How to lose big money in the mortgage business

David Leonhardt:

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It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The competition brought down mortgage fees and spurred innovation, much of which was undeniably good. Why should someone who knows that they’re going to move after just a few years have no choice but to take out a 30-year, fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people — by “people,” I’m referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher, so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.

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There is more. I think he has pretty well nailed what happened. Not mentioned is what did not happened. Normally when you have a market involving highly leveraged investments such as a commodity account, their are triggers built in to require additional collateral or the sale of the underlying commodity before the investor goes below zero.

Even in the not so highly leveraged margin account on stocks the mechanisms are built in to close out the account before it goes below zero in a falling market. Because the institutional buyers were perceived to have large financial resources these triggers do not appear to have been in place for the collateralized mortgage paper which had built a reputation of being pretty secure back when people were putting 10 and 20 percent down on their home purchases.

When that changed and the rule of thumb on not having a house payment that exceeded 25 percent of your take home pay went away, these mortgages became much less secure and much easier to walk away from.

What is troubling now is that because the paper being traded is collateralized with mortgages on property that trades in an imperfect market it is hard to place a value on it so in a declining market the tendency is to mark it down to be safe. This appears to have had a cascading effect in the declining value of these highly leveraged securities. It is also clear that many in the industry did not comprehend the risk factors associated with these investments.

Besides the support the Fed is giving the market right now, there needs to be an effort to define the risks in these instruments better and put mechanisms in place to manage the risk. That would go a long way toward stabilizing the market.