In housing downturn, a new uncertainty factor
Stung by losses in mortgage-backed assets, investors have made the slump worse.
from the November 29, 2007 edition
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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 CommitteeHow 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.
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