Is Your RMBS Fungible?

Say what?! OK, let's give some quick definitions:

RMBS - Residential Mortgage Backed Security(ies)

Fungible - (esp. of goods) being of such nature or kind as to be freely exchangeable or replaceable, in whole or in part, for another of like nature or kind.

I asked this question because of its uniqueness. Before today, you probably didn't know what fungible meant (don't worry, neither did I). But in reading a very interesting article on the topic on HousingWire, I was compelled to share my findings with you all.

I would strongly encourage you to read the article, but in brief, it says that investors did not properly discern the difference in risk between different mortgage backed securities, and thus are now reaping greater losses than they otherwise would (or should) have had they demanded an appropriate return for the risk they consumed.

If you are not familiar with the securitization of assets in general, the basic principal is that assets are bundled together in a pool. The pool is then divided into different "tranches". Each tranch has a level of risk associated with it. There are senior and junior tranches. Junior tranches, as the name implies, are subordinate to senior tranches and are the first to bear losses. The junior tranches also contain the most risky part of the pool of assets. Ordinarily, investors would require higher yields for purchasing the riskier tranches.

The point of the HousingWire article is that investors failed to do so. One expert put it this way, "Good investors were priced out of the market by the quest for yield when the curve started to flatten and the galloping demand emerged from CDOs. CDOs just waved the loans in, thanks to the rating agencies' idea of limited correlation via geographic distribution. And foreign investors did not bother to become experts in the 50-state patchwork that is U.S. real estate law and bankruptcy code. Because everyone else was inhaling this shit.”

Crass, but accurate. Remember, you get what you pay for, and if you aren't adequately compensated for the risk you bear, then you may just end up holding a big pile of... well, you know.