In housing downturn, a new uncertainty factor
Stung by losses in mortgage-backed assets, investors have made the slump worse.
The last time the economy experienced a real estate downturn, in the early 1990s, the reasons were straightforward: an economic slowdown in regions of the country, rising interest rates, and a growing reluctance by banks to issue new loans.
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This time, Americans face a new kind of housing bust, where investor jitters are playing as much of a role as banker worries. Those jitters add an X factor to today's real estate slump. They have sped up the downturn and could deepen it. Worst of all, they have created widespread uncertainty because, unlike the old days when bad mortgages festered in bank portfolios, the risks are now spread among investment firms, insurance companies, and others. No one knows how broad or deep the losses are.
"What it comes down to is, we have an information problem in the markets right now," says Joseph Mason, a finance expert at Drexel University in Philadelphia. "We don't know where all the exposures lie."
The reason for this uncertainty stems from the revolution in mortgage lending. Instead of banks making and holding home loans, in recent years they have increasingly sold them off. These mortgages would get bundled together, often by an investment bank, then sold off in pieces to hedge funds and other investors. The practice reached new heights during the housing boom because it helped make credit widely available, allowed banks to manage their risk, and made money for investors. But this year, thanks to a deep housing slump, things haven't worked out as planned.
Sinking home prices made investors skittish about the mortgage bundles, especially the riskiest subprime ones. When they stopped buying those bundles this summer, key channels of credit to the mortgage industry froze up.
The result is tighter credit for ordinary borrowers – and new uncertainty at a time when the economy could turn down into a recession. At the very least, today's trouble in mortgage-backed derivatives could deepen the severe housing slump.
"You've got a rogue housing cycle," says Brian Bethune, an economist at Global Insight, a forecasting firm in Lexington, Mass. "If there are stresses in the market, then these types of instruments will amplify the stresses in the short term."
The stress in the real estate market is greater than in the past because it involves not just a slowdown in transactions but a big fall in home prices, too. That's causing more homeowners to default, which makes it hard to know what the mortgage-backed bundles, or derivative securities, are worth.
"These derivatives can't function in that environment," Mr. Bethune says. "It's forcing deeper write-offs over a shorter period of time" than in past housing cycles.
Financial giants such as Citigroup and Merrill Lynch, which created and held many of these complex derivatives, have had to mark down the value of those securities by billions of dollars.
Just this week, the British bank HSBC said it would extend $35 billion to help affiliated investment funds avoid a forced sale of derivative assets.
Banks now face a tough choice: Divert their capital to support these affiliated funds, called structured investment vehicles (SIVs), reducing the money they can lend elsewhere, or sell their SIV holdings.
Right now, SIV assets are hard to sell. The reason is not just the uncertainty about how bad the mortgage defaults will get. It's also the complexity of the investments, which blend income from various types of loans and parcel out the default risk of those loans in sophisticated ways.
"The liquidity crunch that started this summer was as much about a loss of confidence in the market's ability to understand and measure risk as it was about economic factors in the 'real' economy," says Eric Beinhocker, author of "The Origin of Wealth," a book about the complexity of modern economies.
That's not surprising, he adds in an e-mail interview. Almost by definition, financial innovations must take root and be tested before private-sector players or regulators can understand them.
Two government sponsored enterprises – Fannie Mae and Freddie Mac – have been able to find investors for their bundles of new loans, because they come with a solid guaranty against default.
But those loans are available mainly to borrowers with strong credit ratings and modest-priced homes.
"Outside of that space, nothing is happening," in terms of new mortgage securities, says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington. That means fewer loan options for people with below-prime ratings or for those taking out jumbo loans, those above $417,000.
But many banks are reining in credit. Lenders are writing about 70 percent fewer subprime loans in 2007 than they did in 2006, according to a recent estimate by mortgage analysts at the investment firm UBS in New York. Jumbo lending is down about 30 percent.
The freeze-up in mortgage-backed derivatives is a key factor behind the recent deceleration in home sales, Mr. Duncan says.
Chronology of a home-loan crisis
2004
June: Federal Reserve boosts interest rates 1/4 point; the first of 17 raises over the next two years.
2005
June: Existing home sales peak. Home ownership in 2005 hits a record: 69 percent. Some 20 percent of home loans are subprime, up from 5 percent in 1994.
2006
December: Ownit Mortgage files for bankruptcy. Dozens of mortgage companies will follow or shed their subprime units over the next year.
2007
July: Standard & Poor's and Moody's, the rating agencies, downgrade securities backed by subprime mortgages.
August: The European Central Bank and Federal Reserve inject billions to keep the financial markets liquid. President Bush calls on the Federal Housing Administration to assist homeowners with FHA-backed subprime loans. Two FHA programs will assist 80,000 homeowners.
September: The Federal Reserve decreases the discount rate 1/4 point, the first cut since June 2003.
October: Countrywide Financial Corp., the nation's largest mortgage lender, announces a drop of 44 percent in lending over the past year.
At the Treasury Department's urging, the three largest US banks announce the creation of a 'superfund,' the Master Liquidity Enhancement Conduit, for a pool of credit to purchase troubled subprime-backed securities. Citigroup announces a $3 billion loss due to the fallout. Two weeks later, Merrill Lynch announces a $7.9 billion writedown as well.
November: Housing prices drop 5.1 percent from a year ago, the largest year-over-year drop on record, the National Association of Realtors reports.
Sources: Census Bureau, Congressional Research Service, Federal Reserve Board, News Reports, US Senate Joint Economic Committee
How derivatives work
Perhaps nothing symbolizes the sophistication of modern finance like derivatives – the power tools for people who wear pinstripes.
They are the family name for investments that are based on, or derived from, more traditional investments, like stocks or currencies. So, instead of buying a stock, sophisticated investors can buy, say, an option, which allows them to buy or sell that stock at a set price on a specific day in the future.
Investors use derivatives to protect against risks, such as sudden changes in stock prices or currency values. Others tap derivatives to take on extra risk, in the hope of extra gains.
Sometimes, though, derivatives go haywire. That's what happened this summer with an entire class of mortgage-based derivatives. Investors had bought them to earn attractive monthly income. But it turned out, when defaults by subprime borrowers began to soar, that these mortgage-backed securities carried lots of risk. Their value plunged.
And the complexity of the newest ones, called collateralized debt obligations (CDOs), makes it hard to know the risk that still remains. So few buyers are showing up.
"It's called financial engineering for a reason," says Joseph Mason, an economist at Drexel University in Philadelphia. "Engineering with space-age materials leads to great performance when it performs well." But a rocket ship can also explode, he adds.
In this case, it didn't help that credit-rating firms gave many CDO products top grades. Each CDO spawns a range of bondlike products defined by "tranches" – segments that carry varying risk and return potential.
"Even within a single CDO there are two tranches of AAA-rated securities with very different risk profiles," writes Joshua Rosner of the investment research firm Graham Fisher & Co. And neither is as secure as government bonds with the same rating, he adds.
These problems don't mean that derivatives are, on balance, bad for the economy. Most economists say they allow an investor to fine-tune his financial risk – and they make markets more efficient. In mortgages, the rise of derivatives since 1980 helped to make credit more available to first-time home buyers, researchers say.
