Housing bubble: mortgage market suffering


Richard Moore

Original source URL:

March 11, 2007
Crisis Looms in Market for Mortgages

On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a 
company that specializes in making mortgages to cash-poor homebuyers. The 
company, New Century Financial, had already disclosed that a growing number of 
borrowers were defaulting, and its stock, at around $15, had lost half its value
in three weeks.

What happened next seems all too familiar to investors who bought technology 
stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New 
Century said it would stop making loans and needed emergency financing to 
survive. The stock collapsed to $3.21.

The analyst¹s untimely call, coupled with a failure among other Wall Street 
institutions to identify problems in the home mortgage market, isn¹t the only 
familiar ring to investors who watched the technology stock bubble burst 
precisely seven years ago.

Now, as then, Wall Street firms and entrepreneurs made fortunes issuing 
questionable securities, in this case pools of home loans taken out by risky 
borrowers. Now, as then, bullish stock and credit analysts for some of those 
same Wall Street firms, which profited in the underwriting and rating of those 
investments, lulled investors with upbeat pronouncements even as loan defaults 
ballooned. Now, as then, regulators stood by as the mania churned, fed by lax 
standards and anything-goes lending.

Investment manias are nothing new, of course. But the demise of this one has 
been broadly viewed as troubling, as it involves the nation¹s $6.5 trillion 
mortgage securities market, which is larger even than the United States treasury

Hanging in the balance is the nation¹s housing market, which has been a big 
driver of the economy. Fewer lenders means many potential homebuyers will find 
it more difficult to get credit, while hundreds of thousands of homes will go up
for sale as borrowers default, further swamping a stalled market.

³The regulators are trying to figure out how to work around it, but the Hill is 
going to be in for one big surprise,² said Josh Rosner, a managing director at 
Graham-Fisher & Company, an independent investment research firm in New York, 
and an expert on mortgage securities. ³This is far more dramatic than what led 
to Sarbanes-Oxley,² he added, referring to the legislation that followed the 
WorldCom and Enron scandals, ³both in conflicts and in terms of absolute 
economic impact.²

While real estate prices were rising, the market for home loans operated like a 
well-oiled machine, providing ready money to borrowers and high returns to 
investors like pension funds, insurance companies, hedge funds and other 
institutions. Now this enormous and important machine is sputtering, and the 
effects are reverberating throughout Main Street, Wall Street and Washington.

Already, more than two dozen mortgage lenders have failed or closed their doors,
and shares of big companies in the mortgage industry have declined 
significantly. Delinquencies on loans made to less creditworthy borrowers ‹ 
known as subprime mortgages ‹ recently reached 12.6 percent. Some banks have 
reported rising problems among borrowers that were deemed more creditworthy as 

Traders and investors who watch this world say the major participants ‹ Wall 
Street firms, credit rating agencies, lenders and investors ‹ are holding their 
collective breath and hoping that the spring season for home sales will 
reinstate what had been a go-go market for mortgage securities. Many Wall Street
firms saw their own stock prices decline over their exposure to the turmoil.

³I guess we are a bit surprised at how fast this has unraveled,² said Tom 
Zimmerman, head of asset-backed securities research at UBS, in a recent 
conference call with investors.

Even now the tone accentuates the positive. In a recent presentation to 
investors, UBS Securities discussed the potential for losses among some mortgage
securities in a variety of housing markets. None of the models showed flat or 
falling home prices, however.

The Bear Stearns analyst who upgraded New Century, Scott R. Coren, wrote in a 
research note that the company¹s stock price reflected the risks in its 
industry, and that the downside risk was about $10 in a ³rescue-sale scenario.² 
According to New Century, Bear Stearns is among the firms with a ³longstanding² 
relationship financing its mortgage operation. Mr. Coren, through a spokeswoman,
declined to comment.

Others who follow the industry have voiced more caution. Thomas A. Lawler, 
founder of Lawler Economic and Housing Consulting, said: ³It¹s not that the 
mortgage industry is collapsing, it¹s just that the mortgage industry went wild 
and there are consequences of going wild.

³I think there is no doubt that home sales are going to be weaker than most 
anybody who was forecasting the market just two months ago thought. For those 
areas where the housing market was already not too great, where inventories were
at historically high levels and it finally looked like things were stabilizing, 
this is going to be unpleasant.²

Like worms that surface after a torrential rain, revelations that emerge when an
asset bubble bursts are often unattractive, involving dubious industry practices
and even fraud. In the coming weeks, some mortgage market participants predict, 
investors will learn not only how lax real estate lending standards became, but 
also how hard to value these opaque securities are and how easy their values are
to prop up.

Owners of mortgage securities that have been pooled, for example, do not have to
reflect the prevailing market prices of those securities each day, as 
stockholders do. Only when a security is downgraded by a rating agency do 
investors have to mark their holdings to the market value. As a result, traders 
say, many investors are reporting the values of their holdings at inflated 

³How these things are valued for portfolio purposes is exposed to management 
judgment, which is potentially arbitrary,² Mr. Rosner said.

At the heart of the turmoil is the subprime mortgage market, which developed to 
give loans to shaky borrowers or to those with little cash to put down as 
collateral. Some 35 percent of all mortgage securities issued last year were in 
that category, up from 13 percent in 2003.

Looking to expand their reach and their profits, lenders were far too willing to
lend, as evidenced by the creation of new types of mortgages ‹ known as 
³affordability products² ‹ that required little or no down payment and little or
no documentation of a borrower¹s income. Loans with 40-year or even 50-year 
terms were also popular among cash-strapped borrowers seeking low monthly 
payments. Exceedingly low ³teaser² rates that move up rapidly in later years 
were another feature of the new loans.

The rapid rise in the amount borrowed against a property¹s value shows how 
willing lenders were to stretch. In 2000, according to Banc of America 
Securities, the average loan to a subprime lender was 48 percent of the value of
the underlying property. By 2006, that figure reached 82 percent.

Mortgages requiring little or no documentation became known colloquially as 
³liar loans.² An April 2006 report by the Mortgage Asset Research Institute, a 
consulting concern in Reston, Va., analyzed 100 loans in which the borrowers 
merely stated their incomes, and then looked at documents those borrowers had 
filed with the I.R.S. The resulting differences were significant: in 90 percent 
of loans, borrowers overstated their incomes 5 percent or more. But in almost 60
percent of cases, borrowers inflated their incomes by more than half.

A Deutsche Bank report said liar loans accounted for 40 percent of the subprime 
mortgage issuance last year, up from 25 percent in 2001.

Securities backed by home mortgages have been traded since the 1970s, but it has
been only since 2002 or so that investors, including pension funds, insurance 
companies, hedge funds and other institutions, have shown such an appetite for 

Wall Street, of course, was happy to help refashion mortgages from arcane and 
illiquid securities into ubiquitous and frequently traded ones. Its reward is 
that it now dominates the market. While commercial banks and savings banks had 
long been the biggest lenders to home buyers, by 2006, Wall Street had a 
commanding share ‹ 60 percent ‹ of the mortgage financing market, Federal 
Reserve data show.

The big firms in the business are Lehman Brothers, Bear Stearns, Merrill Lynch, 
Morgan Stanley, Deutsche Bank and UBS. They buy mortgages from issuers, put 
thousands of them into pools to spread out the risks and then divide them into 
slices, known as tranches, based on quality. Then they sell them.

The profits from packaging these securities and trading them for customers and 
their own accounts have been phenomenal. At Lehman Brothers, for example, 
mortgage-related businesses contributed directly to record revenue and income 
over the last three years.

The issuance of mortgage-related securities, which include those backed by 
home-equity loans, peaked in 2003 at more than $3 trillion, according to data 
from the Bond Market Association. Last year¹s issuance, reflecting a slowdown in
home price appreciation, was $1.93 trillion, a slight decline from 2005.

In addition to enviable growth, the mortgage securities market has undergone 
other changes in recent years. In the 1990s, buyers of mortgage securities 
spread out their risk by combining those securities with loans backed by other 
assets, like credit card receivables and automobile loans. But in 2001, investor
preferences changed, focusing on specific types of loans. Mortgages quickly 
became the favorite.

Another change in the market involves its trading characteristics. Years ago, 
mortgage-backed securities appealed to a buy-and-hold crowd, who kept the 
securities on their books until the loans were paid off. ³You used to think of 
mortgages as slow moving,² said Glenn T. Costello, managing director of 
structured finance residential mortgage at Fitch Ratings. ³Now it has become 
much more of a trading market, with a mark-to-market bent.²

The average daily trading volume of mortgage securities issued by government 
agencies like Fannie Mae and Freddie Mac, for example, exceeded $250 billion 
last year. That¹s up from about $60 billion in 2000.

Wall Street became so enamored of the profits in mortgages that it began to 
expand its reach, buying companies that make loans to consumers to supplement 
its packaging and sales operations. In August 2006, Morgan Stanley bought Saxon,
a $6.5 billion subprime mortgage underwriter, for $706 million.

And last September, Merrill Lynch paid $1.3 billion to buy First Franklin 
Financial, a home lender in San Jose, Calif. At the time, Merrill said it 
expected First Franklin to add to its earnings in 2007. Now analysts expect 
Merrill to take a large loss on the purchase.

Indeed, on Feb. 28, as the first fiscal quarter ended for many big investment 
banks, Wall Street buzzed with speculation that the firms had slashed the value 
of their numerous mortgage holdings, recording significant losses.

As prevailing interest rates remained low over the last several years, the 
appetite for these securities only rose. In the ever-present search for high 
yields, buyers clamored for securities that contained subprime mortgages, which 
carry interest rates that are typically one to two percentage points higher than
traditional loans. Mortgage securities participants say increasingly lax lending
standards in these loans became almost an invitation to commit mortgage fraud. 
It is too early to tell how significant a role mortgage fraud played in the 
rocketing delinquency rates ‹ 12.6 percent among subprime borrowers. Delinquency
rates among all mortgages stood at 4.7 percent in the third quarter of 2006.

For years, investors cared little about risks in mortgage holdings. That is 

³I would not be surprised if between now and the end of the year at least 20 
percent of BBB and BBB- bonds that are backed by subprime loans originated in 
2006 will be downgraded,² Mr. Lawler said.

Still, the rating agencies have yet to downgrade large numbers of mortgage 
securities to reflect the market turmoil. Standard & Poor¹s has put 2 percent of
the subprime loans it rates on watch for a downgrade, and Moody¹s said it has 
downgraded 1 percent to 2 percent of such mortgages that were issued in 2005 and

Fitch appears to be the most proactive, having downgraded 3.7 percent of 
subprime mortgages in the period.

The agencies say that they are confident that their ratings reflect reality in 
the mortgages they have analyzed and that they have required managers of 
mortgage pools with risky loans in them to increase the collateral. A spokesman 
for S.& P. said the firm made its ratings requirements more stringent for 
subprime issuers last summer and that they shored up the loans as a result.

Meeting with Wall Street analysts last week, Terry McGraw, chief executive of 
McGraw-Hill, the parent of S.& P., said the firm does not believe that loans 
made in 2006 will perform ³as badly as some have suggested.²

Nevertheless, some investors wonder whether the rating agencies have the stomach
to downgrade these securities because of the selling stampede that would follow.
Many mortgage buyers cannot hold securities that are rated below investment 
grade ‹ insurance companies are an example. So if the securities were 
downgraded, forced selling would ensue, further pressuring an already 
beleaguered market.

Another consideration is the profits in mortgage ratings. Some 6.5 percent of 
Moody¹s 2006 revenue was related to the subprime market.

Brian Clarkson, Moody¹s co-chief operating officer, denied that the company 
hesitates to cut ratings. ³We made assumptions early on that we were going to 
have worse performance in subprime mortgages, which is the reason we haven¹t 
seen that many downgrades,² he said. ³If we have something that is investment 
grade that we need to take below investment grade, we will do it.²

Interestingly, accounting conventions in mortgage securities require an investor
to mark his holdings to market only when they get downgraded. So investors may 
be assigning higher values to their positions than they would receive if they 
had to go into the market and find a buyer. That delays the reckoning, some 
analysts say.

³There are delayed triggers in many of these investment vehicles and that is 
delaying the recognition of losses,² Charles Peabody, founder of Portales 
Partners, an independent research boutique in New York, said. ³I do think the 
unwind is just starting. The moment of truth is not yet here.²

On March 2, reacting to the distress in the mortgage market, a throng of 
regulators, including the Federal Reserve Board, asked lenders to tighten their 
policies on lending to those with questionable credit. Late last week, WMC 
Mortgage, General Electric¹s subprime mortgage arm, said it would no longer make
loans with no down payments.

Meanwhile, investors wait to see whether the spring home selling season will 
shore up the mortgage market. If home prices do not appreciate or if they fall, 
defaults will rise, and pension funds and others that embraced the mortgage 
securities market will have to record losses. And they will likely retreat from 
the market, analysts said, affecting consumers and the overall economy.

A paper published last month by Mr. Rosner and Joseph R. Mason, an associate 
professor of finance at Drexel University¹s LeBow College of Business, assessed 
the potential problems associated with disruptions in the mortgage securities 
market. They wrote: ³Decreased funding for residential mortgage-backed 
securities could set off a downward spiral in credit availability that can 
deprive individuals of home ownership and substantially hurt the U.S. economy.²

Copyright 2007 The New York Times Company

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