Why the mortgage numbers look so grim
In recent months we have all heard the news stories about how banks, insurance companies and the like are taking billions of dollars in write-downs on their mortgage portfolios. This has caused near-panic some days in the financial markets, and cost stockholders of these firms billions in lost value to their holdings.
In some cases, firms or funds have been forced into bankruptcy because of the declining value of their portfolios. However there is little understanding really by the public and many of those reporting it as to what is actually happening, and there are some terribly distorted perceptions of what’s going on.
What is happening is not that these companies are losing billions on actual defaults by home borrowers, although certainly that is the underlying problem. Rather, the perceived values of the mortgage portfolios they hold are dropping precipitously, causing these companies to take write-downs in the value of their assets.
When a company is funding mortgages it pools its loans and goes to the bond market to raise money to replenish its liquidity. In short, they might lend several billion dollars in mortgages, then go sell an equal amount of mortgage-backed securities (MBS) secured by those loans, giving them the money to lend again.
These securities are then sold and re-sold as securities and can generally be traded daily by investors. Eventually the bond holders are paid off when the mortgages mature. In the meantime, yields are generated on the bonds from the interest collected.
Generally only institutions and large funds play in this sandbox. But here is an example of how this works for an individual and you can see the same logic that the institutions use.
Let’s say you wanted to play the Treasury bill market, and you put $25,000 in your trading account and got a $25,000 line of credit from your broker. Chances are your broker would stipulate if the value of your portfolio dropped below a certain level you would have to pay down your line of credit accordingly.
Now if you buy a 10-year T-bill and hold onto it, you will eventually get your money out of it regardless of the day-to-day fluctuations in value. However, if you borrowed part of the money to buy the bond, your lender doesn’t see it that way. As collateral, the T-bill is only worth what it will sell for on the market on a given day. If you have a bad week in the market, your line of credit gets called due and you have to dump your bonds to pay it down.
So if you are a fund manager at Bear Stearns (for example) and take your clients’ money and buy mortgage-backed securities, you would on one hand be reasonably assured that you will get your money if you wait until the bond matures.
But if the money is leveraged and the market value of your mortgage-backed securities drops and your lender calls your line of credit due, you have to dump the bonds for whatever someone will pay. That means you take a huge hit selling assets for less than you paid for them. You then have a huge problem and may have to bankrupt the fund.
Accounting rules also require companies to value their holdings at current market value. This is what has triggered the massive write-downs of asset values for many companies, including Citibank, Bear Stearns and many others. In some cases they did not have to sell the bonds due to margin calls, but they had to write down the value of their mortgage-backed securities portfolios. That’s because if they wanted to sell the securities, they would have gotten a very low price for them.
In the event of a bankruptcy, the portfolio may become part of the bankruptcy estate. Anyone who picks up the bond portfolio from a bankruptcy estate is going to make a excellent return on it if they manage it correctly and are patient, just like waiting for a T-bill to mature and pay you back your original investment. But investors and lenders don’t always want to wait for years to get their money back.
The historic rate for mortgage defaults is about 1 percent. Recently, as much as 2.5 percent of mortgages are in default. This means that there are hundreds of mortgage-backed securities whose underlying assets are performing like clockwork and in time the bonds will pay themselves off like they are supposed to. However, investors are running scared and the value of most all mortgage-backed securities are low because no one wants to own even the good ones.
It is tragic how overblown this matter has become in the media, and how the frenzy has fed itself into a whirlwind of confusion and gloom and doom, creating a self-fulfilling prophecy that is wreaking far more havoc than it ever should have. The spillover into the stock and real estate markets has been enormous, and for the most part totally unfounded.
I hate to say it but we almost need some new disaster to come along to distract the media and allow the mortgage markets to quietly fix themselves. This crisis will pass if left to the mortgage industry to correct mistakes it has made in the past, but if the government tries to fix it and the media keeps grossly exaggerating the problem, then the fix will take far longer than it ever should.
Chris Neuswanger is a loan officer with Macro Financial Group in Avon and can be reached at 970-748-0342. He welcomes mortgage related inquiries from readers.
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