For weeks I have been writing about the mortgage mess and its causes and solutions.
Almost every bit of talk inside the mortgage business is something like "the mortgage business will never again be the same." Assuming that implies that there are a lot of loans which will never again be possible all that I have to say is "hogwash."
We will in less than a year see the return of almost every type of loan. Yes subprime but maybe not quite so liberal as it was. Yes stated jumbo. Yes Alt-A.
Why?
Real simple. In the past 20 years the mortgage securitization business has become sophisticated through the use of derivatives. In short the risk is spread out so that the lenders and ever the holders of mortgage backed securities and having other parties insure their positions.
This has been massively important to the housing industry because without the ability to pass the risk on mortgage debt along banks and S&L's would not have had the ability to make as many real estate loans as they have.
But What Went Wrong?
In short what went wrong with the recent collapse is that defaults were higher than modeled and the folks who were providing the insurance to pools of mortgage backed securities suffered an abrupt change in their perception of risk. The sharp spike in the cost of credit swap insurance contributed largely to the illiquidity of Jumbo mortgages.
The model is there. It is simply the case that in light of what has happened new parameters regarding rates of delinquencies and foreclosures needs to be input. New costs for credit risk insurance will be calculated and the mortgage machine will be running again. What is needed is simply stability in the costs of insuring the risk on Jumbo mortgage pools. It should be noted that it is not that Jumbo mortgages have really experienced higher late payments rates similar to subprime. It is that the subprime thing created this concern. The concern is probably valid but overstated.
In a real sense what we have is not a liquidity crisis per se as in there is no money out there to lend on mortgages. It is a crisis in the perception that the risks were underestimated and the prices of the increased perception of risk need to be factored in.
Some History
The securitization of mortgages into mortgage backed securities is attributed to what Salomon Brothers did for Bank of America starting in the late 1970's and coming to fruition in 1981. The folks who hold mortgage backed securities get others to take the risks associated with default.
But Isn't This, like, Nuts
Warren Buffet once described derivatives as "financial weapons of mass destruction." While I do not often find comfort in disagreeing with Mr. Buffet I will say this: derivatives do provide for a spreading of the risks associated with the issuance of certain type of risky credit. In that sense they create possibilities. The problem is that some derivatives are complex mathematical entities and few people have the math ability to understand them.
Let me back up and try an example. We all know what a stock is. An option is a derivative of the simplest sort. The ability to buy or sell shares of a stock at a certain price at some future date.
It is accepted that the Black-Scoles model mathematically describes the correct price of an option. This is for some folks an intimidating mathematical model. A lot of folks know what is about and option traders who really do not understand the math can nevertheless calculate the price of an option because they have access to a computer which does it for them.
But equity options are small is total size compared to interest rate risk derivatives. The concerns that folks have about derivative is due to 1) the sheer size of the derivatives market and 2) a lack transparency about who is taking these positions and to what extent they are leveraged. In short, is undercapitalized entities are doing this with borrowed money they might not be able to perform and a counterparty (a large dealer bank) may inherit the liability. In that sense the fear is that derivatives could create cascading failures and magnify into an event which threatened the banking system.
The question will be asked after this episode is over if derivatives performed as advertised mitigating the risk to holders of MBS. The best analogy is the LTCM collapse & Russian debt default of 1998. One deleterious effect was that the relationship between mortgage rates and the 10-year Treasury became so loose (it had widened unexpectedly) that would-be hedgers lost both on the derivatives and the underlying asset that the derivatives was designed to protect.
In addition some of the nuances related to hedging have solely to do with accounting and accounting standards. To some extent this reflects the idea that some of these are relatively new and FASB (Financial Accounting Standards Board) may need to rethink the rules regarding the accounting of derivatives held by banks. I caution here that I am at the edge of my own understanding regarding this and this paragraph should be regarded as speculative.
The recent mortgage mess can be viewed as having been cause by a dramatic increase in the cost of credit default swaps. Lack of stability in the cost of credit default swaps meant that fewer entities were willing to buy mortgage backed securities and that is what caused the mortgage liquidity problem.
Stabilization in the cost of credit default swaps will result from a better understanding of what the real risk with, say, jumbo stated mortgages are. My own notion is that this is solvable entirely by increasing the cost (points) or rate for jumbo stated. I have been suggesting a 0.625% increase in rate for Jumbo stated. I think that is more than sufficient to cover any increased cost in credit swaps.
In short everything will likely return to the way it was before with two exceptions: 1) subprime will be more restrictive and 2) the adds for Jumbo stated will be larger.
Dick Lepre
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