Monday, November 2, 2009

The Warning 3

Brooksley Born's fear of a potential collapse of the unregulated derivatives market proved to be prophetic. The boom in real estate and easy credit during the 90s produced more complex forms of securities and derivatives linked now to the overstated value of millions of homes packaged as "sub-prime mortgages" or "adjustable rate mortgages" issued to borrowers who would ultimately be unable to afford them and keep up payments. This created a new chain of risk stretching from the indebted home buyers to a vast, unregulated web of global contracts.
The derivatives market appeared to provide a safety net, but had the unintended effect of encouraging more risk taking by investors, who bought huge amounts of mortgage based investments, then bought "credit-default swaps" rather than establishing cash reserves to protect themselves. If the mortgages declined in value the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the risk betted heavily that the mortgage market would stay healthy.
The worldwide market in derivatives topped $530 trillion in June of 2008, including $55 trillion in credit default swaps, that $530 trillion represented all contracts outstanding. The actual dollar amount at risk was much smaller, but still represented $2.7 trillion dollars according to some estimates.
To put the amount in perspective, in 2007 it was estimated that the Gross World Product of the entire planet, the market value of all final goods and services made on Earth in that year was between $54.62 and $65.61 trillion.
When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough in reserve to pay.
Instead of dispersing risk, derivatives had amplified it.
The following is a excerpt from Stock Market Invesrters. com:
"Back in the early 2000's, there was an excess capital globally. The world did not even imagine there would be a global financial crisis and all investment managers were concerned about was where to invest their capital in order to make it grow. Generally, the demand was for low risk investments that paid some nice return.
However, such investment options were not easy to find. This pushed a great amount of money straight into the US mortgage market thanks to the unique and wonderful (on principle) vehicle - securitization.
An individual gets a mortgage loan from a broker. Then the broker sells the mortgage to a bank, which in its turn again sells the mortgage but this time to an investment firm on Wall Street. Such firms collect thousands of mortgages in one big pile. This in fact represents thousands of mortgage checks coming every month, a monthly income that was supposed to continue for the life of the mortgages. And of course, the firm in its turn sells shares of that income to investors who are willing to buy.
Mortgage backed securities seemed like the perfect solution to the great demand of assets. After all, in the beginning they were wonderful, safe investments - built out of mortgages with big down payments, proven steady income and money in the bank.
And investors loved them - and not only US investors but investors from all over the world.
The demand for those great, safe mortgage backed securities was really high. In fact, so high, that there was a point somewhere in 2003 when everyone who qualified for a mortgage got one, and still the global pool of money wanted more.
Thus, things needed to change. And they did. The mortgage qualification guidelines did.
At first, the stated income, verified assets (SIVA) loans came out. People didn't have to prove their income any more. They just needed to "state" it and show that they had money in the bank.
Then, the no income, verified assets (NIVA) loans came out. The lender was no longer interested in what you do for a living. People just needed to show some money in their bank accounts.
This wasn't enough to satisfy the huge appetite of global investors. The qualification guidelines kept going looser in order to produce more mortgages, more securities.
NINA is an abbreviation of No Income No Assets. Basically, NINA loans are official loan products and let you borrow money without having to prove or even state anything. All you needed to have in order to get a mortgage was a credit score.
Why would a bank loosen its criteria for lending money so much? Well, banks didn't keep these mortgages. They didn't care whether they are risky and the borrower will ever pay them back simply because they sold the mortgages to Wall Street. The Wall Street then sold them to global investors ... as low risk investments.
Why would any investor consider mortgage backed securities low risk investments?
Well, investors use a special system to assess risk. Credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, give ratings to every type of bond according to its risk. Letter grades mark the safety of the investments - triple A is given to the safest ones, for example US government bonds.
And in this case, the credit rating agencies blessed most of the mortgage backed securities with AAA rating.
The problem with this high rating is that agencies used the wrong data to estimate the risk. Looking back historically, what they saw was a very low rate of defaulting, a very low foreclosure rate. However, the current situation was different - with new qualification requirements, new mortgages given to people who would never have gotten them before, and of course, a big speculative housing bubble that was eventually going to pop.
Up to 2006, the housing market in the US was flourishing.
It was easy to get a home loan, so more people wanted to buy a house. The increased housing demand increased in return the prices. The increased prices attracted investors who were looking to buy houses as an investment, only to sell it later for more. This further created more demand and further increased the prices - a classic speculative housing bubble.
And because of the rising prices, the consequences from all the "bad" loans given to people who could not afford them were delayed. Whenever people experienced difficulties making their mortgage payments, they could easily take another loan against the value of their house, simply because now it was worth more.
Basically, they went into more debt in order to pay off their debts. Thus, the housing bubble made home equity loans and home equity lines of credit extremely popular.
However, in contrast to the rising house prices, the average household income didn't increase. Thus, despite all the incentives and exotic mortgage products, people just couldn't afford those high prices and it was only a matter of time for the problem to come out.
And it did. The big housing bubble burst, the property values stopped increasing and the whole thing came to a point when the mortgage lending industry started witnessing something new - many people defaulted on their very first mortgage payment.
What happened was a chain of reactions very similar to those in the housing bubble but only in the opposite direction. The number of people who defaulted on their mortgages increased more and more which in return increased the number of houses on the market. The oversupply of houses and lack of buyers pushed the house prices down till they really plunged in late 2006 and early 2007.
That was the point when people on Wall Street started to panic. They no longer wanted to buy risky mortgages. Mortgage companies, which used to sell risky loans, experienced the devastating consequences of going out of business.
Unfortunately it was already too late for everybody.
The market has already absorbed enormous amounts of these securities. All kinds of investors from all over the world - individuals and big financial institutions - basically have bought these AAA rated mortgage securities thinking that it was almost as safe as putting money in a savings account. Now that the complexity and the real risk of these securities came out, most of them are already worth less than half their initial value and all those investors lost a great deal of money.
Moreover, foreclosures keep springing up. In the past mortgages were held in the books of financial institutions such as banks, who had real interest in working with their borrowers and making sure that everything possible is done to pay back the loans. However, in the current situation, mortgages have been sold and resold and pooled together into securities and sold to investors in the financial market. It is really really hard to even find who the actual current owner of mortgage is. And it is just as hard to prevent foreclosures."

To be continued.

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