The mortgage-backed credit slowdown-and the rules that caused it.

Abstract

The U.S. credit crisis in sub-par, mortgage-backed securities that began unfolding in July of 2007 now appears to be spreading to Europe, (1) where housing prices are falling and economic forecasts are for slower growth. (2) The crisis is spreading to stock markets in Asia, as well. (3) The crisis has already caused the layoff of 42,000 employees in New York City's financial industry and has threatened the growth of the city's economy, (4) where 20 percent of Manhattan salaries are earned by financial industry employees. The tightening of mortgage credit and corporate loans (5) now threatens to slow the U.S. economy as well. Although bank lending since midsummer grew at the fastest rate in more than 30 years, that credit is now tightening as banks cut back their lending and increase their loan loss reserves. These new reserves (6) will come from earnings, so this tightening will turn the recent banking boom into a bust. (7)

Cheap Mortgage Financing

This credit crisis was caused by an ingenious U.S. mortgage financing system which has been so efficient at providing mortgage financing that it has given what amounts to a subsidy of up to $100,000 to each household that owns an upper middle class home. This subsidy comes to mortgagees in the form of cheaper mortgage financing and tax deductions on mortgage interest payments. But now the credit markets associated with this financing system are frozen because the collateralized debt obligations (CDOs) of banks have been contaminated by a small number of sub-par mortgages. Although the sub-par component of this mortgage market is estimated to constitute only one to two percent of the total--an estimated $600 billion of a total mortgage market of about $30 trillion (8)--it has been sufficient to make most mortgage-backed securities both unmarketable and unpriceable.

Housing Prices Plunge

The sub-par mortgage problem reached crisis proportions when housing sales plunged eight percent in September to the slowest annual pace in a decade. (9) Thomas Zimmerman, head of mortgage credit research at UBS in New York, estimated that should house prices fall another 10 percent over the next two years, the losses due to defaults could wipe out as much as 16 percent of the $600 billion of the sub-prime-backed securities issued in 2006. Although in August of 2007 such losses were equivalent to less than one percent of the total, (10) Zimmerman's scenario is entirely possible. As housing prices fall, the ability of a mortgagee to refinance the escalating payments on an adjustable rate mortgage (ARM) becomes more difficult.

Mortgage Defaults

In this frozen mortgage financing market, purchasers of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) can no longer be certain that their securities are not backed, in part, by some sub-par mortgages. These mortgages have already begun to default and as a result of the clauses and formulas in the CDO agreements, the interest payments on these bonds are beginning to be cut off. (11) These defaults threaten the liquidity of both the funds that hold these securities and the banks that guaranteed the assets in these funds.

Structured Investment Vehicles

There are approximately 30 funds that hold the bulk of the MBS and CDOs. These funds are called structured investment vehicles (SIVs) and account for the approximately $320 400 billion of sub-par mortgage backed securities. These SIVs were created by two former Citigroup bankers, Nicholas Sossidis and Stephen Partridge-Hicks, who called their first SIV the Gordian Knot. (12) These funds used short-dated commercial paper and medium-term notes (13) to finance the purchase of assets such as credit-card debt and mortgage securities from the banks that originated them. (14) The banks then shared in the profit from the spread of mortgage-backed asset sales over the SIV's cost of financing, through fees that they charged the vehicles. (15) Operating in this way, SIVs channeled hundreds of billions of dollars from the global investors in CDOs to American home buyers.(16)

Fannie Mae's Prototype Financial Engineering

The prototype of this form of financial engineering was Fannie Mae, the Federal National Mortgage Association (FNMA). Fannie Mae showed bankers how to spread bank mortgage risk throughout the world of investors who purchased MBS and CDO securities, both of which were secured by mortgages. Thanks to Fannie Mae's securitization of mortgages, savings and loan associations were able to make mortgage loans very quickly to mortgagees with marginal credit ratings. Banks could do this because they could almost immediately get a governmental guarantee of the mortgage through Fannie Mae and then sell this mortgage to Fannie Mae itself. Fannie Mae's payment for the mortgage returned the bank's capital, which could then be used to make a new mortgage loan. Fannie Mae, in turn, collected the mortgage obligations into tranches of varying risk and used these collections of mortgages as security for mortgage-backed securities that they sold to the public. The sale of the MBS returned Fannie Mae's principal, which could then be used to purchase more mortgages from banks.

This process of securitizing mortgage obligations through Fannie Mae provided trillions of dollars of mortgage financing to Americans and spread the default risk on these mortgages globally through the purchasers of the MBS.

Big Bank Financial Engineering

From 2000 to 2007, large U.S. banks began to employ a similar process of financial mortgage engineering through their development of structured investment vehicles (SIVs). The SIVs created collateralized debt obligations (CDOs) which they secured with mortgages that they bought from big banks. In this system, a bank would originate the mortgage, which would then be purchased from the bank by the SIV with funds raised through the SIVs sale of bonds, mortgage-backed commercial paper or medium-term debt. The SIV would then sell securities backed by the mortgages at a spread over their financing costs.

This transfer of risk (17) to the investing public, through mortgaged-backed securities (MBS--Fannie Mae) and collateralized debt obligations (CDOs--SIVs) worked well for the big banks because it occurred off their balance sheets. The mortgages and the securities they backed were on the balance sheets of the SIVs, not the banks and thus the banks that provided the mortgages did not have to raise more capital to preserve their capital adequacy requirements. It is legal to keep assets off a bank balance sheet, held in a subsidiary fund like an SIV, so long as the three percent of the fund is owned by an independent business entity. With no new capital to raise, the banks originating the mortgages maintained high leverage rates with low debt financing costs, which were enhanced by the tax shelter effect of the debt financing. (18) This has been called "banking by post-Enron rules," (19) because it occurs off the big bank's balance sheet.

To facilitate the functioning of the SIVs, the banks that originated the mortgages guaranteed these assets held by the SIVs. This meant, unfortunately, that when the SIVs became insolvent and their CDOs unmarketable and unpriceable, these assets had to be taken back onto the balance sheets of the originating banks. It is difficult to conceive of a financing system which would have been better designed to surprise the originating bank with a multi-billion dollar lump of illiquid assets than this system was.

The Housing Industry--An Engine for Growth

This system worked well from 2000 to 2006 and financed the U.S. housing industry that served as the engine of growth for the U.S. economy after the market bubble of 2000 and the shock of 9/11 the following year. In other words, this system prevented a serious U.S. recession following the 2000 market bubble. In 2006, however, late entrants into this cleverly engineered mortgage-financing industry began to aggressively sell mortgages, determined to make their own fortunes. With this aggressive entry came abuses in the sale of mortgages. The most widely practiced abuse was to use a low interest rate mortgage as the lure in a bait-and-switch mortgage sales strategy. At the closing, an adjustable rate mortgage (ARM) would be substituted for the low interest rate mortgage that had been promised. The ARM would eventually surprise the mortgage with much higher mortgage rates and correspondingly higher monthly payments, one or two years into the life of the mortgage. To close this mortgage deal, the mortgage broker often fraudulently increased the salary of the customer on the mortgage application form. Such mortgage sales practices set up the cascade of defaults on sub-par mortgages which began in July 2007. (20)

An Unfolding Credit Crisis

The U.S. mortgage credit crisis was initiated by Bear Stearns' announcement of large losses in three of their hedge funds holding MBS offshore in the Cayman Islands. Bear Stearns had been an innovator in the sale of MBS and was the largest trader of these securities. This announcement was followed by Deutsch Bank's announcement of a $3.11 billion charge related to mortgage-backed securities (21) and UBS' write-of of $3.41 billion of sub prime mortgages. (22) Within weeks, the Bank of America announced a $1.45 billion trading loss, retired the head of its global Corporate and Investment Banking unit (23) and announced a possible merger with Countrywide, the largest mortgage broker in the United States. Citigroup suffered huge losses connected to mortgage-backed securities and loans to fund leveraged buyouts and these losses left its strategy as a universal bank shaken. (24) Perhaps the biggest shock was Merrill Lynch's announcement of a record $2.5 billion quarterly loss on the write-off of $7.9 billion of collateralized debt obligations and U.S. sub-prime mortgages. (25) This circumstance may have caused CEO Stanley O'Neal to make an unauthorized contact with Wachovia Bank to discuss a merger and may result in his dismissal by the Merrill Lynch board of directors. (26) Bear Stearns ended their credit woes by negotiating a $1 billion cross-investment deal with Chinese investment banker Citic. (27)

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