There is an important aspect to this story about B-paper. This is an example of the changes in folks' view of what the economy is and what is of economic value. It use to be the case that companies which made things were of value. With the change in the economy from goods producing to service producing a change in perception has occurred which has strangely had the effect of making the economy something which runs on the expansion of credit and money supply rather that profit. This B-paper mess would never have existed if property values had not been increasing sharply.
Let me expand that last point. If one were to look at appraisals over the last 10 year one would see that it is not in fact the value of homes that has been increasing sharply but the value of the land under then that has increased. That increase has been fueled by credit markets - the availability of a near infinite money supply for mortgage backed securities. It would be more accurate to talk about a "land bubble" rather than a "housing bubble." Going to the supply side one might simply offer that the lead time to get developments approved and do the actual construction was simply to long. Supply inelsaticity could be deemed the culprit for the large increase in values. The ready supply of money made demand more elastic than supply.
This expansion in credit has affected the economy in other adverse but less obvious manners. Everyone is modestly affected by gasoline prices but the fact is that oil futures are not affected solely by supply and demand but by derivative trading as well. Speculation in oil futures for the sole motive of greed is enabled by credit markets and affects everyone. Derivatives in general and hedge funds in particular are unregulated. I do not subscribe to the thesis that hedge funds are necessarily going to at some time create substantial shock on the economy but they certainly do have that capability.
The B-paper market was enabled by Wall-Street not from the motivation of providing home ownership to folks with bad credit but for profit. Now that it has headed south borrowers and loan officers will be castigated. The effect is similar to that of recent corporate scandals. Short-term profit has been sought even though it threatens the long-term viability of a company or something such as the housing market.
B-paper Angst Redux
Subprime mortgages have received a lot of press lately. What is involved is the perception of the value of B-paper mortgages. The expression "B-paper" merely means mortgages for folks with poor credit. This is also referred to as "subprime" and will probably gain a new handle once the dust settles.
B-paper is not new. What is recent and what is almost entirely responsible for the current problem is the proliferation of absurd lending. I mean specifically B-paper, stated income and especially B-paper stated income 100% combined loan-to-value loans. Many of these are loans which should never have been made. If someone has bad credit and I were lending them money I would like a complete look at their income so that I could answer the question, "can these folks really make this mortgage payment?"
What happened is that Wall Streeters were able to sell investors on high returns in exchange for this truly unknown risk. This was expedited by the fact that these pools of B-paper mortgages were insured. Third (or maybe it is fourth) parties were taking the derivative risk.
What happened was inevitable. This encouraged the funding of loans which had early defaults, default rates on these loans increased, the cost of credit insurance became prohibitive and the originators of these loans wound up with no one to sell them to. This creates serious illiquidity and has resulted in the shutdown of some of the largest players in this field. These changes can be abrupt. Investors simply announce at the start of a business day that they are no longer buying this paper. Individuals may have recently found that they signed loan documents and before the loans could fund investors stopped buying the loans that were about to be funded. This has occurred mainly with high CLTV B-paper seconds.
The B-paper industry will make a come back but hopefully it will do so with sensible underwriting. In short: no stated income 100% LTV B-paper. Maybe no stated income B-paper at all.
I do not think that this will have a wide macroeconomic effect. The effect so far has been on the folks who have these mortgages and are going to lose their homes and on the folks in the mortgage business who made a very nice living by originating these loans. To be sure this will have the effect of creating a few more sellers and a few less buyers but hardly will have a dramatic effect of values in general To be sure there is probably a geographic clustering of B-paper and those places will see a consequent downturn in values but the overall nationwide effect will be a slight downward pressure on values.
It is not yet apparent that there is any significant damage to banks in general or the banking system. The only parties at risk here may be the commercial banks which extended credit lines to these now halted B-paper originators. I don't mean that these commercial banks will go out of business I only mean they will suffer some losses or diminished profits and stock value.
One other point. The is another mortgage space between subprime and "A" paper which is usually called "Alt-A." That may mean slightly different things to different lenders. Alt-A can mean: below 680 but not really terrible credit or it can mean good credit but high-ratios (housing expense divided by income and total debt obligation divided by income). The best description is that it is A-minus and not B paper.
Once the angst plays out Alt-A will probably be affected also but probably not as much a B-paper.
As for housing values I believe that we are looking at several years slightly lower to flat values (on a nationwide average) and in the long run that is healthy. The increase in values in the past few years produced more supply and the market is better balanced. Getting speculation out of the market is also healthy and relates to what I said about derivatives affecting commodity prices. With housing it is not hedge funds but individuals who helped push value too high with speculation.
The good news is that first time homebuyers will get lower prices.
Dick Lepre