Welcome to the the six with final week of Capital Markets and Financial Institutions course. In the last episodes of the previous week, we talked about the fact that the innovations that are invented. And then marketed by investment banks sometimes results in potential damages because these innovations contain high risks. These risks can hardly be properly estimated by the public at large. And when a lot of people get involved in these markets that is potentially a situation when the bubble and the further crash may occur. And we will start this week with the analysis of one special instrument of that kind that played an important role in fueling the most recent global crisis. The peak of which was in 2007, 2008, dependent upon different opinions and which is believed not to be overcome until now. And this instrument is called the collateralized mortgage obligation. In the first episode, we will just say a few words about what it is and what is the idea behind that. Now first of all, this instrument was not introduced yesterday. The first CMO was marketed in June 1983, so it's been more than 30 years since they were introduced and now this is a huge market. The idea of a CMO is very simple. Let's go back to the standard situation. Well, the United States has a huge real estate market. To be true, maybe to own a house has always been significant part of reaching the American dream. And for a long period of time, the percentage of homeowners in the United States has been the highest over all developed countries, well to say nothing of lesser developed countries. So we see first of all the US real estate market. Well, if we looked at that market over the past couple of decades, we will see that the prices of homes have grown up significantly. And therefore, well there were some exceptions in periods when they were sort of braked. Or sometimes even were falling but on average that has been a really growing in a market in a stable way. So it's important to mention right now that this idea of home prices will always rise, play the key role in the depth and width of the crisis. Because this is clearly something that is on average, and a long time periods, right? But, there are certain periods, when this is not right. Now, what is an instrument of buying a house in the US? This is a mortgage. And basically, what is a mortgage? This is a long-term, fixed income contract in which the owner takes a mortgage loan from a bank. Then with this money buys a house from the seller. Becomes the owner of this house, and takes a long-term obligation, and pays it off to the bank, or a standard fixed-rate mortgage, in equal installments every month, for as long as 30 years. Now, the key story is that a mortgage contains a lot of private information. Why, because first of all, when let's say you come at the bank to ask for a mortgage, well, this is a long-term obligation. And the bank should make sure that you'll be able to make these payments. For example, when you come and normally bank starts asking questions like, first of all, can you make a down payment? Let's say I'll give you a loan not for the full value of the house but let's say for 80% or for 90%. But the remaining 10 or 20 can it put it down in cash. If you say yes, well, that means that you saved some money, that's great. Then, the bank checks your employment, your income, your disposable income to make sure that you'll be able to make these monthly payments. This, so the bank does what we call monitoring. Well, you can say, well, wait a minute. When we talked about a smartphone bank, you said that now mortgages can be issued without any monitoring with the use of mobile phone or email. Well, yes, that's been the case, but we will see how this very thing contributed negatively to the development of the recent years. Now, what else can we say about it. Because a mortgage has a lot of private information, it is highly liquid. Because for example, if I'm a bank and they issued the mortgage to you and then for some reason I no longer want to receive these payments. And instead I would like to get out of this contract. Well, it's difficult to do so. I can sell this mortgage to someone else all at a huge discount because of this private information component, because I did my homework. But I did that and I cannot properly translate that to you. You will have to do your homework if you're in another bank again, that is why these discounts. There's one more thing that is a little bit more advanced and few people realize that but normally, mortgages have a prepayment option. That means that the homeowner, let's say, he or she inherited a significant amount of money, and they would no longer want to keep this obligation. Instead they say, well there’s a balance, maybe it’s large, but I now have enough cash to retire that. Now what happens is that not only this is the case when I got some cash inflow, but maybe the interest rates in the economy have gone down, now I can refinance. I can go to another bank, take a mortgage at the lower rate. I raise this money, I retire my previous mortgage, and then I start paying lower payments to another bank. Well, not all mortgages contain this but the majority of them used to and as a result the mortgage becomes a very risky instrument for the mortgage originator, for the issuer, for the bank. Because let's say, the bank issued the mortgage at whatever, 10% a year that was the time when the interest rates were high. Now the bank sort of locked in the receipt of monthly payments at this yield of 10%. And let's say that five years from now, the rates go down to 8%. Now the homeowner refinances and repays me the balance. And instead of receiving these payments at a 10%, you'll now I can reinvest that only at 8, because this is a prevailing market interest rate. So the bank here can have a potential loss. And this prepayment option makes a mortgage actually an extremely risky instrument if you take the bank's perspective. And if this bank originates a lot of them, and has a huge portfolio of all these mortgages on its balance sheet. Therefore, we can see that there is strong demand on the banking side for being able to get rid of these mortgages. And that was the key idea behind the creation of a CMO. Let me also proceed and draw a chart here. So this is the house, And this is a bank. Sort of we'll go a little bit deeper on that. We said that this contract between them, This is the mortgage, and it has a lot of private information. Now, while the bank is kind of protected against a default on the homeowner because let's say, you took out the mortgage. You made these payments, and then, God forbid, you lost your job, you got injured, and you can no longer work. And as a result, you cannot make these payments anymore so you default on the mortgage. So the bank stops receiving the payments. Now, the bank has the right to foreclose. So the bank can take this house from you, throw you away from this house and say well, you stopped making payments. Now I become the title owner of the house, and then to sell it. But the problem is that, first of all, the bank is not in the business of selling houses, the bank is in the business of selling money. And the other thing is that, this bad situation is likely to happen when the overall situation in the economy is not so great. So people lose jobs in general, when the economy is sort of melts down. And that means that it's simultaneously likely that many assets are depressed, including home prices. So a bank does get the ownership of the house but it can sell it at a lower price. And maybe also at a discount because the bank should hire someone who is a professional home seller. So you can see that is the key idea that forces the bank to seek the ability of just getting out of this country. Now, So what was introduced? Let's say that now, here comes an investment bank. And says, I will buy these mortgages from you. And what is and this bank will do, I will create an instrument that will be of the following features. First of all, it will use mortgage payments. These will become collateral, Or sometimes they say underlying for a new security. And this security is called CMO, that stands for collateralized mortgage obligation. So basically, I issue out the securities, here I'll put CMOs, And sell them to, we'll talk about in greater detail to whom. So the idea is that these securities will be based on these mortgages, or mortgage payments. And the most simplistic securities of that kind were called mortgage pass throughs. So basically, mortgages make payments, so these cash flows are somehow passed to the owners of the other security. And that can be done in a way so there is some filter or that goes further on, but that was the very earliest idea of a CMO. Now the story here is, and again, like I said, we're talking about the idea, that if there's the liquid market for the CMOs, what happens is that ill-liquid mortgages are used as pseudo-collateral for some more liquid securities, and this is called the process of collaterialization. So we erase liquidity, we change the profile of risk and return for these instruments, we will talk about that in just a moment. And therefore, we provide the relief for a bank because the bank is not now locked in with this mortgages. So that's the overall idea. And now clearly, there are some questions like why can I be interested in buying them? Who would buy these CMO? And why is that there is huge demand? Now, I will wrap up this episode saying just one thing. That remember, this idea of prepayment risk. Because this will serve as an important clue of why some people will buy parts of these CMOs with the highest risk. Because if, for example, we not only raise liquidity, but also reduce risk then clearly, a lot of people be willing to buy that. But we will see that there is no miracle. You cannot really create the overall highly rated and low risk security from lower rated and actually risky security. So you can redistribute parts of these cash flows, making some parts of them less risky and others riskier. And the question will persist, why is that that someone is willing to buy these sort of riskier parts? We will talk about that in the next episode, seeing not the idea but the mechanics of the CMO.
