WSJ: Strong demand for mortgage-backed securities from investors world-wide is allowing American lenders to make more loans -- and riskier ones -- in a way that is helping prolong the boom in U.S. house prices.
The cash pouring in -- not only from U.S. investors but increasingly from Europe and Asia -- keeps stoking the housing market even as the Federal Reserve Board continues to raise interest rates, normally something that damps home prices. The market has shown a few signs of slowing recently, and talk of a bubble has grown louder, but prices continue to rise or remain at lofty levels as investors continue to gobble up mortgage-backed securities and banks keep lending.
"As the Fed has tightened, lenders have eased" terms for borrowers, says Mark Zandi, chief economist at Economy.com, a forecasting firm in West Chester, Pa.
Investment banks and other firms have been buying mortgage loans from lenders and packaging them into securities for sale to investors since the 1980s. But investor demand has surged in recent years, largely because in an era of low returns, mortgage-backed securities offer yield-starved investors much higher returns than government bonds.
U.S. lenders will make about $2.8 trillion in home-mortgage loans this year, according to the Mortgage Bankers Association. The MBA estimates that about 80% of these loans will end up in mortgage-backed securities. Mortgage-backed securities outstanding at the end of the first quarter totaled $4.61 trillion, up 61% since the end of 2000. In the same period, total Treasury securities outstanding grew 35% to $4.54 trillion.
Investors' strong demand for mortgage debt, besides allowing lenders to offer many borrowers better terms, has also made it easier to offer mortgages to borrowers who might not easily qualify for a loan. The growth of the mortgage markets spreads the risks around. But some mortgage-industry analysts say lenders have become less stringent in their loan terms because they can sell almost any type of loan to those who package mortgage securities for investors.
"Loose lending standards are probably the single biggest thing fueling the speculative fever we have today" in housing, says Kenneth Rosen, an economist who is chairman of the Fisher Center for Real Estate at the University of California at Berkeley.
In a world of low interest rates, the market for mortgage securities is simply too big and profitable for many investors to ignore. Investors can earn about 5.5% on mortgage securities whose payments are guaranteed by Fannie Mae or Freddie Mac, government-sponsored companies. Those who can stomach greater risk can buy subprime mortgage securities, which come with no guarantee but can yield as much as 15%, according to Bear Stearns. By contrast, 10-year U.S. Treasurys yield about 4.2%; the equivalent government securities in Germany yield about 3.2% and in Japan 1.5%.
The buyers of mortgage-backed securities include U.S. pension funds, hedge funds and insurance companies. But overseas investors are the fastest-growing source of demand. The trade publication Inside MBS & ABS estimates that foreigners held $280 billion of U.S. mortgage securities at the end of 2004, or 6% of the total outstanding. The foreigners' holdings rose 26% last year and have continued to bound ahead so far this year, Inside MBS & ABS says.
"There's this insatiable appetite for mortgage-backed securities world-wide," says Andrew Sciandra, a senior vice president at IndyMac Bancorp, a California thrift, who heads a team that creates those securities. In the past year, Mr. Sciandra has met with investors from places like Germany, France and Abu Dhabi. Asian investors now account for roughly 10% to 20% of mortgage securities sold by IndyMac.
For homeowners, the growing international demand for mortgages means it's increasingly likely that the money they borrow to buy a home or refinance their mortgage is coming ultimately from outside the U.S. When Claude Gaty, a chef and co-owner of a bistro in Las Vegas, recently refinanced the mortgage on his four-bedroom Las Vegas home, the lender was IndyMac. But the bulk of the money came from investors in Asia.
IndyMac pooled Mr. Gaty's loan with about 3,000 other mortgages that carry a fixed rate for the first three, five or seven years. Mr. Gaty is paying both principal and interest on his loan, but most of the loans in the pool are interest-only mortgages, which allow borrowers to pay no principal in the early years. When the $650 million offering of triple-A rated bonds backed by these mortgages came to market in June, it drew more than a dozen investors from Europe, Asia and the U.S., according to Deutsche Bank, which handled the deal. Such bonds typically yield 0.75 to 1.15 percentage point more than Treasurys, Deutsche Bank says.
The most recent entrant to the market is China. Its banks are rich with deposits from Chinese companies that earn dollars exporting to the U.S. Dollars have also been handed to some banks by the government in Beijing as part of its efforts to strengthen their balance sheets.
Until a few years ago, Chinese investors restricted U.S. investment mostly to Treasurys. Now, to boost their yields and because they consider the market safe, bankers from a number of institutions say they are devoting more of their portfolios to mortgage securities. Some bankers say their goal is to have 40% of their U.S. dollars in asset-backed securities.
China's government also is testing U.S. mortgage investment. The country's Bank of Communications, the only bank with a mandate to help manage China's $700 billion of foreign-exchange reserves, has recently put a sliver of those reserves into mortgage-backed issues, according to a banker there. The State Administration of Foreign Exchange, the government agency in charge of the reserves, declined to comment.
Zhu Kai, who helps manage U.S. dollar investments at Bank of China, says in a rare interview that his mortgage-backed portfolio has "plenty of room to grow." Mr. Zhu expresses confidence in the U.S. dollar and the health of the U.S. home market. Housing is so vital to the U.S. economy, Mr. Zhu and some of his counterparts at other Chinese banks reason, that U.S. authorities will prevent a bust.
Even the recent decision by the Chinese government to raise the value of its currency by about 2% isn't likely to lead Chinese banks to shift their plans. "The timing may be a little bit surprising but we will not change our investment portfolio," Mr. Zhu says.
While Asian investors have largely focused on triple-A-rated bonds, other investors are buying lower-rated debt. These bonds, which are created when bankers carve up pools of mortgages, offer higher yields, but also bear the first risk of losses should borrowers default. Investors who buy these bonds in effect set the standards for which mortgages are made by deciding how much extra yield they need to compensate for the added risks of lower-quality loans. They include real-estate investment trusts, hedge funds and investors from Europe.
Strong investor interest has also made loans available to borrowers with poor credit and many other people who might otherwise have trouble getting a mortgage. Subprime loans included in mortgage securities totaled $401.5 billion last year, nearly double the total for 2003, according to Standard & Poor's. Meanwhile, loans with less than full documentation of the borrower's income and assets accounted for 70% of mortgage securities rated by Standard & Poor's in this year's first half, double the level recorded in 2000.
"There's no question that [lending] standards have loosened over the past couple of years," says Arthur Frank, director of mortgage research at Nomura Securities International in New York. If house prices fall, "you may well have some pretty serious credit problems," hurting holders of the lower-rated mortgage securities.
Mr. Zhu, the Chinese fund manager, is sanguine, for now. The U.S. housing market is "maybe losing a bit of steam," Mr. Zhu says. "I think the monetary authorities, they don't want this housing market to burst. I don't think it is a bubble. But if things go on like this for another five years, it's a different story."
On a related note, the Economist can't figure out why financial markets aren't punishing economies for budget deficits. It is amazing how low real interest rates are now relative to the last 20-30 years.
...a more efficient international capital market is supposed to ensure that capital is allocated to the most productive use. Yet much of the recent inflow of foreign money into America is not financing productive investment, but a housing bubble and a consumer binge.
...The inevitable correction, when it comes, is likely to be all the more painful. When financial conditions tighten, investors are sure to become more discriminating. Sooner or later, the traffic lights will turn red.