The Investor's Role

The process of pooling mortgages and selling shares to investors is called securitization. Without investors willing to buy these shares, there would be no way for lenders to convert closed mortgages into fresh capital to lend out. This is the basic problem we are facing today. Investors have lost their desire to purchase these securities and when there are no buyers in a market sellers are forced to hold onto their wares.

Investors are extremely important to the mortgage market, because without them there is simply no market. The class of investors purchasing these securities is made up of individuals, companies, mutual funds, pension funds and government entities, both domestic as well as foreign. The spread of these securities is amazing, they seem to be held in every investor’s portfolio regardless of how large or small the investor is.

The world economy has been awash with available cash for some time now and there seems to be no end in sight. Countries that were once seen as “third world” have developed thriving economies and are responsible for generating new wealth. Their economy can be based on modernization; such as we’ve seen happen in China and India. It could be based on the development of a country’s national resource; such as we’re seeing in Nigeria and Venezuela. Whatever the source, new wealth is being created at a record pace.

What this means is there has been and still is a tremendous amount of capital throughout the world looking to be invested somewhere. This has resulted in lower yields than have been historically available. It’s basic economics, the law of supply and demand. In this case, the commodity or “supply” is money and the user or “demand” is companies needing cash to run their businesses. In the case of the mortgage market, lenders need to sell off closed mortgages in order to free up capital to close fresh mortgages. The avenue used is securitization. Investors will typically want to diversify their investments. Some money will be invested in more speculative and therefore higher yielding ventures; other money will be invested conservatively with the appropriate low yield that accompanies a safer investment.

In looking at the different levels of risk an investor is involved in, he will try to get the highest yield possible in each investment made. This includes whatever money he is investing in secure ways. Mortgage Backed Securities have traditionally been considered a safe investment while giving a slightly higher yield than, say, US Treasuries.

As investors pushed for higher yields, the lenders were encouraged to originate mortgages that were at a higher interest rate. The only way for a lender to close loans at higher interest rates was to attract less qualified borrowers, who would be willing to pay the higher rates. This cycle of investors looking for higher yields and the lenders responding by lowering their lending standards brought us to today’s problems in the mortgage market.

What went wrong? The obvious answer is, greed. In the drive for higher profits, the investors destroyed the money making machine know as the mortgage market. I’m not satisfied that investor greed is the only issue in play here. We assume that investors are number-crunching businessmen and all decisions are calculated with nothing else influencing the decision. Humans make investment decisions and all humans have a set of consistent qualities that may vary in intensity from person to person but are always present. The attribute that’s important to this discussion is the desire to be part of the group. The comfort zone we have of running with the pack, the uncomfortable feeling we have in being different, and the fear of jeopardizing our income or reputation by disagreeing with the opinions of our company or the general assumptions of the industry we’re in.

When you combine greed with a pack mentality, the result is always a severe market correction. We’re seeing it right now in the mortgage market, we experienced it with the dot com market and I’m sure 10 years from now we’ll be experiencing yet another speculative bubble burst. Until investors develop the strength to think independently and the confidence to base their decisions on their personal analysis, we are destined to move from bubble to bubble.

Investors have no one to blame their losses on but themselves. Today’s troubled mortgage market is going to prove to be one of the most lucrative investment opportunities for independent thinking investors. One by one we are going to see major investors, hedge funds, companies, high net worth individuals and even foreign governments making selective purchases that will prove to be brilliant investment decisions over the next few years.

We all need to be more independent in our thought process. If we continue to hide in the pack we are destined to eventual failure.