CDOs have been much in the news lately, because of the subprime mortgage mess. Mortgage loan losses, especially among subprime mortgages, have shaken the real estate markets and contributed to the 311 point drop in the Dow Jones Industrial Average on July 26, 2007. While the market turbulence and losses have gotten plenty of headlines, what has been less discussed is how the market for CDOs increased risks and likely exacerbated current problems.
CDOs, as you may know, are entities (usually trusts) that hold pools of mortgages and other loans. The stream of payments (interest and principal) from this pool is subdivided into different segments called "tranches" (which is French for slices). Each tranche has different rights to the stream of payments from the pool. The highest tranche has the best claim, and is the most expensive to buy while offering the lowest rate of return. That's because it also has the lowest risk of nonpayment. As one descends through the tranches, claims to the stream of payments from the pool become ever more subordinate, prices drop and potential rates of return increase. But risks of loss also increase, so you can do very well or very badly in the lowest tranches.
How do the banks that package CDOs sell these things? It's easy enough to understand why someone might buy the highest tranches. They are often comparable to highly rated corporate debt (although the rating agencies seem to have been caught slightly flat-footed by the drop off in the mortgage markets). But where do buyers for the riskier tranches come from?
Some investors seek out risky investments. Hedge fund operators look for risky investments because they have to beat the S&P 500 in order to attract investor money. Pension funds, university endowments and other institutional investors, often seen as bastions of investment prudence, also seek out risk. Here's why.
The 1929 market crash and subsequent Great Depression cured an entire generation of any interest in risky investments. Even the go-go days of the 1960s didn't involve anything approaching the derivatives boom that led to the creation of CDOs. Starting in the 1970s, an idea evolved that taking some degree of risk was good. A well-rounded investment portfolio, it was argued, should include a speculative fillip, something that could boost returns above the boring level of the S&P 500. Sure, greater risk could lead to losses. But if the amount of the portfolio invested in dicey bets was confined, to say 5% or 10%, then the investor would have a good chance of being better off.
The idea that increasing risk was good was marketed by hedge fund operators and other market players who sold risky investment opportunities. Gradually mainstream institutional (and wealthy individual) investors began to accept the idea. Money flowed into the "alternative investment" sector. The hedge fund industry boomed.
As more money flowed into hedge funds and other alternative investments, they needed to find risky investments. After all, a hedge fund operator who claimed to be an investment genius couldn't put his investors' money into S&P 500 index funds. He had to find something that made him look like he deserved the annual 2% of assets and 20% of gains he charged his clients.
The result was that demand for risky investments grew. CDOs, among other things, attained popularity. Subprime mortgages, with their apparent higher risk levels, looked like a good play. They had higher interest rates because they were riskier. But the rising real estate market of the early 2000s usually gave the borrower an escape hatch--if the borrower couldn't repay the loan (especially after an increase in monthly payments), he or she could refinance or sell the house, and the rising real estate market would make that easy. In this way, subprime mortgages appeared to have low risks, even though they were priced as high risks. In the minds of a money manager, that meant they were cheap in comparison to the risks they supposedly had. And if they were cheap, it would make sense to buy a lot of them and generate larger profits. The CDO was a convenient way to sell these high-risk loans to the investment community.
One thing about institutional investors is that they have a lot of money. Even if they divert only 5% or 10% of their portfolios into alternative investments, the result would be a flood of cash. And that's what happened. Money flooded into the alternative investments market. The banks packaging CDOs began looking for more subprime loans. Commissions paid to mortgage brokers for subprime loans increased, and gave them the incentive to steer more customers into subprime mortgages. No doc loans and low doc loans, popularly known among mortgage bankers as "liar loans," became more commonplace. These loans often wouldn't have been made in the past. Now, though, since they weren't being held by the loan originator, but were being sold--first to the banks packaging the CDOs, and eventually to the investors who thought they should be taking more risk--no one had an incentive to exercise caution. The borrowers thought--perhaps erroneously, perhaps because of fraud--that they were getting a good deal. The mortgage brokers collected big commissions while selling the doggy loans to someone else, so they thought they had offloaded the risk. The banks packaging the CDOs made more money with each new deal, while passing the risk onto investors. The hedge funds and institutional investors thought risk was good, so they wanted to buy more risk. Many hedge funds borrowed heavily to buy even more subprime mortgages (or their CDO derivatives), thinking that the more leverage they used, the greater the return on capital they would achieve. The use of leverage magnified demand for subprime loans.
The result was that a ton of imprudent, reckless, ridiculous, and downright stupid mortgage loans were made. The numbers are perhaps impossible to determine at this point, but the rising default rates show that the losses are and will continue to be very large. Because risk came to be seen as a good thing, the market responded to demand and provided more risky investments. A lot more. It literally paid the mortgage industry to create a lot of bad loans. Now there are a lot of losses that have to be suffered.
The sheer quantity of losses is having systemic impact. The bond market is fleeing toward high quality debt and the stock market is becoming more turbulent. Will the world collapse? No. No need to freshen up your secret stocks of batteries, distilled water and freeze-dried food. But the pain will probably increase before it decreases.
The idea that some risk is good for your investment portfolio is a valid idea in a textbook sense. Historical financial data can be used to demonstrate, in a mathematical way, that you would have been better off with a bit of risk during the last 25 years than without it. But the last 25 years have been exceptionally good ones for the financial markets. The 25 years from 1929 to 1954 were little more than break-even, after adjusting for inflation. Past performance is no indication of future performance.
But what happened in the subprime mortgage and CDO markets wasn't just the manifestation of a boilerplate disclosure in the prospectus for every SEC-registered securities offering. We're where we are today because the idea that risk is good became fashionable--too fashionable. And prudence fell out of fashion. Skirts can be made shorter, but there's a limit to how short. And there's a limit to how much risk is good. Investor appetite for risky investments--fueled by incautious marketing by Wall Street--created the monster that we now must deal with. Since the CDO market and hedge fund industry are essentially unregulated, it's unclear how things will play out and who will ultimately hold the bag. One senses that the legal profession will feast; but many others will have a taste of Oliver Twist's gruel.
Skirts eventually became longer, and financial prudence is making a belated re-appearance. Prudence would be advisable for individuals as well as institutions.
Crime News: bad boys sentenced to do the funky chicken. http://www.wtop.com/?nid=456&sid=1201466.
Showing posts with label subprime mortgages. Show all posts
Showing posts with label subprime mortgages. Show all posts
Friday, July 27, 2007
Wednesday, June 27, 2007
The Subprime Mortgage Mess on Wall Street
You're probably familiar with the problems on the home front created by subprime and other adjustable payment mortgages. Monthly payments are rising. Many homeowners are defaulting, and some face foreclosure. The problems are particularly acute in areas where housing prices rose abruptly and have now plummeted, or where economic distress is spreading.
The pain has spread to Wall Street. In the last week, the financial press has reported on difficulties at two hedge funds sponsored by an investment bank called Bear Stearns, which had invested indirectly in subprime mortgages. Bear Stearns agreed to provide a $3.2 billion loan to stabilize one fund. It's unclear what will happen to the other fund. What's going on here? How did we get from some defaulting homeowners in places like Michigan and Florida to a $3.2 billion bailout on Wall Street?
Here's an overview. We are speaking generally, and not about the Bear Stearns-sponsored hedge funds.
Fifty years ago, mortgage lending was primarily done by specialized banks usually called "Savings and Loan Associations" or "Building and Loan Associations." Broadly referred to as thrift institutions, these specialized banks held onto many or most of the mortgage loans they made. They earned profits from the difference between the interest they paid to depositors and the higher interest rate they charged for mortgage loans. Interest rates were stable in those days, and thrift institutions were able to make a comfortable living without working real hard.
In the 1970's, however, interest rates began to fluctuate widely, and the thrifts had a harder time maintaining profits. Regulatory restrictions on them were loosened in the early 1980's, but that resulted in a some poorly conceived lending strategies that led to the collapse of a number of thrift institutions. By 1990, the thrift industry was diminished and other players, like mortgage companies and banks, began to make more mortgage loans. They, however, did not hold onto the loans, but instead tended to sell them.
A mortgage provides a flow of cash, and can be bought or sold like a bond or other investment providing a cash flow. Investment banks pool large numbers of mortgages together into an entity often called a CDO (or collateralized debt obligation). These mortgage pools provide a large, aggregate flow of cash. Investment banks "subdivide" the aggregate flow of cash into classes called "tranches." Each tranche has different claims on the cash flowing from the pool of mortgages. The result is a tier of tranches, with the most "senior" having the best claim to the cash flow from the mortgage pool, the next most senior having the second-best claim, and so on, down to the most "junior" tranche, which basically has a speculative claim to the residual value of the pool.
The CDO issues bonds that correspond with the various tranches. The most senior bonds have the best claim to payment from the mortgage pool. The next most senior bonds have the second-best claim, etc. The potential returns from these bonds varies by the position of the bond in the hierarchy for repayment. The interest paid on the most senior bond will be the lowest, since its likelihood of repayment is the highest. The interest rate on the more junior bonds will increase, since they have greater risk of not being fully repaid. The most junior bond may even be called the "equity tranche," a term that reflects its high risk levels (not unlike the risks of equity investments like stocks).
Why did Wall Street create these CDO's? Because subdividing the mortgage pool into different tranches allowed them to sell a variety of investments that might serve the needs of different investors. Some investors want conservative, reliable investments with a low risk of default. They would be interested in the senior bonds. Other investors want bonds that pay a higher return, even if there's a greater risk of default. They'll take the risk of the default in order to get a better return, and would be interested in the more junior bonds. Some investors want to speculate, and the equity tranche, with its high returns and high risks--might fit into their strategy.
There has been, as you probably know, a hedge fund craze in recent years. Hedge funds have proliferated, and as their numbers have grown, their interest in new and different investments has grown. CDOs have drawn their interest. Hedge funds have borrowed, sometimes heavily, to invest in CDO bonds. Borrowing increases the quantity of bonds a hedge fund can buy and therefore leverages the returns it might receive if all goes well. However, borrowing also leverages the losses the hedge fund would receive if things go badly.
Things have gone badly. The real estate boom is over in most markets and defaults are occurring at well above normal levels. CDOs aren't receiving the cash flow they expected, and CDO investors like hedge funds are taking losses. Those that invested on a leveraged basis may be taking sharp losses.
How did this happen? On the most basic level, the market pros didn't correctly predict the level of defaults. That means they over-estimated the investment quality of many CDO bonds, and priced them too high. Losses are now resulting.
Who's responsible? Homeowners who took out mortgages they should have known they couldn't pay? Mortgage brokers, mortgage companies and banks that made loans to people who shouldn't have qualified? Investment banks packaging CDOs that didn't look close enough at the quality of the mortgages they were buying? Investors that borrowed to invest in illiquid assets like many CDO bonds? All of the above? Now that things are hitting the fan, Congress is holding hearings, government agencies are investigating, and lawsuits will be filed.
There has been very little regulation of the mortgage markets, especially at the Wall Street level, where hedge funds roam unsupervised among herds of CDOs. An absence of regulation sometimes allows markets to grow and evolve more quickly. But markets are created by humans and are therefore capable of error (as is evidenced by all the bubbles, booms and busts of recent years). The enormous growth of the mortgage market included many loans that never should have been made in the first place, and, once made, never should have been purchased for packaging in CDOs. Some of the losses from CDO investments are falling on wealthy individuals who invested in hedge funds to get money to buy a larger yacht. Such a shame. But other losses are falling on pension funds that ordinary people count on for retirement, or on university endowments that could help cover some of the costs of your child's education. In the end, many people will be hurt.
Congress, government agencies and state governments will be confronted by the question whether the mortgage industry should be more heavily regulated. If thrift institutions were still at the heart of the mortgage business, the problems we see today might never have happened. Thrift institutions were heavily regulated, and it's highly doubtful they would have been allowed to make the large numbers of low doc/no doc, don't-have-the-means-to-repay subprime mortgage loans that now weigh down on parts of Wall Street. Had those loans never been made, the losses wouldn't have occurred. And let's not think that subprime loans are a boon to home ownership. Extending loans that people can't pay and result in foreclosures not only doesn't increase home ownership, it damages the borrowers' credit ratings and impairs their future ability to own a home.
On an individual level, stay away from loans that have the potential for increasing monthly payments. As we discussed earlier, the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.
Animal News: the search for Bigfoot continues. http://www.wtop.com/?nid=456&sid=1175579.
The pain has spread to Wall Street. In the last week, the financial press has reported on difficulties at two hedge funds sponsored by an investment bank called Bear Stearns, which had invested indirectly in subprime mortgages. Bear Stearns agreed to provide a $3.2 billion loan to stabilize one fund. It's unclear what will happen to the other fund. What's going on here? How did we get from some defaulting homeowners in places like Michigan and Florida to a $3.2 billion bailout on Wall Street?
Here's an overview. We are speaking generally, and not about the Bear Stearns-sponsored hedge funds.
Fifty years ago, mortgage lending was primarily done by specialized banks usually called "Savings and Loan Associations" or "Building and Loan Associations." Broadly referred to as thrift institutions, these specialized banks held onto many or most of the mortgage loans they made. They earned profits from the difference between the interest they paid to depositors and the higher interest rate they charged for mortgage loans. Interest rates were stable in those days, and thrift institutions were able to make a comfortable living without working real hard.
In the 1970's, however, interest rates began to fluctuate widely, and the thrifts had a harder time maintaining profits. Regulatory restrictions on them were loosened in the early 1980's, but that resulted in a some poorly conceived lending strategies that led to the collapse of a number of thrift institutions. By 1990, the thrift industry was diminished and other players, like mortgage companies and banks, began to make more mortgage loans. They, however, did not hold onto the loans, but instead tended to sell them.
A mortgage provides a flow of cash, and can be bought or sold like a bond or other investment providing a cash flow. Investment banks pool large numbers of mortgages together into an entity often called a CDO (or collateralized debt obligation). These mortgage pools provide a large, aggregate flow of cash. Investment banks "subdivide" the aggregate flow of cash into classes called "tranches." Each tranche has different claims on the cash flowing from the pool of mortgages. The result is a tier of tranches, with the most "senior" having the best claim to the cash flow from the mortgage pool, the next most senior having the second-best claim, and so on, down to the most "junior" tranche, which basically has a speculative claim to the residual value of the pool.
The CDO issues bonds that correspond with the various tranches. The most senior bonds have the best claim to payment from the mortgage pool. The next most senior bonds have the second-best claim, etc. The potential returns from these bonds varies by the position of the bond in the hierarchy for repayment. The interest paid on the most senior bond will be the lowest, since its likelihood of repayment is the highest. The interest rate on the more junior bonds will increase, since they have greater risk of not being fully repaid. The most junior bond may even be called the "equity tranche," a term that reflects its high risk levels (not unlike the risks of equity investments like stocks).
Why did Wall Street create these CDO's? Because subdividing the mortgage pool into different tranches allowed them to sell a variety of investments that might serve the needs of different investors. Some investors want conservative, reliable investments with a low risk of default. They would be interested in the senior bonds. Other investors want bonds that pay a higher return, even if there's a greater risk of default. They'll take the risk of the default in order to get a better return, and would be interested in the more junior bonds. Some investors want to speculate, and the equity tranche, with its high returns and high risks--might fit into their strategy.
There has been, as you probably know, a hedge fund craze in recent years. Hedge funds have proliferated, and as their numbers have grown, their interest in new and different investments has grown. CDOs have drawn their interest. Hedge funds have borrowed, sometimes heavily, to invest in CDO bonds. Borrowing increases the quantity of bonds a hedge fund can buy and therefore leverages the returns it might receive if all goes well. However, borrowing also leverages the losses the hedge fund would receive if things go badly.
Things have gone badly. The real estate boom is over in most markets and defaults are occurring at well above normal levels. CDOs aren't receiving the cash flow they expected, and CDO investors like hedge funds are taking losses. Those that invested on a leveraged basis may be taking sharp losses.
How did this happen? On the most basic level, the market pros didn't correctly predict the level of defaults. That means they over-estimated the investment quality of many CDO bonds, and priced them too high. Losses are now resulting.
Who's responsible? Homeowners who took out mortgages they should have known they couldn't pay? Mortgage brokers, mortgage companies and banks that made loans to people who shouldn't have qualified? Investment banks packaging CDOs that didn't look close enough at the quality of the mortgages they were buying? Investors that borrowed to invest in illiquid assets like many CDO bonds? All of the above? Now that things are hitting the fan, Congress is holding hearings, government agencies are investigating, and lawsuits will be filed.
There has been very little regulation of the mortgage markets, especially at the Wall Street level, where hedge funds roam unsupervised among herds of CDOs. An absence of regulation sometimes allows markets to grow and evolve more quickly. But markets are created by humans and are therefore capable of error (as is evidenced by all the bubbles, booms and busts of recent years). The enormous growth of the mortgage market included many loans that never should have been made in the first place, and, once made, never should have been purchased for packaging in CDOs. Some of the losses from CDO investments are falling on wealthy individuals who invested in hedge funds to get money to buy a larger yacht. Such a shame. But other losses are falling on pension funds that ordinary people count on for retirement, or on university endowments that could help cover some of the costs of your child's education. In the end, many people will be hurt.
Congress, government agencies and state governments will be confronted by the question whether the mortgage industry should be more heavily regulated. If thrift institutions were still at the heart of the mortgage business, the problems we see today might never have happened. Thrift institutions were heavily regulated, and it's highly doubtful they would have been allowed to make the large numbers of low doc/no doc, don't-have-the-means-to-repay subprime mortgage loans that now weigh down on parts of Wall Street. Had those loans never been made, the losses wouldn't have occurred. And let's not think that subprime loans are a boon to home ownership. Extending loans that people can't pay and result in foreclosures not only doesn't increase home ownership, it damages the borrowers' credit ratings and impairs their future ability to own a home.
On an individual level, stay away from loans that have the potential for increasing monthly payments. As we discussed earlier, the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.
Animal News: the search for Bigfoot continues. http://www.wtop.com/?nid=456&sid=1175579.
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