Paradigm Press Customer Satisfaction Guru Dustin Weisbecker sends me questions, comments, and feedback from the Rude’s outstanding subscribers.

I appreciate all of them, even the critical ones. I owe many people some sort of response, but this one question from James T. inspired me to dedicate an entire edition of the Rude to answering it.

Here’s his query:

Sean,

This was a great read and a most important read. I’ve taken time to watch and read The Big Short multiple times and think I have a pretty good understanding of what you are talking about here. However, you threw out some things that escaped me. So:

• If I remember right, securitization was done to create a product to sell and make the investment banks and hedge funds a lot of money; to make an attractive investment to sell. I'm not sure that they were actually trying to spread the risk.

• What is the CFPB supposed to do?

• Where do we buy credit default swaps?

• How big are commercial MBS problems compared to the home MBS in 2008? Can you quantify in any way what the banking system is in for?

Great writing as usual. If my ponderings are remotely intelligible, the credit goes to Paradigm Press, and in particular you and Jim Rickards, for being great teachers and opening up minds! JR has mentioned the looming issue several times and this read really hit home.

Thanks again.

Your paisano,

James T.

Thank you, Paisano! I appreciate such a rich question. Let me get right to answering it.

Securitization

James, nothing is ever done unless it’ll make hedge funds and investment banks a lot of money. This invention was particularly lucrative.

Imagine a bunch of bankers getting together and thinking up a plan to make more money from mortgages than they already make. But they were all at one bank. If you liked The Big Short movie, you may like Liar’s Poker, Michael Lewis’ first and best (in my opinion) book. That book was required reading on Wall Street when I first started out. If you didn’t know what “Equities in Dallas” referred to, or why Lewis’ friend Alexander called him up when Chernobyl happened and said, “Buy potatoes!” you weren’t in the club.

Liar’s Poker described how the mortgage department at Solomon Brothers, then the fixed income bank on Wall Street, invented mortgage-backed securities through securitization. The book is hilarious. The invention of MBSs? Nothing short of genius.

Securitization is merely bundling assets (such as mortgages) together to create a new security. When you bundle mortgages together, they become a mortgage-backed security. When you bundle credit card debt, auto loan debt, and other debt, you’ve got a collateralized debt obligation.

Once you bundle them, you can slice them into tranches (which means “slice” in French). Some investors can then own tranches that only pay the principal back, while others could own ones that repay interest.

The trick was knowing how to price them. Since Solomon Brothers invented MBSs, they were the only ones who knew how to price them. They ripped everyone’s face off, practically minting billions in profit. The big mistake was not paying the mortgage guys enough. One by one, they left to join other banks, sharing their secrets. Once that happened, making money wasn’t as easy. Still, it’s worth billions to Wall Street currently.

Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau (CFPB) is a federal regulatory agency that oversees financial products and services offered to consumers. 

The CFPB was established in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Its primary mission is to protect consumers by enforcing federal consumer financial laws and ensuring that markets for consumer financial products are fair, transparent, and competitive.

The CFPB regulates mortgage lenders, brokers, and servicers to ensure compliance with federal laws. This includes overseeing practices such as loan origination, underwriting, and servicing.

The bureau has the authority to take enforcement actions against companies that violate consumer protection laws. This can include imposing fines, requiring restitution for affected consumers, and other corrective measures.

The CFPB provides resources and information to help consumers make informed decisions about mortgages and other financial products. This includes tools for comparing loan offers, understanding mortgage terms, and avoiding predatory lending practices.

The bureau operates a consumer complaint system where individuals can submit complaints about financial products or services, including mortgages. The CFPB then works with companies to address these complaints and resolve issues.

The CFPB has the authority to create new rules and regulations to protect consumers. For mortgages, this has included rules on mortgage servicing, disclosure requirements, and protections against unfair lending practices.

With all that said, I don’t remember the CFPB doing anything notable since its inception.

Credit Default Swaps (CDSs)

CDSs, or credit default swaps, can be considered “bond insurance.”

The CDS spread - prices of CDSs are called “spreads” - is typically quoted in basis points (bps) and represents an annualized percentage of the notional amount.

CDS spreads are the one number traders look at to assess default risk.

But for fund managers and retail investors, credit ratings matter.

Fund managers cannot put any bonds in their portfolios that don’t reflect the risk they can take.

Where can you buy one? You can’t. Sorry, that’s only for the institutional players. (The ISDA agreement part of The Big Short is all about this.)

CMBSs Versus MBSs

In 2008, the size of the commercial mortgage-backed securities (CMBS) market was significantly smaller than that of the residential mortgage-backed securities (MBS) market.

The residential MBS market, which includes securities backed by residential mortgages, was much larger. In 2008, its total value was estimated to be around $7 trillion. This market primarily includes securities issued by government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae, as well as private-label securities.

The CMBS market, which includes securities backed by commercial real estate loans, was considerably smaller. In 2008, its total value was estimated to be around $700 billion to $800 billion. CMBSs are used to securitize loans on commercial properties such as office buildings, shopping centers, hotels, and multifamily housing units.

CMBS Market in 2024

The market size for CMBS loans scheduled to mature in 2024 and 2025 is approximately $900 billion. 

New issuance for CMBS is forecasted to reach about $55 billion in 2024, rebounding from the significant drop in 2023 when the issuance was around $39.3 billion.

However, the market continues to face headwinds with rising delinquency rates, particularly in the office sector, which has been significantly impacted by the shift to remote work and higher borrowing costs. Delinquency rates for office-related CMBS are expected to rise, potentially reaching as high as 8.1% in 2024.

Residential MBS Market in 2024

The residential MBS market remains considerably larger than the CMBS market. As of mid-2024, the issuance of residential MBS has continued to grow, with a total issuance of approximately $560.4 billion by May 2024. As I mentioned above, the residential MBS market benefits from strong backing by government-sponsored enterprises like Fannie Mae and Freddie Mac, contributing to its larger size and stability compared to the commercial sector.

That’s an enormous amount of money at risk for investors. However, the CMBS market is still much smaller than the residential market. The key here is that many regional banks are at risk from commercial mortgages, so the knock-on effects are very different from last time.

Wrap Up

Thanks, James, for the great question. I hope I answered it to your satisfaction.

If you have any questions, comments, or issues, please feel free to write to feedback@rudeawakening.info. I read all the mail in the bag; I just don’t always have time to answer live.

Have a great week ahead.