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Speaker 1: Brought to you by the reinvented two thousand twelve camera.

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Speaker 1: It's ready. Are you welcome to Stuff you should know

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Speaker 1: from how stuff works dot Com? Welcome to the podcast

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Speaker 1: located from deep within the bowels of how stuff Works

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Speaker 1: dot Com headquarters. It's Josh and Chuck. Chuck. That makes

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Speaker 1: it sound really fancy or creepy or something. I don't know.

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Speaker 1: I like it. I was going for creepy. Okay, I'll

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Speaker 1: take it. It didn't work. I'm creepy out. Yeah, okay, Chuck.

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Speaker 1: Did you look out the window today at all? I have?

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Speaker 1: Did you did you notice that everything is spinning very

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Speaker 1: quickly clockwise? I have? Yeah. Do you know what that is?

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Speaker 1: A downward spiral? It is. It's the US economy circling

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Speaker 1: the drain very quickly and taking the entire nation with it.

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Speaker 1: It's pretty bad. Have you heard about this economic downturn? Yeah?

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Speaker 1: I mean you can't miss it, man, It's everywhere it is.

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Speaker 1: It is popping up everywhere. Um. Huge investment banks that

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Speaker 1: did whether the depression are starting to go under. Um.

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Speaker 1: You know, there's there's all sorts of financial groups that

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Speaker 1: are suffering as well. A i G. The largest insurance

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Speaker 1: company in the United States who ensures all these people

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Speaker 1: is going under right, Well, now it's owned by the

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Speaker 1: government almost completely. Yeah, we well, uh, eight percent stake

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Speaker 1: seventy nine point nine percent stake is owned by the

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Speaker 1: federal government, owned by you and I we own we

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Speaker 1: own part of that. I feel it. I feel it inout.

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Speaker 1: I know, did you feel richer? I know if you're

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Speaker 1: wearing your top hat and monocle today very appropriately. Um,

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Speaker 1: So all of this stuff is going on. Yeah, it's

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Speaker 1: impossible to miss it. The crazy thing is that all

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Speaker 1: of it can be traced back to a single thing,

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Speaker 1: a single investment instrument that caused all of this problem.

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Speaker 1: And I was happy to learn this. Do you you

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Speaker 1: know what it is? Yeah, I'll go ahead, and it's

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Speaker 1: called a mortgage backed security. And you're kind of the expert.

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Speaker 1: I want to go ahead and preface this by saying

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Speaker 1: that Josh wrote these articles, and uh, I'm an economic

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Speaker 1: idiot basically. So I learned a lot by reading them,

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Speaker 1: and hopefully people will learn a lot by listening. Oh,

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Speaker 1: I learned a lot by writing them. So if people

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Speaker 1: if people learn a lot listening, then it will be

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Speaker 1: a trifecta. Everyone will have learned. So yeah, what we're

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Speaker 1: talking about today are subprime mortgage backed securities. There's different kinds.

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Speaker 1: Some more mortgage backed securities are are worse than others,

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Speaker 1: and the worst of the bunch or subprime mortgage backed security, Well,

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Speaker 1: go ahead, and I think the the raw definition probably

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Speaker 1: would get people interest right off the bat. So basically

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Speaker 1: what it is is a mortgage backed security is an

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Speaker 1: investment tool that is based on a pool of mortgages.

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Speaker 1: So you take Chuck's mortgage and our producer Jerry's mortgage,

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Speaker 1: and you know, everybody at how stuff works mortgages, you

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Speaker 1: pull them together and then you divvy them up into

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Speaker 1: basically shares of all this this one single pool of mortgages.

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Speaker 1: And as long as everybody like Jerry and you, Chuck

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Speaker 1: are are paying UH on your monthly your monthly mortgage payments,

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Speaker 1: everything's fine right there. Like dividends, it gets distributed across

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Speaker 1: the shareholders of this pool of mortgages and everybody's happy, right. Well,

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Speaker 1: who are the shareholders though, they're the people who bought

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Speaker 1: uh these mortgage backed securities which are banks larger than

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Speaker 1: the banks. It can be anybody, it can be anyvidy, Yeah,

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Speaker 1: what you're talking about is the process of how this works.

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Speaker 1: So that what I just said, that's a that's a

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Speaker 1: mortgage backed security. You could purchase a mortgage backed security,

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Speaker 1: no way you if you wanted to, you could, and actually,

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Speaker 1: ironically enough, um, because these mortgage backed securities are based

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Speaker 1: on mortgages, and because they've been so divided up and

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Speaker 1: repackaged and repurposed. Will get to that in a little bit. Um,

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Speaker 1: it's actually possible that if you have like a four

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Speaker 1: oh one K, or you invest in a mutual fund

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Speaker 1: or something like that, you may actually own a share

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Speaker 1: of your own mortgage. Right. I couldn't at that in

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Speaker 1: your article and I was blown away. Isn't they cool?

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Speaker 1: That cool? I don't know if the if the economies

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Speaker 1: in in the in the tank, then yeah, it's not good,

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Speaker 1: but yeah it could be cool if you're making money

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Speaker 1: off of your own mortgage, paying back yourself. It's positive

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Speaker 1: about luck kind of. Yeah. So what you just mentioned, Chuck,

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Speaker 1: is is how a mortgage becomes a mortgage backed security.

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Speaker 1: So say you go in and you you get a mortgage,

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Speaker 1: you go through all the rigamar role and they issue

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Speaker 1: you a mortgage. The bank when mortgage backed securities were hot,

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Speaker 1: would turn around, put it together with you know, several

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Speaker 1: other of their mortgages that they'd issued that day, and

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Speaker 1: turn around and they sell it to UM an investment bank. Right, Okay,

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Speaker 1: an investment bank takes the your bank's mortgages and some

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Speaker 1: other banks mortages and pulls them together. Even more so,

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Speaker 1: now you have several hundred different mortgages and all of

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Speaker 1: a sudden, it's a single UM mortgage back security. Right.

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Speaker 1: And then they start selling shares. The investment banks starts

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Speaker 1: selling shares, and then the investors, your your your mutual

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Speaker 1: fund manager or somebody at JP Morgan Chase who who's

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Speaker 1: looking for an investment, they buy these shares and they

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Speaker 1: start collecting the dividends. So that's how it works, right, Okay.

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Speaker 1: It's actually a lot simpler than I thought. It's very

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Speaker 1: very simple, Like if you look at it, just uh

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Speaker 1: just it's a very basic method of investing. But it

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Speaker 1: was completely totally radical when it came about. I think

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Speaker 1: it was the late nineties when they first really hit

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Speaker 1: the scene, maybe early twenty first century. And here's the thing.

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Speaker 1: It's a really safe way to invest as long as

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Speaker 1: you know the housing markets going well. Uh, the economy

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Speaker 1: is doing well, and people are making their monthly mortgage payment.

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Speaker 1: There were rich times there for about a decade, probably

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Speaker 1: right in the housing and it was it was based

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Speaker 1: on that that housing Uh, that housing boom was keeping

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Speaker 1: mortgage backed securities. Uh, it was making them perform well.

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Speaker 1: So because of that, because the interplay between the housing

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Speaker 1: market and mortgage backed securities, mortgage backed security has become

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Speaker 1: this hot commodity on Wall Street. Everybody's buying, everybody wants them.

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Speaker 1: They're just great. It's money in the bank, right. The

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Speaker 1: problem is is that demand created a situation where we

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Speaker 1: needed more mortgages. So I mean basically, say you know

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Speaker 1: you're a good prime borrower. Uh, you're somebody who you know,

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Speaker 1: based on your credit rating, your credit history, your employment history,

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Speaker 1: that kind of thing, you pose little risk of defaulting

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Speaker 1: on your loan. There's a finite amount of prime borrowers

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Speaker 1: in the United States. And after a couple of years

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Speaker 1: with you know, with the mortgages being pulled together and

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Speaker 1: put into mortgage backed securities, UM, this pool of people

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Speaker 1: dried up. And then I know what came next was

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Speaker 1: the sub prime market, which is the big reason why

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Speaker 1: the housing boom, uh, the bubble burst exactly because subprime borrowers.

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Speaker 1: A lot of people think that subprime is uh has

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Speaker 1: something to do with the rate, the interest rate. It's

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Speaker 1: a below prime rate, That's what I always thought as well.

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Speaker 1: But no, it refers to the barrow exactly, as people

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Speaker 1: that don't have enough income or the right credit. Basically,

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Speaker 1: they were just writing things. Uh. You know, it's kind

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Speaker 1: of like a blank check, a false market almost very much,

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Speaker 1: very much so. But when banks change their lending practices

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Speaker 1: to include subprime borrowers, all of a sudden, there's this

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Speaker 1: huge untapped pool of people who can create mortgage backed

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Speaker 1: securities because you can't have mortgage backed securities without mortgages.

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Speaker 1: So basically, to answer this clamoring for more mortgage backed

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Speaker 1: securities on Wall Street, UH, banks had to uh start

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Speaker 1: issuing more mortgages, and the investment banks were more than

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Speaker 1: willing to buy all these mortgages no matter what. Right,

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Speaker 1: So your local bank you go to say you're a

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Speaker 1: sub prime barrowerk. And subprime has this really evil connotation

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Speaker 1: here in two thousand and eight, but but really, if

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Speaker 1: you think about it's just somebody who has a credit

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Speaker 1: score maybe below. I think right now it's six thirty.

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Speaker 1: It could be six nine. When you're a subprime barrower,

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Speaker 1: or maybe you've even changed jobs in the last year,

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Speaker 1: they could make you a subprime bar There's there's a

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Speaker 1: lot of factors. It doesn't mean like you're this um

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Speaker 1: you know, nefarious drug dealing cat burglar. You're not taking

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Speaker 1: the bank, drawing the welfare checks and swindling houses out

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Speaker 1: of banks, exactly right. Um, necessarily, some some have, but

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Speaker 1: for the most part, it's you can't really categorize these

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Speaker 1: people beyond their credit score. UM, so the banks since

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Speaker 1: they're no longer hanging onto the mortgage. You know, time

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Speaker 1: was you went to a bank. You've got a mortgage

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Speaker 1: that sat in the bank's vault, that piece of paper

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Speaker 1: did and you made monthly payments to the bank and

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Speaker 1: they took it in. And then after thirty years or whatever,

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Speaker 1: you paid your last you made your last payment and

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Speaker 1: they sent your mortgage and they were they did a

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Speaker 1: lot of investigating into your history at that time because

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Speaker 1: they were the ones, you know, that had the most

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Speaker 1: to lose. They were carrying all the risks. If you

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Speaker 1: defaulted on your loan, that bank took the hit and

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Speaker 1: that was it ended there right. Um, with with the

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Speaker 1: subprime or with the mortgage backed securities, that all changed.

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Speaker 1: Banks no longer had any risk whatsoever. They would almost

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Speaker 1: literally issue you a mortgage and possibly that same day,

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Speaker 1: turn around and sell it. That really explains it right

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Speaker 1: there in a nutshell. So whoever ended up with this

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Speaker 1: mortgage in whatever form, whether it was a mortgage backed

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Speaker 1: security and it was divided among like fifty or a

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Speaker 1: hundred or a thousand people, um, whoever ended up with

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Speaker 1: it in the end assumed the risk. So these investment

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Speaker 1: banks didn't necessarily carry the risk either. The risk of

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Speaker 1: you not paying your loan went to the individual investors. Right,

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Speaker 1: Since all all these mortgages started to become based on

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Speaker 1: subprime mortgages, all all the mortgage backed securities became based

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Speaker 1: on subprime mortgages. When the foreclosure started, the market almost

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Speaker 1: immediately plummeted, right because it was directly tied. Yeah, it

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Speaker 1: wasn't a trickle down effect. That were directly linked. There

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Speaker 1: is another instrument too that we're based on mortgage backed securities. Right,

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Speaker 1: So think about this. You have a mortgage, it's turned

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Speaker 1: around and sold packaged with some other mortgages and then

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Speaker 1: divided into shares. Those shares can actually be divided further

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Speaker 1: and repackaged into something called collateral debt obligations. And some

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Speaker 1: of these these can be based on all sorts of

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Speaker 1: different things. You can take just mortgage mortgages from a

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Speaker 1: mortgage backed security and that will all mature in five years,

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Speaker 1: or that are all interest only, or that are all

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Speaker 1: fixed interests. There's all sorts of ways to package it.

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Speaker 1: But one of the hottest items on Wall Street for

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Speaker 1: collateral debt obligations were these, uh these instruments that were

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Speaker 1: made exclusively from subprime mortgage backed securities. Because you're a

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Speaker 1: subprime borrow where you get a higher interest rate, So

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Speaker 1: the security the investment on whether or not you're gonna

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Speaker 1: pay your loan. It's riskier, but the dividends are higher

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Speaker 1: because the interest rate is high. Sure and not unlike

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Speaker 1: a lot of just the regular Wall Street stock market stocks,

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Speaker 1: great risk equals great rewards and and that that pays off.

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Speaker 1: But really, if you look at it long enough, arc

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Speaker 1: it never pays off. It always it always goes under.

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Speaker 1: So what you have now is is a bunch of

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Speaker 1: people playing playing hot potato with these things. They were

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Speaker 1: they short excited, They're greedy, greedy, It's as simple as that.

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Speaker 1: Was it a live for now type of thing that

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Speaker 1: they plan on dumping knees? I guess here's that's I

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Speaker 1: would assume, yes, that that once people started realizing, wait

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Speaker 1: a minute, eventually, when you follow these down the line,

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Speaker 1: you're going to get to a house, and that house

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Speaker 1: is basically its value is in this situation based on

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Speaker 1: whether or not the person is making payments, and we're

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Speaker 1: we're betting on subprime borrowers making payments, and if they don't,

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Speaker 1: this this security tanks and we lose all of our money.

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Speaker 1: Someone somewhere down the line, around say two thousand six

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Speaker 1: figured out that these things were going to tank because

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Speaker 1: of foreclosures, and that's exactly what happened. So it started

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Speaker 1: this domino effect. Well, who's it fault here? Or is

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Speaker 1: that even important? I mean, was it? Or? I guess

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Speaker 1: everyone kind of shares in the plane because the homeowner

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Speaker 1: that that really doesn't have the money shouldn't go out

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Speaker 1: and try to get the house. The lender certainly they

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Speaker 1: were making the commissions correct the mortgage brokers, so they

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Speaker 1: were making money and then selling them immediately, or actually

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Speaker 1: I think the mortgage lender it immediately goes to the bank,

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Speaker 1: so they're not even really tied to the bank necessarily,

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Speaker 1: and then the bank sells them. And it's just seems

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Speaker 1: like the more it gets spread out and split up,

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Speaker 1: the more fractured it gets. It's really hard to even

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Speaker 1: tell who's to blame anymore. It is. And I mean, ultimately,

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Speaker 1: you know, finding the person to blame isn't gonna help

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Speaker 1: anything now exactly, but it kind of eases the pain

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Speaker 1: a little bit, or at the very least you have

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Speaker 1: someone to direct your I or two. Well, I know,

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Speaker 1: in an election here though a lot of people are

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Speaker 1: looking at point fingers. If this is not an election year,

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Speaker 1: probably going down a little bit differently. I think, Um,

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Speaker 1: I think there's a lot of people to blame, as

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Speaker 1: you said, And I don't think it's just the lending

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Speaker 1: industry or the investment banking industry. And I don't think

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Speaker 1: it's just the people who who yeah, or the hockey

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Speaker 1: moms don't forget them right. I don't think it's it's

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Speaker 1: the average subprime barrower who took out a loan larger

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Speaker 1: than they can because they were sold a bill of goods,

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Speaker 1: oftentimes because I wrote an article on subprime mortgages and

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Speaker 1: a lot of people didn't even know what they were signing.

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Speaker 1: These mortgage lenders would kind of use tricky dialogue to

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Speaker 1: get them to sign on the dotted lines so they

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Speaker 1: could make their commissions. Yeah, there's there was a lot

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Speaker 1: of predatory lending going up big time. Um so regard

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Speaker 1: list of who's to blatant. These foreclosures start happening, and

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Speaker 1: they start happening big time, widespread, all over the place, right,

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Speaker 1: and like I said, it starts this domino effect. The

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Speaker 1: weird thing is is new houses that were being constructed

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Speaker 1: stop stop being sold as quickly because all of a

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Speaker 1: sudden they had to compete with these four closed homes

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Speaker 1: on the market exactly that were maybe half price. Yeah,

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Speaker 1: I bought my house and foreclosure. Yeah. I mean this

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Speaker 1: was even before the big, big foreclosure bust where they're

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Speaker 1: all over the place, So we just got kind of lucky.

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Speaker 1: But yeah, all of a sudden, these new houses are

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Speaker 1: sitting empty because, like you said, they can't compete with

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Speaker 1: the house that's discounted. So all these four closed homes

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Speaker 1: have this effect on the market the housing market, right,

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Speaker 1: more new homes on them or more homes on the

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Speaker 1: market means that the new homes aren't being sold because

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Speaker 1: the foreclosures are going. It's like a fire sale out

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Speaker 1: there in real estate in the US. UM but the

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Speaker 1: presence of more homes on the market, the presence of

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Speaker 1: more anything, the more supply, the lower the price. Housing

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Speaker 1: prices dropped. So you've got people all of a sudden

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Speaker 1: who are like, wait a minute, I'm in this huge

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Speaker 1: terrible UM maybe hybrid arm adjustable rate mortgage, and all

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Speaker 1: of a sudden they owe more on their house than

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Speaker 1: it's worth. How long are you gonna stick around? When

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Speaker 1: are you gonna leave and start renting? So, foreclosures keep

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Speaker 1: going and going and going. And as these this wave

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Speaker 1: of foreclosures takes over in the US housing market, it

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Speaker 1: also directly impacts the the investment market as well, because

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Speaker 1: everybody was, you know, so heavily invested in subprime mortgage

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Speaker 1: backed security. And then you have the construction companies who

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Speaker 1: own all these houses that aren't selling, so they have

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Speaker 1: to lay people off, and then it leads unemployment. It's

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Speaker 1: it's a huge domino effect. That's exactly right. Everything, Uh,

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Speaker 1: pretty much in the modern economy and the global economy

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Speaker 1: and the US economy, everything is in a related precariously so,

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Speaker 1: but it all goes back to mortgage back securities in

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Speaker 1: this case. That's exactly right. Whose idea was this to

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Speaker 1: begin with? I don't know, I've I've never found that

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Speaker 1: out and I've actually looked. I think that they are

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Speaker 1: laying low. There's got to be a dude, there's one

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Speaker 1: guy who had this idea. Yeah. Well, there's a lot

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Speaker 1: of financial instruments that are out there, and they come

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Speaker 1: out of places like Harvard Business or Wharton School and

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Speaker 1: you know, among other places, and they're modeled. You know

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Speaker 1: that you can run them through an an economic model,

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Speaker 1: but it's really just a model and you can't really

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Speaker 1: tell what kind of effect it's going to have until

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Speaker 1: after it's introduced in the market. In the real world

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Speaker 1: is a little different sometimes, right, And there's no as

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Speaker 1: far as I know, there's no regulation over introducing a

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Speaker 1: financial instrument to the market, you know. I mean, we

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Speaker 1: we regulate whether or not you can introduce a non

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Speaker 1: native fish into a lake, but nobody's you know, watching

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Speaker 1: over the financial instruments that are being introduced to the

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Speaker 1: to the the market right right. So I'm thinking basically,

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Speaker 1: if we had regulation of that, if things were tested

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Speaker 1: out on a small scale first before being released on

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Speaker 1: mass that could be helpful. I think there's a whole

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Speaker 1: lot of regulation that that could that could you know,

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Speaker 1: take place. Well, maybe these guys should start listening to

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Speaker 1: Josh Clark. Yeah, I guess this is a pretty dense

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Speaker 1: subject to agree, Chuck. It's dense or I'm dense, one

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Speaker 1: of the two. I don't think. I don't think you're dense.

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Speaker 1: It is. It's a very dense subject that I would recommend, uh,

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Speaker 1: anybody listening to this podcast going on to how stuff

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Speaker 1: works dot com and typing in how can mortgage back

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Speaker 1: securities bring down the US economy? And stick around to

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Speaker 1: find out which four articles Chuck and I consider essential

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Speaker 1: reading right now? So, Chuck, four articles essential reading, right,

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Speaker 1: I'll say them because I know you're shy. Uh. They're

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Speaker 1: all articles that you wrote, and they're really great in

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Speaker 1: depth articles, and they are about the four uh candidates

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Speaker 1: for president and vice president for this upcoming election. So

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Speaker 1: we have how John McCain works, how Obama works, how

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Speaker 1: Sarah H. Palin Palin Palin works, and how Joe Biden works.

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Speaker 1: And I don't haven't read the Joe Biden one yet,

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Speaker 1: but I'm hoping there's something in there about his teeth.

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Speaker 1: Nothing about his teeth, a lot about his um foot

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Speaker 1: in mouth condition. Right, Well, if there's room in that

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Speaker 1: mouth for a foot from all those teeth, then past

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Speaker 1: does have amazing teeth. They're great beans and choppers like that.

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Speaker 1: You can check all four of those out by typing

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Speaker 1: in Joe Biden, Sarah Palin, Barack Obama, John McCain, any

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Speaker 1: of them in our wonderful search bar on how stuff

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Speaker 1: works dot com for more on this and thousands of

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Speaker 1: other topics. Is it how stuff works dot com. Let

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Speaker 1: us know what you think. Send an email to podcast

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Speaker 1: at how stuff works dot com. Brought to you by

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