One reason the effect of the US subprime loan crisis has spread so far and so quickly is that financial institutions have many ways of participating in the debt market other than issuing or buying debt instruments. Most of the financial news I have read omits explanations of how it happens, other than generic references to “derivatives.” Here are some of the other ways to have a loss without touching a mortgage.
Credit default swaps are a very common form of derivative. They work this way: A bond holder who is worried about the creditworthiness of the issuer can purchase a credit default swap from a bank. The bank is essentially agreeing to act as a co-signer on a loan. If the debtor defaults, the bank pays off the principal to the bondholder. In return, the bank receives a periodic fee calculated as percentage of the loan. The discounted value of the cash flows from the fees goes on the bank’s books as an asset. If the debtor’s credit deteriorates, the asset’s value goes down, since it becomes more likely that the bond will go into default. Credit default swaps can also be aggregated as investments. Investors, especially hedge funds, may buy either side of individual or aggregated credit default swaps without owning the underlying bond.
Ambac, MBIA, and other companies offer their guarantees (for a price) to bond issuers which might not be able to attract investors otherwise. This guarantee improves the quality of the bond by acting as insurance for bond buyers. These bond insurers are big issuers of credit default swaps, and they are under pressure.
Collateralized Mortgage Obligation (CMOs) These are mortgages with different maturities, rates, and risks, bundled together and sold as securities. Mutual funds are big buyers of these securities, so this is where the individual investor is likely to see the problem in his own pocket. The CMO’s value is determined by estimates of the rate of prepayment or default of the underlying mortgages; when it becomes clear that these estimates have become too optimistic, the value of the CMO drops. CMOs are one type of what are generically called asset-backed securities. Other kinds would include Collateralized Debt Obligations (based on commercial or consumer loans), and mortgage-backed certificates (pass-through mortage pools, with or without a government guarantee). Problems in one part of the credit markets are likely to affect other types of asset-backed securities as well.
Those are just the direct effects. The indirect effects are widespread. The subprime mortgage problem will result in less credit available to other borrowers, regardless of their qualifications, as lenders try to conserve their capital. The financial markets as a whole have begun to doubt whether they even understand the risks of the mortgage-backed securities they already own, which makes new mortgages or other asset-backed loans difficult to sell. Some banks have had to keep mortgages in their own portfolios that they were unable to sell, in part because investment banks have been unable to find buyers for the CMOs they have packaged. The uncertainty itself is an additional risk factor depressing prices. Share prices of financial firms will be a while in recovering.
Their uncertainty, unfortunately, is well-founded and too late. While the immediate trigger for the current crisis was the resetting of adjustable-rate mortgages, the problem was a long time developing. For years, mortgage originators other than banks have been lightly regulated. There is no question that some of them have misrepresented the financial health of the borrowers. The newspapers are full of stories about applications being changed, with borrowers’ income magically doubling, and complacent or complicit appraisers inflating the value of real estate. Most of it is not fraud, however; just bad business practice. I know of one couple who got a primary mortgage for 80% of the purchase and borrowed the 20% down payment on a HELOC (home equity line of credit). They did not even have to pay for primary mortgage insurance. They also have about $50,000 debt on various credit cards and a couple of car loans. Personal bankruptcy or mortgage default would finish their careers in accounting or financial services, so they may hang on and pay it. In fact, they’re current and paying down the debt. You have to wonder, though – what else is out there? Until that question gets answered, the pain will continue.
Right after I thought I had finished this, Freddie Mac, an enormous mortgage finance company, announced a huge loss and indicated it will need to raise capital. Freddie Mac and Fannie Mae were originally established by the federal government, although they are nominally independent and sell shares to the public. If either of these entities has to stop processing loans, there will be no loans processed. Two other things to note:
- Freddie Mac and Fannie Mae’s securities are not guaranteed by the US government. However, they have always been understood to carry an implied guarantee, at least as far as their bonds are concerned. That’s you and me, folks.
- Neither Freddie Mac nor Fannie Mae deals with sub-prime mortgages. They do, however, trade in derivatives related to interest rates and credit. These results indicate that write-downs of asset-backed securities are moving up the quality charts to investment-grade issues.