Exporting mortgage risk

Oh goody, foreigners are stepping up to take on the default risk from our housing bubble! Better them than us when the market pops :-) I'm glad Fannie and Freddie have been reigned in -- too bad Franklin Raines seems to have gotten off scott free, thanks to friends in high places.

WSJ: When the American housing boom winds down, some of the first howls of pain are likely to be heard in Europe and Asia.

That is because investment banks have been moving more of the risk of defaults on home mortgages to foreign investors, leaving less with U.S. lenders and investors.

This change comes amid concern among U.S. bank regulators about frothy house prices and about lenders' heavy promotion of loans that allow borrowers to afford pricier homes by delaying repayments of principal. The offshoring of such risk also comes as Fannie Mae and Freddie Mac -- formerly the main holders of credit risk in the U.S. mortgage market -- are playing a smaller role in that area.

Lenders wrap home loans into securities known as mortgage bonds, and foreign investors are gobbling up some of the riskiest ones, says Daniel Ivascyn, a portfolio manager at Pacific Investment Management Co., or Pimco, even as "many sophisticated investors at home" shy away from the riskier types of these bonds.

The vehicle for this shift of risk is the fast-expanding market for collateralized debt obligations, or CDOs, pools of debt instruments that are a rich source of fees for investment banks and money managers. CDOs are investment vehicles created by investment banks and others that sell equity and debt to investors. The proceeds are used to buy an array of bonds and other fixed-income assets. More and more CDOs are being created to buy U.S. mortgage-backed securities and other types of asset-backed securities.

Issuance of this type of CDO in this year's first seven months totaled about $35 billion, compared with $49.7 billion for all of 2004 and $23.1 billion in 2003, according to Bear, Stearns & Co.

Gyan Sinha, a senior managing director at Bear Stearns, says CDOs are an easy way for foreign insurers, pension funds and others to put money into the vast U.S. mortgage market. CDOs wrap a variety of mortgage securities into one package, sparing the investor from having to research each individual security.

CDOs, in turn, are the biggest buyers of the riskier types of mortgage securities, Pimco's Mr. Ivascyn says. If defaults reduce the amount of cash available to pay holders of a mortgage-bond issue, the holders of the lower-rated, higher-risk portions absorb losses before holders of the investment-grade portions suffer.