RMBS Markets Explained

A: OK, so the stock markets are getting killed down almost 3% with the psychological effect much greater which is what comes with a day where the DOW is down 400 points. I'm getting emails from UrbanDigs readers asking me to explain what the Residential Mortgage Backed Securities (RMBS) is and why its causing such a stir. So let me attempt to explain to you in lay terms what is going on.

There have been many advancements in the financial systems over the past decades. In the real estate lending industry, there was the introduction of real estate investment derivatives called CMO's, or collaterized mortgage obligations. The purpose of this financial derivative, beyond the spread of interest rate risk, was to provide more liquidity in the mortgage markets so that fresh new cash can be supplied to YOU, the consumer, keeping loan product options plentiful and costs relatively cheap. I hope I don't need to explain why more loan options is beneficial to the consumer; but to get an idea, think back (or research it if you are like me and was too young to understand) to the 1970's/1980's where the traditional method of funding home loans was derived from funds raised by savings banks. The savings and loan crisis followed soonafter.

Moving on. Lets define CMO's so I can proceed in explaining its significance.

Collaterized Mortgage Obligations - is a financial debt vehicle that was first created in June 1983 by investment banks Salomon Brothers and First Boston. Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules. The mortgages themselves are called the collateral, and the bonds are called tranches (also called classes), and the set of rules that dictates how money received from the collateral will be distributed is called the structure. The legal entity, collateral, and structure are collectively referred to as the deal.

Now lets translate to today's world. To get a fresh supply of cash to fund more credit, the lenders pooled the mortgage loans and sold them to investment bankers who in-turn packaged and resold them to investors. The dollars were huge, and so were the fees. These CMO’s were seen as safe investments since their value was 'derived' from underlying mortgages that were collateralized by the real property itself.

Lets now sum up the current housing environment and why there are these issues in the RMBS markets:

--> Nationwide housing is slumping big-time
--> Home Builders are in big trouble
--> Interest Rates have been rising / Debt is more expensive
--> Defaults & Foreclosures have been spiking
--> Home prices across nation (outside Manhattan) have been falling
--> Home Equity Withdrawal surged as home prices rose leaving little equity as housing market turned
--> Creative Loan Products reset at higher rates
--> Inventories at record highs (outside Manhattan)
--> Credit Tightening / Credit Spreads Widen
--> Loan Standards Tighten / Fewer options for borrowers
--> Umm, oil prices are near $80/barrel by the way. That can't help!

Get the picture of what is going on? Now, the face value of the mortgage backed securities as I mentioned above is worth a hell of a lot less than it was years ago and finding buyers for the packaged loans intended to be resold is not as easy as it used to. In other words, its less liquid!

Problems are NOT just limited to subprime borrowers as Countrywide Financial CEO publicly stated that he is seeing evidence of a spread to prime borrowers with rising defaults there as well. Up until a few days ago, arguments were being made that subprime was contained. Doesn't appear to be the case. Nobody knows how deep this rabbit hole goes and how many buyout plans in the private equity world may not go through! Its all a guessing game.

These are credit fears. These are fears that liquidity, which was so crucial during the most recent stock market boom and buyout mania, is drying up. In an illiquid world, no one is happy and it puts our fed in a very tight position of having to consider a rate cut to pump liquidity into the financial systems in the face of global growth and inflation; a very dangerous game!

The markets right now are in RISK REDUCTION mode! That means crazy volatility in equities and an end result that will be very hard to predict. Man, I wish I was a trader in this type of market as these were the most profitable type of days.

Few Thoughts Unrelated To RMBS

1. As stock markets correct, fund managers and private equity hedge funds may pull the trigger on some longs and reduce their risk. This may add to the volatility on the downside.

2. Yen/Carry trade may come back in the spotlight as the Yen gains in value against the US dollar. Recall this is what caused a huge selloff in stock markets back in February as the value of the Yen rose against the US dollar causing panic for these investors. In case you didn't know:

A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates - which can often be substantial, depending on the amount of leverage the investor chooses to use.

3. With all the uncertainty, strange how Gold prices (normally considered a safe haven) aren't rallying and instead are sharply lower? Perhaps a link to the Yen/Carry trade liquidation?

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