Module 5: Case Background Transcript
“Wall Street” is a street in New York where the New York Stock Exchange and related financial businesses are located. The term “Wall Street” refers to trading in financial products carried out in the major financial firms located on Wall Street and the people who work there. These people and activities often seem disconnected from the financial decisions undertaken by ordinary people on a day-to-day basis. Do the financial decisions of individuals affect the broader world of corporate finance? Put differently, how are the worlds of personal and corporate finance interrelated? We explore this issue in the following discussion as we consider how a personal loan becomes a tradable financial product called an “asset-backed security.” An asset-backed security is a complex financial instrument traded in major financial markets, including and firms located on Wall Street.
Whether it is originated or traded on Wall Street or on Main Street, the value of a financial asset or instrument depends on its stream of future payments. For instance, financial institutions consider a loan as an asset because its repayment creates a stream of income. Like all financial assets, however, loans are risky because their value depends on the repayment capacity of the borrower.
In the Module 2 Discussion: The Big Picture, we saw that borrowers differ in their capacity to provide assurance of ability to repay a loan. A borrower is considered risky who is less able to document income, assets, debt to income ratios or who has a history of poor repayment habits. The borrower may still be offered a loan at a higher rate of interest (this is called a sub-prime mortgage). In the Module 4 Discussion: Lending to Borrowers with Poor Credit Histories, we learned more about lending to borrowers who show evidence that they may not have the ability or inclination to meet the demands of debt agreements.
In Module 5, we learn about mortgage-backed securities traded on Wall Street. Mortgage-backed securities are long-term debt securities offering expected principal and interest payments as collateral. Mortgage-backed securities are composed of many mortgages gathered into a pool guaranteed by principal and interest cash flows. When a risky sub-prime mortgage loan is combined with a less risky mortgage loan, as a lender “packages” and sells mortgage-backed loans of varying risk, a diverse set of loans will have a lower risk of default and a higher probability of repayment than a single loan. In other words, the package should also have a lower risk of default and a higher probability of repayment than any of its underlying loan agreements, for reasons we will investigate more deeply in Module 6.
Mortgage loan agreements are somewhat unique because these financial instruments are additionally guaranteed by homes and land that may be seized and sold by the lender, if the borrower cannot repay their debt. If we assume prices of home and land are stable or rising in value (as has historically been true, except in rare circumstances), the homes and land serve as an effective supplementary guarantee to the holder of the loan package or “security” (Bernanke, 2019, p. 259). The assumption that mortgage loan agreements backed by real estate that consistently rises in value makes Wall Street comfortable trading in these assets. Wall Street trading in mortgage-backed securities originated in the 1970s and had become widespread preceding the Great Recession of 2008-2009. These assets were much riskier than Wall Street originally assumed, and this fact contributed to a rapid downturn in Wall Street trading as it became clear that many financial institutions held these very risky investments, which lost value suddenly as the real estate market collapsed.
Assume that professional experience secures you employment at a well-known, large investment bank that trades in securities of many types, including mortgage-backed securities. This large bank is unlike a small community bank (a “Main Street” financial institution, such as the one you worked at while serving Jucheng and Dave in the Module 2 Discussion: The Big Picture), which typically holds loans after origination. Larger banks purchase loans from Main Street financial institutions and sell these to Wall Street firms, packaging and selling mortgage-backed securities to investors and financial intermediaries. Mutual funds, retirement funds, financial institutions, and large investors typically hold these securities as investment goods.
Noticing that home prices nationally have been rising at seemingly high rates while wages do not appear to be rising as quickly, you wonder how so many borrowers can qualify for home loans given this mismatch in price versus ability to pay. Your colleague Loren explains that most home loans are packaged and sold, so banks issuing mortgages frequently lend to “sub-prime” borrowers who may not necessarily be expected to meet loan demands in the longer term. She notes that few investors worry about default since home prices historically only move upward, on average, and loans are sold and packaged with many others, lowering the risk that the whole package, versus a few underlying assets, will fail. You wonder if managers at your firm fully understand the risks of holding mortgage-backed securities. Your colleague does not believe that your worries are valid, based on the structure of these large packages backed by homes and land. Loren asks you to consider two facts. First, large numbers of mortgages, packaged together, are low risk because the numbers or underlying mortgages reduce the risk of default. Second, most financial institutions, particularly large ones, hold these securities as investments, and these securities are reasonably liquid because so many entities purchase them regularly. In other words, asset-backed securities are easily sold if they appear troubled. She concludes that many large financial institutions probably hold substantial amounts of these securities, so she hopes she is correct.
Based upon this module’s required reading and the background information given here, form an initial post covering the following four issues:
Explain briefly how interest rate movements affect the valuation of any one debt or equity asset traded in financial markets.
For the purchaser of mortgage-backed securities (e.g., financial institutions, intermediaries, or investors) or any other security that has an increased risk of default, identify one risk that you think is possible and explain your conclusion.
Comment on any one aspect of the connection between Wall Street and Main Street that you learned about.
Responses to the questions do not need to exceed 1 paragraph.