In a Turn of Events That’s Sure to End Well, Mortgage-Backed Securities Are Cool Again

You’ve probably heard the phrase “mortgage-backed security” plenty of times in recent years. And if you’re anything like me, and most of the rest of the country, you probably don’t have the clearest idea of what that is.

To most people, a “mortgage-backed security” is little more than a piece of paper that somehow brought the Western world to the brink of economic collapse.

Anyway, the New York Times is reporting that these legal and financial instruments are regaining in popularity, largely due to the fact that most analysts believe that the housing market has finally bottomed out, and real estate prices now have nowhere to go but up. And mortgage-backed securities are so cheap that many investors see them as no-lose propositions: even in the worst case scenario, they are betting that they can still make money off of them.

A mortgage-backed security is a type of bond that involve mortgage debts being pooled together into large bundles, and then sold to investors, who collect dividends which are ultimately derived from the payments that homeowners make on the original mortgages. These pools often contain hundreds of mortgages, and they can be chopped up and resold countless times – to the point that a homeowner who dabbles in investment can end up owning shares of their own mortgage and never know it.

These securities found their way into countless investment portfolios around the world. So, when the housing crisis hit, and record numbers of borrowers began defaulting on their mortgages, these bonds suddenly became worthless, causing huge amounts of wealth to simply evaporate.

So, could this resurgance in interest lead to a repeat of the 2008 financial crisis? Obviously, that question is impossible for even the most brilliant economists in the world to answer, so I’m not even going to try.

It is worth noting, however, that the legal landscape has changed since 2008. Most significanlty, the Dodd-Frank Wall Street Reform and Consumer Protection Act (usually just referred to as “Dodd-Frank”) has created many new rules regulating risky financial instruments such as mortgage-backed securities, which are meant to smooth out some of their rough edges, and give investors incentives to be more prudent.

One of the biggest factors that led to the rise and fall of the mortgage-backed security was the fact that banks were able to lend money to people without much regard to their ability to repay the loans. They could simply issue the loan, and sell it to a bigger bank, which would, in turn bundle it up in a package of securities to be sold to investors. The investors down the line bore the ultimate risk of the borrower defaulting. Because of this fact, banks were issuing mortgages to anybody with a pulse when the housing market was booming. And why shouldn’t they? They profit even if the borrower defaults.

Dodd-Frank requires the originators of assets (lenders) to retain at least 5% of the credit risk of the loans they issue. This should, in theory, give them an incentive to be more diligent in issuing mortgages than they were before the financial crash.

However, if you listen to any pundit talk about this law, you’ll probably hear one of two things: it doesn’t go far enough, and leaves plenty of loopholes for Wall Street to exploit, and they’ll be back to their old ways in no time. At the other end of the spectrum, you’ll hear people saying that the law goes way too far, and will cripple banks’ ability to issue credit, which is necessary for any modern economy to function.

Maybe it’s just a symptom of how divided the political discourse has become in the last few years, but you’d be hard-pressed to find anyone making the case that Dodd-Frank strikes a good balance between protecting consumers and ensuring that banks are able to continue to easily issue credit to deserving borrowers.

Even one of the cornerstones of Dodd-Frank couldn’t be implemented until very recently: one of the key provisions of the law was the creation of the Bureau of Consumer Financial Protection, which is intended to regulate financial products aimed at individuals, such as credit cards, payday loans, and others. However, President Obama wasn’t able to appoint a director for this bureau until just a few months ago, because Senate Republicans refused to allow a vote on the confirmation of the president’s appointee. They openly stated that they had no objections to the director’s qualifications – they were simply opposed to the bureau’s very existence, and would do everything they could to stop it form being implemented. This required the president to resort to a recess appointment.

So, will Dodd-Frank ensure that this new wave of mortgage-backed securities doesn’t collapse the economy? In theory, its provisions do give incentives for everyone involved to be much more diligent in assessing the risks of their actions, since it makes it more difficult for them to shift risks elsewhere. I honestly have no idea. What I can say, however, is that the predictable calls to repeal it are premature. The fact is, the old way of doing things on Wall Street simply do not work anymore. We should give this law at least a few years to see if it works. If there are parts of it that do more harm than good, they should be changed. And, if the entire law proves to be an unmitigated disaster, it should be scrapped. What we should not do with Dodd-Frank, however, is let the perfect be the enemy of the good.