C
Cardano
Member
I found this on a financial forum - authored by someone called Mike Holmes. It is a very witty and thorough analysis of the state of the American mortgage market. I don't necessarily agree with all of it, but the sentiment is clearly right -
In a manner of speaking. The way modern mortgage finance works is:
Algie borrows from Bertie the lender/broker/bank.
Bertie sells the loan (or technically the income stream arising from the
loan) to Clarence.
Clarence collects 1000 mortgages and turns them into an asset backed
bond (mortgage-back) which makes a monthly payment which is the
aggregate of the mortgages in it. Clarence may insure this against
default (with credit default swaps); against interest variance (interest
rate swaps); or against currency risk (currency swaps). One of the
problems to note in this market is that mortgage-backs tend to have
individualised contracts (see later).
Clarence sells his package to Daniel who collects a whole bunch of
mortgage-backs. These get a credit rating from one of the agencies who
rate how likely a bond is to go into default or credit-imapirment.
Usually the rating will be below best (best is AAA in the jargon).
However Daniel wants to sell AAA bonds because they fetch a good price
and are rated highly enough to be held in pension funds etc. Daniel
needs to turn mortgage-backs rated only B into AAA assets.
To manage this alchemy Daniel takes his bunch of mortgage-backs and
makes a CDO (Collateralised Debt Obligation). He splits the CDO into
tranches. Contracts are set up so that the first defaults hit only the
bottom tranche ("toxic waste" in the lingo), then the next up
("mezzanine") and then the rest ("equity"). So most of the risk is piled
on the very bottom tranceh, some on the rest, ad the top tranche only
gets hit when all the others have been wiped out. These tranches are then
rerated with the equity tranches hopefully this time getting a AAA rating.
These then get sold to Eddie the Hedge Fund Manager. Eddie obviously
prices his bids such that he gets much more interest if he takes on
mezzanine or toxic waste bonds. Often enough though these will be hard
to sell at a good price and Daniel will just hold them on his own
books.
Eddie typically gets a billion or so of his subscribers money and then
borrows nine billion on the back of that from an investment bank so that
he can buy loads and loads of CDOs and lever up his profits (and his
annual bonus).
Of course the flip side is that if these somehow drop in price by 10%
then the net investment of his clients goes to zero. An 11% drop means
the bank is then losing its money. If that happens though, Eddie will
wind up the fund and start another one where he'll do the same. In a
good year Eddie's fund gets 20% of multi-billion rises and in a bad year
zilch. For Eddie, the good years generally cover the bad ones enough to
keep him in yachts made of caviar.
Part of what Eddie is holding is the risk of the CDO going into default
and he's effectively being paid for that in interest. If however he
doesn't want to hold that risk then he can transfer risk portion to Freddie
the Insurance Guy. Freddie is in the business of rating risks and
taking a premium to insure derivatives against default.
Freddie now has an income stream coming in from insuring the CDO.
That's just the sort of stream that an asset-backed bond can be made out
of. Freddie takes a bunch of these, splits them into tranches as with
the CDO and then sells these on to Gary the derivatives trader. These
are "synthetic CDOs". This one's a "CDO Squared" but there are CDO
Cubed derivatives as well which have been round the lather, rinse,
repeat cycle one more time.
So far, so straightforward (OK I simplified). So what's gone wrong?
Well, the trouble with all these CDOs is that nobody really knows what
they're worth. There are some lovely equations that will tell anyone
who wants to know (just as there were telling the PhD's and Nobel
prizewinners at LCTM that if they held out long enough, the market would
conform to their theories) exactly how to value them. These values were
all priced as "held to redemption" which means based on the idea that
they'd pay their interest on time every month and then return the
capital value when they expired.
This seemed a pretty good bet because so few people would default on the
mortgages on which the whole edifice was based. After all, prices
hadn't fallen in the US since The Great Depression in the 1930's
(technically The Great Depression II since the 1880's depression was
also accorded that title). Thus anyone in trouble with the mortgage
could just sell the house, pocket the profits and pay any outstanding
mortgage arrears out of those.
It was such a good bet in fact that ever more money was thrown at it.
The Japanese have generally found themselves with an embarassment of
savings and their own banks had an interest rate of zero. This was as a
result of Japanese house prices falling by 50% through 90% between 1989
and now as a result of an awfully similar setup in Japan in the 1980's.
But everyone figured that lightning doesn't strike twice, and a six
percent return looks pretty damn good when the alternative is zero, even
if deflation is automatically hiking the value of cash under the mattress.
Then there's the Chinese. Their currency is low against the Dollar and
they make most of the stuff consumed in the US because a low
currency, plus low wages, makes stuff cheap. So the yanks raise as much
cash as possible to buy Chinese goods. They raise this by remortgaging
the house to "realise" the money they've made by their houses rising in
price. This of course also creates a whole bunch more mortgage-backs and
CDOs. The US then gets a trade deficit of 6% of GDP (a size which
killed Argentina) and the only thing the yanks export to China is
Dollars to pay for it all.
So what's your average Huan to do with a few trillion Dollars? If he keeps
them under the mattress he'll need a spacesuit to sleep. So he sticks it
into the banking system and it all ends up in Jim-Bob's hand when he
remortgages and uses the loot to buy more Chinese made plasma screens.
All this leveraged cash being bid on housing (nobody ever bid rationally
when they were bidding with someone else's money) guaranteed that [rices
would rise, thus closing the loop.
That then is the nice little virtuous circle of money that's been running
the world economy pretty much since the bonds crash of '94.
Remember that part where the pricing was predicated on "held to
redemption"? Well, that there's one of the flies in the ointment.
The warnings were there in 1994 when Countrywide (big big US mortgage
guys) saw the mortgage defaults climbing on their mobile homes unit.
In that business though, the way to deal with defaults is to grow the
business faster than the rate of defaults is rising, that way the
percentage of overall business which comprises the defaults will fall,
and that will keep the creditors and the shareholders happy.
Surrendering business to competitors by being more careful with loans is
not the way you get to be, or stay, Numero Uno
Lather, rinse, repeat across the entire business and everyone is trying
to expand their loans book. After all, it's not like they're on the
hook for the loans. They make 'em, sell 'em on and with the money from
the sale they can make new loans. They get a sparkly fee on every one
and they get income for servicing them every month too. There are no
prizes for being too careful. It's what's called "perverse incentive"
amongst folks paid to be less than credulous about the wonders of
markets.
Thing is that when around two thirds of folks already own homes, the
other third are pretty much deadbeats who can't even keep their car
loans or credit cards current. Still, if they're the market then they
gotta be sold more loans. What's interesting is that these guys also have
their own perverse incentives.
Let's say you start with zilch. You can get a 100% loan on asset A.
Every year asset A appreciates by 10%. You do this and after a year
you've made 10% of the value of asset A from nothing. After ten years
you've made 100% of the value of asset A (more if you include
compounding). There are only two catches. One is that every 90 years
asset A goes down by maybe 90%. The other is that you have to be able to
service the loan.
On catch one. If you start with zilch and you hit the bad year, you go
bankrupt and end up back where you started. If you hit any of the good
years, which is much more likely, then you're in the money. It's a
no-brainer: having nothing to lose is a positive asset on that bet.
On catch two. That's where the creative business comes in. The lender
will offer a 2-28 loan. The first two years will be discount years.
You might only have to pay the interest but no capital. You might not
even have to pay all the interest (a "negative amortisation" or "neg-am"
mortgage). They'll roll it up into the capital. Sure, you'll have to
pay the normal subprime rate (2 to 3 percent above that of a normal
monrtage) plus capital repayments (remember that rolling up part?) but
by then house prices will have risen 20% so you can remortgage with 20%
down and get a prime mortgage. Sorted!
In fact, a better plan would be to buy a house bigger than you want or
can afford and then at the two year mark sell and buy the one you do
want. That way you maximise your profits. Sure, you can't afford the
full payments on it, but this way you'll never actaully have to make
them see? Of course your income statement needs to show that you can,
but this is a "no-doc" loan where you don't have to prove it and we will
never check. If you tell me you earn twice as much as you really do,
I'm obliged to believe you. Sign here, and here....
So the bankers have the incentive to make loans without regard for
whether the borrowers can pay and the borrowers have the incentive to
take loans regardless of whether they can pay. The bondholders, square,
cube, or dododecahedral meanwhile have everything priced for perfection
and keep on shovelling cash into the maw of the beast.
So everyone ignores the mobile homes ructions and buries them in a slew
of new loans. The trouble starts when some folks start going into the
28 part of the 2-28 and some others who have never been able to make two
months of payment in a row on a car loan are running into trouble on the
third month of their home payment. Some folks never even make anything
but the first payment they made when they signed the forms and just live
rent-free until the courts run out of patience. Meanwhile the Mafia
have noted the "we don't check" part of things and are taking mortgages
on houses that don't even exist (we don't even check that!) and
vanishing with the cash.
So subprime mortgage defaults ratchet higher and higher. Some of the
more creative lenders see defaults nearing 20%, though 5% and climbing
is around average.
A finance house called Bear Stearns runs two hedge funds which play the
CDO markets. They're borrowing in one case ten and the other five times
the cash their investors put up. As noted above, the market doesn't have
to drop so far to run the value to zero. Their bankers notice these
subprime defaults and a little lightbulb goes off in some worrywart's
head and he gets on the phone to ask for more deposit or call in some
loans.
The price of CDOs based on subprime have been falling and these hedgies
have some problems repaying just at the moment. They ask for help. The
other houses, remembering that Bear Stearns were the guys who refused to
help bail out LTCM when it looked like global finance was about to
collapse, decide to give 'em some of their own medicine and refuse.
The hedgies have to quickly raise cash to repay the bank. They decide
to sell some CDOs on the open market. The first lot go at 80% of value
and the mood quickly sours. By the time bids are down to 30% of alleged
value, the other funds figure that if stuff actually sells at that and
the price gets recorded, they'll have to mark their own assets down so
far that they'll be in trouble too. They get the auction called off
by promises to help the hedgies in trouble. Sooner or later though
investors in one fund are told they'll get nothing and the others will
get pennies on their billions.
Over the next month everyone else starts to take note and worry about
what's on their own books. Bondholders quit buying subprime CDOs,
mortgage-backs or indeed anything to do with them and sell whenever they
can actually get a bid.
Subprime banks can't resell their mortgages due to this. If they can't
resell, they can't make more. The subprime market grinds to a halt. If
you can't make new mortgages, not only can't you earn fees but you can't
keep drowning the defaults in an ever-expanding business. With no new
business, every default increases their percentage. This looks bad to
bankers and investors. They want their money back.
There's worse to come. All those mortgage-backs are individual
contracts. Many say that if 6 months of payments aren't made on time,
they can be sold back to the bank at the original price. Bad loans
start piling in. Mortgage banks, some of them big ones, start going
bankrupt. A hedge fund and a mortgage bank a day go bankrupt, some in
Australia, France and Germany. Financial contagion starts.
Folks then start to worry about Alt-A mortgages. They're not subprime.
Typically they're second mortgages of prime borrowers who took out
another loan to borrow the 20% deposit. Defaults are climbing on those
too. The Alt-A markets start to shut down.
Then there's the jumbo loans. Big loans made on big houses to folks who
are prime borrowers. These start to look dodgy and things grind down
there too. By now 60% or so of the mortgage markets in the US are having
difficulty making loans.
Demand for houses has been dropping leading to a mismatch between
sellers and buyers and now most buyers may not be able to get credit.
Folks know that this will ratchet down prices yet more. With 4 million
homes about to hit the 28 part of the 2-28 in the next 18 months, this
means that a bunch of people will be unable to sell out of a foreclosure
(reposession) situation because they're already in negative equity.
This means that defaults will ratchet up yet more and put more
mortgage-backs and CDos into trouble. Conservative estimates based on
this and the current default rate are that foreclosures will easily hit
a rate of 2 million per annum.
Congress tries to organise help for homeowners in trouble through
renegotiating loan terms. However, any individual loan they look for
was packaged with another 999 and sold. Then these were wrapped up with
other packages and sliced and diced and sold again. Then these were
reinsured, packaged and sold, then sliced and diced and sold again. Try
finding your own mortgage in that lot to renegotiate it and then repeat
the trick two million times. Many folks are stuck just trying to find
the guy who owns their mortgage, never mind get a deal. This while
they're on the clock for having their furniture put on the lawn.
Besides, it turns out that a lot of the contracts at some point of the
proceedings specify that loans can't be renegotiated or that only a
small percentage can. The renegotiation effort runs into the sand.
Some of the banks try to organise bailouts of some mortgages that can be
saved. However there's a problem. Remember those credit default swaps
which pay if a bond goes into default? The guys holding the other end of
those deals will make money when things go awry and they've been making
their monthly payments on that basis. They're an essential part of the
mortgage markets. When the banks try to save mortgages, these guys sue
for breach of contract and interference in the markets. It's essentially
insider trading. The banks thus have their hands tied too.
The latest knights in shining armour are being called to the battle.
Fannie Mae and Freddie Mac. These are the twin mortgage supergiants who
insure or own 90% of US prime mortgages. They have 1.4 trillion of
mortgages on their books with capital of about 3% of that (readers
who've been following the bits about leverage will spot the flaw here).
Their markets have not seized up mainly because bondholders figure that
the Federal Reserve (US central bank) will always bail them out if
there's trouble. This ain't written down anywhere, but Fannie and
Freddie get preferential borrowing rates on the back of it, which
explains how they competed to get 90% of their markets.
However Fannie and Freddie have been naughty. They played fast and loose
with their numbers, somewhat like Worldcom and Enron, and lost or hid 15
billion or so between them. Even they don't know because a veritable
army of accountants are still trying to figure out their numbers for the
past few years. The financial cops spanked them by limiting the amount
of mortgages they could speculate in by holding them on their own books.
What they and their friends want now is for them to have the limits
moved or removed so that they can ride in and save the day. Those
who've read my meanderings in the past will know I have had them pegged
as Ground Zero for a future credit crunch. That future is now and the
irony is not at all lost on me. Who knows though? Perhaps taking a
bunch more dodgy mortgages onto their own books will be the straw that
breaks the camel's back
In a manner of speaking. The way modern mortgage finance works is:
Algie borrows from Bertie the lender/broker/bank.
Bertie sells the loan (or technically the income stream arising from the
loan) to Clarence.
Clarence collects 1000 mortgages and turns them into an asset backed
bond (mortgage-back) which makes a monthly payment which is the
aggregate of the mortgages in it. Clarence may insure this against
default (with credit default swaps); against interest variance (interest
rate swaps); or against currency risk (currency swaps). One of the
problems to note in this market is that mortgage-backs tend to have
individualised contracts (see later).
Clarence sells his package to Daniel who collects a whole bunch of
mortgage-backs. These get a credit rating from one of the agencies who
rate how likely a bond is to go into default or credit-imapirment.
Usually the rating will be below best (best is AAA in the jargon).
However Daniel wants to sell AAA bonds because they fetch a good price
and are rated highly enough to be held in pension funds etc. Daniel
needs to turn mortgage-backs rated only B into AAA assets.
To manage this alchemy Daniel takes his bunch of mortgage-backs and
makes a CDO (Collateralised Debt Obligation). He splits the CDO into
tranches. Contracts are set up so that the first defaults hit only the
bottom tranche ("toxic waste" in the lingo), then the next up
("mezzanine") and then the rest ("equity"). So most of the risk is piled
on the very bottom tranceh, some on the rest, ad the top tranche only
gets hit when all the others have been wiped out. These tranches are then
rerated with the equity tranches hopefully this time getting a AAA rating.
These then get sold to Eddie the Hedge Fund Manager. Eddie obviously
prices his bids such that he gets much more interest if he takes on
mezzanine or toxic waste bonds. Often enough though these will be hard
to sell at a good price and Daniel will just hold them on his own
books.
Eddie typically gets a billion or so of his subscribers money and then
borrows nine billion on the back of that from an investment bank so that
he can buy loads and loads of CDOs and lever up his profits (and his
annual bonus).
Of course the flip side is that if these somehow drop in price by 10%
then the net investment of his clients goes to zero. An 11% drop means
the bank is then losing its money. If that happens though, Eddie will
wind up the fund and start another one where he'll do the same. In a
good year Eddie's fund gets 20% of multi-billion rises and in a bad year
zilch. For Eddie, the good years generally cover the bad ones enough to
keep him in yachts made of caviar.
Part of what Eddie is holding is the risk of the CDO going into default
and he's effectively being paid for that in interest. If however he
doesn't want to hold that risk then he can transfer risk portion to Freddie
the Insurance Guy. Freddie is in the business of rating risks and
taking a premium to insure derivatives against default.
Freddie now has an income stream coming in from insuring the CDO.
That's just the sort of stream that an asset-backed bond can be made out
of. Freddie takes a bunch of these, splits them into tranches as with
the CDO and then sells these on to Gary the derivatives trader. These
are "synthetic CDOs". This one's a "CDO Squared" but there are CDO
Cubed derivatives as well which have been round the lather, rinse,
repeat cycle one more time.
So far, so straightforward (OK I simplified). So what's gone wrong?
Well, the trouble with all these CDOs is that nobody really knows what
they're worth. There are some lovely equations that will tell anyone
who wants to know (just as there were telling the PhD's and Nobel
prizewinners at LCTM that if they held out long enough, the market would
conform to their theories) exactly how to value them. These values were
all priced as "held to redemption" which means based on the idea that
they'd pay their interest on time every month and then return the
capital value when they expired.
This seemed a pretty good bet because so few people would default on the
mortgages on which the whole edifice was based. After all, prices
hadn't fallen in the US since The Great Depression in the 1930's
(technically The Great Depression II since the 1880's depression was
also accorded that title). Thus anyone in trouble with the mortgage
could just sell the house, pocket the profits and pay any outstanding
mortgage arrears out of those.
It was such a good bet in fact that ever more money was thrown at it.
The Japanese have generally found themselves with an embarassment of
savings and their own banks had an interest rate of zero. This was as a
result of Japanese house prices falling by 50% through 90% between 1989
and now as a result of an awfully similar setup in Japan in the 1980's.
But everyone figured that lightning doesn't strike twice, and a six
percent return looks pretty damn good when the alternative is zero, even
if deflation is automatically hiking the value of cash under the mattress.
Then there's the Chinese. Their currency is low against the Dollar and
they make most of the stuff consumed in the US because a low
currency, plus low wages, makes stuff cheap. So the yanks raise as much
cash as possible to buy Chinese goods. They raise this by remortgaging
the house to "realise" the money they've made by their houses rising in
price. This of course also creates a whole bunch more mortgage-backs and
CDOs. The US then gets a trade deficit of 6% of GDP (a size which
killed Argentina) and the only thing the yanks export to China is
Dollars to pay for it all.
So what's your average Huan to do with a few trillion Dollars? If he keeps
them under the mattress he'll need a spacesuit to sleep. So he sticks it
into the banking system and it all ends up in Jim-Bob's hand when he
remortgages and uses the loot to buy more Chinese made plasma screens.
All this leveraged cash being bid on housing (nobody ever bid rationally
when they were bidding with someone else's money) guaranteed that [rices
would rise, thus closing the loop.
That then is the nice little virtuous circle of money that's been running
the world economy pretty much since the bonds crash of '94.
Remember that part where the pricing was predicated on "held to
redemption"? Well, that there's one of the flies in the ointment.
The warnings were there in 1994 when Countrywide (big big US mortgage
guys) saw the mortgage defaults climbing on their mobile homes unit.
In that business though, the way to deal with defaults is to grow the
business faster than the rate of defaults is rising, that way the
percentage of overall business which comprises the defaults will fall,
and that will keep the creditors and the shareholders happy.
Surrendering business to competitors by being more careful with loans is
not the way you get to be, or stay, Numero Uno
Lather, rinse, repeat across the entire business and everyone is trying
to expand their loans book. After all, it's not like they're on the
hook for the loans. They make 'em, sell 'em on and with the money from
the sale they can make new loans. They get a sparkly fee on every one
and they get income for servicing them every month too. There are no
prizes for being too careful. It's what's called "perverse incentive"
amongst folks paid to be less than credulous about the wonders of
markets.
Thing is that when around two thirds of folks already own homes, the
other third are pretty much deadbeats who can't even keep their car
loans or credit cards current. Still, if they're the market then they
gotta be sold more loans. What's interesting is that these guys also have
their own perverse incentives.
Let's say you start with zilch. You can get a 100% loan on asset A.
Every year asset A appreciates by 10%. You do this and after a year
you've made 10% of the value of asset A from nothing. After ten years
you've made 100% of the value of asset A (more if you include
compounding). There are only two catches. One is that every 90 years
asset A goes down by maybe 90%. The other is that you have to be able to
service the loan.
On catch one. If you start with zilch and you hit the bad year, you go
bankrupt and end up back where you started. If you hit any of the good
years, which is much more likely, then you're in the money. It's a
no-brainer: having nothing to lose is a positive asset on that bet.
On catch two. That's where the creative business comes in. The lender
will offer a 2-28 loan. The first two years will be discount years.
You might only have to pay the interest but no capital. You might not
even have to pay all the interest (a "negative amortisation" or "neg-am"
mortgage). They'll roll it up into the capital. Sure, you'll have to
pay the normal subprime rate (2 to 3 percent above that of a normal
monrtage) plus capital repayments (remember that rolling up part?) but
by then house prices will have risen 20% so you can remortgage with 20%
down and get a prime mortgage. Sorted!
In fact, a better plan would be to buy a house bigger than you want or
can afford and then at the two year mark sell and buy the one you do
want. That way you maximise your profits. Sure, you can't afford the
full payments on it, but this way you'll never actaully have to make
them see? Of course your income statement needs to show that you can,
but this is a "no-doc" loan where you don't have to prove it and we will
never check. If you tell me you earn twice as much as you really do,
I'm obliged to believe you. Sign here, and here....
So the bankers have the incentive to make loans without regard for
whether the borrowers can pay and the borrowers have the incentive to
take loans regardless of whether they can pay. The bondholders, square,
cube, or dododecahedral meanwhile have everything priced for perfection
and keep on shovelling cash into the maw of the beast.
So everyone ignores the mobile homes ructions and buries them in a slew
of new loans. The trouble starts when some folks start going into the
28 part of the 2-28 and some others who have never been able to make two
months of payment in a row on a car loan are running into trouble on the
third month of their home payment. Some folks never even make anything
but the first payment they made when they signed the forms and just live
rent-free until the courts run out of patience. Meanwhile the Mafia
have noted the "we don't check" part of things and are taking mortgages
on houses that don't even exist (we don't even check that!) and
vanishing with the cash.
So subprime mortgage defaults ratchet higher and higher. Some of the
more creative lenders see defaults nearing 20%, though 5% and climbing
is around average.
A finance house called Bear Stearns runs two hedge funds which play the
CDO markets. They're borrowing in one case ten and the other five times
the cash their investors put up. As noted above, the market doesn't have
to drop so far to run the value to zero. Their bankers notice these
subprime defaults and a little lightbulb goes off in some worrywart's
head and he gets on the phone to ask for more deposit or call in some
loans.
The price of CDOs based on subprime have been falling and these hedgies
have some problems repaying just at the moment. They ask for help. The
other houses, remembering that Bear Stearns were the guys who refused to
help bail out LTCM when it looked like global finance was about to
collapse, decide to give 'em some of their own medicine and refuse.
The hedgies have to quickly raise cash to repay the bank. They decide
to sell some CDOs on the open market. The first lot go at 80% of value
and the mood quickly sours. By the time bids are down to 30% of alleged
value, the other funds figure that if stuff actually sells at that and
the price gets recorded, they'll have to mark their own assets down so
far that they'll be in trouble too. They get the auction called off
by promises to help the hedgies in trouble. Sooner or later though
investors in one fund are told they'll get nothing and the others will
get pennies on their billions.
Over the next month everyone else starts to take note and worry about
what's on their own books. Bondholders quit buying subprime CDOs,
mortgage-backs or indeed anything to do with them and sell whenever they
can actually get a bid.
Subprime banks can't resell their mortgages due to this. If they can't
resell, they can't make more. The subprime market grinds to a halt. If
you can't make new mortgages, not only can't you earn fees but you can't
keep drowning the defaults in an ever-expanding business. With no new
business, every default increases their percentage. This looks bad to
bankers and investors. They want their money back.
There's worse to come. All those mortgage-backs are individual
contracts. Many say that if 6 months of payments aren't made on time,
they can be sold back to the bank at the original price. Bad loans
start piling in. Mortgage banks, some of them big ones, start going
bankrupt. A hedge fund and a mortgage bank a day go bankrupt, some in
Australia, France and Germany. Financial contagion starts.
Folks then start to worry about Alt-A mortgages. They're not subprime.
Typically they're second mortgages of prime borrowers who took out
another loan to borrow the 20% deposit. Defaults are climbing on those
too. The Alt-A markets start to shut down.
Then there's the jumbo loans. Big loans made on big houses to folks who
are prime borrowers. These start to look dodgy and things grind down
there too. By now 60% or so of the mortgage markets in the US are having
difficulty making loans.
Demand for houses has been dropping leading to a mismatch between
sellers and buyers and now most buyers may not be able to get credit.
Folks know that this will ratchet down prices yet more. With 4 million
homes about to hit the 28 part of the 2-28 in the next 18 months, this
means that a bunch of people will be unable to sell out of a foreclosure
(reposession) situation because they're already in negative equity.
This means that defaults will ratchet up yet more and put more
mortgage-backs and CDos into trouble. Conservative estimates based on
this and the current default rate are that foreclosures will easily hit
a rate of 2 million per annum.
Congress tries to organise help for homeowners in trouble through
renegotiating loan terms. However, any individual loan they look for
was packaged with another 999 and sold. Then these were wrapped up with
other packages and sliced and diced and sold again. Then these were
reinsured, packaged and sold, then sliced and diced and sold again. Try
finding your own mortgage in that lot to renegotiate it and then repeat
the trick two million times. Many folks are stuck just trying to find
the guy who owns their mortgage, never mind get a deal. This while
they're on the clock for having their furniture put on the lawn.
Besides, it turns out that a lot of the contracts at some point of the
proceedings specify that loans can't be renegotiated or that only a
small percentage can. The renegotiation effort runs into the sand.
Some of the banks try to organise bailouts of some mortgages that can be
saved. However there's a problem. Remember those credit default swaps
which pay if a bond goes into default? The guys holding the other end of
those deals will make money when things go awry and they've been making
their monthly payments on that basis. They're an essential part of the
mortgage markets. When the banks try to save mortgages, these guys sue
for breach of contract and interference in the markets. It's essentially
insider trading. The banks thus have their hands tied too.
The latest knights in shining armour are being called to the battle.
Fannie Mae and Freddie Mac. These are the twin mortgage supergiants who
insure or own 90% of US prime mortgages. They have 1.4 trillion of
mortgages on their books with capital of about 3% of that (readers
who've been following the bits about leverage will spot the flaw here).
Their markets have not seized up mainly because bondholders figure that
the Federal Reserve (US central bank) will always bail them out if
there's trouble. This ain't written down anywhere, but Fannie and
Freddie get preferential borrowing rates on the back of it, which
explains how they competed to get 90% of their markets.
However Fannie and Freddie have been naughty. They played fast and loose
with their numbers, somewhat like Worldcom and Enron, and lost or hid 15
billion or so between them. Even they don't know because a veritable
army of accountants are still trying to figure out their numbers for the
past few years. The financial cops spanked them by limiting the amount
of mortgages they could speculate in by holding them on their own books.
What they and their friends want now is for them to have the limits
moved or removed so that they can ride in and save the day. Those
who've read my meanderings in the past will know I have had them pegged
as Ground Zero for a future credit crunch. That future is now and the
irony is not at all lost on me. Who knows though? Perhaps taking a
bunch more dodgy mortgages onto their own books will be the straw that
breaks the camel's back