I would appreciate it someone in the industry could dumb this down a level or two and explain what has been going on with the market over the past few days. Also, how will this affect those of us who are not currently buying a house but could (will) be within the next 18 months? Thanks.
We’ve been discussing it under the “CNBC guy goes crazy thread”… People may disagree, but here is my take (I’m confused about some of this too and NOT an expert):
- Banks financed billions in “sup-prime” loans (typically people w/ credit scores under 560) usually with a 2/28 ARM product (fixed for 2 yrs then adjust yearly if not monthy)
1a. These banks packaged them as CDO’s and sold them in secondary markets to other banks, hedge funds, pension funds, investors, foreign funds, or anyone willing to buy.
- The homeowners got killed when their rates adjusted up and could not pay their mortgages and are getting foreclosed on. Banks taking back millions of houses which aren’t worth what they thought they were. Banks don’t want the houses and dump them and take major losses.
2a. The buyers of CDO’s stopped buying b/c they found out they were buying bad loans. Many mortgage originators got stuck hodling paper they could not sell. Many mortgage companies sell ALL of their loans to others. These companies went broke and several closed shop.
2b. Then those stuck with bad CDO’s could not move them and they dropped in value wiping out all equity. These banks could not borrow on that equity to fund other activities, essentially leaving them with no money.
- Fed “buys” the CDO’s for 3 days w/ $130 billion to supply liquidity to those people.
3a. Not sure what happens on Monday now…
Expert advice would help here filling in the blanks
If you are getting a jumbo loan (over $400K) or a non-owner occupied loan you be in trouble. If you are getting a conforming loan on your own property, you are probably OK.
This is something I submitted to the NYT today that got printed - mine is the long-winded one.
http://krugman.page.nytimes.com/
The short story is this. A lot of subprime loans were made that shouldn’t. Many of them defaulted on the first payment. In addition, a lot of them, and prime loans, were floating rate, and with rates going up and a major ARM reset in October, a lot of people are expecting more default behavior. In addition, much of the economic growth through the last few years has been driven by consumers who were pulling home equity out and spending it. Now that people can’t buy houses, and therefore can’t sell them either, housing values drop, people’s wealth drop, and their access to wealth and capital recede, potentially causing serious macroeconomic problems. You add in that the housing industry affects something like 40% of the overall economy, and you can see why people looking forward are concerned.
In terms of the markets, investors are looking forward and seeing a potential recession.
More specifically, most mortgage loans were repackaged and sold to investment vehicles called CDOs, which then issued certificates which were held by a lot of different investors. The problem is that these certificates aren’t liquid - you can only buy and sell them through banks, and there aren’t often many buyers, which means that prices aren’t always great. On top of that, since default behavior is increasing, and nobody is really sure what these mortgages look like, then the real value of the certificates is also in question.
This overall dislocation results in risk spreads on bonds going up, and more importantly, a lot of lenders pulling back and deciding not to lend, regardless of price. This is known as the market freezing up, and it is bad - it’s bad when there is no lender regardless of price.
On top of this, a lot of investors, including huge hedge funds, use a lot of leverage, so that when their investments drop in price, especially mortgage bonds, they get margin calls. This results in forced selling, and as I said, forced selling into illiquid markets. This then puts a price out into the marketplace, which can force other margin calls from other lenders to other investors. And so on and so forth.
The Fed stepped in 3 times today to provide liquidity to the markets - they provided repo loans to large investors in return for mortgage bonds as collateral. This prevents panic selling and a serious waterfall of selling due to lack of liquidity, and allows the market to be more orderly.
Unfortunately, I’m net short the market and am betting on a blowup, so the Fed screwed me today, but the fact is that the Fed can’t keep doing this, and it’s pretty clear that this still has weeks/months to go.
Basically, think about a house of cards propped up by cheap and easy credit. You take out some of the lowest cards, and the whole thing gets real precarious real quick. Markets only work when there are buyers and sellers working within reasonable spreads and reasonable information available. Otherwise, things lock up and life gets real unpleasant.
Wifey is in the mortgage bidness, so here goes: If you have sh*t credit, you won’t get a house. Plain and simple.
You may be getting a great house for little $$$, because a few really dumb lenders let some people get too much house for their debt and credit worthiness. Just have plenty of cash for a down payment.
“Markets only work when there are buyers and sellers working within reasonable spreads and reasonable information available.”
you expect politicians and others who don’t have actual skin in the game to repeat the mistakes of their predecessors. what slays me is when corporations and financial institutions do it. post-WWII a framework was constructed of parallel and complementary institutions. you went to Home Savings, applied for a loan, they checked your credit with TRW, you put down 5% or 10%, and off to the races.
was it difficult to forecast what would happen when you give no-money-down, 24 or 36mo ARMs, to uncreditworthy people? i guess the last 50 years of institutional experience didn’t matter, or didn’t happen. it seems like once a generation some sort of legal-mega-ponzi scheme cripples wall street. junk mortgages make bear stearns wistful for the days of junk bonds.
In finance, its what’s called an agency problem. That means that that there is a different set of incentives for managers versus owners. Managers want to generate short-term gains and fees and are willing to take great risk because they don’t take equity risk, while owners are longer term and are taking the risk. It’s the reason management has options and equity now in public corporations - to try and bridge that gap, although options are a highly imperfect way of doing so.
In terms of mortgage, the problem is that there is so much intermediation now that the originator of the mortgage is almost never the ultimate owner of the debt. It will go from mortgage broker (as agent), mortgage bank, to investment bank and/or CDO, then to pension funds and hedge funds. That’s a lot of steps, and through the process, some financial alchemy is performed to make individual bad risks a better collective risk. At least that’s supposed to be how it works. It certainly generated a lot of fee income at every level.
There was also a heavy reliance on recent default behavior in modeling these. Defaults have been low because housing values have been high and continued to rise, so that cures a lot of ills. But when values drop, its like the tide receding, revealing a lot of garbage. And the models which were based on only recent behavior turn out to be quite wrong.
There are something like $30 billion in ARMs resetting in October, with a lot more next year. There is a strong possibility of an avalanche effect, where rising rates force more defaults, lowering RE values, then potentially reducing sales, and potentially invoking more defaults.
It shows you how precarious our markets really are, especially if its being driven by a large single plank, in this case, cheap and easy credit.
very comprehensive explanation. nevertheless, a layman could predict this from a bird’s eye view, even two or three years ago. i’ve been telling the wife for the last two years, 2009 is the year. we save our pennies and buy investment real estate during 08 and 10. i figure that’s the bottom (homeowners’ asking prices are still lagging behind the downward trendline). we figure to buy it (starting in about a year, more or less) and rent it out, because half the world will be too afraid to buy in an uncertain market, and the other half can’t qualify for a loan. the landlord’s perfect storm.
though your explanation is correct, i’m pretty sure there were 60-somethings in those boardrooms cautioning restraint, and the 30- and 40-somethings, who ended up carrying the day, were explaining how it was the old ways don’t parallel our current financial landscape.
It just reminds me of how in the late 90s during the tech boom all we heard about was how you have to “value companies differently now.” Dividends were out, it’s all about growth, etc. And it turned out that 200 years of experience is still relevant. I cringe whenever I hear, particularly in the financial markets, “things are different now, the old way of doing things is out.” Makes for a gret headline, and makes a few people some money, but the piper always ends up getting paid in the end, and it’s usually a pretty ugly scenario.
As Bluefan says, its not dissimilar from the dotcom boom - logic goes out the window and it reaches a certain mania level, but like tulips and toys.com, it all comes back to roost.
It seems strange now that people with no documented income could get huge loans with 0% down, or in fact get money back (illegally), at low floating teaser rates, or better yet, negative amortization rates. From a pure finance standpoint, its insanity, but in a certain light it works if all the pieces fall into place. And they did, at least for a little while. But like musical chairs, its a question of whose left standing when the music stops. For awhile, I was engrossed in the story of Casey Serin, the 24 year old from Sacramento who managed to buy 8 houses with no job, no money down, and in fact taking money back at closing. That ended in tears, and the saga has been fascinating. A lot of people thought it was easy money, and maybe it was for the first few. For a lot of other people, they would’ve been better off taking a bucket of cash and setting it on fire.
You of course, add in a lot of personal malfeasance and fraud to this and it becomes the same human story, over and over. A couple of years ago, I worked with some people to try and put together a subprime lender, which is a lot easier than you think. Working with brokers from an existing shop was an eye-opening experience. The top brokers were making between $500k and $1 million or more. The borrowers typically didn’t read the HUD statements, or they would’ve realized that they were paying fees between 2% and 6% of the balance, of which the broker took a healthy piece. And the brokers were just swimming in business. Borrowers were both ignorant and also at the mercy of brokers, to the extent that bad credits have fewer options than prime borrowers.
The funny thing is that the brokers were, like a lot of sales guys, people who live wholly in the moment. Despite making enough money that they could essentially retire, they typically spent all of their money. A friend of mine was interested in investing in one shop, and when he visited he saw a Bentley in the lot. He asked the owner if it was his, and he said, hell no, that’s my top broker, and I like it that way. He’s got a $4000 car payment and $500 in rent - this way I know he’s always going to be coming to work so he can cover his nut.
As people have noted, the problem now is that the people who own the loans have no connection to the borrowers, so the opportunities for some sort of workout process are pretty limited. Ordinarily you could negotiate during foreclosure, but with this process, it looks pretty grim.
I guess I don’t really get the problem, trio_jeppy. The people who bought these mortgage funds obviously knew they were essentially buying junk bonds. I would expect these bonds to ultimately pay 85 to 90 cents on the dollar. So the bond investors take a small haircut. Big deal.
I am guessing your answer is that these aren’t placed typically with ultimate investors, but instead are leveraged out beyond belief with all sorts of derivatives “hedging” exposure and failing miserably. That triggers some sort of chain reaction, but it is hard to see that it gets out of control. If they junk bond people don’t take the occasional haircut, where is the discipline?
I guess I am missing a lot. Any further insights are appreciated.
As usual, Art, I can’t tell if you’re serious or asking another pseudo-question dripping with sarcasm. I’ll contravene my normal policy and answer this.
I’m not at all suggesting that this isn’t normal rationalization of markets. There was a question posed as to how to understand all of the market gyrations, and here is my explanation.
That said, you’re incorrect in saying that they were buying junk bonds. For instance, the Bear Stearns HGSCS funds which blew up owned AAA rated bonds - the highest available. These bonds were the highest rated tranche of a pool of mortgage bonds. That said, they did diminish in value, which ordinarily isn’t a big deal, but it is when you’re leveraged between 10x and 30x, as these funds were, in order to generate yield. I, representing an investor in the fund, spent an hour on the phone with one of the fund managers last year, trying to understand why they would want to leverage up to 30x. Effectively, the answer is that you want to take AAA credit and generate a BBB or BB level return. I asked him, knowing that there are no free lunches in finance, unless your name is Art Laffer, what makes you think you can get away with that much leverage to generate a BB return? Wouldn’t it just be easier to buy the BB tranche instead? To make a long story short, there existed an arbitrage between a levered up AAA and a straight up BB, at least at the time. That arbitrage exists no more, evidently.
The problem is not that some investors will lose money, which is normal course of business. The problem is that markets can completely freeze up, which is the pendulum swinging the other way, which can do a lot of damage. If you own a lot of stock in say, Exxon, because you think that long term oil is the place to be because they’re not making any more of it, and the planet is only burning more of it each day, then you’ve taken a long term view. But let’s say you own that Exxon and its margined up, and for some reason Exxon stock won’t trade in the markets, and when it does, it trades at a tremendous haircut. What’s going to happen is that you may very well be right about Exxon, but you’re going to get margin called, and be forced to sell. And so are a lot of other people. And then this feeds upon itself and can create an overall contagion, which can do a lot of damage in the short term. You may be right long term, but you won’t be there to see it. This is partially what happened to LTCM in 1998.
As I said above, markets only work when there is some order, and spreads between buyers and sellers are reasonable. Otherwise, its no longer a market. If you went to a fish market, and all of the stalls would only sell you fish at 2x what you were willing to pay, because you couldn’t see the fish and couldn’t tell if it was sick, old, spoiled, or whatever, the market would quickly ground to a halt. In that case, nobody wins.
I don’t have a view as to whether this is right or wrong. I’m only explaining what the Fed did, which was to buy time for people to be able to sell their mortgage bonds over time, as opposed to everybody selling RIGHT NOW. All I know is that the Fed cost me money because I made a bet that Friday would be a crap day in the markets, which the Fed rescued, at least in the short term. Longer term, I think it is what it is, and my personal view is that there is serious risk of a recession, in the absence of a Fed rate cut, although Fed Funds futures say there will be one in 1 month. Even a rate cut might not be enough. In any case, the markets will continue to be volatile, because we’re only going to hear about more losses over the next weeks and months and the whole thing clearly hasn’t worked itself through the system yet.
I am not an economist or a financial expert at all, but from what I understand this whole thing could have been averted if the banks did not loan so many people with poor credit ratings and great risk, so much money, just so they cound buy a house. What ever happened to the old adage of spending within your means. If you can’t afford a house, or qualify for a mortgage then you don’t get one - keep renting and wait until you can.
I bought my first house with my fiance two years ago. We waited a few years, built up a decent down-payment by saving as much as we could and cashing in some investments and then took out a mortage that was WAY less than what we could have got from our bank and with monthly payments that are easily made. That was what I was told was the right approach, by the many people I spoke with about the way we should go about it. Makes sense.
Interesting that right next door in Canada, we are not experiencing the same problem for two simple reasons:
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Banks are much more conservitive in terms of who they loan money to
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Canadians as a whole are more frugal and save more then their American counter-parts thus better assuring the chances of getting a loan in the first place.
You validated part of what I thought the answer was. That is that “funds” are leveraged up, not actually owning the debt but just in an equity position on the debt with like 3% or 5% down. Just like the mortgages themselves, but I digress.
Who is it that owns these funds? My assumption is that it is not Bear Sterns that owns them, but they have dumped them into their customers’ portfolios. Frankly, if Joe Blow loses $10K because he has 5% equity in mortgages that in turn have 5% equity, thus investing one dollar to control $400, I really don’t give a damn. Screw Joe Blow and screw everyone like Joe Blow, be it hedge fund or whatever. It is not like we haven’t been down this path before.
I really don’t see how this chain reacts to normal mortgages with 20% down and good credit. Those things are cast in gold. They aren’t going south.
I just don’t see how a market would get disorderly for long. The $300,000 mortgage on the $400,000 house is always going to be readily marketable at about 100 cents to the dollar.
Now, if there are market wide liquidity problems, I understand why the Fed is going to conduct open market operations to keep liquidity in the system. Why they would be buying mortgage securities is beyond me though, unless they are the solid kind I describe. The Fed certainly shouldn’t be buying subprime paper under any circumstances. I do see why they should step in to make sure that solid securities aren’t unmarketable due to trauma elsewhere.
If you leverage your investment in Exxon seeking the long term play and get margined out, well screw you. Shit just happens. No one bails me out of such investments.
I am not being sarcastic at all. Naive maybe. Let me know where I go wrong.
“For instance, the Bear Stearns HGSCS funds which blew up owned AAA rated bonds - the highest available. These bonds were the highest rated tranche of a pool of mortgage bonds. That said, they did diminish in value, which ordinarily isn’t a big deal, but it is when you’re leveraged between 10x and 30x, as these funds were, in order to generate yield. I, representing an investor in the fund, spent an hour on the phone with one of the fund managers last year, trying to understand why they would want to leverage up to 30x. Effectively, the answer is that you want to take AAA credit and generate a BBB or BB level return. I asked him, knowing that there are no free lunches in finance, unless your name is Art Laffer, what makes you think you can get away with that much leverage to generate a BB return? Wouldn’t it just be easier to buy the BB tranche instead? To make a long story short, there existed an arbitrage between a levered up AAA and a straight up BB, at least at the time. That arbitrage exists no more, evidently.”
How is this practice explained in a prospectus? This is probably the most interesting thing I’ve heard in this entire “debate.”
“We waited a few years, built up a decent down-payment by saving as much as we could and cashing in some investments and then took out a mortage that was WAY less than what we could have got from our bank and with monthly payments that are easily made.”
Stay in Canada. We don’t need your type in the US.
There is no prospectus. That’s why its a hedge fund. It’s explained in a presentation, partnership documents, and some nice Powerpoint slides.
You have to understand that CDOs and other similar debt investment vehicles are basically moneyboxes. The box takes equity capital, levers it up 10:1, then goes out and buys debt instruments, pays interest on the debt, and whatever’s left goes to the equity holders. In this case, HGSCS was a hedge fund instead of a CDO, but the principle is the same.
In a CDO, the idea is that if you slice up the tranches of debt correctly, and do it in a way that is most advantageous based on market appetite for various types of debt, you can arbitrage the cash flows and the underlying credit quality of the collateral. HGSCS bought one of the top tranches of one of these issuances. However, since a AAA return is not exactly exciting, something like 20 bps over Treasuries or LIBOR depending on whether its swapped or not, you have to lever in order to make real money - 10-12%.
What happened was that the first fund was levered about 10:1 with repos and other debt. The second fund was similar, except that Barclays bank was willing to lend 3:1 to the equityholders, so the effective leverage was something like 30:1, which based on a AAA collateral and recent historic volatility, makes some sense. However, it doesn’t take account of a lot of things, obviously, including serious deterioration of collateral, illiquidity, etc.
Credit theory dictates that if you’re going to take AAA default risk, you get a AAA return. Likewise, if you take BB risk, you get BB return. However, if you take AAA default risk, but lever your interest so that small fluctuations in credit impact your equity dramatically, this should be equivalent to the aforementioned BB risk. But these guys, for awhile, found a small arbitrage where they could generate a few more bps doing this, at least until the collateral blew up.
I remember being on this call and asking this question to the manager; i.e., how long do you think this small arbitrage will exist. Not to toot my own horn, but I think I was the first investor to ask them this question - the Bear broker told my boss that I “really got it.” However, that didn’t prevent my client from ultimately losing $5 million in this little venture.
I think the short answer is that it wasn’t explained. They drew some nice pictures, talked about historic volatility of the collateral and volatility of the return, and clients felt is was a pretty safe way to juice returns. Oh well.
Stay in Canada. We don’t need your type in the US.
Art,
Thank you.
I assure you, that despite it’s many attractions, I have absolutly no interest in moving to the U.S.
OK, your explanation was just about what I expected.
There are still a couple of things I don’t understand. What did the Fed buy? If it bought AAA bonds for cash money, in order to bring order to what would have been a disorderly market, I have no problem with that. If it really did bring order, then it bought low and will sell high when it unwraps. Somehow, I am not counting the profits just yet.
If it bought junk bonds to bail out your Bear Sterns buddies, I have a real problem with that.
I get a kick out of the arbitrage you describe. Any idiot would know that it would fall apart under the right circumstances. It will work just fine until it doesn’t. Then they go running to the government.
I hope all those funds go down and take their investors with them. Discipline is a bitch.
You nailed it. If they start auditing some of the mortgage applications done in 2004-06, I believe you will find wholesale fraud. It is a crooked dirty business and the weak link in the chain are mortgage brokers who’s whole exisitance comes from making loans, good, bad or otherwise. 100% greed.
I’m in the appraisal side of the business and 2004-06 were “fun” years to be an appraiser. You had pressure from the buyers who lacked inventory to choose from, mortgage brokers and sales agents who wanted a commission. Too many people with a vested interest in the transaction. The future of appraisal is a company called Zaio. No more interference from all the scoundrels in a transaction. Check them out.