Mortgage Risk - Part 1 & 2

This is the first section of a four-part article in which I will talk about what is happening in the credit markets. I think it is important for homeowners to have an understanding of the mortgage system because it significantly impacts their lives. Ultimately, these markets are driven by risk or, more to the point, the avoidance of risk.

“Risk” in this sense is the possibility of loss. To investors, U.S. Government obligations are risk-free. There is no question about getting your money back plus interest. All other investments carry more risk. The principal on corporate bonds or periodic interest payments might not be paid when due. Investments in stocks have historically returned over 10% per year for long periods of time, but this return doesn't happen every year and individual stocks can and will lose value or, sometimes, get wiped out entirely. That's risk too.

Theoretically, when anyone makes an investment, whether by putting money into a CD or buying a mutual fund, the investment decision should always come after a consideration of the risks and the rewards. This is true for you as you invest for your retirement and it's true for investment professionals who are responsible for investing millions and sometimes billions of other people's money.

When something goes wrong, it's almost always a matter of human error when calculating the risk side of the equation. That was true of all of us who bought dot-com stocks that later went into a free fall.

This principle of human fallibility is also true today as the financial markets reel due to the actions of some supposedly very smart people who made some very dumb risk assessments. When it comes to investment professionals, you can safely say that those guys are paid to make those decisions. When they make a mistake, there are always consequences. Usually, but not always, risks are factored into the equation, but not necessarily correctly. That's the rub.

Pension planners that are looking for higher yields may be interested in 8% on mortgage-backed securities, for example. They would, or should, be fully aware that there are going to be losses. They should be prepared to take that risk instead of sticking with the less risky 4% yield on T-Bills. That's their business.

But here is the other factor: FEAR.
 
In this instance, fear is an emotional response to a consideration of the possibility that a risk might well be larger than what was anticipated. It's okay to think that instead of getting an 8% return, you might only get 7%. You can live with that. It gets dicey when someone calls to tell you that you might get no interest and only get back 50% of your money, or maybe none at all. And that's what is happening in the financial markets as of mid-summer 2007.

What has happened is that no one is currently able to assess what the risk is in the sub-prime mortgage market. I'm actually going to be a little blunter and call them what I think they should have been called all along: junk mortgages.

A normal market consists of buyers and sellers making their investment decisions and then executing them. But today, no one can properly assess the risks in the junk mortgage market. There are just too many unknowns. 

Let's assume that some fund owns, say, $1 billion of junk mortgages. Let's say that the company that manages the loans tells them that 15% of the borrowers are behind in their payments. That triggers some more calculations like:

1. How many are going to foreclosure?
2. What are the homes worth relative to the mortgage balance?
3. Can we help some borrowers if we cut them some slack?
4. What losses are we likely to suffer if we foreclose?

Of course, there are no immediate answers to any of these questions. They will all be revealed in time, but today you can't tell. So you have this great uncertainty, which leads to a reassessment of risk, which leads to fear that it might get worse.

When this happens, there are no buyers! They all just head for the sidelines out of fear. They cannot assess risk and they don't NEED to buy. If someone NEEDS to sell, he may well be offered 30 cents on the dollar for something that really is worth 85 cents. That lack of buyers is called a liquidity crisis and that's exactly what is happening.

One additional factor makes the situation even worse: Banks. We know that somewhere along the line, banks provide liquidity to markets. All lenders that aren't banks themselves have banks that provide funds for their operations. When the banks see risk, they run for the sidelines faster than anyone.

What they did to the junk lenders was to withdraw liquidity. They stopped lending to them and when they did, the lenders couldn't fund any more loans. They had borrowers waiting at the closing table but they weren't going to fund ANYTHING!

That happened in one form or another to more than 100 firms that have ceased or dramatically curtailed operations. For more information on this subject and to see how many were affected, check out the Mortgage Lender Implode-O-Meter at http://ml-implode.com/

This topic is far more complex than this. We'll continue our discussion in Part 2.

Mortgage Risk – Part 2

In the previous segment, I talked about risks in the sub-prime – or “junk” – mortgage market. As foreclosures mount, the inability to ascertain the future values of these loans has led to increased fear -- fear that it could be worse than whatever the last risk assessment report was.

As someone who has been writing about the impending junk mortgage implosion, it is not surprising to see my predictions finally come true. But what has been even worse and even less gratifying is to see how widespread the aftershocks have been, both in the credit markets, understandably, but in the equity markets as well.

The interesting part of this is to try to determine the part that risk plays in this whole situation. If you want to be completely honest about most activities in the financial world, they have to do with identifying risk and laying that risk off on someone else while keeping your profit.

With mortgages, perhaps a mortgage broker like me originates them, but we never own the loans so we cannot be tagged with a potential loss. The companies that fund the loans, whether they are banks or mortgage bankers, take a little risk because every day they are buying commitments to sell the loans they are funding. They sell the loans a few days after they fund them.

The next stop is FannieMae, FreddieMac, or the Wall Street firm that bought the loan. Their job is to assemble the loans into pools and sell participations in those pools to investors. Again, these guys are playing hot potato too, and they want to lay off the risk on someone else as quickly as they can.

A bunch of supposedly smart guys are pricing these pools to accurately reflect the risk. FannieMae loans are underwritten to reliably strict standards and are sold at the lowest yield. They are like the T-Bill of mortgage investments. The foreclosure rate on these loans is usually somewhere in the 1% range, meaning 99% are paid on time. But even if there is a foreclosure, surely most of the loan balance is paid off. That means that the losses are minimal.

That is not the case with the junk loans where the quality of the borrowers is lower and there is less equity to protect the lender. Everyone, in their heart of hearts, knew that the default rate was going to be higher. The only question was how bad it would be. That said, I'm sure that the salesman told investors that they were high quality loans. For example, sub-prime sounds fancy, doesn't it? How much harder would it be to sell the same thing when it has a name like “junk?” 

In order to improve the PERCEPTION of risk, rating services examined the quality of the loans and assigned a quality rating to the mortgage pools. Note that a rating doesn't change the actual risk of owning the loans, just the perception of its risk. My guess is that these guys were as far off-base as the guys who originated the loans. I mean, it is obvious that many, many pools were far riskier than the rating services said they were.

Another aspect of this is that once these loans, or rather the participations in the pools backed by the loans, are packaged and sold, the theory says that the risks are spread so widely that the risk of loss to any one investor is minimal.

Let's talk about final owners. Let's assume that an insurance company needs to invest policy premiums to pay future claims. They invest a portion of their huge portfolio in mortgages, but, importantly, they are long-term investors and are perfectly happy waiting for the loans to pay off at some time in the future and collecting interest payments in the meantime. Sure, there may be some defaults, but that was factored into the price they paid for the investment.

But what happened next was a re-concentration of investments in these pools, an act that increases risk. It's a little different if you are a hedge fund or mutual fund that buys the mortgages for investors. Remember that these mortgages are not liquid. The hedge fund cannot call the borrower and ask him to refinance so you can have your money back. You are stuck with them.

It turns out that as these junk mortgages started heading south, some of the investors called the managers and asked for their money back. But with these pools of illiquid loans, there weren't any buyers and they can't be turned into cash as is the case with a stock fund. When the funds were unable to raise cash, they announced that they would suspend redemptions. Of course, that injects even more fear into the equation.

Even worse, some hedge funds did a lot more than buy junk mortgages. They went out and borrowed money -- a lot of money -- to leverage these funds. This is like what you do when you buy a home. You put down, say, 10% and borrow 90%. If the value goes up 10%, you double your money. But if it goes down 10%, your equity is wiped out.

That's exactly what happened to two such funds assembled by Bear Stearns. The investors' positions were wiped out. They lost everything. Some French and German funds faced liquidity crises too when the sponsors ceased redemptions. They got the jitters and that started spilling over into the equity markets.

The other problem is that funds did not buy loans or mortgage-backed securities. Whenever you have any type of security, it is possible to dice it and slice it anyway you want. I'm making this up, but you could sell half of a mortgage to one guy who would get interest payments in January, March, May and so forth and sell the other half to a guy who would get the interest payments during the other months.

This falls under the umbrella of Collateralized Debt Obligations. It's far too complicated to go into further here, but it is covered well at Wikipedia. See the entry at http://en.wikipedia.org/wiki/Collateralized_debt_obligation

This dicing and slicing exacerbates the problem because it makes it increasingly difficult to tell exactly who owns what, what the value is, and what the risks of owning it might be. The more uncertainty, the worse the crisis is.