Multiplying Mortgage Trouble
The big financial news this week-end is Bear Stearns' decision to put $3.2 billion into its struggling hedge fund to try to stave off collapse of both the fund and the larger mortgage securities market. An academic paper, "How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions," presented early this spring at the Hudson Institute suggests that the mortgage market has been structurally realigned, and that the whole system is far riskier than rating agencies, regulators or investors have recognized. If the paper is right, Bear Stearns has taken the financial equivalent of striking up the Titanic band to play "Nearer My God to Thee."
Everyone acknowledges that subprime mortgages are riskier than prime mortgages and that more defaults were to be expected. But what do all those defaults mean in a world in which no lender keeps its own mortgage paper? Now that there is a very active, very profitable, and VERY complex market for purchasing, bundling and trading mortgage securities and their derivatives, what will be the effect of sharply rising defaults?
The conventional wisdom among the don't-worry crowd has been that the new complexities of the mortgage market will provide a level of diversification that will insulate the economy from the impact of defaults. Yes, lots of people will lose their homes, but they are the only ones who will suffer. (We'll put aside the morality of that view so we can stay on point about the market.)
Along come Joseph Mason and Joshua Rosner with their paper. They have some fascinating empirical data about the interaction among various parts of the new, restructured mortgage market. The authors give a very detailed explanation of how all the pieces of this complex mortgage market are linked and--here's the key--how at each stage, the risks associated with default become more obscured. The cumulative effect is that the financial markets have hidden both what is wrong with these mortgages and how deeply dependent the economy is on the continued successful repayment of these mortgages.
The authors conclude:
The structural changes witnessed in the mortgage markets have interacted with complex MBS and highly CDO volatile funding structures to place the U.S. housing market at risk. Equally as important, however, is that housing market weaknesses feed back through financial markets to further weaken financial instruments . . . . This feedback mechanism can create imbalances in the U.S. economy that, if left unchecked, could lead to prolonged economic difficulties.
What are those "economic difficulties"? The authors explain that the collapse of housing markets will be followed by bad trouble in the construction industry, the building industry, and the home products industry. These industries, they point out, are key industries for overall economic performance in the US market. Worse yet, as these industries decline and more people are laid off or lose overtime, mortgage defaults, of course, will continue to rise.
A lot of people got richer off speculation in mortgages. Now the question is how many more ordinary families--people who work at Home Depot or people who stretched to buy houses at inflated prices or people whose jobs depend on a strong economy--will get a lot poorer.
I’ve commented on this topic before, and am not terribly surprised that the situation keeps coming up. What we’re seeing is a correction in the market for risk that has not been properly identified or accounted for in credit ratings. The industry is catching up with this dilemma: ``The overarching issue here is that this was a market that wasn't pricing in risk correctly,'' said David Pearl, who helps manage $5.4 billion at Epoch Investment Partners in New York. ``This was a clear risk to the stock market in general and the financial market in terms of confidence in owning what you think you own.''
BS’s dramatic reaction to sure up it’s fund was the result of an even more dramatic reaction when Merrill Lynch tried auctioning off $800M in assets. Keeping high risk investments on a downward trajectory is not sound business. Clearly the market is no forcing the issue of better risk identification and mitigation. If the trajectory remained upward, you would likely never have heard a peep that risk was not being properly managed. Now Wall Street is getting its fingers burned, I suspect we’ll see a lot of punitive market reaction to overly leveraged funds, which sadly will restrict lending on mainstreet; after all, we all know what flows downstream. As for solutions, I’ve suggested better risk control as a regulatory action. What’s frustrating about that approach is jurisdiction. The Fed has some oversight, as does congress, and the FCC and the states. No single entity, however, has the necessary authority over the whole scene to fix this problem. See Bernake’s take on it as linked herein. The market will fix it, but likely at the consumer’s expense. The old, “we seriously screwed up, but now that we know we can effectively pass the buck to the little guy.”
What we want in a solution includes a regulatory oversight for risk management and Truth in Lending, clear authority to implement such regulations, and a market-partnership that has a say in implementing better risk management and credit ratings. We need the industry who got us into this mess to be part of the solution, otherwise subprime will become a no-man’s land and many offerings that benefit good people will be off the table for good. /c In the blogosphere every one is an expert, so no one is an expert.
June 25, 2007 10:14 AM | Reply | Permalink
Now the question is how many more ordinary families--people who work at Home Depot or people who stretched to buy houses at inflated prices or people whose jobs depend on a strong economy--will get a lot poorer.
Presumably, very few.
In the absence of the relaxation of mortgage standards (elitist restrictions?) they wouldn't have had the jobs or the houses (in reality owned by the banks and not by the so-called homeowners) to lose in the first place. Hard to see how they're "poorer" for having enjoyed the benefits of jobs and residences they otherwise would not have had the opportunity to acquire.
June 25, 2007 7:33 PM | Reply | Permalink
in reality owned by the banks and not by the so-called homeowners...
I recently heard an economist make the point that if you "own a home" you essentially pay rent to yourself.
To boldly go...
June 25, 2007 9:47 PM | Reply | Permalink
There's an "economist" out there who will say anything. Besides, foolish advice--or, more appropriately, "boosterism"--like that is what has encouraged so many people to get into this mess in the first place. Running a household is just like running any other business. It's net cash flow after overhead. Renting/buying is the biggest part of household overhead. Defaulting on a mortgage is the result of choosing to pay more than you could cover in even a short downturn in your income.
Keeping your family out of financial jeopardy today--even if that means renting or buying a cheaper home--is more important that break-even equity 30 years down the road. (And that's about all that most Americans could hope for after interest and maintenance costs.) Also, the whole idea of being able to depend on a level income over a 30 year period to cover an outrageous monthly payment is foolish for most households. But, you won't hear the government's home-ownership propaganda organs--Fannie Mae and Freddie Mac--tell you that. It's the "American Dream," don't you know?
What really gets me about all of this is how the Democrats have let this happen. This system has done nothing but reward bankers, real estate agents, insurange agents, and homebuilders. All of them are staunch GOP constituencies. The Democrats should re-invente this system around the interests and market-moving power of the homebuyers, currying their favor directly since they have the votes. But, expecting any degree of political common sense from the Democrats is a waste of time. Now--watch--I bet we take the self-defeating approach and bail out the bankers directly rather than use their plight to set our own terms.
June 27, 2007 8:30 AM | Reply | Permalink
There's an "economist" out there who will say anything.
true. but that economist simply suggested that the sanity of renting versus buying a home can be checked by looking at the costs of "owning" as rent.
for example, if you spend $2400 a month, after adjusting for your income tax rebate, and a similar rented home costs $1200 a month, you're paying over $14,000 a year too much-- almost enough for a family car or, if you save the difference, like I do, an IRA contribution, 529 contribution or money for a rainy day!
And that's about all that most Americans could hope for after interest and maintenance costs.
I agree... and maybe, if laws are written, maybe real estate agents should be asked to do a comp of renting versus buying...
To boldly go...
June 27, 2007 10:41 AM | Reply | Permalink
I don't disagree with the benefit of owning in an abstract sense. But, what I am saying is that being a first-time home-buyer in the actual reality of today's wildly inflated home prices is no better an idea than jumping into the stock market near the peak of the dot com boom. People have been encouraged to leap like lemmings into a super-hot market--especially by TV "economists" (who more often than not represent firms with a stake in the market).
Renting now and saving for a down payment and retirement is better than paying a mortgage over your head for break-even equity 30 years down the road. This is the philosophy that has been ridiculed the last few years by the purveyors of no-money-down 2/28s.
You and I might have financial flexibility, but the average middle class homeowner does not. Moreover, I don't think that foreclosures are the big problem. The real problem will be negative equity. Many neighborhoods nationwide are headed for 25-40% home price reductions that will take decades to recover. It's already happening in my parents' Midwestern neighborhood where I grew up.
June 27, 2007 12:30 PM | Reply | Permalink
How so?
The first assumption in your argument is that a person who would not have had the opportunity to own a home previously is not the loser. The second assumption is that because not many people would have had such an opportunity before, therefore, not too many people are poorer now as a result. As for the first argument, there are such things as interest costs, real estate taxes, insurance, home maintainence, water taxes, assesments etc that eat up a homeowner's income. So a person who could not have purchased a home before, but who purchased a home in the last few years is definitely poorer now than before for the above-mentioned costs. I am not even including the effects of the job market.As for the second argument, because people who could not have obtained credit for a home before, but who received credit recently because of the subprime lending, plus, because there are additional costs involving homeownership, those people have spent a lot more money in owning their homes that does not involve paying for the ownership alone, leads to teh conclusion that all those people are poorer.
Another point, homeownership is NOT like paying rent to yourself. And a mortgagor doesnt necessarily OWN the home, in the sense, that whatever appreciation (or depreciation) that the house enjoys goes to the homeowner, not the bank. Contrast that with renting, whatever appeciation, the house enjoys goes to the landlord, not the renter!
July 4, 2007 10:13 AM | Reply | Permalink