MBS or Mortgage-Backed Securities became infamous for their role in the 2008 Global Financial Crisis. What seemed like a high-paying investment soon turned out to be a bag of shit that piled on until it choked the entire economy! But that was not the end of MBS, it still remains one of the sought-after modes of investment.
Firstly let's start by answering what is MBS?
Suppose you want to buy your dream house but don't have the required capital. What do you do? You go to the bank and take a loan by providing the house as security. Banks use the depositor's money to give loans or they borrow from the market at a lower rate and give it out as loans at a higher rate thereby earning the difference in interest rates, which is known as the spread. Banks keep on giving such loans, but at some point, it either becomes over-levered or has cash constraints in giving out loans. In order to overcome this challenge, the bank sells the loans to investors, at a discount. In this way, the banks are able to clean up their balance sheet and overcome liquidity crises.
Banks either sell off the loans individually (if the amount is huge) or bundle several loans together and then sell them. The Institution buying the loans, bundles together several loans, which may or may not have the same credit rating, and then sells them to investors and earn commission on the transaction. The big investors are capable of buying the entire portfolio whereas the small retail investors get a small portion of the entire pie just like investing in mutual funds. The reason investors invest in such an instrument is that any repayment of the loan, by the borrower will flow to the investors.
Obviously, some borrowers will default hence the concept of bundling up arises. Even if some of them default, others will pay, and overall the investor will gain. In case of default, the investors can sell off the security (property against which the loan was taken) and recover losses. The MBS is broken into various tranches depending on the quality of the loan and priced based on risk taken and priority of repayment.
How to hedge the risk?
The risk of default will always be there and the process of selling the properties and recouping money can be cumbersome. Enters Credit Default Swaps, it's like insurance where you pay the premium and get some fixed amount in case something drastic happens, in this case, the default by the borrower. So if the amount that the investors get in case of default is higher than the sum of all the premiums paid, then the investor gains. One can watch how CDS helped make billions during the financial crisis in the movie 'The Big Short' starring Christian Bale and Brad Pitt.
Real estate prices have been plummeting even before the Covid-19 crisis had an effect on the global economy. The mall owners are the ones who are affected the most. Malls are situated at prime locations thereby making the land costly. With the growing popularity of online shopping, we are witnessing the closure of many retail shops. So being a mall owner is not ideal at the moment.
CMBX 6 was an MBS that was made up of many 'mall loans'. Those big investors who had purchased the CMBX 6, also happened to purchase CDS to hedge against the default. The Covid-19 hit the economy hard, the business started to close and mall owners started to default. An ideal scenario to cash in those CDS!! Carl Icahn added a profit of $1.3 billion to his kitty by cashing in his CDS whereas Private equity fund and fund managers like Jason Mudrick, Scott Burg have made around $100-$250 million. Interestingly most of them have not yet closed out their position meaning they are expecting greater payouts in the future.
The situation reminds me of Jared Vennett from the movie 'The Big Short' when he said 'No one's paying attention' and 'A few outsiders saw what no one else could: The whole world economy might collapse'. This strengthens the fact that there is an opportunity in every crisis, one just has to be aware and ready to make most of it!
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