patrick.net

I have plenty of thoughts on this.

In general, I agree with much of what you say. I do think you're being overly biased against the fundamental underlying MBS, and instead focusing on the abuses of the current implementation.

First, the goal of MBS/CMO is _not_ "risk transference". Or as you say "Privatize profits, socialize risk". The fundamental goal is *risk management*, which is entirely legitimate. Risk management is employed in many areas, not just finance. It's common in insurance, worker safety, highway design, public policy, just about everywhere. The simple fundamental is the idea of reducing volatility (risk as a measure of standard deviation) by spreading an independent variable out over more dependent variables. There's nothing wrong with that.

What is wrong with the current abuses of risk management as it relates to MBS is simple mispricing of the risk premium. This could easily be due to a couple of main factors:

1) Over speculation by hedge funds. In fact, if there is a hedge fund bubble (as I believe), then this contributes to mispricing of risk premiums.

2) Over demand/captive demand by foreign investors. Foreign holders of USD denominated debt have non-equilibrium high demand. Although this demand has receded *a small amount*, it is still very high, and probably will be for a long time to come. The main reason is the "global imbalances" we keep hearing about. We in the US are basically the largest, most important market for every major export nation. Add to that the currency manipulators like China, India, Korea, less so Japan, and you have long-run disequilibrium demand for USD-denominations.

That puts even more strain on the risk premiums.

HARM is correct that about the only thing likely to correct this problem is failures. Unlike HARM, I don't see a catastrophic, cascading collapse as necessary. Just a big dump in hedge funds and a slow unwinding over many years of foreign demand.

One irony of all this. Taking the specific case of foreign currency manipulators -- China being the biggest offender -- there is an unfortunate paradox. China *benefits* as MBS' collapse and default, even though it causes them to "lose" asset value. It's really no different from their current capital sterilization inside China. Only, instead of making bad loans to their own businesses on purpose, with the full knowledge of mispriced failures, they're making those loans to US homeowners. All that much the better. Let the US take the pain while China gets to depressurize inflation a bit, all without a hiccup in export surplus.

@Randy,

Interesting perspective on China benefiting from an MBS market collapse. Most people (myself included) were under the impression that large institutional investors owning MBS would be hard hit by any collapse (barring a taxpayer funded LTCM style bailout, that is). One side effect of this they would NOT escape IMO is the recession & severe consumer spending pull-back that could result. We are by far their biggest customers (and inflation safety valve).

Generally good points, however, I would say you missed one key factor in the MBS mispricing of the risk premiums:

3) Implicit taxpayer guarantees / aka "Greenspan/Bernanke Put" for GSE-issued debt. This may even spill over to privately issued MBS/CMOs if the shit really hits the fan and pension funds (owned by AARP investors) get hit hard enough.

I also take issue with this statement:

First, the goal of MBS/CMO is _not_ “risk transference”. Or as you say “Privatize profits, socialize risk”. The fundamental goal is *risk management*, which is entirely legitimate. Risk management is employed in many areas, not just finance.

Ok, in theory I see the distinction, but in actual practice/reality, aren't they the same thing? This to me sounds a little like the local mobster telling you that Rocko breaking your legs isn't really "punishment" for not paying your debts, it's "reasonable loss mitigation".

Randy H,

Good points as always. I don't want to speak for others but most here are not under the delusion that mortgage lending will somehow revert back to a circa 1950's model. What we have, is here to stay.

Using risk management is a one thing, "testing to destruction" is another. Why is it necessary to push the envelope when it's pretty obvious many of these types of loans are creating problems for borrowers right out of the gate?

@skibum,

Yes. What Randy terms "catastrophic, cascading collapse" (CCC - do we have a new acronym?) would bring about a severe re-pricing of MBS risk premiums, and in fairly short order.

"testing to destruction"

@DinOR,

This was posted on Calculated Risk yesterday, and I think it provides a valuable analogy on how things really are "different this time":

In the 90's workouts were done as forebearance agreements. Usually the lender let the borrower pay a minimum amount and tacked the accrued interest on to the principle until the property could be sold.

In 2004-06, Option Arms gave borrowers this opportunity to accrue the interest and tack on the negative amortization at the time of purchase. In effect these "neg am" loans were started as forebearance agreements.

Neg-am loans as "out-of-the-gate" forebearance agreements. I could not have thought up a more apt metaphor myself. Makes you wonder what the "workout" agreement could be when the loan itself already IS the "workout"!

HARM

Ok, in theory I see the distinction, but in actual practice/reality, aren’t they the same thing? This to me sounds a little like the local mobster telling you that Rocko breaking your legs isn’t really “punishment” for not paying your debts, it’s “reasonable loss mitigation”.

Fair enough. But then the same can be said of auto insurance, home insurance, automotive safety requirements, medical drug approval decisions, etc.

If auto insurance, for example, was strictly deterministic and not "risk transferred", then many people would pay close to $0 while a few would pay almost all the costs. Of course, they couldn't, so they wouldn't drive. This effect would keep going until you ended up with only a very select few paying all the cost, and being the only ones who got to drive. At that point, we'd all pay anyway (in lost productivity, labor shortage, everyone living in some anti Robert Cote'ian uberdense urbania, etc.). It is actually *cheaper* to "transfer" the risk. That's the point.

Randy,

The thing is, when you sign up for auto insurance (or homeowners insurance, et al.), the consumer generally has some idea that the whole thing is a risk-sharing scheme, where everyone pays a little to avoid paying a lot if you have an accident. Plus, the insurance company (who btw is on the hook for payouts) typically works very hard to ACCURATELY PRICE the risks, and bases policy premiums on that (+ profit margin). Win-win for everyone.

The problem with MBS is there is basically NO RISK for the loan or MBS-issuer. Unlike insurance, the risk-reward relationship basically has been completely severed. This to me is a key reason (if not THE key reason) why MBS risk has been so badly mis-priced.

Add to this the total lack of truthfulness/transparency in terms of borrower qualifying, and we see MBS investors being lulled into a false sense of security. Ultimately, taxpayers may end up being on the hook for $Trillions in PBGC-style bailouts for a risk transference scheme we had no say in. I stand by my earlier assertion:

unstated-but-true MBS/CMO goal: privatize profits, socialize risk

HARM,

Plus, the insurance company (who btw is on the hook for payouts)

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.

HARM,

Didn't get to catch that, glad you brought it to my attention! That's no place anyone (if the fully understood the consequences) would want to be. Here's a question, since everything about our society is FICO driven is/should someone who's elected to go with a Forebearance Loan have their DTI/credit score looked at differently?

I mean, they are not sophisticated, can't afford to live here w/30 yr. FRM and will be forced into default the instant this "thing" resets! So, just b/c you're current on FL (TM) should your FICO remain the same? I think NOT! Of all the ways creditors have of dinging your score ( this ain't one of 'em?)

@Randy H,

Ok, I don't work in the insurance (or reinsurance business), so I'll buy that. But please explain something for me: how is it that every time there's a major disaster requiring large-scale insurance payouts (think Katrina, Northridge/Loma Prieta quakes), insurers scream bloody murder? If they've offloaded all their payout liabilities to some foreign schmuck (MBS-style), then why should they care? I recall right after the Northridge quake, tons of smaller insurers went out of business, while the big guys simply dropped earthquake coverage.

The insurance policy issuers must bear SOME payout risk, correct? Or am I missing something?

HARM

Certainly insurers bear more than some of the risk. I would say the answer to your question is exactly in line with what I see as the real complaint against the whole MBS industry: ABUSE.

Insurers are notoriously self interested. That's why we (and every other state) have an insurance commissioner. These companies will exploit every chance they can to get out of obligations at the cost of the public. The true socialization of costs. But rest assured that big disasters are heavily covered by reinsurance. Just not 100%, so the insurance companies scream and cry. Such is the norm for any regulated industry. The more heavily regulated, the more the company tries to wiggle out of every obligation.

You'll notice that every major and most minor insurance companies that didn't go under have come back. They always do. They're back in FL, they're moving back into LA, they've been back in CA for a while. It's all part of their strategy -- grand game theory with the gov't and insurers as kings and us as pawns.

And as for MBS, banks also don't sell *all* their loans into secondary markets. Wells Fargo is a great example. They hold onto quite a bit of loan stock themselves.

But HZ pointed out the real underlying difference between MBS and other examples: the USD. The Fed can print more. And for at least the next couple of decades, we don't pay the full price of the consequent monetary inflation (referring to all the foreign exchange discussions). But that's an argument for another thread (or a previous thread, lol).

They would tell them that unsold homes are at a record level and sellers need to lower their prices.

Apparently someone forgot to tell these sellers that prices aren't sticky. Prices aren't sticky, damnit! It's just that these sellers don't know how they *should* play the game.

http://www.marinij.com/marin/ci_4540507

Foreclosures spike in Marin.

I would say the answer to your question is exactly in line with what I see as the real complaint against the whole MBS industry: ABUSE.

Yeah, I'll buy that. Plus, the large-scale transferal of default & bailout risk to Mr. Taxpayer c/o GSEs. I posted something like this a few threads back (can't find the exact post):

How to Make a fortune in the Sub-Prime Mortgage Business

1. Incorporate exotic mortgage shell/holding company in the Bahamas, Caymans or some other mobster-friendly locale.
2. Originate toxic Option-ARMs & I/O loans with usuriously high fees & points.
3. Sell toxic waste to clueless specuvestors, recent Carleton Sheets graduates & Casey Serin.
4. Re-package & sell off toxic waste to GSEs. Or, just repackage them yourself and sell as "low risk" private MBS/CMOs to unsuspecting hedge funds, pension funds & FCBS.
5. Wire obscene profits to various numbered Swiss bank accounts.
6. Declare BK, go out of business and disappear. Avoid regulators & burned investors with "repurchase agreements" at all costs.
7. Change identity, location and open another exotic mortgage shell/holding company under your new name.

Repeat as needed (until you are independently wealthy).

Not quite the picture that comes to mind from your typical "good neighbor" insurance commercial, is it?

"the downside risk of all the loans is correlated"

FRIFY=genius

Well perhaps not "all" of the loans but definitely enough for investors to say "It used to hurt, now I can't even hold an apple in there anymore"!

Brilliant!

Re: #4
GSEs don’t buy subprimes. They buy conforming loans.

Actually, they do. Their investors just haven't been made aware of it yet. There are more ways for crooked lenders to squeeze toxic waste into a GSE "conforming" loan than there are flies on a turd. It's all in the fine print...

HARM,
Contrary to popular belief (which was what I had thought also), there was there was not a taxpayer bailout of LTCM. Admittedly, it was the Fed who organized the bailout, but it was all private money. I suppose it could have really gotten ugly if they ran through all the bailout money and then the taxpayer would have had to pony up. At any rate, LTCM doe not leave me with good feelings for HFs.
"It was saved only by the Federal Reserve Bank of New York sponsoring a bailout of LTCM by its creditor banks. The Fed justified its intervention on the basis of the potential of the failure of LTCM precipitating a financial crisis and the creditor banks were enticed into extending credit to LTCM because their financial losses in a general financial crisis could well be more than what they stood to lose if LTCM defaulted on its loans. As it happened LTCM survived long enough to pay off its indebtedness but by early 2000 it was liquidated."
http://www.sjsu.edu/faculty/watkins/ltcm.htm

I also tend to be a bit conspiratorial and agree with you that the last step in "risk management" is usually "foist upon an unsuspecting public."

FRIFY=genius

Not genius - basic portfolio theory. LTCM and the recent Gas Futures debaucle from that other hedge fund show that plenty of smart folk think they've diversified away risk. Too often, they haven't. Bundling 10,000 assets that are all tied to the same pair of dice looks fine until snake eyes comes up and your principle is halved.

My greatest fear about buying a house in the Bay Area is that as soon as I sign the papers, 50-70% of my net worth will be tied to a single instance of a single asset class (even with 0% down). To add further insult, my position would be highly leveraged. In the current market, that still looks like financial hari-kari.

If there is a bailout, it should be a systematic one. First they should take all the mortgage brokers that sold these things, turn them upside down and shake em…..and if they don’t get enough from them, they should turn to the appraisers, then to the Realtwhores and so on until the bailout is complete.

Don't forget that (not so) indirectly, a lot of the extra dough generated by this house of smoke and mirrors was/is siphoned off in the form of bonuses for all these hedge fund, mutual fund, Fannie and Freddie managers. Too bad that money's down the drain. Probably spent on some overpriced "loft" in Tribeca or some "estate" in Greenwich.

H.Z.,

We won't really know how much toxic waste exists hidden among all the GSE "AAA-rated" paper until the SHTF, will we? Delinquency rate = lagging indicator.

Are you really expecting due diligence from an outfit so crooked it hasn't released its books in over two years (though amazingly manages to keep its listing on the NYSE) and whose CEO resigned over accounting "irregularities" that would send the less politically-well connected to prison?

The delinquency rate on MBS --just like the mortgages on which they're based-- always hit their lowest level right at a market's peak. Just like we saw headlines last year touting "lowest delinquency/foreclosure rates in decades", same goes for Fannie & Freddie. Mortgage delinquencies & foreclosures are now creeping up, soon to be followed by MBS & hedge fund blowups. Who/where/how bad are the only unknowns (IMO).

The LTCM issue is ironic. My understanding is that the Fed's bailout plan in part has enabled this "hedge fund bubble" we are seeing today.

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.

@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.

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.

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.

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.

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.

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?

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%.

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.

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.

"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

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.

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.

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

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?

"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.

Who solved the Poincare Conjecture?

Who cares. Who invented Chicken a la King?

Who invented Chicken a la King?

Yes, that person should be shot.

Yes, that person should be shot.

Why?

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