Sunday, November 02, 2008 Making sense of the meltdown By Romeo R. Briones Contributor
(First of 2 parts)
RECORD number of Americans lose homes.Bear Stearns hedge funds go belly up. Global financial institutions, pension plans suffer huge losses from US mortgage investments. Credit markets freeze, start to hurt Main Street. Global shares plunge to record lows. US lawmakers pass $700-billion bailout package for ailing banks.
These are just some of the headlines that have screamed at the public since July 2007, when reports of Bear Stearns’ troubles with its mortgage-backed securities (MBS) portfolio first surfaced.
What does all this disturbing news mean? Should we Cebuanos be worried? This commentary aims to answer both questions.
Backdrop to the Crisis
Let’s go back to the early part of this decade. A sustained low-interest policy of the US Government during this period led to heightened lending and lots of liquidity, i.e., too much money floating around. People reacted to the easy credit environment by loading up on personal debt such as home mortgages, new car loans and credit card purchases.
There was also the lingering large US trade deficit fuelled by the insatiable appetite of Americans for imports. This made the US pump dollars continuously to exporting countries such as China, Japan, South Korea, Taiwan, Singapore and the Arab Gulf States. All those dollars out there have to be invested somewhere somehow.
Professional money managers entrusted with deploying this huge pool of dollars placed them in stocks and bonds of developed and emerging markets, money market funds, hedge funds, private equity and in exotic products such as collateralized debt obligations (CDOs) and structured investment vehicles (SIVs). The bulk of the money found their way back to the US since it continued to be regarded not only as a vibrant economy but a safe one as well.
Coinciding with this rush of liquidity was a general acceptance that the global economy was growing at a much stable rate than in the past. The ups and downs in the economy were moderating—a phenomenon some termed “The Great Moderation.”Others described the absence of violent swings in the business cycle as the “Goldilocks” economy, not too hot and not too cold. This view fostered widespread optimism accompanied by a lax attitude towards risk.
These two elements—a liquidity surplus and a benign perception of risk—were very much evident when the US housing boom started in early 2004 and contributed much to the eventual meltdown of the housing market and the ensuing global financial crisis.
The US Residential
Mortgage Market
The roots of the current global financial crisis lie within the American home mortgage market, specifically its sub-prime sector. The US mortgage market is very much unlike the Philippine.
Here in the Philippines, the risk of non-repayment of the loan almost always remains with the original provider. In the US, that risk leaves the primary lender and it is
then sliced, diced and distributed to investors all over the map in very complicated and arcane ways.
Securitization enables this widespread transfer of the risk of non-repayment.It starts when a bank or financial institution makes a mortgage loan to a borrower to finance (or refinance) the purchase of a home or other property.
These loans are granted to the borrower under varying terms, e.g., 15-year, 30-year, fixed or adjustable rate, etc. During the life of the loan, the balance is amortized until paid off.
The borrower usually repays the loan in monthly installments that include both principal and interest. Because mortgage loans may take years to pay off, lenders must find ways to replenish their funds to make more mortgage loans in their communities.To do this, lenders sell groups of mortgages with similar characteristics into the secondary mortgage market to issuers of mortgage securities—Federal Housing Administration (“Fannie Mae”), Federal Home Loan Mortgage Corp. (“Freddie Mac”), Government National Mortgage Association (“Ginnie Mae”), commercial and investment banks.
These institutions then pool qualified loans together and convert these packages into securities known as mortgage-backed securities.As the borrowers whose loans are in the pool make their loan payments, the money is distributed on a pro rata basis to the investors who hold the securities.
The mortgage-backed securities are then distributed through the dealer network just like any bond or fixed-income security.The MBS market valued at some $12 trillion comprises a big chunk of the US bond market.Through the magic of financial engineering, the MBS are repackaged into new pools many times over to cover a wider swathe of buyers.
For instance, bank-sponsored conduits use them as collateral to sell commercial paper debt to investors, mainly, money market funds. Banks also set up independent structured investment vehicles and collateralized debt obligations and sell different bond classes to investors worldwide. The funds gathered by these vehicles are then invested in relatively higher-yielding assets, primarily in mortgage-backed securities.
This securitization process provides two significant insights. Firstly, the primary mortgage provider ends up holding no risk, thereby gaining no incentive to apply strict lending policies while the MBS investor is so far removed from the homeowner/borrower that he is unable to assess his risk directly and has to rely on ratings from credit agencies.
Secondly, through the wonders of modern financial technology and through the globalization of financial markets, a mortgage loan given in Palmdale, California could end up in the investment portfolio of a Frankfurt bank, enabling local events in the US to impact the fortunes of investors worldwide. The California borrower’s failure to pay his mortgage means the Frankfurt bank has to book a loss, not his Palmdale bank.
Finally, because of their relatively higher yield, MBS in their pure form and in all their complex permutations constitute significant slices of financial firms’ and institutional investors’ assets throughout the globe.
The Meltdown
Aggressive lending by banks and other financial institutions greeted the year 2004. Urged on by low interest rates and large fees, mortgage lenders started to give loans to people who otherwise would not have qualified. These borrowers had bad credit scores or had problems making payments on other kinds of credit, such as credit card debt.
To mitigate the ensuing risk, the lenders required larger down payments.
However, by the end of 2005 and into 2006, mortgage lenders threw all caution to the wind.
“Subprime mortgages” became the flavor of the period. These were mortgages given to borrowers who not only had lousy credit histories but also failed to show satisfactory evidence of their assets and their capacity to repay. In some cases, lenders did not even bother to verify applicants’ assets and repayment capacity.
In addition, borrowers had little or no equity at all.
Some industry observers mischievously called subprime mortgages “Ninja” loans or loans to persons with “no income, no job and no assets.”Why would otherwise prudent lenders grant subprime mortgages? The answer is “ever-rising house prices.”
Most of these lenders have only seen prices of homes going up during their careers and never thought that the housing boom would ever end. They were banking that in a short time, the subprime borrowers could sell their houses or refinance their loans under normal terms.
Many of these subprime loans were adjustable rate mortgages (ARMs), which carried low initial teaser interest rates that got higher in time.
The 2/28 and the 3/27 mortgages, which both have 30-year maturities, are fine examples.In the 2/28 loan, the borrower pays a low and very affordable interest rate during the first two years and pays a market-based rate starting the third year and each year thereafter until maturity. In the 3/27 mortgage, the borrower begins to pay the market rate on the fourth year. Market rates are set by adding a fixed margin to an underlying rate such as the yield on one-year US Treasury bills.
Steep hikes
ARMs are fine for so long as interest rates are declining or leveling off. Once rates rise, however, the borrower suffers from larger monthly repayments. For instance, between 2003 and early 2007, one-year treasury rates jumped to about five percent from just over 1.25 percent.
As a result, ARM borrowers faced steep hikes in their monthly payments as prevailing interest rates rose.
Most subprime borrowers who would have found it hard to service their loans even under normal times immediately buckled under and went into default. Surprisingly, even several prime borrowers, i.e. creditworthy debtors, also defaulted on their monthly repayments.
These were the ones, for example, who would have easily qualified for a 30-year fixed mortgage on a $300,000 house well within their repayment capacity but instead were tempted to take out an adjustable rate mortgage (with a low interest rate and affordable monthly amortizations during the first two to three years) in order to buy a much larger and more beautiful house for $450,000.
Foreclosures mounted, adding more houses to the existing supply and further depressing home prices. Large home construction companies stopped expansion plans and went into reverse mode.
On the other hand, defaults piled up in a dizzying fashion and things in the MBS market and in the associated structured finance sector (collateralized debt obligations, structured investment vehicles and asset-backed commercial paper conduits) unraveled at a pace that shocked even the industry experts.
Bondholders lost bundles as a result.
Banks and other financial institutions ended up with severely depleted capital resources as they absorbed write-down after write-down on their MBS-related investments.
(To be continued tomorrow: What the ‘R’ word means for Cebu)
(Romeo R. Briones is a retired investment banker and worked at the Saudi Industrial Development Fund in Riyadh and at the Kuwait-based Gulf Investment Corp. [GIC] for 25 years.In his last position as head of alternative investments with GIC, he managed the firm’s $1.4-billion portfolio of structured investment vehicles, hedge funds, MBS, CDOs and private equity funds. Mr. Briones has a postgraduate degree in Finance from the University of London and earned his BSBA in Accountancy from UP-Diliman. He also holds a CPA certificate.)
