off in order of seniority. So, to oversimplify a little, let's say the pool of mortgages your house is in got securitized and divided up ten ways, with each bondholder getting ten percent. Those ten bondholders get paid off in order: one bought the first and safest ten percent, then another bought the second ten percent, all the way down to bondholder number ten, who gets the last ten percent of the money from you paying your loan (or rather, from all of the loans in your pool). All of this was done, in part, by clever financial engineers who figured that this would remove the risk from financing mortgages. (Cue hollow laughter here.)

In the old days, if you ran into trouble paying your mortgage and had to renegotiate, the mortgage had one owner, the bank holding the note, and if you only ended up paying two-thirds of what you owed, that bank took the whole hit. If the mortgage-backed securities were divided equally and you only paid two-thirds of what you owed, then all then bond-holders would get 66.6% of what they'd planned. But under the current system, if you only pay two-thirds of your mortgage, six of your bondholders get paid in full, one gets a two-thirds return, and three get nothing at all. (It's more complicated, actually, because the bonds are actually tied to all of the mortgages in a pool, but the concept remains: if half of the mortgages pay in full, and the other half get written down either through negotiations or through foreclosure and resale a a lower price, at least half of the bondholders are fine but others lose the whole investment.)

Why does this matter to people who are neither Goldman nor Sachs? Because it changes the incentives for dealing with troubled mortgages. In the old days, if your mortgage went south and the bank holding it was going to take a haircut, you could rely on them, at least, to do the economically rational thing. They had an interest in getting back as much of the loan value as they could. That might lead them to refinance. In a housing market that had collapsed since the original home purchase, it might make the bank less eager to seize and resell the home (at a big loss), when they could potentially work something out. Their interests were clearly aligned to maximizing the value of the home.

Under the mortgage-backed-securities system, the incentives get scrambled. Some of the bondholders are getting paid, no matter how much the mortgage declines in value. As long as 20% or 30% of the expected return comes in, they're sitting pretty. At least one or two of the bondholders are holding worthless paper no matter what, because they were only getting paid if the loans returned the full amount of interest on top of the principal, and they are basically out of the decision making loop. A few in the middle could either gain or lose, depending on how specific mortgages are resolved. But there's not a single party with decision-making power whose profit and loss are tied to maximizing the actual value of the asset. Maybe it makes more sense to keep a homeowner in the house rather than sell the house at a fifty percent markdown, but it makes more short-term sense for the "senior" bondholders to take what they can get up front ... sure, the house lost half its value, but their investment was in the "top" half of its value anyway.

The same thing goes for the problem of mortgage backed securities that turn out to be based on fraudulent paperwork. As I've blogged before, there are legal remedies that allow bond-holders to make the issuing banks eat that bad paper, buying back the bonds at the original price. But here, again, the holders of different tranches have different interests. If you bought tranche #8 of 10 in a mortgage backed by a pool that's cratered in value, you want to stick that bad investment back to the bank who put it together, and if it turns out that they didn't perform due diligence, you'd be negligent not to sue them. However, even the crappiest mortgage pool in the world has at least one or two traches of bondholders who are actually turning a profit, and they clearly don't want the deal undone. Why would they? They get the first ten percent, even if only ten percent of the expected returns come in. So we can expect a litigation bloodbath over this.

I have no idea how all this plays out. But I'm afraid that no one else does, either.