Hi again welcome to part two of the Three Little Securities. If you haven’t watched the first part you may want to watch that first just so that you can fall along with the story.
This part of the story is called When Bond Sells a Clever New Product and Faces a Scary Result. Here we go.
At first, bond security couldn’t figure out a way to make money from selling these risky mortgages that he got from his investment banker friend. Instead, he did what came naturally. He greeted the market in the town where folks with money, got loaned it out and lock in an interest rate until they got their money back with their contract material.
Since the investor locked in an interest rate with the entity issuing the bond contract, the market was nicknamed the fixed income market. And in the move of Huberist to ean his pinstripes that investment bankers wear, bond security required that the terms of the loan be expressed in a Bond security contract.
The contract included a rating reflecting the credit quality of the issuer which expressed the likelihood that the issuer of the bond would pay the investor his or her money back when the contract is up or matured.
Now Bond security was happy that the enable local companies to borrow money for local residents to grow by issuing and selling corporate bonds and he was happy that he allowed the way for conservative investors to supplement their income in a predictable way by receiving the interest payments from the issuer.
Bond was even able to allow the town and other parts of the local municipalities to raise money for street improvements and other things by selling municipal bonds, and in an added benefit to the buyers of municipal bonds, that interest income was tax-free because why would the Federal government tax their state local can if they could tax everybody else.
So this is all very satisfying the bond however, he still wanted to build a mound of money to protect himself in case the wolf inflation came knocking at his door. So he dusted off those mortgage contracts and he calls this investment banker friend and started applying.
Now the Bad Credits and the New Money Down mortgages they’re paying back their mortgage loans which had low introductory interest rates so that those families could afford the payments. However, the rates were due to dramatically increase within the next few years.
Now, Bond saw that rate increase as an opportunity for someone to earn a high amount of interest income if they owns these loans and were the recipients of the loan payments from the No Money Down and Bad Credit families, but who would knowingly own a loan being paid back by folks like the Bad Credits. How could Bond Security replaced what would be a low rating with a stellar one.
Bond figured that if he buddle the bunch of these risky loans together he would lower the risk of one potentially not being paid back. It’s like a bouquet of balloons if one pops you still have a bunch of other balloons keeping that bouquet of balloons to float.
So Bond Security bundled these risky mortgages together into one pool of mortgages and created a new contract type to be sold in his fix income market. Several loan repayments will be group together. It will go to the investment to the investors who bought the contracts and receive that interest income over specified period of time. And being the issuer of the contract Bond Security used his seller name to get a good rating for these contracts. He called these new contracts mortgaged back securities.
Now Bond sold contracts and these mortgaged back securities to many different investors seeking a high level of interest income. They became extremely popular even with conservative investors who saw the high ratings on those contracts.
Now Bond felt that pooling loans together really lower the risks to the investor of one risky loan defaulting out of the bunch. So he decided to try pulling together other things like auto and equipment loans as the collateral behind the contract, and named this new contract collateralized debt obligations. These two sold like gangbusters all around the world.
Now, few years later, Bond Security set within his 15 room mansion eating pork rinds when he heard a knock on his door. “Who is it?” he yields to the door. “Little security, little security let me in.” the voice replied. Bond jumped from his chair choking on his poor friends. He cleared his throat and look who the people. It was inflation. Bond guest, “I didn’t expect to see him so soon.” But then Bond kicked himself for not noticing that inflation was lurking. The cost of groceries and services like pizza delivery were rising. Also the federal open market committee who is responsible for monitoring markets like Bonds fixed income market raise interest rates recently since inflation was becoming a threat. Thus, loans will become harder for people to repay due to the higher rates of interest not to mention that since goods and services are most expensive. Families like the Bad Credits and the No Money Downs didn’t have as much cash available to pay back their loans.
Bond imagined a nasty scary scenario that he never predicted will happen. How many investors would be holding a mortgage back security contract or collateralized debt obligation contract with a loan from the Bad Credits and a No Money Downs when these families stop repaying their loans. What if more families with mortgages in the same pool also started to faulting? What would the holders at the mortgage back security contract do when the contract if it ultimately became worthless.
Now way would they be able to sell it and get their investment back. “Oh, my God!” said Bond. He tried finding protection under this turf that was sent to him as a present by the government, but realize after getting into it that it had several holes and didn’t really work so well at all, so instead he climb at the back window and run to the next town to be with his brother Option Security.
And that’s it the part two. Join me next time with the part three of four when I talk about how Option and Bond became the center of a perfect economic storm. I’ll see you then.
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