Dangers of a runaway mortgage market
The warning signs are everywhere. And conservative financial institutions -- insurers and pension funds -- are set dead in the path of the runaway train.
By Jim Jubak
The long-awaited slowdown in the U.S. housing market is upon us. So far the deceleration is a long way from a car wreck. Housing sales and housing prices are still projected to climb in 2006, just not as fast as in 2005.
But over-revved markets generally crack up rather than slow down gracefully: They've built up too much momentum to handle a change in direction without at least a bang against the guardrail.
Adding to the odds of a crackup is the very peculiar nature of the investment market for mortgages. Right now, there's a huge disconnect between the folks who are making the mortgage loans and the investors who ultimately wind up owning the mortgages. The mortgage lenders who know individual mortgage borrowers the best -- and the risk they do or don't represent -- are selling their riskiest mortgages. The investors who buy them know nothing about individual borrowers and are relying upon the magic of the Wall Street derivative market for risk protection.
Sound like a car wreck waiting to happen?
Let me explain how the wonders of Wall Street financial engineering have put conservative financial institutions such as insurance companies and pension funds in the path of the runaway mortgage market.See the news
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A warning bell Tolls
First, the obvious: The signs of a slowdown in the U.S. housing market are everywhere.
* On Nov. 8, Toll Brothers (TOL, news, msgs), a bellwether among home builders, lowered its guidance for the upcoming fiscal year. Instead of delivering 10,200 to 10,600 homes as the company had projected previously, Toll Brothers now estimates delivering 9,500 to 10,200 homes. That's still above the 8,769 homes delivered in fiscal 2005, but represents a drop from the earlier range of 16% to 21% growth in deliveries predicted for fiscal 2006 to a range of 8% to 16%.
* The number of new home-purchase contracts signed in October dropped 8% from October 2004, according to a survey of 48 of the largest real-estate companies by Real Trends, an industry research company.
* The number of houses currently listed for sale climbed in October to a 4.7-month supply at the current rate of housing sales, according to the National Association of Realtors. In January 2005, the number of houses listed for sale added up to just a 3.8-month supply.
* The annualized rate of increase in the price of a new home fell to 1.9% in September from a peak of 16% at the beginning of 2004.
You don't have to work too hard to figure out why the housing market is slowing down. The supply of home buyers isn't infinite, and every time housing prices go up, the supply of buyers shrinks a bit. But mortgage rates for a 30-year fixed loan hit 5.2% in June 2003, expanding the pool of potential buyers who, at such a low rate, could afford to buy houses even at inflated prices.
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But mortgage rates have been on the rise lately, climbing to 6.5% on average, the highest level in more than two years, according to HSH Associates. And rates are expected to keep climbing into 2006.
Mortgage lenders have fought back against rising prices and rising mortgage rates with all kinds of mortgage products designed to make it possible for more buyers to take on more debt and still, hopefully, meet their monthly payments.
One of the riskiest mortgage types, the option adjustable-rate mortgage, was among the fastest-growing type of mortgage in the first half of 2005. Option-adjustable-rate mortgages give the borrower the option of making payments that pay interest and principal, that pay just interest, or that pay less than the interest due each month. That last option actually increases the amount the borrower owes on the mortgage.
And, most recently, the mortgage industry has promoted low- or no-documentation mortgages for buyers who might not qualify for a mortgage if they had to reveal information such as the size of their income or the level of outstanding debt. Low- and no-documentation mortgages made up 46% of all non-Fannie Mae and Freddie Mac mortgages in the first eight months of 2005, according to LoanPerformance, a mortgage industry risk analysis company. In 2000, such loans made up 28% of that market.
A ladder of risk
All the risky mortgage schemes aren't a problem as long as home prices keep climbing and as long as interest rates are steady or falling. If prices are climbing, the buyer and the lender can always sell the house in question for more than enough to pay the balance on the loan, even if the balance of the loan has been climbing. If interest rates are steady or falling, the low initial interest rate of an adjustable mortgage stays low, and so do those monthly payments.
But that's all changed recently. Home prices have started to level off and some industry experts predict that prices will fall in 2006. The National Association of Realtors is still predicting a 6% increase in median home prices in 2006 after a 12% increase in 2005. But Realtors in some of the markets that have been hottest during the boom are looking for prices to decline by 5% or so next year.
Interest rates on the 10-year Treasury note, the benchmark for many adjustable mortgages, have climbed to 4.6% from 4% in June 2005. Higher energy prices make any increase in monthly mortgage payments even more of a strain on the family budget.
All this creates a ladder of risk that begins with the individual home buyer/mortgage holder on the lowest rung and climbs toward the top rungs of the global income markets. The risk for the individual homeowner, of course, is default on that mortgage because higher interest rates lead to higher mortgage payments. Add enough individual mortgage defaults, and the mortgage banks that made the riskiest mortgages start to feel the pain. In October, 18% of the mortgages made by Countrywide Financial (CFC, news, msgs), the country's largest mortgage lender, were option-adjustable-rate mortgages. Interest-only mortgages made up 19% of all mortgages for the month. Adjustable-rate mortgages of all sorts made up almost 50% of mortgages in October.
But recently the risk hasn't stayed with the mortgage banks making the loans. Countrywide Financial sold 80% of the option-adjustable-rate mortgages it originated in the third quarter to other parties. Countrywide Financial isn't alone in this policy. Washington Mutual (WM, news, msgs), for example, sold 70% of the option-adjustable-rate mortgages it originated in the third quarter. (Some mortgage lenders, confident that they have controlled the risk in the mortgages they've originated, have held onto their mortgages: Golden West Financial (GDW, news, msgs), where 99% of mortgages in the recent quarter were for short-term adjustables, kept all those mortgages for its own portfolio.)
Passing the trash
These mortgages are being sold to institutional investors in the form of a derivative called a collateralized debt obligation, or CDO. CDOs, managed by Wall Street investment shops such as BlackRock, include a mix of bonds and other fixed-income assets. Increasingly those pools include mortgage-backed securities, which are batches of mortgages originated by a lender like Washington Mutual and then purchased and packaged for resale by Fannie Mae (FNM, news, msgs) or another institution. Wall Street is on a pace to break last year's record creation of $50 billion of this kind of CDO in 2005.
In theory, these pools of mortgages are less risky than the individual mortgages themselves. But in practice, that almost certainly isn't true today. Lenders that know these mortgages best are packaging and selling their riskiest mortgages. Worse, these are exactly the products that the mortgage lenders know the least about because most are new products with very limited track records. No one knows very much about how they will behave if times get tougher for borrowers.
It's hard to predict the behavior of a pool of any kind of mortgages when interest rates are moving -- in either direction. If rates go down, mortgage holders refinance and prepay their mortgages. That's a problem if enough borrowers prepay because investors get their cash back at a time when current yields are lower than the yields they were receiving.
It can be just as bad if interest rates are going up. Then the default rate for these adjustable mortgages will rise. If the defaults go high enough, that will affect the yield and value of the pool.
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But higher rates have another effect you might not expect. As interest rates go higher, fewer mortgage borrowers refinance their mortgages or resell their houses. That extends the life of the mortgage and the mortgage-backed security, stretching out the time until the principal is paid off. That lowers the value of the mortgage-backed security because the investor is being forced to hold it for a longer period. That means there's more risk for the investor. If the price of the mortgage-backed security falls enough, it will encourage other holders to sell and further depress prices.
As you might expect, hedge funds have been among the main buyers of these packaged risky mortgages. But they haven't been the biggest players. That honor goes to European and Asian insurance companies, pension funds, and banks.
AXA (AXA, news, msgs), the French insurance giant, has been extremely active in this market, according to The Wall Street Journal. CommerzBank (CRZBY, news, msgs), the German financial giant, has also significantly increased its holdings of CDOs this year. With yields so low in Europe, the lure of the U.S. mortgage market has been impossible to resist.
Those higher yields will be little comfort if the risk in this market turns out to be higher than the buyers of these pools of mortgages expect. It's never a good sign when the folks that know an asset best are selling. |
