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Some people say it’s the economy, stupid. I think it’s the stupid economy and that there’s nothing surprising about not understanding what’s going on. How can we, when we even the eminence grises in the ivory tower have to resort to seemingly magical actions like adjusting interest rates in the hope of influencing the economy’s health? Adjusting interest rates? It seems like there’s this whole other parallel world of economics. A world in which interest rates set by the Federal Reserve affect how money is loaned and borrowed. A world in which arcane economic/legal constructs founded on other such constructs allow for “creative” ways to make money.
The vocabulary of this other world is especially baffling. Repackaged securitized mortgages? What in the name of Phil Gramm does that mean? I did a search and found this in a blog (http://economistsview.typepad.com/) called Economist’s View, although the quote actually comes a document called The Role of Securitization in Mortgage Lending by Richard J. Rosen, Chicago Fed Letter (http://www.chicagofed.org/publications/): “The process by which most mortgage loans are sold to investors is referred to as securitization. In the mortgage market, securitization converts mortgages to mortgage-backed securities.”
Well. That’s certainly clear. In essence, this has to do with how mortgages from an issuer like a bank are sold to a third party like Fannie or Freddie Mac, or another private financial entity. But it doesn’t necessarily stop there. These mortgages can then be bundled together for the payment rights to be sold to investors. It might not stop here either. These investors may use the payment rights to “back other securities they issue.” In other words, “the eventual buyers of the mortgage—the parties that provide the funding—can be many steps removed from the originator of the mortgage.” In this lies the subprime mortgage crisis, in that borrowers with bad credit who don’t make their payments derail the entire enterprise.
The Games Number-Shufflers Play
And this is just the tip of it. For a fun-filled headache, read the entire Chicago Fed Letter to get hit in the head with how complicated it can really get. It’s worth paying attention to this bit:
“There are three major risks to MBS investors…The second risk is prepayment risk. Many mortgages in the United States can be prepaid without penalty. Prepayments introduce timing risk, since investors do not know when their bonds will be repaid (thereby eliminating future interest payments). Additionally, prepayments are generally larger when investors want them to be smaller. That is, when the interest rates on new mortgages fall, investors like the fact that they continue to receive the old, higher interest rates on existing MBSs. But this is precisely when borrowers are most likely to prepay loans by refinancing their mortgages.”
So if prepayment is in the interest of borrowers but simultaneously not in the interests of the lender, doesn’t that create an incentive for lenders to screw over borrowers? Doesn’t this whole multi-tiered arrangement go against the idea of an honest deal between two parties who know each other? But never mind that. This fascinating foray into the world of mortgage-backed securities is a good example of the shenanigans that go on to make money for number-shufflers but, when they go wrong, take down the rest of the economy.
This leads to something scary, the notion that this parallel economic world is outside our control. And by “our,” I mean those of us for whom economics consists of working at a job earning money, spending that money, and working some more. But what if the problem is actually worse than this? What if the so-called “science” of economics – what is often referred to as neoclassical economics – is itself not on solid ground? What if the problem isn’t only with the number-shufflers’ convoluted financial maneuvers, but with the field of economics itself?
(To be continued…)
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