Mortgage-Backed Securities and the Housing Market

Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.

The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.

Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.

Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.

This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.

How Bad is the Housing Market? Pretty Bad

The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay.
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.
With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.

With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending, which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.

Subprime Mortgage Debacle: What is the Impact?

Last year, the market overcame a wrenching period of soul-searching in May and June (2006). Back then, the Federal Reserve was at the end of a two-year campaign to raise interest rates, and the housing boom had started to fade. The concerns that dominated the minds of investors, however, did not linger, and the market had a solid second half.

Many market specialists assert that the current concerns will play out similarly. Weaknesses like those in the market for subprime mortgages issued to borrowers with weak credit will not threaten the broader financial markets, these experts say, because the world economy is growing, corporate profits are rising, and consumers with good credit are not defaulting at high rates.

Most of us (especially those living in areas with very high housing costs) are aware that lenders have pushed the envelope in recent years and granted loans to enable people to buy homes they would otherwise be unable to afford. In so doing, many of these buyers have stretched themselves financially and have little margin for error. Low starter rates and temporary interest-only terms are winding down or expiring. The rates on these loans are resetting at a much higher level because interest rates are rising. As a result, defaults among subprime mortgages have climbed sharply. How widespread is the problem? Well loans in this segment ac-counted for 24% of loan originations in 2006, and late payments in Alternative-A mortgages are esca-lating (the default rate in this sector is in the 13% to 14% range). The result: people are losing their homes and some subprime lenders have either experienced big financial losses or gone out of business.

Research analysts at PIMCO have suggested that this is a meaningful source of risk to the housing market, since these defaulting buyers have starter homes (less expensive homes) which are the first rung on the housing-market food chain. So on its face, rising delinquencies in a high-growth part of the market could be a serious concern.

Defaults and tighter lending standards will mean that growth in the subprime arena will stall, causing demand to sag even further in the housing market. PIMCO’s analysts believe that we’re in the middle of the housing downturn, and that this will ultimately cut roughly another 1% from GDP growth over the next few quarters (and that there is at least some risk that it could be worse). Clearly that’s not good, but it is also not as bad an outcome as many others seem to expect given the extensive media play that this problem has received.

The reason the spill over effects on the economy and corporate earnings aren’t more severe becomes clear when you break the U.S. consumer into quintiles. The bottom 20 percent of U.S. consumers generate only 8 percent of consumer spending. These are the very consumers that are caught in the sub-prime lending squeeze and could lose their homes. Conversely, the top 10% represents about 40% of consumer spending and these consumers are unaffected. The subprime debacle will effect will cause dislocations in the housing market but won’t deliver a crippling blow to the economy. It is just another road hazard that the economy and financial markets will need to navigate around.

Sam Stovall Interview

Sam Stovall's insights are right on point in this interview he did for Nightly Business Report on Tuesday March 13, 2007.

There is no reason to panic in fact I see the market correction as a great opportunity to put cash to work.

Here's the transcript.

The Financial Pragmatist
Libby Mihalka

SUSIE GHARIB: Joining us with analysis of today's market sell-off, Sam Stovall, chief investment strategist of Standard & Poor's. Hi Sam.

SAM STOVALL, CHIEF INVESTMENT STRATEGIST, STANDARD & POOR'S: Hello, Susie.

GHARIB: Are we looking at a correction here in the markets or is this the beginning of a bear market?

STOVALL: I think it's the correction, not the beginning of a bear market. I think certainly this has been something that's long overdue. On February 27 we snapped a 949 straight day period in which the market did not decline by 2 percent or more in one day. And normally we see an average of four of them per year.

GHARIB: But how big a problem is this sub-prime mortgage market?

STOVALL: Well, I think certainly because it bleeds it leads, and it is a cause for concern. And as a result it's, I think, triggered this slump in sentiment for investors right now primarily because of the uncertainty surrounding what kind of an impact it could have on the other areas of mortgages and mortgage-backed securities markets. So in general I believe investors are worried that possibly they did not anticipate this and that the uncertainty is that it could be worse than they're currently forecasting.

GHARIB: You talk about the impact on other mortgage markets. There's also concern about its impact on the economy and on corporate earnings. Do you see a huge spillover effect here?

STOVALL: Not really. Because when you break up the U.S. consumer into quintiles, the bottom 20 percent represents only about 8 percent of consumer spending and that's the category that typically would be involved in the sub-prime lending. Whereas the top 10% represents about 40% of consumer spending and that's the area that's not really being affected by this and is in the prime category.

GHARIB: I was talking to another market strategist the other day who was saying that he was very optimistic about the markets, saying because there there's so much liquidity out there, although today there seem seemed to be more people talking about a liquidity crisis. Which is it?
STOVALL: Well, I think there is the concern which could be exacerbating the markets decline today. Why financials fell 3 percent, why all 10 sectors in the S&P declined on the day is because people are worrying that the engine of growth, global liquidity, as you just mentioned, could start to dry up as lenders worry about extending credit where the credit is not due or at least not likely to be paid back. We at S&P basically believe that we're still likely to see a 15-10 target for the S&P 500 at the end of this year and we remind investors don't bail out of a lot of large financial institutions. Companies like Bank of America, like Citigroup, like Wachovia offer dividend yields that actually rival the 10- year yield on the bonds. So it's not just looking good compared with the S&P 500 but you're looking at 4.3, 4.4 percent dividend yields and quality rankings that are superior because over the past 10 years they have been able to increase their earnings and dividend growth.

GHARIB: Just a few seconds left. Some people think a cut in interest rates by the Fed would end all this selling. In a few words, what do you think?

STOVALL: I think certainly it could improve overall sentiment and add to the liquidity.

GHARIB: All right. We'll leave it there. Sam, thank you so much for coming on the program.

STOVALL: You're welcome, Susie.

GHARIB: We've been speaking with Sam Stovall, chief investment strategist of Standard & Poor's.