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New Paradigm? The Rise of Mortgage-Backed Securities


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2006 Oct 24, 7:11am   15,575 views  174 comments

by HARM   ➕follow (0)   💰tip   ignore  

Option-ARM

This is a topic that seems to come up fairly often and I think is worth exploring: Does the rise of Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) represent a true "paradigm shift" in how risk is decoupled from mortgage originators/lenders and transferred to individual investors and taxpayers? Is this a temporary trend soon to follow unprofitable Dot.coms into the dustbin of history, or a true revolution in risk transference?

MBS/CMO goal: Privatize profits, socialize risk

We have often derided those in the REIC over the past year or so who have claimed that the unprecedented run-up in housing prices over the last 6 years was a "new paradigm", i.e., a permanent, historic shift in severing the traditional relationships between incomes, rents and RE prices. But what if there's a kernel of truth to this?

We must remember that MBS/CMOs are what have made issuing NAAVLPs and I/Os profitable, even with tiny risk premiums, because of that oh-so-critical risk-transference. Even the most toxic option-ARM is profitable to the originating lender –in fact, the fees & points (profits) are far higher on toxic loans than they are on traditional 15/30-year FRMs or amortizing ARMs. If you're a lender, why wouldn't you want to take boat-loads of risk-free (for you) money? You'd have to be crazy not to, right? Of course, there's always the possibility of repurchase agreements or class-action lawsuits if things get really bad, but, hey that's for some other guy to worry about. You're in it for the short-term profits and couldn't care less about the long view, right?

The new MBS/CMO risk transfer model has been working SO well for lenders that I fear only a complete economic meltdown (resulting from it) would deter banks from voluntarily continuing its use in the future. And, as Randy has pointed out, the current anti-regulation/pro-banking bias in government is so strong, involuntary regulations (with real enforcement) are pretty much out of the question –for now.

I believe our best hope where toxic loans are concerned is for MBS investors to begin to recognize that the underlying risk has been severely under-priced and demand greater premiums and/or risk disclosure. This should result in higher mortgage interest rates and the return of "quaint" things like full-documentation, which in turn would deter widespread use of these loans. Of course, this would require FB defaults on a massive scale, something we could expect to see beginning next year, and continuing in waves for several more years.

"Next year, a trillion dollars worth of mortgages will have their rates reset, said Dan Mudd, chief executive officer of Fannie Mae. That's a significant share of $9 trillion in mortgages outstanding, he said."
Source: Reuters

Add to that the roughly $.5 Trillion that started resetting this year, and another $1 Trillion that will start resetting in 2008, and you have approximately $2.5 Trillion in neg-ams and option-ARMs that will be resetting monthly by end of 2008. We're not talking small resets either. When you factor in a typical 1-2% "teaser" shooting up to LIBOR + 2-3% (typical mark-up for option-ARMs), PLUS the loans starting to amortize (having to start paying back principal as well as full interest), payments could shoot up 100-200% for Mr & Mrs. Howmuchamonth.

Thoughts, opinions...?
HARM

#housing

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24   skibum   2006 Oct 24, 10:36am  

OT, but could it be that the conspiracy theorists are right after all, and oil/gas prices WILL rise after the midterm elections? I know, I know, prices are determined by complex factors, etc etc., but the timing of this below:

http://biz.yahoo.com/ap/061024/oil_prices.html?.v=11

is uncanny.

25   HARM   2006 Oct 24, 10:45am  

@H.Z.,

Point taken. I agree that private, subprime MBS will get hammered worse that the GSEs (at least in terms of the % of loans that go bad), but here's the rub: the GSEs are orders of magnitude larger than any piddling private MBS outfit. Even if a small % of their loans turn out to be camouflaged turds, the economic and political repercussions could be enormous.

It's true (some of) their chicanery was exposed before the absolute market peak, but not before a lot of damage was done. I wouldn't assume they're completely "safe" until this mess fully unwinds, years from now.

26   Different Sean   2006 Oct 24, 10:57am  

Add to that the currency manipulators like China, India, Korea, less so Japan, and you have long-run disequilibrium demand for USD-denominations.

Are they, though. They were low wage countries before globalisation and large-scale international flows of capital, and they are low wage countries during globalisation -- in fact, that's probably the major reason globalisation kicked off. That there are many people in the world on very low incomes compared to the West is not manipulation, nor is it news.

27   Different Sean   2006 Oct 24, 10:59am  

Insurance companies use Reinsurers, like Swissre. The scheme is almost exactly like the MBS scheme. I doubt most people who sign up with Progressive or the little lizard guy or whatever know that their specific risk (like being a terrible driver in excess of what the “risk adjusted rates” should reflect) is effectively funded by large institutional and foreign buyers of that risk.

Yes, I wonder how the $7bn bill for the WTC towers collapse echoed around the world -- they were mostly insured with European insurers who in turn would have been reinsured, possibly back in the US.

28   Boston Transplant   2006 Oct 24, 11:22am  

Skibum began the thread with a comment regarding MBS threat to mutual funds. At the risk of asking a dumb question, how does one investigate this with regard to one's portfolio?

For example, does Vanguard's Total stock market fund (VTSMX) have MBS risk? (https://flagship.vanguard.com/VGApp/hnw/FundsHoldings?FundId=0085&FundIntExt=INT)

Are index funds less likely to have MBS risk than managed funds?

I'm learning a lot from this thread...thanks to all.

29   HARM   2006 Oct 24, 11:31am  

For example, does Vanguard’s Total stock market fund (VTSMX) have MBS risk? (https://flagship.vanguard.com/VGApp/hnw/FundsHoldings?FundId=0085&FundIntExt=INT)

A stock fund --by definition-- would have zero MBS exposure. Bond funds OTH, may have considerable exposure. Vanguard Total bond market index fund has exposure to both GSE issued & private MBS paper, as I recall. Best to refer to your fund's prospectus.

Are index funds less likely to have MBS risk than managed funds?

Frankly, I don't think there's any correlation one way or the other. I'd thoroughly review the prospectus regardless.

30   Boston Transplant   2006 Oct 24, 11:58am  

HARM,

Thanks...you're right, the Vanguard Total Bond Fund has the following holdings:

Asset-Backed 1.5%
Commercial Mortgage-Backed 4.3%
Finance 8.5%
Foreign 3.0%
Government Mortgage-Backed 35.3%
Industrial 9.1%
Other 0.1%
Treasury/Agency 36.3%
Utilities 1.9%
Total 100.0%

What I find interesting is that under the "risks" section, this is the only comment I could find with respect to MBS:

"The Total Bond Market Index Fund is subject to call risk, which is
the chance that during periods of falling interest rates, issuers of
callable bonds may call (repay) securities with higher coupons or
interest rates before their maturity dates. The Fund would then lose
potential price appreciation and would be forced to reinvest the
unanticipated proceeds at lower interest rates, resulting in a
decline in the Fund’s income. For mortgage-backed securities,
this risk is known as prepayment risk."

It seems like this is the opposite of what we are discussing here, and I guess I find it surprising that there is no mention of default risk. Thoughts/comments?

31   hugel   2006 Oct 24, 12:11pm  

Here's a very interesting report done on ABX by Nomura.

http://tinyurl.com/yjv8s9

It is quite shocking to me that MASTR (one of the 20 constituent deals) backed by UBS has the highest concentration in the West with over 73% and also the highest concentration of IO with, read this, 100%.

32   Randy H   2006 Oct 24, 1:27pm  

LTCM has become popularly misunderstood. I sometimes think it's ripe for Oliver Stone to redefine for us as most people believe things about it that aren't true.

Good point about Amaranth. The real proof is that monster crashed and yet hardly registered anywhere but in the NG futures markets. And, there were quite a few traders on the other side of Amaranth's superstar who made their yearly return off of his ego. It's also a liquidity thing. The irony is that Amaranth's trades were the right ones, and would have made a lot of money, except that they became the market, which isn't hard for big HFs to do in some of the futures markets.

33   Randy H   2006 Oct 24, 1:29pm  

And Marin Capital went down losing the better part of $2b a little over a year ago. Most people have never even heard of them, even though their failure was in GM stock & convertible bonds.

34   frank649   2006 Oct 24, 1:48pm  

"Taking the specific case of foreign currency manipulators — China being the biggest offender"

@Randy,

LOL, sure we try to inflate away our debt to them and call THEM the offenders for trying to keep the game fair. But that's off topic. Here's an insightful piece on the derivatives market - http://www.lewrockwell.com/north/north456.html

35   Peter P   2006 Oct 24, 1:59pm  

The irony is that Amaranth’s trades were the right ones, and would have made a lot of money, except that they became the market, which isn’t hard for big HFs to do in some of the futures markets.

The only right trades are those who make money. There is no would-have, should-have, or could-have.

36   Peter P   2006 Oct 24, 2:02pm  

The real proof is that monster crashed and yet hardly registered anywhere but in the NG futures markets.

How much leverage can you have in the regulated futures markets? I guess not enough to cause cascading failure.

37   SP   2006 Oct 24, 2:04pm  

Randy H said:
“Taking the specific case of foreign currency manipulators — China being the biggest offender"

frank replied:
LOL, sure we try to inflate away our debt to them and call THEM the offenders

For the specific case of foreign currency manipulation, I don't see anything inaccurate about what Randy said. He took great pains to point out that forex manipulation was the specific issue. The fact that the US can (and does) inflate its way out of debt is another matter.

SP

38   DinOR   2006 Oct 24, 2:04pm  

Boston Transplant,

One of the basic premises at Vangard is that it's very difficult to outperform an index b/c an index frankly has no overheads. O.K, I guess I can go along with that but over 2/3 is in gov't paper. I'll be honest I don't like gov't paper, never have. Doesn't it strike anyone else as a little strange to why these types of funds are so prevelant in qualified plans?

Wouldn't participants be better off (long term) with more exposure to corp/pfd's? Convertibles? Anything but this pulp?

39   DinOR   2006 Oct 24, 2:13pm  

"The only right trades are those who make money"

God love you sir!

It seems like the level of understanding here regarding MBS is as good as anyone that trades them for a living. The bond desks at most firms are no longer pushing this paper. It's tough to retail and w/all the neg. MSM coverage surrounding RE who needs the headache? It's not my job to create a script to move that inventory, it's done.

40   Peter P   2006 Oct 24, 2:30pm  

Who solved the Poincare Conjecture?

Who cares. Who invented Chicken a la King?

41   skibum   2006 Oct 24, 2:35pm  

Who invented Chicken a la King?

Yes, that person should be shot.

42   Peter P   2006 Oct 24, 2:36pm  

Yes, that person should be shot.

Why?

I do make Chicken a la King from time to time. It is not that bad.

43   skibum   2006 Oct 24, 2:40pm  

I've always associated it with bad 1950's-style heavy-creamy vat-like foods. BTW, I prefer epicurious.com for recipe and food facts info. It's more commercial, but the recipes are generally good. Maybe I should head over to the food blog sometime...

44   Peter P   2006 Oct 24, 2:43pm  

I’ve always associated it with bad 1950’s-style heavy-creamy vat-like foods.

I do not usually use a lot of cream. You can even use low-fat milk. I like it more watery than usual. And I use ONLY dark meat.

Somehow breast meat is usually dry no matter how you cook it.

Maybe I should head over to the food blog sometime…

Do come over! greencrabs.blogspot.com

45   Peter P   2006 Oct 24, 2:46pm  

Chicken skin is the best part! :)

I think the popularity of MBS will only go down from here.

How about Labor-Backed Security? The loan can be backed by a guarantee of service or labor over a period of time. :)

46   skibum   2006 Oct 24, 2:49pm  

How about Labor-Backed Security? The loan can be backed by a guarantee of service or labor over a period of time.

Why not just reinstitute debtors' prison?

47   Peter P   2006 Oct 24, 2:57pm  

They invest for the risk-adjusted returns.

Really? :)

I think it is because most people believe they are above-average stock pickers.

How many people even know what risk-adjusted returns are? They look at all the success stories and they want to be one of them. When they fail, they cry in front of their mothers, or worse yet, government.

48   Peter P   2006 Oct 24, 2:58pm  

Why not just reinstitute debtors’ prison?

You mean debtor's labor camps? :)

49   Peter P   2006 Oct 24, 3:14pm  

OK. Then they “should” invest for risk-adjusted returns. Now if someone could figure out how to quantify risk. Don’t tell me volatility is risk.

Risk is the conceptual possibility of an adverse outcome.

You can perfectly quantify risk only if you can perfectly predict the future. But if you can perfectly predict the future, there is no risk.

Therefore risk does not exist.

Not investment advice

50   Peter P   2006 Oct 24, 3:32pm  

Apparently according to one interpretation of Quantum Mechanics, we don’t really exist either.

Cogito, ergo sum.

BTW, what is the cheapest legal way to shop for canned ox-tail soup and Bovril beef tea?

UK internet stores usually charge $40+ for shipping.

51   Peter P   2006 Oct 24, 3:35pm  

Cogito, ergo sum.

BTW, the phrase means "I think, therefore I eat". :)

52   lex   2006 Oct 24, 5:12pm  

Doesn't it say it all:

"history has not dealt kindly with the aftermath of protracted periods of low risk premiums"

Remarks by Chairman Alan Greenspan
Reflections on central banking
At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming
August 26, 2005

http://www.federalreserve.gov/boarddocs/speeches/2005/20050826/default.htm

53   OO   2006 Oct 24, 6:25pm  

You'd be real surprised at how many funds that are apparently set up for the sole purpose of betting ON the US demise are investing in MBS and GSEs.

I just found out from my prospectus that Pimco's UNhedged foreign bond fund invests about 10% of its portfolio in GSE and MBS, denominated in USD.

Excuse me, the whole point of me investing in the fund is because I am betting on the USD going DOWN, so what good does it do to me for them to shuffle my money right back into USD, not into treasury, but into the stinky GSE bonds?

So read your propsectus carefully, I guess the fund managers are just running out of ideas.

54   DinOR   2006 Oct 25, 12:11am  

I'll have to agree w/H.Z when it comes to distancing yourself from MBS. It's nearly impossible. Just a few years ago "green investors" had extreme difficulty washing their hands of things like Phillip Morris etc. I don't suppose any of us can participate in our company 401K or take positions in our brokerage accounts and have the expectation that we're "in the clear"!

Perhaps there's a marketing angle for a new Patrick.net offering above and beyond T-shirts and coffee mugs? Invest in our certified MBS FREE Mutual Fund!

55   DinOR   2006 Oct 25, 12:17am  

Oh, I should add that in spite of our best efforts we still wind up with (as OO notes above) w/some weighting in MBS doesn't mean we give up! This is the good fight.

As Peter Schiff notes in Allah's audio link, the time to get rid of a bomb is when it's still ticking!

Institutions don't have a lot of choice. Each pay period means a fresh infusion of cash. It has to go somewhere! As individuals we have other options.

56   DinOR   2006 Oct 25, 12:21am  

Allah,

I like Peter, he and I share a lot in common. My wife works for a Fortune 500 company though and I don't think in spite of her tenure that she would have much say in how their plan is administered. (Most of us don't). But you're right and it's about exercising the freedoms and options when we have them before us!

57   DinOR   2006 Oct 25, 12:39am  

Person,

In ways, we miss Vangard. When my wife's company got bought out they terminated the long and profitable relationship w/Vangard and went w/Fidelity. Sheesh, take your pick, the 2010, 2020 or the ever popular 2030 Fund! It sucks.

I believe the reason the 401K industry has elected to take the low road is all about liability. That's why we're seeing so much emphasis on "education" at the participant level. After the market meltdown plan sponsors are doing everything in their power to distance themselves from the process! Hence the generic "buffet" of offerings. Allowing real choice like ETF's and country specific funds is more fiduciary liability than most employers are willing to take on. I agree, yuck.

58   skibum   2006 Oct 25, 12:43am  

September existing home sales volume AND prices down YoY:

http://biz.yahoo.com/ap/061025/economy.html?.v=4

59   DinOR   2006 Oct 25, 12:48am  

Allah,

I can't disagree with what you say but at some point we all have to decide wether we're going to fish, or cut bait.

When my wife and I decided to sell our home prior to the peak of the market and NOT re-deploy those assets toward an even bigger more ridiculous home we made the choice to rent. I know it sounds simplistic but that's what we did. Since we no longer have a HUGE Schedule "A" to lean on we take the Standardized Deduction of around 10K. (Married filing joint). When you're used to having around 30K + in itemized deductions, this is a huge hole. Since neither of us is 50+ we don't get the catch up clause for IRA contributions. Even though I max out my SEP/IRA we still have income that needs to sheltered so for her to take full advantage of her company sponsored plan just makes sense.

(Of course for Peter P this is all moot b/c he believes in "pay as you go" anyway).

60   DinOR   2006 Oct 25, 12:53am  

Oh Oh Oh,

and when your daughter (whom you support almost entirely) asks you if she can claim herself so she can "get back" $346 in taxes...... that doesn't help either!

Of course you can dear.

61   Glen   2006 Oct 25, 12:54am  

Speaking of international diversification, does anyone agree with me that younger investors should probably have something like 90-100% of their investable assets in foreign securities? I know this seems drastic--especially compared with the conventional wisdom that you should not have more than 25% exposure to foreign markets--but is it really?

For instance, in my case I know that 100% of my future earnings will be dollar-denominated. So if the dollar crashes, my paycheck will not buy nearly as much gasoline, heating oil, or foreign-made goods. It is likely that my future earnings will be at least 10 or 20x the amount of my investment portfolio. So then isn't it true to say that 90-95% of my future net worth is *already* tied to the dollar? Why not hedge this massive exposure by investing my small investment portfolio entirely in foreign markets?

62   DinOR   2006 Oct 25, 1:00am  

Glen,

Not radical for you at your age or me at my age! Like FRIFY said, for him to buy a home in the BA would mean something like 98% of his net worth would be in ONE undiversified investment, all dollar denominated btw.

I got no problems with where you're coming from.

63   DinOR   2006 Oct 25, 1:03am  

skibum,

The article you linked noted a decline in the median price of a home but failed to define what "median" implies! Now we have to log on to Realty Times to get that informations......

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