Wednesday, September 17, 2008

Explaining the mortgage mess

Someone just asked me to try to explain the current mortgage mess. Here's my attempt at a neutral, simple explanation:

1. in order to underwrite (sell) a new mortgage loan security (a bond that is really a bundle of similar mortgages), sometimes the bankers behind them offer a default guarantee. An unguaranteed mortgage bond might have a 10% interest rate, but with a default guarantee, it might only need to be, say, 7%. It wasn't always the practice guarantee mortgage bonds, but banks like the fee income they could take from underwriting.

The biggest guarantors of mortgage loans are Fannie and Freddie. The positive spin is that by making guarantees, the cost of borrowing is lower for most Americans. The negative spin is that Fan and Fred have been gobbling risk for decades (with the US taxpayer underwriting their activities), while Fan and Fred shareholders received the profits. The Fan/Fred maneuver 2 weeks ago is basically the US taxpayer stepping up to pay for Fan/Fred's default guarantees.

2. The banks protected themselves from default by swapping their default guarantees among themselves. In other words, if Lehman made a guarantee on $100M in mortgage bonds, they might trade half of that guarantee to AIG, for a quarter of the default risk on their separate $200M car loan bond issuance. (They trade more than just $$$ amounts of risk. For example, a California mortgage bank might sell California home mortgage loan risk in exchange for NYC commercial mortgage loan risk, with the thought that spreading risk further insulates the loan originator.)

3. This whole system is dependent on things continuing as usual - that default rates stay within historical averages. That lets each risk swapper accurately price what's been swapped.

Turns out, in the rush to issue mortgages, some borrowers were given too much credit, and some rated much higher than they should have. These people have been unable to cover their mortgage loans, leading to defaults.

4. With mortgage defaults rising, all of the math underlying the default guarantees has gone to h3ll, and some bond guarantees are being called on. (some default guarantees aren't even being called and are still wreaking havoc, as accountants adjust the value on the books of troubled bonds down, and increase the (expected) liabilities of the guarantees. Banks need to keep a certain amount of capital in reserve for these situations, and the amount of required reserves is rising as a result. Money "reserved" by banks to meet requirements is money that really can't be used for investment. The result: less investment capital available for everyone. (Why this matters, pt. 1))

5. Some finance companies (Bear Stearns, Lehman) don't have the capital to make good on their guarantees, and they're going out of business. Other companies like AIG are feverishly trying to get more capital.

6. Why this really matters (pt 2.): in many ways, the finance world still operates on little more than a handshake (because the volume of transactions prohibits you from getting full legal paperwork done for every deal including regular settling of trades.). Many transactions rely on both sides believing that the other will still be around tomorrow, but now everyone is questioning everybody else, gumming up the system, and ultimately making transactions more expensive (in many different ways, including making a new mortgage for you or me more expensive), and hurting the economy.

7. If the problem described above were limited to a few companies or even just one sector (like home loans), the reaction would probably be "let 'em fail," but there's 2 larger issues that are also in consideration: 1) the mortgage default rate problem has creeped into other credit (financial) markets, such as auto loans and student loans. (As some consumers are swamped by their mortgage rate adjusting higher, they're defaulting on credit cards, car loans, etc.) The result of the problem creep: all financing is getting more expensive and more rare. Good companies with nothing to do with the financial mess are having a hard time getting loans and investment capital. and #2) investors (particularly foreign investors) are loosing faith in US markets, and demanding a risk premium on investments in the US. This hurts our economy in the short term, and makes it really hard to finance our national deficit. This difficulty is magnified by the weak dollar. (Though the dollar has been strengthening recently.)

Feel free to lob me any follow-up questions...

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With my new friends on the Great Wall of China

With my new friends on the Great Wall of China
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"I do not choose to be a common man. It is my right to be uncommon -- if I can. I seek opportunity -- not security. I do not wish to be a kept citizen, humbled and dulled by having the state look after me. I wish to take the calculated risk; to dream and to build, to fail and to succeed. I refuse to barter incentive for a dole, I prefer the challenges of life to the guaranteed existence; the thrill of fulfillment to the stale calm of utopia. I will not trade freedom for beneficence, nor my dignity for a handout. I will never cower before any master, nor bend to any threat. It is my heritage to stand erect, proud, and unafraid, to think and act for myself, to enjoy the benefit of my creations, and to face the world boldly and say, "this I have done." All this is what it means to be an American." -- Anonymous