“I do think the unwind is just starting. The moment of truth is not yet here.” Charles Peabody of Portales and Partners.
The front page of the New York Times on Sunday 11 March, reports on declining investments, and lax regulation in the wobbly subprime market. It reveals the extent to which the very nature of mortgage securities has changed, as Wall Street has been swallowing up mortgage companies, trading securities in a manner reminiscent of the technology bubble, are now beginning to feel the pinch. It also presses home how rating companies are only delaying the inevitable by stubbornly refusing to downgrade ratings. Only stable or increased home values can hold in check the increase in defaults, and apparently, we only have to wait until the Spring to find out which way the cookie crumbles. Nothing really new here I guess, but following Greenspan’s comments recently perhaps we should notch up the seriousness with which we view the impending problems ahead, to alert “orange”.
Below is a paraphrased and abridged version of the article:
If spring home prices do not appreciate or fall, defaults will rise, and there will be record losses in pension funds and other other areas exposed to residential mortgage-backed securities. Decreased funding for these securities, could spark a decline in credit availability and substantially hurt the US economy.
Bear Stearns wrote an upbeat report on New Century Financial, a lender to the ‘cash poor’, whose shares had lost half their value in three weeks, and needed emergency funding to survive. Failure to identify such problems was symptomatic of the technology stock bubble burst, as was the issuing of questionable securities, with upbeat sales pitches and lax standards and regulation.
The magnitude is worrying since it involves $6.5 trillion mortgage securities market, which is larger than the US treasury market. Hanging in the balance is the housing market, that has been driving the economy.
More than two dozen mortgage lenders have closed their doors, and shares of big companies declined significantly. Delinquency on subprime mortgages has reached 12.6%. Many Wall Street firms have seen their stocks decline, and many are surprised at how fast the downward trend is unravelling, though some say the mortgage industry is not collapsing. Home sales are now expected to be weaker than many thought two months ago, and is going to be ‘unpleasant’ in those areas where it looked like things were stabilizing.
Investors are going to learn that how easy is has been to prop up mortgage securities values, as it is only when they are downgraded, that they have to reflect market prices. Many have therefore been overstating their values.
Subprime remains at the heart of the problem. 35% of all mortgages issued last year are in that category (13% 2003). Also, willingness to lend has increased the amount borrowed over and above the property value by as much as 82% in 2006 (48% 2000). Lax lending criteria was led to 90% of borrowers to overstate their income by +5%, and 60% of borrowers overstated their income by +50%. These “liar loans” account for 40% of the Subprime market.
Since 2002, pension funds and insurance companies have been voracious in their appetite for home mortgage backed securities. Wall Street now dominates this market with a 60% share. The profits from the practices of big firms buying mortgages, pooling them to spread the risk, and then selling them, has been very large. It has become less a ‘buy-and-hold’, and more of a trading market. Fannie Mae et al traded on a daily basis, more than $250 billion in 2006 ($60 billion 2000). Large companies (UBS, Merrill Lynch etc) that have been buying up the mortgage companies, are now starting to show large losses.
Lax standards has invited fraud, but nobody knows to what extent this has happened yet.
20% of BBB rated bonds backed by subprime mortgages in 2006 are expected to be downgraded. However, rating agencies are sticking to their guns and say their ratings reflect the market, and are more confident that loans will perform better than some think. However, some believe rating agencies fear a downgrade on securities will lead to a stampede. Below investment grade securities would lead to a wholesale shedding by insurance companies. Some say Moody’s depends on revenue from the subprime market, and may therefore be biased towards an optimistic outlook.
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