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More Risk in the Mortgage Market?

posted by Elizabeth Warren

The big financial news this week-end is Bear Stearns' decision to put $3.2 billion into its struggling hedge fund to try to stave off collapse of both the fund and the mortgage securities market.  An academic paper,  "How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions," presented early this spring at the Hudson Institute suggests that the mortgage market has been structurally realigned, and that the whole system is far riskier than rating agencies, regulators or investors have perceived.  If the paper is right, Bear Stearns has taken the financial equivalent of striking up the Titanic band to play "Nearer My God to Thee."

Everyone acknowledges that subprime mortgages are riskier than prime mortgages and that more defaults were to be expected.  But what do all those defaults mean in a world in which no lender keeps its mortgage paper?  Now that there is a very active, very profitable, and VERY complex market for purchasing, bundling and trading mortgage securities and their derivatives, what will be the effect of sharply rising defaults?  The conventional wisdom among the don't-worry crowd has been that the new complexities of the mortgage market will provide a level of diversification that will insulate the economy from the impact of defaults.  Yes, lots of people will lose their homes, but they are the only ones who will suffer.  (We'll put aside the morality of that view so we can stay on point about the market.)

Along come Joseph Mason and Joshua Rosner with their paper.  It has some fascinating empirical data about the interaction among various parts of the new, restructured mortgage market.  The authors give a very detailed explanation of how all the pieces of this complex mortgage market are linked and--here's the key--how at each stage, the risks associated with default become slightly more obscured.  The cumulative effect is that the financial markets have hidden both what is wrong with these mortgages and how deeply dependent the economy is on the continued successful repayment of these mortgages. 

The authors conclude:

The structural changes witnessed in the mortgage markets have interacted with complex MBS and highly CDO volatile funding structures to place the U.S. housing market at risk.   Equally as important, however, is that housing market weaknesses feed back through financial markets to further weaken financial instruments. . . . This feedback mechanism can create imbalances in the U.S. economy that, if left unchecked, could lead to prolonged economic difficulties.

What are those "economic difficulties"?  The authors explain that once housing markets collapse, construction, building and home products collapse, which are key to economic performance.  As these decline, mortgage defaults, of course, continue to rise.   

A lot of people got richer off speculation in mortgages.  Now the question is how many more ordinary families--people who work at Home Depot or people who stretched to buy houses at inflated prices or people who have jobs only in a robust economy--will get a lot poorer.


Nice theory but...
Not knowing any more than what what can read, it appears that Bear's fund is in trouble just for believing what you've said. Apparently they were long the less risky "high grade" class of the CDO and short the subprime sector.. i.e long protection on ABX..

Complicated instruments make the usual single factor analysis meaningless... of course they're risky, but the issue is how much more risky than the other part of your portfolio...

While the paper you cited sounds nice..it's totally "specuulation"
Whatever happens to the housing market... its clear than there is no reliable model as to what the impact will be on the economy... so far, quite the contrary... the rest of the US economy much less the world's... seemingly goes on without missing a heart beat...

But I'm curious...if I was lucky enough to secure a house with an advantegeous mortgage, and for less than I would have paid rent... lived in my own home for the last 4 to 5 years, and now have the option to essentially walk away from that house and give it back to the lender, or re negotiate the terms of my loan, either directly or through political intermediation.. How am I worse off?

The point of the research was to show that more complex mortgage financing is obscuring risk. If the authors are right and there is more risk in the marketplace than investors have believed, then Bear Stearns is unlikely to prop up the market by itself.

Nice hypo. I wish I knew someone who had lived it. I'm worried about the people who were refinanced out of safe mortgages, those who were tricked into signing on to mortgages they could not possibly afford, and those who would have qualified for lower-priced mortgages but whose brokers got big yield spread premiums for selling them much higher priced instruments. I'm pretty clear on how those people were hurt.

Though I see only my tiny little slice of the real world, the view that I have somewhat matches what Elizabeth sees. We see refinancings to "fix" defaults, resulting in higher interest rates and sometimes ARM's. We see home equity loans that fix a short term cash flow problem, but create a long term cash flow crunch once the equity is all consumed and new debt (cars, credit cards, etc) once again pile up (inflation in cost of living as a percentage of disposable income is much more rampant in the lower and middle income levels). We see ARM's that can't, as a practical matter, be fixed, so the borrower loses the house, and becomes a sub-subprime borrowing candidate -- in other words, they often never qualify for a home loan again.

Want an eye-opening (ear-opening?) experience? Turn on your average AM talk radio station in your average city, and listen to the ads that Wells Fargo is running these days, encouraging folks to use their homes to pay for that new pick-up, that long-awaited vacation. The ad even tells you that you can have a checking account feature on your new home equity loan.

Little wonder to me that many loans are getting wobbly. Wonder how the numbers geniuses who build the models for CDO's factor in the kind of behavior that those Wells Fargo ads induce.

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