Who will be left holding the bag as subprime mortgages go bad?
By Dave Mulcahey July 17, 2007
NOW THAT THE real estate bubble seems poised to go the way of its dot-com predecessor, a new narrative has taken hold in the business press. Where once reporters breathlessly touted double-digit, year-on-year gains in home prices, they now warn darkly of the "meltdown" underway in the class of exotic mortgages that added so much punch to the party.
After months of dismal reports for the real estate industry--declining sales, rising inventories, softening prices, rising foreclosure rates--the news took a sharp turn for the worse in late June, when the investment bank Bear Stearns shut down two hedge funds whose holdings were laden with securities backed by subprime mortgages.
Suddenly, finance pundits and insiders were speculating about just how far the damage of bad subprime loans would spread. Could it be "contained"? Were more hedge funds on the verge of implosion? Was the debacle about to touch off a system-wide credit crunch?
Meanwhile, a bemused public was wondering what the rarefied world of hedge funds had to do a bunch of poor suckers who had bought more house than they could afford. How many of these loans could there be--and how many defaults--that a Wall Street powerhouse like Bear Stearns was taking it on the chops? And what's the story behind all these subprime loans, anyway? Whose idea was all that funky lending?
The insiders' questions have yet to be answered. But for financial naifs, the Bear Stearns imbroglio was highly instructive. It briefly pulled back the curtain to reveal the machinations behind the mountain of mortgage debt the American peasantry has piled up during the great housing bubble. Subprime lending in the United States rose from $35 billion annually in 1994 to $625 billion in 2005. A shocking proportion of this financing was extended on the flimsiest pretenses of due diligence by lenders, and carried terms and conditions sure to ruin a large number of borrowers. According to Fannie Mae, between $1.1 and $2.2 trillion in adjustable-rate mortgages will reset to higher rates in 2007. Another $1.4 to $2.4 trillion will reset in 2008--half of it subprime and another quarter less than prime. It's difficult to see how that will end well. Yet for a while, the bubble seemed like some millennial, never-ending win-win scenario.
By now it should be apparent to most Americans that we're beyond the George Bailey model of mortgage lending, in which banks and other mortgage lenders hold on to the loans they write. Most mortgage paper nowadays is instantly sold, and the buyers are the big Wall Street investment banks, which repackage it as mortgage-backed securities and various "structured finance" products (such as the gizmo that got Bear Stearns into trouble, the "collateralized debt obligation" or CDO). The point of "securitizing" home loans is easy enough to understand: It takes an illiquid obligation--Joe Doaks' mortgage--and, by pooling it with similar debt, transforms it into a fungible, liquid security that can be rated for creditworthiness and sold to institutional investors.
Many institutional investors, such as pension funds, mutual funds, insurance companies and so forth, are restricted from buying debt unless it's investment-grade--that is, debt with a rating of BBB or better (the rating expresses default risk, not value). And here is where the genius of structured-finance products like CDOs comes into play. These securities can pool quite unsavory debt--subprime mortgages, for example--and repackage it in ways so that at least some of it will be suitable for the more choosy investors mentioned above.
They do this by dividing the pool into segments, called tranches. The senior tranche might carry the highest rating (AAA), while the "mezzanine" tranche carries AA to BBB. The lowest segment, the so-called equity tranche, is typically unrated. Again, the entire pool might be made up of shaky loans -- downright dodgy ones, in fact -- but the senior tranche may still merit the AAA rating because it always claims priority of payment. It gets the first dollar of cash flow, while the lowest tranche takes the first dollar of loss. Because most borrowers--even subprime ones--pay their mortgages, money managers can buy AAA tranches with a relative degree of confidence.
Theoretically, that is. But more about that in a moment.
The other great thing about CDOs was that they typically carried higher yields than similarly rated bonds and other securities. Investors, not surprisingly, developed quite an appetite for them--so much so that mortgage brokers could not write mortgage loans fast enough. Future historians inquiring into the strange phenomenon of the stated-income (or "liar") loan should begin by looking here.
But what about the risk? Didn't anybody think about the risk?
In a word, no. Chalk it up to the bubble sweet spot--excellent economic conditions, plus cheap and plentiful credit. Under classic bubble conditions, so-called "risk premium"--i.e., the return investors expect for putting their capital at risk--tends to dwindle. Investments can't seem to go wrong, money's easy to borrow, confidence is high, so investors willingly take on more risk in their portfolios for less reward.
But with CDOs, a great deal of risk appears to have been hidden from view. For example, questions have been raised about the accuracy of their ratings. Moody's, Standard and Poor's and the other agencies that traditionally have made their money charging debt issuers a fee for rating their bonds, decided a few years ago to--how to put it?--change their business model. They started to work much more closely with the Wall Street firms in creating these wonderful new securities, to the point where they were for all intents and purposes part of an underwriting team. They were paid accordingly. Net income at Moody's, to cite one example, increased from $159 million in 2000 to $705 million in 2006, according to Fortune, thanks largely to their forays into structured finance.
Things get pretty murky from an ethical standpoint when a credit-rating company has such an obvious financial interest in the creditworthiness of the securities it's rating. That conflict of interest came into high relief as the Bear Stearns crisis unwound. "Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans," reported Bloomberg shortly after bad hedge trades got one of the Bear funds in trouble,
As was widely reported, creditors of the Bear Stearns High-Grade Structured Credit Fund seized $800 million of the fund's collateral and began auctioning it off. But Bear management pledged $3.2 billion of the firm's capital to stop the auction when it became clear that those securities were likely to sell at a hefty discount. In other words, a fire sale on AAA-rated, subprime-backed CDOs was not going to be good for business going forward, as the securities ratings would certainly come under suspcision.
"Downgrades by S&P, Moody's and Fitch," Bloomberg explained, "would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets." CDO business would dry up, possibly causing mortgage lending to contract, creating more havoc in the housing market. The virtuous circle that created the bubble might then be reversed, leading to more defaults and still lower real estate prices.
If subprime-backed securities do indeed "melt down," who will be covered in goo? Right now, that's anybody's guess. Some speculate that hedge funds are hugely freighted with toxic subprime waste, and that a rolling implosion is in the offing. Others point out that any pain will be spread generally throughout the financial sector, including to insurance companies, pension funds, even boring old mutual funds. A credit crunch is possible, which in turn raises the specter of recession (or, for those who argue a recession has already started, tight credit could deepen its severity). At that point, consequences for consumer spending, for the stock market and for the dollar would be anybody's guess.
On the other hand, holders of subprime debt may just muddle through. CDOs, for example, are not very liquid, nor is it easy to assess their risk. But those who can afford to hold onto them--at least the higher-rated tranches--could emerge almost whole. The lesson of this recent brush with mortality is that we now live in a world where liquidity can go away. All that stupid money can vaporize, and we won't even know what caused it.
Hopefully, the unfortunate events at Bear Stearns will add a new wrinkle to the journalistic morality tale about subprime lending. For months we've been treated to all manner of scoundrels and fools. Greedy, dissembling lenders preying on the ignorance of poor homeowners. Greedy, dissembling borrowers who tried to ride the boom for too long. Feckless suckers who can't look out for their own good. Choose your favorite narrative--they're all true!
But now it may be time to examine how the promise of the bubble turned into its opposite. The greatest boom in property values since record-keeping began has produced a population more in debt, and with less equity, than before it all got going. Alan Greenspan and other puffers of the late bubble hasten to point out that the mortgage industry's liberality with subprime borrowers extended the American dream to a class of people who otherwise would have been shut out. That's true enough, anecdotally. It has also converted a huge amount of unsecured household debt into secured debt--not a good place to be if the family finances go pear-shaped.
The bubble has driven people in desperation to chase spiraling home prices with stagnant wages. And those lucky enough--or foolish enough--to have stretched their finances to the breaking point now face the real possibility of being trapped in an upside-down mortgage.
Maybe the American middle class faces an indefinite future of being strapped, waiting for inflation to ease their burden. That's a best-case scenario, and it's not very good. I'm not so sanguine. A reckoning is on its way. And there's an old saw on Wall Street that, in times of panic, money returns to its rightful owners. Let's not have any delusions as to who that might be.