The Mortgage Meltdown


August 10, 2007

You may be wondering why a fiction writer is blogging about this, but it makes a lot of sense. Really, it does!

In my books, I often write about large, sweeping issues. Our economy, both here and abroad, makes a big difference in our lives. Our financial welfare influences how we feel and how we act. It also influences how we behave as a nation, within our borders and in other parts of the world.

I am working on a couple of investment books. I plan to make these very different than the traditional dry fare. My investment books won’t be out for at least a year, after my upcoming books, The Varicose Vigilantes and The Presidential Pretender. I also have a 1350 page tome that weaves real worldwide events into the plot over the course of a hundred and fifty years. So, I thought I might vent a little on the economy. Here we go:

I have worried for several years about the mortgage derivative market, and what it might do to the stock market and the U.S. economy. This August, we began to see some of the shakeout of the hangover that will result from this uncontrolled Toga Party.

This is not the first time that Wall Street has made a “Pig” look like a “Beauty Queen,” and it won’t be the last. I am afraid that few people (perhaps even the Federal Reserve Board) understand the extent that mortgage derivatives may poison our financial waters. It reminds me of lyrics from an old Jerry Lee Lewis tune “All The Girls Look Prettier At Closing Time…” Well, the party is over!

So, what is really going on? And what caused all this in the first place? I’ll try to make it simple.

Over the past decade or so, there was a growing demand in the marketplace for high-grade corporate debt. At the same time, there has been a dwindling supply. This was an inequilibrium that was just too good for Wall Street to pass up. With billions of dollars of fees and commissions on the line, Wall Street figured out a way to create new high-grade debt. In other words, a silk purse out of a sow’s ear..

There is a great, “unfunded liability” in the pension marketplace, particularly with defined benefit plans. Defined benefit plans are the anachronistic (yet beautiful) retirement plans that paternalistic companies used to offer their employees. They guarantee a defined benefit, usually a percentage of salary, to employees at retirement time. These pensions owe far more to their covered employees than they have put away for them.

Pension regulations are quite complex, and I am simplifying the issue here, but these pension plans owe billions to their employees that they do not have. Ultimately, the companies themselves would have to make up this shortfall (provided they don’t enter bankruptcy). But many of the liabilities are in the future, so the pension plan managers have time to make up the shortfall, provided they can earn high investment returns.

Unfortunately (for the managers only) these managers usually have strict guidelines about how they can invest a pension plan’s money. This is outlined in an Investment Policy Statement—essentially the plan’s business plan for investment operation. Pension managers are held to what is known as a “Fiduciary” standard, and must manage pension money without taking a whole bunch of risk. Good for plan safety, bad for plan managers if the companies underfund the plan—which they often do. Keep in mind that many of these plans were put in place decades ago when the business climate was far more profitable and predictable.

Pension plan managers (typically) must invest in a diversified portfolio. Usually, this consists of a healthy diet of stocks, bonds and cash. Bigger pension plans (like CALPERS, the California plan) have been known to allocate money toward a host of more exotic investments aimed for higher returns. Hedge funds, venture capital, etc. But, by and large, though, pension plan managers are expected to invest the majority of their plans assets in investment-grade bonds. Bonds are IOUs issued by companies, governments, agencies, etc. They pay a stated interest, and are generally backed by significant assets. This makes them safer than stocks, with more predictable long-term returns. Of course, with lower risk, they provide a lower long-term return.

The last decade has seen many of the old investment-grade stalwarts vanish from the scene. There are fewer and fewer investment grade bonds (with BBB ratings or above) available for pension managers to buy. Many new bonds are non-investment-grade, also known as junk bonds, issued through leveraged buyouts or companies acquiring others through debt borrowing.

As higher demand from pension managers chased a dwindling supply of investment grade bonds (which were paying paltry yields in this low-interest rate environment) WALL STREET rode to the rescue! “You need higher-yielding investment grade bonds,” they said to pension managers. “If you will buy them, we will CREATE them.” WINK WINK.

There were other big buyers of these things, most notably hedge funds and banks. Did I say banks? Uh, oh.

This is how it has been working. Companies like Countrywide borrow money and use it to issue mortgages. Then they sell the mortgages in the aftermarket, adding fees to make a profit. No problem here. This is good business and good for the country. The after market is dominated by Wall Street. They gather investor money to buy pools of mortgages from the Countrywides of the world. This allows Americans to own the American Dream and capitalists to earn profits for providing this essential service.

The U.S. Government also plays a big role in this as well. They purchase the safest loans (up to a maximum of $417,000/per loan) through quasi-government agencies such as “Fannie Mae” and “Freddie Mac.” Wall Street wraps these mortgages into what are known as “Ginnie Maes,” government backed mortgage securities. Because of certain government guarantees, investors will accept lower returns, so borrowers get better terms. What a great country!

If you have bought a home, you know that the safer your loan is, the lower the interest rate. If you have pristine credit and lots of equity in your home, mortgage companies compete to lend you money. Most of these loans end up being purchased through government backed programs. However, if a mortgage does not “conform” to the government’s strict credit and equity standards, it must be purchased through different entities, funded by investors.

There are different types of “unconforming” loans. There are those that are too big for Fannie Mae to touch. But if the equity and credit are good, these can still be a relatively “safe” bet. Others are not so safe. Some mortgages are issued to borrowers with little or no credit. Some are issued where there is little or no equity. Some are issues with a “fixed” interest rate, while others carry a “variable” interest rate. Uh, oh. Again.

A good portion of these mortgages are sub-prime variables that are potentially set to explode. This is a bad combination—borrowers with poor credit, with little equity, and payments that are about to skyrocket.

Unfortunately, many of the investors who own these things think that what they own is safe! Wall Street buys a whole bunch of mortgages, some safe, some not so safe. Then they package them together and sell bonds to investors. These have become known as CMOs (Collateralized Mortgage Obligations) or CDOs (Collateralized Debt Obligations). The investment bankers split bonds these bonds up into hundreds of little pieces, known as “tranches.” They construct very complicated formulas with lots and lots of numbers that “prove” that these are “low-risk” investments, but with “high return potential.” Investors look cross-eyed at the formulas, nod their heads and gobble them up like ice cream.

Walls Street earns a nice fee. Investors get low risk investments with absurdly high returns. What a country!

The purchasers of these CDOs, including all of their derivatives and tranches, are our friends the pension managers. Not to be outdone, banks, hedge funds and money managers jump on the bandwagon. Everyone buys a piece of the pie (their tranche), the one that best suits their need.

So, what’s the big deal? Let’s look at an example. A hedge fund manager may buy just the interest beginning two years from now. On an ARM this could adjust to LIBOR (London Interbank Overnight Rate) plus six. What started out at 6%, could adjust to a hefty 11.5%. This is a heck of a spread and will give the borrower, and the country, a good case of indigestion. If borrowers default, enormous sums of capital can be lost—just like we are about to see. And if equity vanishes, investors could not only lose interest, but capital as well. Uh, oh.

The scary thing is that there is no real “market” for these instruments, and the current “value” is often determined by the same Wall Street bankers who sold them in the first place. Hedge funds use “leverage.” They borrow huge sums of money to buy these things. Banks have been known to do the same. This is done to earn that theoretical “spread” between the borrowed rate and the earned rate from the mortgages. So now, if a bond defaults, not only do they lose the interest and a good deal of the principal, they are also left owing on the debt they incurred to buy in the first place! Uh, oh.

Companies like Countrywide often borrow short-term funds (through Money Market instruments) to provide the capital they need to fund mortgages—using the mortgages as collateral. Uh, oh. Aren’t money market funds supposed to be safe?

There is now a liquidity crunch (Duh) as investors realize that much of the “gains” or “value” they thought were in these things was simply on paper, and not material. Germany’s central bank had to inject more than a hundred billion to shore up its banking system. The US Federal Reserve did the same. This could be just the first few drops of a coming flood. Publicly, the U.S. Fed does not see this as an impending crisis. However, the SEC has announced that they are now going to examine how these CDOs (and all their derivatives) are valued by the brokerage/investment banking firms. No one on the outside really knows if the investment bankers have been playing it straight all along. If they have been over-valuing these things to keep generating their fees, we could be looking at an unprecedented liquidity disaster in the CDO bond markets, unlike anything we have ever seen. This could spread quickly to stocks, and we could see trillions of dollars in lost wealth.

Do I think this will happen? I don’t really know. It all depends upon how ethical and truthful the valuation of these derivatives has been. Certainly, what we have seen in the last few weeks of the stock markets would get worse if mortgage defaults accelerate and the “value” of these things get written down precipitously. Yesterday, Countrywide pulled $1 Billion in mortgage securities off the market (ones they had been planning to sell). Then they wrote them down to a value of $800 million. Who was the unsuspecting buyer of these things for $1 billion supposed to be? Two hundred million dollars gone in the stroke of a pen. Poof, like Pixie dust.

I am not recommending that people try to time this market, although I have been warning about this scenario for the past six months. And anyone who has listened to me has adjusted their portfolio accordingly. I have a fundamental belief in the long-term viability of the stock market. But, every now and then, something can really throw things out of kilter (like the tech bubble), and perhaps, now, the mortgage aftermarket. As the immortal John Fogarty once said, I see a Bad Moon Arising.

I am paying close attention to the Fed and the SEC to get a feel for which way the wind is blowing. It wouldn’t surprise me if Bernanke lets the economy slow down for a bit. It would certainly cool inflation, and that seems to be his hot button. And it wouldn’t surprise me if the SEC sweeps a good chunk of the issue under the rug. (It is getting very dirty under that rug.) And it wouldn’t surprise me if there are a few hundred billion dollars (or more) that simply vanish from the balance sheets of companies around the globe.

This was a fabrication of Wall Street, that took advantage of very willing (and knowing) participants, from the borrowers on up to the investors who bought this stuff. Unfortunately, there are a lot of innocent investors who will have to pay the dues, including the U.S. taxpayer. What else is new?

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