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.

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.

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