A Subprime Market for Subprime Securities?

Calculated Risk says this article on problems in the mortgage securities industry is a must read:

Crisis Looms in Mortgages, by Gretchen Morgenson, NY Times: ...Investment manias are nothing new... But the demise of [the mortgage securities market] has been broadly viewed as troubling, as it involves the nation’s $6.5 trillion mortgage securities market, which is larger even than the United States treasury market.

Hanging in the balance is the nation’s housing market, which has been a big driver of the economy. ... “The regulators are trying to figure out how to work around it, but the Hill is going to be in for one big surprise,” said Josh Rosner, ... an expert on mortgage securities. “This is far more dramatic than what led to Sarbanes-Oxley,” he added, referring to the legislation that followed the WorldCom and Enron scandals, “both in conflicts and in terms of absolute economic impact.” ...

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 well.

Traders and investors who watch this world say the major participants ... 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. ... Even now the tone accentuates the positive. ...

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

“I 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 ..., this is going to be unpleasant.”

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

At the heart of the turmoil is the subprime mortgage market... 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 ... by the creation of new types of mortgages ... that required little or no down payment and little or no documentation of a borrower’s income. ...

Mortgages requiring little or no documentation became known colloquially as “liar loans.” An April 2006 report by the Mortgage Asset Research Institute..., analyzed 100 loans in which the borrowers merely stated their incomes, ... 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...

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...

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 ... 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. ... 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 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 ...

Still, the rating agencies have yet to downgrade large numbers of mortgage securities to reflect the market turmoil. ... The agencies say that they are confident that their ratings reflect reality...

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. ...

Brian Clarkson, Moody’s co-chief operating officer, denied that the company hesitates to cut ratings. “We made assumptions early on that we were going to have worse performance in subprime mortgages, which is the reason we haven’t seen that many downgrades,” he said. ...

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.

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

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. ...

Depending on how this works out, I may have to start a new series of posts called "Government Failure in Some Things: The Regulation of Mortgage Securities Edition."