Joe Doakes from Como Park emails:<\/p>\n\n\n\n
Suppose you are an investor looking for a safe investment. You want some collateral for your investment, something the borrower has a strong interest in keeping and thus, a strong interest in paying the loan guaranteed by the collateral.<\/p><\/blockquote>\n\n\n\n
Mortgage-backed securities are great. People might fail to pay on their credit card bills but they don’t fail to pay their home mortgages. And if they do, the lender can simply foreclose and sell the home. This investment is literally “safe as houses.”<\/p><\/blockquote>\n\n\n\n
But buying a mortgage means paying off the bank to receive an assignment. You have to pay the entire balance due up front. That is expensive and you take all the risk of one homeowner defaulting. But if the lender were to pool all its mortgages together, you could buy a share of the pool for a smaller investment and reduced risk of default. In fact, if you only wanted the stream of interest payments generated by the mortgage and not the repayment of principal, you could buy in for an even smaller price. Your investment is technically not backed by the mortgage, it’s backed by the lender’s promise that the pool of mortgages is sound, but your payments are a derivative of the mortgages so it’s still a pretty safe investment.<\/p><\/blockquote>\n\n\n\n
Until it isn’t. If interest rates fall and everybody in your pool of adjustable-rate mortgages refinances to a lower fixed rate mortgage, they no longer make interest payments to you. And if the economy has a hiccup, marginal borrowers (who shouldn’t have qualified for loans in the first place) begin to default. That’s what happened in 2006 and it led to the real estate crash that lasted a decade and required billions in TARP bailouts, mostly for overseas lenders (and a few domestic corporations which hastily reorganized themselves as ‘banks’ to grab a slice of the pie – looking at you, Chrysler). <\/p><\/blockquote>\n\n\n\n
Lesson learned – don’t invest in derivatives. Except the housing market depends on investors to generate the funds to lend to borrowers to buy houses. If nobody invests, nobody can get loans, the housing market collapses. So the Federal Reserve stepped up and began to buy mortgage-backed securities guaranteed by a pool of mortgages. Safe as houses, right? <\/p><\/blockquote>\n\n\n\n
Maybe not. The Fed apparently didn’t foresee the Lesko Brandon Administration dumping billions of dollars into the economy in stimulus payments. Too many dollars chasing too few goods equals inflation and not just a little, the highest in decades. The Fed’s purchase of mortgage-backed securities inflated housing prices while racking up a mountain of debt instruments which cannot be repaid in this inflationary economy. It’s unsustainable but this time, we won’t be bailing out HSBC, Deutsche Bank or Royal Bank of Scotland, this time it’s the Fed itself which will go bankrupt. When that happens, the value of the American dollar disappears.<\/p><\/blockquote>\n\n\n\n