Explaining The CRUNCH In Mortgage Land
A: Yves Smith's blog Naked Capitalism points me to a great chart on Econbrowser showing the dramatic retrenchment of securitizing mortgage loans. This death of securitized mortgages, as Yves calls it, explains why our housing market is in the shape it's in and one reason why banks balance sheets continue to be crunched! Lets delve into this topic for a moment to understand how the system used to work, and what is happening now.
First off, let us not forget my piece on January 2nd, where I explained this very topic in detail. In the discussion, "Bonuses: It's 2009 That Will Hurt More", I stated:
The derivatives trade of securitizing loans and selling them off in pieces on the secondary mortgage markets generated billions in revenue for these banks & brokerages. Now that the housing bubble popped nationally, risk has been re-priced, secondary mortgage markets are not functioning properly, liquidity dried up for mortgage backed securities, and the announcement of billions in losses and potential insolvencies, THE GAME IS OVER! How will these banks and brokerages generate the kind of revenue that they got used to generating the past few years?I can't get clearer than that statement, as it reminded me of decimalization ruining volatility/spreads when I was day trading NASDAQ equities! Of course, this statement was used in the context for discussing why the 2009 wall street bonus season will be the troubled one, and not the upcoming 2008 wall street bonus season that every agent was looking forward to at the time (put yourself back in time 6 months when the post was written).
Fast forward to today, and Econbrower's Peter Hooper provides this very compelling chart showing you the current extinction of securitizing mortgage loans:
This is one crazy and extremely important dataset! What does this all mean and what caused it? Well that is a very long discussion for another day. What you need to know is that this securitization model is what allowed the housing boom to occur in the first place; and now its dead. It was a volume & fee based securitization model where quality was replaced by quantity in order to generate as much revenue as possible, and now we are paying the price! In went a little something like this:
BANK PROVIDES LOANS WITH OWN CAPITAL ---> BANK BUNDLES TOGETHER A POOL OF LOANS ---> BANK SECURITIZES THIS POOL OF LOANS & CREATES A RESIDENTIAL MORTGAGE BOND ---> BANK SLICES & DICES MORTGAGE BOND AND SELLS OFF IN TRANCHES ON SECONDARY MORTGAGE MARKET --> BANK GENERATED REVENUE/PROFIT VIA FEES ON EACH LOAN AND ON SECURITIZATION PROCESS ---> BANK NOW HAS FREED UP CAPITAL FOR MORE LOANS ---> PROCESS REPEATS
See "How Mortgage Back Securities Work" for a visual and more details on this money making process. Of course this is the short short version, but you should get the idea of how the securitization model and a normal functioning secondary mortgage market allowed banks to offload loans on their balance sheets, make money in the process, and free up capital to lend all over again. This cycle is now broken because:
a) housing bubble burst, making home loans a risky asset
b) demand for mortgage assets dropped sharply, resulting in an illiquid secondary mortgage market
c) securitization model dies, banks/IB's can no longer off load mortgage assets without incurring a huge loss (resulting in write downs of these assets as price discovery for trades brings down the value of everything still held on the books)
...resulting in a capital CRUNCH! This is credit deflation resulting from housing deflation, destroying the balance sheets of the very banks that lend to consumers to purchase a new home. The end result for consumers is:
a) elimination of risky loan products
b) much tighter underwriting standards to be approved for financing
c) higher lending rates; disconnect from bond market as risk is re-priced into loans
d) higher reliance on debt-to-service ratio
e) higher correlation between credit score and lending rate
f) lower loan-to-value ratio; no more 100% down!
Now think, in this new crunchier environment, how is housing supposed to get the spark it needs to bottom and recover? This is what is happening and will continue to happen as long as housing prices are pressured to the downside and wall street restructures their balance sheets. Unfortunately, even as housing stabilizes and prices start to rebound, regulation resulting from the fed's unprecedented liquidity actions will put a bit of a stranglehold on this securitization model in the future to prevent another credit crisis from repeating. In short, wall street will NOT be the same for a while...as I said 6 months ago, THIS GAME IS OVER!
Comments (1)
Whaddya know? Median co-op resale prices rise year over year, quarter over quarter and in all catagories. Look at the reports.
I said it here first - median 2008 co-op resale will beat median 2007 co-op resale. Looks like a good call. :)
Doom and gloom and gloom and doom. But there are few quality apartments on the market, and the city is where it is at, and cheap on a worldwide basis.
Posted by Buyer | July 2, 2008 8:06 PM