Saturday, October 11, 2008

What caused the failure of Mortgage Back Security?

Mortgage back security (MBS) and Collateralized Debt Obligation (CDO) were invented with the same concept of life insurance. The goal was risk sharing. In life insurance, there is an important assumption that people don't die at the same time. From historical data life insurance companies know that, in a group of 1000 people age 40, they can reliably expect 3 deaths a year. So they go out to collect $3 from each participant in the beginning of the year, and then distribute $1000 to the family of each deceased member at the end of the year. This is called risk pooling and risk sharing.

MBS is expected to work the same way. Because the pool of mortgage from across the country, and from borrowers who work for different industries, it is assumed that default won't happen en mass. In statistical jargon, default would be independent event.

This independent event assumption works under normal condition. But under certain circumstances, the assumption can be completely wrong. In the life insurance case, when a deadly flu virus sweeps through a country, or a major war breaks out, or a large scale natural disaster strikes, people can suddenly all die at the same time. The events are no longer independent, because one underlying cause links all of them.

The current financial crisis starts from mortgage suddenly default en mass. The underlying factor is low interest rate for an extended period of time. Low interest rate causes housing price to go up nationally, because the same monthly payment can buy more expensive houses under a low rate environment. When housing price shots up too high, it can no longer be supported by income. Naturally it would have to come down a bit. When it comes down people with weaker credit and lower income start to be late on their payment. Market re-priced their risk and their interest rates went up. Now they can no longer affort the monthly payment, their bank foreclosed their houses. Foreclosure depresses housing price, causing even tighter credit. More delinquency ensue followed by more foreclosure. A downward spiral accelerates.

En mass default of mortgages means risk sharing no longer work. Banks understand that the MBS and CDO they hold as assets worth less. But how much less? It is difficult to value. The complexity of these financial instruments blocks transparency. The lack of transparency results in a confidence crisis on counter party default. Credit suddenly freezs, LIBOR and commercial paper rate shot up. Consumer credit deteriorates, and bank solvency becomes an issue.

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