Thursday, September 22, 2005

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.


Mr. Naybob said...

Steve, love the blog, and I agree, Asian and European MBS holders are going to take a blood bath.

Foreign holdings of US MBS rose 26% last year, making them the fastest-growing source of demand.

Foreigners held $280 billion of U.S. mortgage securities at the end of 2004, or 6% of the total outstanding.

Asian investors now account for roughly 10% to 20% of mortgage securities sold by IndyMac.

Regarding MBS, CDO, Swaps, derivatives and risk:

Traditional concepts of financial diversification are becoming undermined by common risk management practices of progressively similar capital pools.

The pools all use methods where there are similar investment goals, similar responses to change and similiar quantitative models.

This means in times of crisis, there will be similar reactions by market participants to financial catastrophes.

To make matters worse, Many of the methodologies used were developed in other fields of endeavor and subsequently bastardized for the financial world.

This fact dictates that the performance of derivatives, in evolving market conditions and different financial circumstances, can and will be very unpredictable.

Anonymous said...

Blood bath can be in US too after all the foreigners damp US bonds... although barely realistic, still a scenario.

who said that about us dollar to the French prime minister:
"It's our money, but your headache"

people do remember what happened after that...

Anonymous said...

The leverage and illiquidity of derivatives reminds me of a documentary on tunnel building circa the last century where the nitro-glycerin was transported by donkey drawn carts into the mountains. sometimes the carts and donkey would go unstable after being shocked by a bump in the road. After M-M' goes boom, M-C-M' will be all the rage again.

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