A New Flavor of Mortgage Trouble

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Wednesday, June 27, 2007 | The financial press is all worked up about the recent travails of two hedge funds involved in the world of structured mortgage finance.

The reader may wonder at this point why everyone is so upset over a couple of hedge funds -- let alone why the typical San Diegan, uninvolved in the financial industry as he or she is likely to be, should care at all.

The answer is that the hedge funds blowups may illuminate similar vulnerabilities facing many financial institutions. Closer to home, they do a great job of illustrating just how it was that mortgage lending ever got so incredibly lax -- and just why the easy lending we've all come to know and love may not be with us for too much longer.

Germany's first chancellor Otto von Bismarck once remarked, "Laws are like sausages. It's better not to see them being made." I believe Bismarck would have a similar feeling about mortgage-backed structured finance. I know I do. But for the sake of background, let's go through the creation and funding of a typical batch of high-risk mortgages. I will try to keep it brief and to simplify things where possible for everyone's sake.

As we've all heard for years, the mortgage originators who wrote all those teaser-rate, low-down-payment loans to obviously unqualified borrowers didn't actually pause to worry about whether they'd get paid back. This is because they quickly bundled up a batches of their new mortgages into bond-like instruments called "mortgage-backed securities," which were in turn eagerly snapped up by investment banks and other varied financial institutions. The mortgage originator had gotten fees on the original mortgages, and after selling the mortgage backed securities they'd now gotten more money with which to fund more loans and repeat the above process. They are no longer involved with the group of mortgages in which we are interested, however, so let's move along to the investment banks that bought the mortgage-backed securities.

The banks now had fixed-income instruments that they could sell to investors (thus generating fees, of course), but they had a problem. Many investment institutions have rules that encourage them to buy fixed-income instruments that have been deemed by third-party ratings agencies as being at low risk for default, which, put another way, means that the institutions are very unlikely not to be paid back. The types of mortgages described in the above paragraph clearly didn't fit the bill. So, in order to make them attractive to buyers, the banks engaged in a bit of financial engineering.

What they did was to separate the pool of mortgages into different layers, called "tranches," each with a different interest rate and a different level of default risk. This was accomplished by granting the low-risk tranches first access to whatever mortgage payments were made. These least risky tranche would be first in line to receive mortgage payments but would pay out the lowest rate. The next layer down would only start to receive its mortgage payments when the first layer had been fully paid for the month. This layer would pay more interest, but being second in line for payments it was subject to a higher risk of default in case homeowners stopped paying the bills. The payments cascaded all the way down to the very bottom layer, which was last in line for payments and thus had high default risk but was rewarded with a very high interest rate for its owner.

The resulting multi-tiered collection of securities was referred to as a collateralized debt obligation, or CDO. CDOs were typically made up of subprime mortgages, other risky loan types, or even other CDOs. They often had very little actual home equity backing them up -- many of them had only 5 percent equity, many even less. Nonetheless, the restructuring of cash flows enabled the top CDO tranches to received AAA ratings -- the highest possible -- from the ratings agencies, who often worked closely with the banks to structure the CDOs (earning huge fees in the process).

In the end, despite the questionable nature of the original home loans, the banks were usually able to convert about 75 percent of a given pool of loans into fixed income securities that were stamped as being effectively free of default risk. And with that, the more cautious institutions lined up to buy these securities in droves.

There was still a problem, of course, but it was one of those long-term problems that everyone likes to ignore when the money is rolling in. The problem was that the ratings agencies were estimating default risk based on computer models which were, as it should now be crystal clear, very flawed. It's tough to know exactly what was going on behind the scenes, but it seems like many of the models extrapolated the trends during the recent good times -- when home prices were skyrocketing and defaults were at all time lows -- well into the future. The modellers apparently didn't take into account the possibility that home prices would decline and that, lacking the cushion provided by continually growing home equity, many borrowers using risky loans would be forced into default.

In other words, those top-tier CDO tranches were probably not as safe as their AAA imprimatur would suggest.

But this AAA-rated chicken has not actually come home to roost yet. As one might expect, the problems are first showing up in the risky lower-rated tranches, which are often half-jokingly referred to among financial industry types as the "toxic waste."

While they were able to generate huge fees selling off the the highest-rated CDO tranches, the banks were still stuck with the lower-rated tranches that many investors didn't want to buy. What was to be done with them? In the case of Bear Stearns, purveyor of enormous amounts of CDO paper and owner of the two hedge funds that just blew up, the answer is pretty clear: They created a couple of hedge funds to buy the junk tranches and got ill-informed investors to pay the tab.

Like so many of today's financial shell games, this worked great -- until it didn't. The higher-than-expected rate of mortgage defaults caused the bottom CDO tranches to drop in price. The hedge funds, which had borrowed heavily using CDOs as collateral, essentially went bankrupt as their collateral value dropped. Creditors seized the hedge funds' holdings and set out to auction them off.

Here's where these two hedge funds' troubles get relevant to the market as a whole.

Because CDOs are rarely traded, it's difficult to determine how much a given CDO tranche is actually worth. Institutions own boatloads of them, and they do try to assign a value to their holdings. But because it's tough to determine an actual market price, the values of a company's CDO holdings are more typically based on what those same old computer models say they ought to be.

If the Bear funds' creditor, Merril Lynch, suddenly auctions off a large collection of CDO holdings at bargain prices, they may demonstrate that the market values of these securities is not what CDO holders the world over have on their books. These other institutions may be forced to recognize that their holdings -- and their shareholders' wealth -- are not what they thought.

As it happens, after Merril Lynch threatened to sell off a laundry list of the Bear funds' CDO holdings, they were convinced by Bear Stearns to hold off for the hopes that other investment banks would bail the funds out. Why would other banks do that? Many observers postulate that the banks are trying to prevent a CDO fire sale that would force everyone to reprice their holdings. As of now, it looks like Bear itself may step in with a multi-billion dollar infusion of their shareholders' money to bail out at least one of the troubled funds.

There is still some question as to whether the banks will prevent the CDO sale, if indeed that is their intent. The more leveraged of the two funds -- and the more likely to fail -- is about $7 billion in the hole. That's a lot of money even for these folks.

There's no question that the situation has many in the financial industry a bit concerned.

Meanwhile, that AAA chicken is still waddling its way home. Many people maintain that the real trouble will begin when the ratings agencies are finally forced to downgrade some of higher-rated, for now, anyway, CDO tranches.

We aren't quite there yet, but it's nonetheless clear that the CDO-producing sausage machine is sputtering, if not about to outright seize up. Beyond the threat to financial company book values the world over, this whole mess is relevant even here in little old San Diego. Without the toxic-waste-into-gold wizardry that CDOs have provided, the seemingly boundless stream of easy mortgage lending -- crucial as it is to keeping San Diego home prices so far above local incomes -- may someday dry up.

Rich Toscano hosts the blog "A Nerd's Eye View: A fact based research blog on housing and economics in San Diego." You can contact Rich directly at rich.toscano@voiceofsandiego.org.