COMMENT.
Doesn’t sound so ominous after all. In fact, the numbers are
up because they “had fallen to extreme lows.” Note: this article
was a year ago. The trend in delinquencies has indeed continued
up. However, as of March 2007 the most recent data we have subprime
delinquencies were still well below their peak in June 2002.
(Source Bloomberg News — DLQTSUBP Index)
Good News/Bad News
Okay — that is the good news. Things
are not nearly as bad as the headlines suggest, and for most people
the word “crisis” is not applicable. We are not going to have
huge numbers of mortgage-paying Americans dragged out of their
homes and thrown into the streets.
The bad news is there really are
problems associated with the subprime mortgage market. They are
mostly technical, dealing with the way world financial markets
work. The way financial markets are wired means a problem like
this can send shock waves through the entire system.
The subprime issue is also a problem
for many people who work in mortgage lending, real estate sales,
construction, and so on. The housing market got ahead of itself
and now it will cool down.
Technical Problems with Exotic New
Financial Technology
What is going on in the financial
markets is not easy to explain. It involves fancy new financial
technology. Frequently, when there is fancy new technology it
leads to excessive excitement and misuse — resulting in an old-fashioned
speculative bubble and just as old-fashioned speculative collapse.
Here are a few things you should
know.
Subprime Mortgages. You should know that subprime mortgages are not new. There
have always been lenders willing to lend to people with bad credit.
Of course, they charged much higher interest rates, knowing that
a higher percentage of such borrowers would default.
Securitization. You should
know that for some years now there has been a growing trend in
the securitization of mortgages (and every other type of consumer
loan). This means your lender does not keep your mortgage the
way lenders use to. Your mortgage will be sold and packaged with
other mortgages into huge pools and sold like a single bond. This
is known as .
These days, more than 70% of the
mortgages are securitized. Because of their size and complex structures
these mortgage-backed securities, as
they are called, are nothing you or I would be interested for
our personal portfolios. But they are attractive to huge pension
funds, insurance companies, large foundations, and many other
investments pools with billions of dollars to invest.
Securitization
has been around for a number of years, but technology has moved
it to whole new levels. Using powerful computers they can break
these mortgages apart and reassemble them in almost any way an
investor might like.
For example,
they can strip out just the interest payments for a particular
month for a whole pool of mortgages put them in a package and
sell a security that looks like a zero coupon bond with interest
payment. They can strip out just the principle portion of the
payments and package those into a separate bond. They can mix
and match mortgages of different qualities, different geographical
locations, and different types of properties.
There is almost
no end of the ways your simple mortgage can be taken apart and
put into various investment products, each attractive to some
institutional investor out there. And this is exactly why it
is done, to appeal to many different types of investors — investors
that would not normally have any interest in holding a home mortgage
in their portfolio. This opens up vast new sources of money for
mortgages. That is good for people that want to buy homes.
Hedge funds. You should know there are many
large investors interested in these mortgage-backed securities,
but of all those investors, none have been growing as rapidly
as the so-called hedge funds. You likely have heard of hedge
funds. They are everywhere. (I run one.)
Generally, a
news article simply describes them as large, unregulated, highly
secretive investment pools. Those things are true. The reason
nobody describes them further is that there are so many, they
are so complex and they invest in so many things they cannot be
described in a few hundred words or even a few hundred pages.
Some do equities, some do currencies, some do commodities, some
do art, movies, royalties, even patents. Many do exotic mortgage
backed securities. Some do everything and some invest only in
other hedge funds.
They are unregulated
because most are set up as limited partnerships and often in offshore
tax havens. The law says they can only sell partnerships to wealthy
sophisticated investors and institutions who theoretically know
what they are doing and therefore do not need the government to
look out for them. (We’ll see if that theory gets tested in here
with all the hedge fund problems that keep cropping up.) They
are secretive because all the managers think they are smarter
than everyone else and have a proprietary investment approach
that they do not want stolen. (I fit that category.)
You should know
that hedge funds have been growing rapidly in recent years, attracting
billions and billions of dollars. This has given them a ferocious
appetite for new investments.
Remember there
is no easy way to generalize about hedge funds or even get data
on them. However, most of them are trying to produce steady above-average
returns in good and bad markets. To find the high returns many
of them have been attracted to securities backed by subprime mortgages.
Remember, by
the time these mortgages have gone through the securitization
process they have become highly exotic. Managers of these hedge
funds are brilliant, with IQ’s off the charts and working for
some of the best firms on Wall Street. They know these highly
exotic securities carry highly exotic risks. They seek to hedge
or offset these risks selling short (borrowing and then selling
a security you do not own with hope of buying it back at a lower
price) a security that should go up in value if the subprime mortgage
security goes down in value.
A very simple
example might include buying a mortgage backed security with a duration of 10 years and hedging that by shorting 10-year
government bond futures. Elaborate computer models have been
built to select and control these investments. Frequently, the
computer enters the trade untouched by human hands. These computer
programs represent very new and very powerful financial technology.
Another interesting
thing about hedge funds is that typically they can borrow money.
How much they can borrow often depends on regulations and how
convincing they are to the banks that their investments and computer
models will work. For example, the partners may invest $1 billion
in a hedge fund. The hedge fund will go to the bank and borrow
more perhaps $4 or $6 or $10 billion or more. This creates substantial
leverage.
Perfect Storm
This all works
until something goes wrong. The Federal Reserve has been raising
interest rates for more than three years, trying to contain inflation.
Rising interest rates always hits the housing and other interest
sensitive markets first — that is what the FED is trying to do.
The effort to cool housing did not work very well this time because
of all the money chasing mortgage-backed securities. Eventually,
however, rising rates did have an effect, especially with mortgage
borrowers that had purchased Adjustable Rate Mortgages (ARM).
As interest rates rose their monthly payments increased. This
often hit people who couldn’t realistically make the payment they
already had, and defaults increased.
In the meantime,
the pressure on hedge funds to generate high returns had created
an abnormally large market for subprime mortgages. Just think
of all the ads you have heard in the past several years. “Poor
credit, no credit, bankrupt, we’ll approve you — no questions
asked.” The good news is that a lot of deserving people with
an unfortunate credit history got approved. The bad news is a
lot of not-so-deserving people with an unfortunate credit history
got approved.
I assure you,
the smart guys in the subprime mortgage market knew these loans
were risky. But even smart guys get caught up in a speculative
frenzy. This means these mortgage-backed securities were mispriced.
This was easy to do because these securities are so exotic and
do not trade on organized exchanges it is very difficult to price
them properly. Then throw in the speculative enthusiasm on top
of that. This meant borrowers were getting money too easily and too
cheaply, and investors were paying too much for the mortgage-backed
securities. (Oh yeah, and there was some downright fraud and falsified
documents along the way, but these well publicized anecdotal incidents
were on the margin. Remember, beware of headlines.)
Because we are
not allowed look inside the computer models (I won’t show you
mine) we do not know whether the models failed or over-enthusiastic
managers with pressure to produce big returns overrode the computers.
We do know increasing defaults and mispriced securities meant
losses began to appear. We also know the computer-generated hedges
either didn’t work or were inadequate. Hedge funds began to experience
losses.
Then the negative
effects of the leverage (the borrowed money) began to kick in.
Whatever losses were showing up were
magnified many times over. For example, the subprime mortgage
may have lost 5% of its value. In the world of investing, 5%
is no big deal. But if you are leveraged 10 to 1, the 5% decline
is suddenly a 50% decline. That makes investors and bankers nervous,
especially when they know it may be much worse because of the
difficulty in pricing the assets. Often the hedge fund could
not be certain what their portfolio was worth.
This leads to
a classic “run on the bank.” Bankers and partners are trying
to pull out their money and the hedge funds are trying to raise
money by selling securities that suddenly no one wants to buy.
I have been
picking on hedge funds, but they are not the only people investing
in subprime mortgages. The hedge funds were important and in
many ways were driving the market, both up and down. But many
mainline banks, insurance companies, savings and loans, pension
funds, foundations and others also invested heavily in them to
improve their own returns.
The Rich
and the Pros get Hurt
It truly has
been a classic speculative blow-off — except this one has been
perpetrated almost entirely on and by professionals. You know
— the folks who usually scoff at the little guy that doesn’t know
what he is doing, gets caught up in a frenzy, and loses his 401k? Remember, the Internet speculation
7 or 8 years ago, for example? Lots of ordinary people lost a
lot of money in that one. Well, this speculative blow-off with
all its losses belongs almost entirely to the wealthy. This time,
do not even expect any heartrending headlines. A wealthy investor
losing money in a hedge fund partnership does not generate much
sympathy on the evening news.
The FED to
the Rescue
Because financial
markets are so intertwined what really is just an ordinary problem
to be worked through can quickly turn into a full blown financial
crisis. That has been occurring here. As I write, central banks
around the globe are pouring money into the financial system worldwide.
It is way too early to know if they have already succeeded or
whether it will require months of effort. In the end they will
be able to contain it.
I want to make
a point about the intervention of central banks like the Federal
Reserve. Their purpose is not to bail out unwise investors —
especially some of these wealthy investors. Neither is it their
goal to save the subprime mortgage market so that people who can’t
really afford a mortgage will keep getting them. It isn’t even
their goal to assure full employment in the real estate and construction
markets. Their goal is to prevent the financial markets from
melting down. Having the markets seize up and quit working is
not in anyone’s best interest.
I said at the
outset it will be (and already is) more difficult to find a mortgage,
especially a subprime mortgage. Another classic characteristic
of a speculative blow-off is that many participants swear off
the market completely. One might think investors would just scale
back a little bit to more appropriate levels, but frequently it
doesn’t work that way. Frequently, the board says, “No more,
get out completely!” Thus the money available for mortgages (and
subprime mortgages particularly) can shrink sharply in a short
period of time.
This too will
pass. In the mean time be prepared for whatever may follow.
Reduce your debt and improve your work performance. “..if
ye are prepared ye shall not fear.” (D&C 38:30)
P.S. My firm
does not participate in any mortgage-backed securities, so I can
be philosophical this time. And as always all these opinions
are mine alone and do not represent those of Meridian any company or organization I am affiliated
with — or even those of my wife.
