Thursday, March 29, 2007

Who pays?

I'm trying to understand how the subprime mortgage mess is going to unwind. Below are links to two recent articles I found useful.

1) WSJ on leading subprime lender New Century and how its bankruptcy was driven by decisions on Wall St. by firms like Citi, JP Morgan and Merrill that both lend to mortgage issuers and repackage their loans for resale as CMOs.

2) The Economist's remarkably sanguine summary of the situation. (Some useful excerpts below -- the first hard analysis numbers I've yet seen.)

America's residential mortgage market is huge. It consists of some $10 trillion worth of loans, of which around 75% are repackaged into securities, mainly by the government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Most of this market involves little risk. Two-thirds of mortgage borrowers enjoy good credit and a fixed interest rate and can depend on the value of their houses remaining far higher than their borrowings. But a growing minority of loans look very different, with weak borrowers, adjustable rates and little, or no, cushion of home equity.

For a decade, the fastest growth in America's mortgage markets has been at the bottom. Subprime borrowers—long shut out of home ownership—now account for one in five new mortgages and 10% of all mortgage debt, thanks to the expansion of mortgage-backed securities (and derivatives based on them). Low short-term interest rates earlier this decade led to a bonanza in adjustable-rate mortgages (ARMs). Ever more exotic products were dreamt up, including “teaser” loans with an introductory period of interest rates as low as 1%.

When the housing market began to slow, lenders pepped up the pace of sales by dramatically loosening credit standards, lending more against each property and cutting the need for documentation. Wall Street cheered them on. Investors were hungry for high-yielding assets and banks and brokers could earn fat fees by pooling and slicing the risks in these loans.

Standards fell furthest at the bottom of the credit ladder: subprime mortgages and those one rung higher, known as Alt-As. A recent report by analysts at Credit Suisse estimates that 80% of subprime loans made in 2006 included low “teaser” rates; almost eight out of ten Alt-A loans were “liar loans”, based on little or no documentation; loan-to-value ratios were often over 90% with a second piggy-bank loan routinely thrown in. America's weakest borrowers, in short, were often able to buy a house without handing over a penny.

Lenders got the demand for loans that they wanted—and more fool them. Amid the continuing boom, some 40% of all originations last year were subprime or Alt-A. But as these mortgages were reset to higher rates and borrowers who had lied about their income failed to pay up, the trap was sprung. A new study by Christopher Cagan, an economist at First American CoreLogic, based on his firm's database of most American mortgages, calculates that 60% of all adjustable-rate loans made since 2004 will be reset to payments that will be 25% higher or more. A fifth will see monthly payments soar by 50% or more.

...Mr Cagan marries the statistics and concludes that—going by today's prices—some 1.1m mortgages (or 13% of all adjustable-rate mortgages originated between 2004 and 2006), worth $326 billion, are heading for repossession in the next few years. The suffering will be concentrated: only 7% of mainstream adjustable mortgages will be affected, whereas one in three of the recent “teaser” loans will end in default. The harshest year will be 2008, when many mortgages will be reset and few borrowers will have much equity.

Mr Cagan's study considers only the effect of higher payments (ignoring defaults from job loss, divorce, and so on). But it is a guide to how much default rates may worsen even if the economy stays strong and house prices stabilise. According to RealtyTrac, some 1.3m homes were in default on their mortgages in 2006, up 42% from the year before. This study suggests that figure could rise much further. And if house prices fall, the picture darkens. Mr Cagan's work suggests that every percentage point drop in house prices would bring 70,000 extra repossessions.

The direct damage to Wall Street is likely to be modest. A repossessed property will eventually be sold, albeit at a discount. As a result, Mr Cagan's estimate of $326 billion of repossessed mortgages translates into roughly $112 billion of losses, spread over several years. Even a loss several times larger than that would barely ruffle America's vast financial markets: about $600 billion was wiped out on the stockmarkets as share prices fell on February 27th.

In theory, the chopping up and selling on of risk should spread the pain. The losses ought to be manageable even for banks such as HSBC and Wells Fargo, the two biggest subprime mortgage lenders, and Bear Stearns, Wall Street's largest underwriter of mortgage-backed securities. Subprime mortgages make up only a small part of their business. Indeed, banks so far smell an opportunity to buy the assets of imploding subprime lenders on the cheap.

Some open questions (experts please help!):

1) Effect on housing bubble: how much of the recent bubble was driven specifically by increased availability of credit (as opposed to the usual irrational exuberance or speculation)?

2) How much of bad mortgage debt is insured by CDO derivatives? Who is on the hook? Selling this kind of insurance was reportedly a popular income strategy for hedge funds.

3) Is $100B of mortgage-related losses over several years a big number or a small one? Will anyone blow up (CMO insurers)? Who is holding the riskiest CMO tranches?

4) If $100B over several years is chump change, what are the chances of contagion still leading to a housing bust, credit crunch and recession?

Earnings of big Wall St. banks will be negatively impacted, but some smart guys are surely buying up these loans on the cheap, as markets overreact in the negative direction.


Anonymous said...

Some of your questions are worth millions if not billions :)

Citadel and Farallon are buying aggressively. Usually it is 95-97c/$ which is not too bad.

Most ppl look at the monthly "nut".
Here is approximately what a $1000/month can buy at various 30Y mortgage rates:

7% 150K
6% 167K
5% 186K
4% 210K
3% 237K

Subprime owners have short term views guided by the numbers above -- they have purchase a put on their house for cheap.

Anonymous said...

ps -- it wasn't clear to me what excactly citadel and farallon are buying 95-97 cents ...

Steve -- I found gillian tett's analysis helpful.

she effectively argues that lots of the institutions with long CMO positions aren't selling, and valuation is hard. she also hints that various banks are sitting on a fair amount of potential losses. certainly a few HFs used the CDS market on MBS/ CMOs to basically go short subprime last fall and subsequently have done well (i.e. buy insurance against default on something you don't hold and watch the value of the insurance rise), but i also suspect that even more HFs were going long parts of the market. Afterall, isn't the market fundamentally long subprime (lots of credit was extended)? hence the real question is, as you note, whether those who took the risk can bear it -- hence i too am quite interested in the response to your questions!

brad setser

Anonymous said...

"The direct damage to Wall Street is likely to be modest. A repossessed property will eventually be sold, albeit at a discount. As a result, Mr Cagan's estimate of $326 billion of repossessed mortgages translates into roughly $112 billion of losses, spread over several years. Even a loss several times larger than that would barely ruffle America's vast financial markets: about $600 billion was wiped out on the stockmarkets as share prices fell on February 27th."

There are two possible major flaws in the above.

One flaw is the estimate that there will be only roughly $112 billion in losses.

Among the assumptions on which Cagan bases this are that home prices won't decline much, that this is only a problem of sub-prime lending and adjustable-rate mortgage resets, and that "only 7% of mainstream adjustable mortgages will be affected" (because the borrowers will be able to cope with the resets). By analyzing the situation thus and with the additional implicit assumption that there will be no regenerative amplification, Cagan concludes that losses will be only a few tenths of a percent of GDP, which he believes so negligible as to justify his belief that not only the economy as a whole, but even the real estate market itself, will sail along as before, noticing only a slight "ripple" in the sea.

But in the areas of the nation where most of the homes are they have about doubled (and in parts of California more than tripled) since 2000, though incomes (except of the wealthy) have risen perhaps 30%. It's not at all unreasonable to expect prices to revert to their historical relation to incomes: about 30% above 2000 prices. That's a drop of 35% for most, and 50+% in SoCal, with significant risk of overshoot taking them even lower. Because only about 6% of homes are sold in any one year, and normally only about 2% are on sale at one time, a foreclosure rate of just a few percent equates to a glut of foreclosed homes on the market, with the risk of regenerative effects as it destroys the myth that home prices hardly ever fall, and even if they do will bounce back quickly and go higher than ever. Being fluent in Japanese, and having watched the evolution of their economy since the mid-70s, I have witnessed how a market in which "everyone knew" that prices could never go down -- that no matter how much you paid, there'd always be a greater fool to pay more -- could change to where the watchword became, "Never buy real estate that doesn't flow cash,", and a young couple would tell me, "We've been thinking of buying a condo, but we're going to wait a few years until they're cheaper." And that was in a context where there still truly was great pentup demand for better housing.

Since such a large fraction of the economic growth since 2000 has been housing-related, if (when?) such a sea change occurs here, regenerative effects will come into play, with rising unemployment forcing more and more people to sell and driving prices even lower, such that more and more of them have negative equity. Not only will the number of defaults be much larger than what Cagan predicts on the basis of rate reset alone, the prices will be lower, and the foreclosure loss rate will be higher. Moreover, economy-wide, the foreclosure losses won't be the only losses that result -- default rates will rise on every sort of debt. If losses would be only $112 billion without such knock-on effects, they'll be many times larger in the end.

The second flaw lies in the argument that, "Even a loss several times larger ... would barely ruffle America's vast financial markets ...".

This oft-heard argument relies on an apples-to-baseballs comparison. A nominal $600 billion loss in stock market valuation represents the multiplication of total market valuation by the percentage price change in one day's stock trading -- not only is it not the amount lost by that day's sellers relative to what they paid for the stock, it's most definitely not the amount lost by brokers lending to let them buy on margin.

In an earlier (Feb 2006) paper on mortgage resets, Cagan showed household real estate and mortgage values, respectively, as $11.4 trillion and $4.8 trillion in 2000, rising to $19.1 trillion and $8.2 trillion in Q3 2005, and opined that, since the percent equity hardly fell, this was just rational asset managment -- that the $3.4 trillion increase in mortgages was more than offset by the $7.7 trillion rise in home valuation.

However, with a few back-of-the-envelope calculations we can infer that about $6 trillion of the $7.7 trillion value increase must have been due to rising prices for existing homes, rather than of new-construction additions to the housing stock, and that $3 trillion or more of that "wealth" will vanish if prices drop back to their historical ratio to income.

To compare apples to apples (extension of transaction prices to nominal valuations market-wide), we should be comparing a $3,000 billion dollar drop against the $600 billion drop of Feb 27. Since there is abundant evidence that people take losses in housing value more seriously than losses in the stock market, and we know for certain that home ownership is far more widespread than stock ownership, even that is an understatement.

(See for an earlier Cagan study.)

Steve Hsu said...

JM and PS, thanks for the thoughtful comments.

If Citadel and Farallon are paying 95-97 cents on the dollar for tranches of subprime loans things apparently aren't perceived to be that bad yet.

I was firmly convinced a few years ago (when I started this blog) that the housing bubble would burst with a bang. But it's easy to forget the fundamental arguments when things persist for so long! When will it all unwind? ...

Steve Hsu said...


I just noticed your comment (somehow I missed it a minute ago). I keep telling myself to get an FT subscription since the analysis there often seems better and more detailed than even the WSJ or Economist.

I suspect only a relatively small number of people (perhaps no one?) who are in the mortgage business or on Wall St. really know even roughly who is holding what. You are right that lots of people had to be long for all that credit to be available in the first place!

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Unknown said...

I hope subprime mortgage mess is going to unwind soon as I heard with interest rates on a large number of subprime mortgages and bad credit mortgages due to adjust upward during the 2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or defer interest rate adjustments was implemented to limit the impact. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Restrictions on lending practices are under consideration. Many lenders have stopped subprime lending or dramatically curtailed it.

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