Posted on 12/08/2006 10:07:04 AM PST by RobRoy
“It’s different this time,” are four of the most alarming words an investor can hear. Very rarely do things turn out differently; history shows that normally they go wrong in almost exactly the same way they did last time round the cycle.
But when it comes to the US housing market, there are reasons to expect that things will be different this time. But not in the way that optimists expect – instead the difference is that the damage could be more far-reaching than ever before.
Plenty gets written about the vast scale of this real estate bubble, the world of pain that housebuilders, realtors and overstretched buyers are finding themselves in and the likely impact that falling prices will have on the American consumer’s willingness to run up debt at the mall.
What’s sometimes overlooked is the other end of the equation: the huge amount of risky loans that have been issued to fuel this bubble and the question of who will be left holding the baby when it all blows up... In the modern mortgage market, loans often don’t remain with the bank that issued them. Instead they're parcelled up into bond-type structures called mortgage-backed securities (MBSs) and sold on to investors. The buyers range from hedge funds and pension funds to the Chinese government diversifying its dollar assets away from Treasuries.
This process - called securitization - looks like a winner for all involved. The mortgage lenders get rid of the risk of more borrowers than expected defaulting on their payments. The buyers get a higher interest payment from the MBSs than they would from a corporate bond with a comparable credit rating (this is because individually the mortgages are riskier, which means they pay a higher interest rate; but if you collect enough together, you reduce the risk of too many defaulting, which makes for an improved credit rating). And the investment banks collect a fat fee for arranging the deal.
MBSs aren’t a new development. The first ones appeared during the 1980s and played an important part in the Savings and Loans crisis. The banks persuaded S&Ls to turn their mortgage portfolios into MBSs and sell them, then use the proceeds to buy MBSs issued by other S&Ls. That may not sound like great business acumen, but it should be borne in mind that the S&Ls were run by near-amateurs working on the time-honoured 9-6-3 business model: lend money at 9%, take deposits at 6% and be on the golf course by 3pm.
Since then, the scale of the MBS market has expanded enormously. And one segment that has grown particularly strongly in recent years is subprime mortgages - loans granted to borrowers who are a higher credit risk.
Banks charge higher interest rates for subprime loans, making them a very profitable segment during boom times. So as the housing bubble inflated, subprime originations soared from around $100bn six years ago to over $800bn last year. In the process, lenders lowered their standards, throwing money at people who wouldn’t have even qualified as subprime in previous years.
The problem is that when the housing market or the broader economy turns down, delinquencies (late payments) and default rates on subprime mortgages shoot up. And that seems to be what’s happening now. Investment bank UBS reports that nearly 4% of subprime mortgages issued and bundled into MBSs this year are 60 days or more behind on their payments. While that may not sound too alarming, it’s the highest rate in over a decade - almost one percentage point higher than in the 2001 recession - and the economy as a whole isn’t even officially in trouble yet.
These delinquencies don’t bode well for the performance of this crop of MBSs in years to come. Typically, delinquencies and defaults pick up from year three of an MBS’s life; high delinquencies in year one are generally a sign that higher-than-usual defaults can be expected later on (because people who struggle to meet payments from the off are likely to struggle even more in subsequent years). That means that many investors who have bought subprime MBSs may soon find high default rates eating into their returns.
In theory, this will mostly affect investors who have bought bonds with lower credit ratings, but in practice even investors who bought higher-rated bonds may take a hit. Nobody really knows how subprime MBSs will perform during a falling housing market, because there’s so little historical evidence to assess them. One Merrill Lynch report reckons that a 5% fall in house prices could see defaults rise to double digit rates, which would be enough to hurt some investors who’ve bought seemingly-safe A-rated paper, the analysts reckon.
And of course, not many MBSs would actually have to cut payments; just the increased threat of it could send their prices tumbling. As happened with the S&Ls, plenty of investors will then find that they didn’t understand the risks they were taking on. But this time, the scale will be much greater.
Still, at least the lenders can take comfort in the fact that they’ve got all the risk off their books, can’t they? Not quite. MBS buyers may have been very reckless recently, but they’re not completely stupid. Usually the lender must buy back mortgages that go bad within the first few months. That could prove a trap for reckless lenders. This week, Ownit Mortgage, a formerly fast-growing subprime lender in California, shut its doors after apparently running out of cash to meet its repurchase obligations. It’s unlikely to be the last firm to meet that fate.
Still, at least the lenders can take comfort in the fact that they’ve got all the risk off their books, can’t they? Not quite. MBS buyers may have been very reckless recently, but they’re not completely stupid. Usually the lender must buy back mortgages that go bad within the first few months. That could prove a trap for reckless lenders. This week, Ownit Mortgage, a formerly fast-growing subprime lender in California, shut its doors after apparently running out of cash to meet its repurchase obligations. It’s unlikely to be the last firm to meet that fate.
Thought some of you might be interested
Recession cometh.
They ought to write about UK housing market - a market where you can now get a mortgage up to five times annual salary. Talk about risk.
They do that in California now.
Don't they also have a 100 year mortgage in the UK now?
I was under the impression that to be securitizable loans had to meet some threshold requirements - either because the market required it, or the government regulators did, and that the really flaky loans were not turned into Mortgage Backed Securities.
How many loans go bad in the first few months???? I would guess almost none. Much to do about nothing.
They've got no room to talk. A dear friend of mine is a young married woman, lives in Bristol England. Her husband has advanced degrees in physics and computer science and a good job. They were looking ten or more years of renting before they could afford their first home until her parents came along and loaned them the money. There really is no such thing as a "starter home" over there.
They do more than than in California. With the average price of a home approaching $500,000, you can't honestly believe but a small percentage of the people buying these homes are clearing $100,000 per year. It's just not realistic.
And then there is that whole divorce thing...
Thanks for posting this.
The author of the article - Heaton - is both stupid and ignorant.
He's stupid because he doesn't understand that lower interest rates cause higher home prices. You can buy twice as much home at 4% as you can at 8% interest rates.
He's ignorant because he doesn't know that inflation has dropped to 2% from 6% in the past decade, lowering the real rate of interest.
Another example of half-wit whooping from the undeducated and inexperienced.
>>How many loans go bad in the first few months???? I would guess almost none.<<
One would think so or, in your case, "guess" so. But read the last paragraph again. One important point is that if that IS happening, then "Houston, we have a problem". That is what the author is saying.
Gettin close to time for Bernanke to fuel up the chopper.
>>He's stupid because he doesn't understand that lower interest rates cause higher home prices. You can buy twice as much home at 4% as you can at 8% interest rates.<<
Actually, thanks to the rule of 72, you can buy MORE THAN twice the home at 4%. Actually, I mean twice the price, as you accurately mention in the first sentence.
But I don't see where the author doesn't understand that lower interest rates cause higher home prices. Very few people that can fog a mirror don't understand that axiom. It is a given that he is going beyond.
>>He's ignorant because he doesn't know that inflation has dropped to 2% from 6% in the past decade, lowering the real rate of interest. <<
I doubt that as well. It is also based on doctored figures. But that is a topic of another thread.
I think your main issue is not that he is "stupid" but that he did not specifically bring up basic details to educate the reader. He assumes perhaps a more sophisticated reader. Not too much, of course, because he does feel the need to expain an acronym. But you can only cover so many basics without turning an article into a textbook.
Don't worry! Mrs. Clinton will be along to save common people from those waskely weblicins--while the Dixie Chicks will have one hit after another!!!!!
My sister in law once was a realtor, she quit to raise kids adn went back to teaching after. She told me once that at a large agent seminar and development course held for agents belonging to Century 21 agencies that one of the presenters told them that the most common time for mortgages to go into default was the first 6 months. The reasons are the owners go into hock to mach on things for the house like furniture and such or they did not count on higher bills (taxes, insurance, utilities), and they did not leave enough room in their budgets to cover maintenance and life emergencies. In other words they cut it to close.
The agent and the loan officer go their money so they did not care if the buyers were on the bubble.
Why would Bernanke need a chopper?
I'm not sure I buy into this. In my own experience, my mortgage on my first house became less and less of a problem simply because over time I started earning more from raises and even cost of living increases.
Unless these people have a balloon rate, or continue to spend beyond their means, the fact that the mortgage payment doesn't rise over time should make it easier to pay over time.
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