by Bill McBride on 9/17/2006 01:21:00 AM
Sunday, September 17, 2006
The NY Times asks: Who Bears the Risk?
The housing boom would never have lasted as long as it did if mortgage lenders had to worry about being paid back in full. But instead of relying on borrowers to repay, most lenders quickly sell the loans ...Of those us that thought there was a housing bubble, Dr. Hamilton asked last year: If there is a housing bubble, "[W]hy are banks making loans to people who aren't going to be able to pay them back?"
As the boom thundered on, the pool of available credit grew larger than the pool of creditworthy borrowers, resulting in an explosion of risky mortgages with features like no money down, interest-only payments and super-low teaser rates. Investors ... currently hold $2 trillion in mortgage-backed securities from investment banks, triple the amount from three years ago. Investors also own $4 trillion in mortgage-backed securities from government-sponsored agencies.
... everyone knows that if mortgage defaults should rise, damage could reverberate throughout the financial system. So far, defaults have inched up. But many homeowners are at a dangerous juncture. Interest rates on adjustable mortgages are rising as home values are weakening, precluding for many the chance to refinance. Economists calculate that $750 billion of outstanding mortgage debt is now at measurable risk of default — about 7 percent of the total.
This is a great question, and the NY Times hints at a possible answer. "In a market so vast and dynamic" it is possible that numerous participants are underestimating the systemic risk.
UPDATE: Tanta understands this market far better than I can ever hope to - I'll post her comments in full. From Tanta (THANK YOU!):
Let me have some coffee and some time to ponder the wisdom of the NYT Editorial Board (*shakes head like Labrador Retriever exiting swimming pool*) and I shall try to have something worthwhile to say.To add to Tanta's comments, here is the story on H&R Block:
First thought of the day, meanwhile: selling loans in the secondary market is, of course, a way of dispersing default risk. But that isn't the only, or even the main reason banks sell loans. There is the matter of interest rate risk (prepayment, duration) for one big thing, plus capital needs and general balance sheet management, plus the desire to book gain on sale right now versus future accrual income. This is important to understand because in reality some banks end up selling/securitizing their best loans (from a pure credit risk standpoint) and keeping the weakest credit risk on their books, even in times like the present with record rates of sale/securitization. You miss this dynamic if you assume that the primary reason for loan sales is to pass off credit risk.
It's also harder to completely pass through credit risk than the NYT probably thinks. There are reps and warranties in every loan sale that can come back to bite the seller of loans even without explicit recourse agreements--H&R Block just recently got its ass bitten by that, as an example. If and when credit risk starts to rise, there's a huge push-back in the industry, as every current holder of toxicity tries to put it back through the chain to the originator. That means that if and when the originator has to take back an impaired loan, it is generally at the wrong time, the wrong price, and the wrong market for resale. So even if the loan comes current or otherwise cures, it still gets written down relative to its original market value. At a certain point, you can end up wishing the damn thing had gone into foreclosure, because you'd have lost less money on it. There is no such thing as "pure" credit risk, in other words.
If that made a limited amount of sense, blame it on caffeine imbalance in my cranial portfolio. I'll be back when I have hedged my coherence gap.
... early defaults have forced lenders such as NetBank Inc., Fremont General Corp. and H&R Block Inc. to buy back loans already sold to whole-loan acquirers, particularly Wall Street investment banks that pool and package those loans into asset-backed securities and then sell them to large investors such as insurance companies and hedge funds. The buybacks, in turn, have led lenders to incur losses and set aside more money in their reserve funds for potential loan repurchases in the future. ... H&R Block told investors ... "an increase in early payment delinquencies" and the resulting "higher level of repurchase requests from loan buyers" led it to increase its loan reserves. ...Original Post: I am reminded of this quote:
"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."John Maynard Keynes, "Consequences to the Banks of a Collapse in Money Values", 1931
Posted by Bill McBride on 9/17/2006 01:21:00 AM