Friday April 18, 2014

Home Mortgage Market: Crash or Bounce?

by Christopher Chantrill
December 12, 2006

Perhaps the most radical change in the financial markets in the last generation has been the securitizing of home mortgages, the bundling of home mortgage obligations into mortgage bonds which are then sold to investors.

But Lewis Ranieri, the Wall Street guy who is credited with creating the market is worried that risky mortgages are creating a problem, according to Patrice Hill.

Banks and mortgage brokers have been passing along to unwary investors as much as $600 billion a year in risky mortgages they made through untested channels in the junk-bond market. That raises the threat of a financial crisis beyond the ability of the Federal Reserve to remedy.

Now the point here is that this is not the same as banks holding risky mortgages. Banks are uniquely vulnerable financial institutions because they inherently make promises they cannot keep. They promise to pay to their lenders (depositors) on demand monies that they have lent out long term. They cannot pay back all their creditors at once. If mortgages held by a bank go bad then there is a risk of systemic financial failure, like in the Great Depression.

But mortgage bonds are different. If the mortgages behind an issue of mortgage bonds go bad then only the bondholders suffer the losses. There just isn’t the same level of systemic risk.

Obviously, there is still risk.

Bank regulators told the National Housing Forum here yesterday that they have found major banks punting to investors questionable mortgages they could not legally keep in their own loan portfolios. Mr. Ranieri said brokers on Wall Street have raised the risks by repackaging the mortgages in deceptive and opaque ways so that the small investors and foreigners who buy them are unable to understand the risks.

"No securities market can stand if we do not have true disclosure, and we do not have true disclosure" of the growing risks of exotic mortgages whose payments can double overnight and force buyers into default, said Mr. Ranieri.

The financial markets are in the business of selling paper. And they do what it takes to get the paper out there. No doubt, stuff “gets sold to the public and to foreign investors who don't have a clue what to look for.” Happens all the time. And willy-nilly, the fact that a mortgage bond has junk-bond status should be telling the investor something.

Rep. Barney Frank (D-MA), incoming chairman of the House Financial Services Committee, seems unconcerns about the risks. “If a few speculators get burned, that's just icing on the cake.”

Probably the big take-away is that

Some banks are selling the questionable loans to investors to avoid keeping them in their portfolios, where they would be unacceptable to regulators.

That is exactly what bank regulation is supposed to do. The systemic risk of bank default is due to the concentration of risk in a few financial insstitutions. But when the risky mortgages are sold to investors then the systemic risk is removed. The concentrated risk proposition is diluted as the risk is allocated to thousands of bond holders.

Of course, the question: is how many public employee pension funds have picked up the risky mortgage bonds? And then there are Fannie Mae and Ginnie Mae, the government sponsored mortgage-bond issuers, who are already in trouble with their financial shenanigans. But then in the worst case taxpayers would have to pick up the shortfall. And who cares about them?

The real risk is that if the sub-prime mortage market contracts sharply then the reduced supply of mortages will be reflected in further house price declines. That would turn off the home equity ATMS. And that could spread to the whole economy.

Christopher Chantrill blogs at