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New Paradigm? The Rise of Mortgage-Backed Securities


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2006 Oct 24, 7:11am   15,524 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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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......

64   DinOR   2006 Oct 25, 1:19am  

George,

I'd read an article about a home in an exclusive FL area that had been on the market for months on end at like 900K without a single written offer. Then out of the blue someone offers 1.15 mil! Yeah, that's what I thought. What, was the buyer in some sort of imaginary bidding war with himself? No, not really. Just a "helpful" neighbor. Seems even those in "upscale" communities could use a little MEW love once in awhile. Because they can't legitimately sell their homes on the market, they sell them to each other AND at above asking price! Wish I lived in a neighborhood with that much "love".

Scumbags.

65   DinOR   2006 Oct 25, 1:27am  

Allah,

During the 90's when people were throwing money at the US market with both fists who the hell needed to pay a dividend? Dividend at that point meant cash cow and cash cow meant no growth! People actually shunned these "old economy" stocks. Twisted..... I know.

Back in the day old timers bought the stock not so much for appreciation but simply for the div. If it went up at all great but it really was about the dividend. Things have come full circle and they're now back in vogue (along w/ "old economy" stocks!)

One definite advantage that I see for the ADR's and pure Euro plays is that their accounting is handled on a rotational basis so you don't have the "Arthur Anderson Effect" where auditors get too chummy!

66   Glen   2006 Oct 25, 1:42am  

DinOR and Glen: You’ll have to help me out, since monetary economic theory always throws me for a loop. How does the dollar denomination of a house or domestic equity investments expose you to a risk of the dollar declining? If dollars are worth less, then the house or domestic equities will be worth more … in dollars. Even if the dollar becomes completely obsolete, you could redeem those (non-money) investments in whatever the new currency is, right?

This is a tricky issue for me too and I don't claim to have mastered it. However, it seems to me that your dollar exposure of any asset is related (though not perfectly) with the source of income earned by the asset. A few examples:
1. House: Compare a US house to a house in Japan. In both cases, the income is derived from real or imputed rental income. For simplicity, assume both houses are rented out. If I buy a house in Japan and the dollar declines 20% vs. the Yen, then my rental stream increases by 20% and the cost of Toyotas in the US increases 20%. Thus, my ability to buy a Toyota is unaffected. If I buy a house in the US and the dollar declines 20% vs. the Yen, then my rental income stream stays constant in US dollars, but I have 20% less Toyota purchasing power.
2. Stock: The analysis is complicated by the fact that many global companies earn money all over the world. A foreign company that exports most of its product to US consumers may actually have more exposure to the dollar than a US company that earns most of its money overseas (not to mention the complicating factor of hedging by US and foreign companies). But overall, it is safe to say that a foreign index fund has much less exposure to the dollar than a US stock index fund. For simplicity, assume I can choose between two stocks--USA Co. or Canada Co. USA Co. makes products exclusively for the US market. They earn $10M US dollars per year selling products to the US market. Canada Co. earns $10M Canadian dollars per year selling products to the Canada market. Assume we start the analysis when the US and Canadian dollars are trading 1 for 1. Now the dollar crash hits. One US dollar only buys 80 cents Canadian. Now the $10M in US earnings only buys 80% as much Canadian goods. But the $10M Canadian dollars still buys $10M worth of Canadian goods (or $12.5 Million in American goods).

67   skibum   2006 Oct 25, 1:53am  

Who writes this stuff? Realtwhores? How can they say that these places are bubble-proof?

Funny, that's more or less the list I would have come up with for some of the bubbliest places in the US! Actually, Boston is first-tier bubble - poor jobs market, population decline, high prices. NY, SF and LA are "second tier" bubblespots, as they do have an economy outside of RE speculation. Parts of FL, LV, SD, AZ, Central Valley on the other hand...

68   skibum   2006 Oct 25, 2:03am  

@DinOR,

I just checked over with our friends at RealtyTimes.com - no explanation of "median" price drops. What a shocker. I did go to the NAR press release, though:

http://www.realtor.org/press_room/news_releases/2006/ehs_sept06_existing_home_sales_ease.html

Gotta love the spin! Here are some choice lies, er, quotes:

Title:
September Existing-Home Sales Ease, Setting State for Stable Market

Yeah, setting the stage for a stable market in about 10 years, maybe.

NAR President Thomas M. Stevens from Vienna, Va., said the industry is encouraged that the number of homes on the market is starting to decline. “It appears we have passed a cyclical peak in terms of the number of homes on the market,” said Stevens, senior vice president of NRT Inc. “The good news is that fewer new listings are coming online. A stable sales pace is expected to draw down the number of listings to a supply balance that will support positive price growth within a few months. Taking the long view is always the best way to approach housing decisions, and right now, buyers are in a very favorable market.”

That's right. We're all set now. I guess we can forget to mention that inventory always decreases in the winter months. BTW, has this guy's home in VA sold yet? Or is he still not listening to his realtor?

Mojo already gave us Learah's choice quote. These guys are inadvertantly setting us up for a Spring massacre. I think these types of comments will give many sellers hope that this Spring will be the start of a return to price apprecation. It's going to be ugly.

69   skibum   2006 Oct 25, 2:06am  

Sorry to keep harping on this issue, but looks like oil's up again. The timing seems like we'll see price increases at the pump right after the elections! Funny how that is, eh? Yeah yeah, I know, the market's too complex to be manipulated....but...

http://biz.yahoo.com/ap/061025/wall_street.html?.v=16

70   skibum   2006 Oct 25, 2:10am  

You can buy Microsoft stock just before the market crashed. It owuld have lost most of its value, but if you didn’t cash in, you could hold on to it for another 30 years and you probably won’t lose nominally on it…..

A better example is Google stock. In my layperson opinion, waaaay overvalued.

71   Glen   2006 Oct 25, 2:23am  

A better example is Google stock. In my layperson opinion, waaaay overvalued.

Conoco Philips: >$22 Billion in earnings in the last 3 years, $104B market cap.

Google:

72   skibum   2006 Oct 25, 2:27am  

@Glen,

Good one.

73   Peter P   2006 Oct 25, 2:28am  

Isn’t Campbell down near you somewhere?

Thanks SFWoman. I will check it out.

Oxtail soup may still be difficult though. British beef.

I think mad-cow disease is over-hyped though.

74   DinOR   2006 Oct 25, 2:43am  

skibum,

I've gotta agree. I can't imagine what Tom Stevens or anyone else at NAR could be thinking? In almost any other business when you have excess inventory putting it off until another quarter or another fiscal year seldom resolves anything. True, in RE the "owner" is paying for the cost "warehousing" the stock but either way it's a burden.

Maybe that's the way we should view NAR's relationship w/the country. We pay the carrying cost for the "merchandise" and they get a commission if and when it sells? At whatever price? I don't know about you guys but anytime I've been charged with moving inventory the first thing you do is at least attempt to sell it existing mark up. Then you discount until you're left with basically close outs and/or consider writing it off as a loss?

Perhaps b/c you believe that "they aren't making any more of it" that it will somehow appreciate or at least retain it's value over the fall and winter and then be able to retail it again in the spring? My experience has been if you can't sell it the previous qtr/year at that price it becomes even more difficult as time goes on. I just don't know where these guys are trying to take the buying public?

75   astrid   2006 Oct 25, 2:47am  

"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!"

DinOR,

If it makes you feel better, this sort of thing happens in reverse too. My boyfriends' parents dropped his car insurance coverage with them (oh, and unlike your daughter, did not bother to tell him til after the fact) when he went on a 3 months internship in Germany. Result? Maybe $200 of savings to his parents and several years of ramped up car insurance because he had lapsed coverage.

76   skibum   2006 Oct 25, 2:49am  

@mojo,

I'm certainly one of the less qualified people on this board to comment on this, but I will anyway...

I'm no gold bug, but I do have a small portion of my portfolio in a gold-related mutual fund. Very volatile, but I think it's reasonable to keep some stake in this asset class.

I check out kitco.com once in a while to see what's going on:

http://www.kitco.com/charts/livegold.html

You can see that prices didn't really shoot up until about a year ago, more acutely from this winter into Spring, but they've been on the decline since then. So current prices are not too bubbly imo when you compare to longer term prices. Gold investment's all about your concern/fears for geopolitical destabilization, US monetary instability, and oil prices. I don't claim to have a firm grasp of how all these factors affect gold prices, but there you go.

Speaking of this, it seems about this time last year there were a slew of gold bugs on all the RE blogs. Where are they now?

77   DinOR   2006 Oct 25, 2:52am  

SP,

We could make an entire thread on that topic! Obviously I have a vested interest in that and it would make MY business grow immensely. And why not? No one's happy, everyone feels "captive" and performance is lackluster at best. Just sign here that we are forwarding your contribution along w/vested portion to ABC Firm and you are absolving us of any and all liability! Where's the problem?

The way I see that being an uphill battle is that the fund company lobby is powerful and I believe the employers list these funds as an asset on their balance sheet? Since employers are doing everything possible to wash their hands of this where's the problem? Hey, I'll send you a duplicate confirm alright!

78   skibum   2006 Oct 25, 2:53am  

not compared to the valuation of Youtube though Isn’t Google worth ~Youtube X 100? See what happens when you have funny funds to play with?

@SF Guy,

Even better! Did anyone else have a flashback to 1999 when the YouTube story came out?

79   astrid   2006 Oct 25, 2:54am  

skibum,

I'm still here. My enthusiasm for gold waxes and wanes with my natural cycle of paranoia. I'd still rather be primarily in commodities and cash equivalents for the next couple years, and the rest in ETF or index funds.

80   DinOR   2006 Oct 25, 2:59am  

astrid,

Good morning btw! Yeah I do hear ya'. As parents we're very careful of these penny wise, pound foolish traps and they are legion! They way we've kind of gotten around that is b/c I do most of my work from home I basically threatened the agent with pulling our business if they didn't make allowances for that. You just gotta call them on everything.

(Also you have to give too) so I do other things with them that makes the rep look good to his regional mgr. If you work it right, throw some referrals at him/her and be receptive to what they're peddling and you'd be surprised with what you can get away with.

81   skibum   2006 Oct 25, 3:08am  

@DinOR,

Nice analogy re: sales inventory. It just highlights the fact that Realtors are truly middlemen, profiting off the transaction process. The claimed services they offer are not worth the going commission rate (6%). But we've beat this dead horse back to the Stone Age before on previous threads.

82   Claire   2006 Oct 25, 3:11am  

Peter P -

British Beef is probably safer than US or Canadian now.

Also, have you tried cooking a chicken upside down and turning it right side up for the last 20 mins or so to brown the skin (with some seasoning and water in the bottom of the pan)? - I believe that makes the breast meat juicier.

Have you tried Piazza's for Bovril? They have Bisto and OXO, but never looked for Bovril - in their store in Palo Alto - don't know about other locations. Now all I need to do is find the Shepherd's Pie mix again.

83   skibum   2006 Oct 25, 3:13am  

RE: The 401K choice issue: I'd play devil's advocate and say SP, DinOR and others are asking questions 90%+ (random guess) of employees don't ask. It's well-established that the bigger problem is that most employees don't even fully vest in their retirement plans. That's the first problem. Then there's the well-established phenomenon of paralysis due to too much choice. My suggestion is to keep it simple. What employers should do is offer more low-thought but reasonable choice fund options. Indexed funds would work, as well as the "life-cycle" type funds that automatically change allocation as you get older. These types of options would probably work much better for the vast majority of employees.

84   Peter P   2006 Oct 25, 3:17am  

Also, have you tried cooking a chicken upside down and turning it right side up for the last 20 mins or so to brown the skin (with some seasoning and water in the bottom of the pan)? - I believe that makes the breast meat juicier.

Thanks for the tip.

British Beef is probably safer than US or Canadian now.

I never worried about BSE. It is probably just another international vegetarian conspiracy. :)

Have you tried Piazza’s for Bovril? They have Bisto and OXO, but never looked for Bovril - in their store in Palo Alto - don’t know about other locations. Now all I need to do is find the Shepherd’s Pie mix again.

I will try. Bovril should not be a big challenge. I have seen them in Half Moon Bay ($8+ though). They have Marmite too!

I may have too cook my own oxtail soup from scratch though.

85   Claire   2006 Oct 25, 3:22am  

Yeah - but I have this feeling that the people offering the 401k's have vested interest in steering people to the more expensive funds - like Great Western Retirement Services - where are they getting their money from to operate? From inflated fund prices or kickbacks for favoring select fund offerings? I don't know because nothing is clear cut.

I think I am very paranoid about this, but this is because the information they give you is very vague, fund prices are hard to follow as they have their own way of working out how much your funds are worth, and often don't exactly correlate to what the market funds are named or priced at. Clear as mud comes to mind, and makes me very wary.

86   Glen   2006 Oct 25, 3:27am  

Correction on my post from waaay back:

Conoco Philips: >$22 Billion in earnings in the last 3 years, $104B market cap.

Google:

87   Glen   2006 Oct 25, 3:28am  

Dang it!

Why won't my comment register? GOOG has less than two billion dollars in earnings and a one-hundred forty-five billion dollar market cap... Now will it register?

88   Claire   2006 Oct 25, 3:29am  

Peter P - Piazza's has Marmite, can't remember the price though - they have a little British Section with quite a few goodies, and carry hellishly expensive Christmas Puds closer to Christmas - or they did last year.

A friend has also recommended CostPlus World Foods (Mountain View) as a source of some goodies, but I have never been in there to check. And speaking to some other friends - a lot of the Indian supermarkets carry "English" lines too.

89   Glen   2006 Oct 25, 3:29am  

Oh... I see the problem.... can't use the "less than" symbol.

90   Claire   2006 Oct 25, 3:32am  

Glen - the other issue is how many sharaes are issued in total by each company - I haven't checked either examples, but if has issued a lot more shares than the other, then they should be worth less per share.

91   Different Sean   2006 Oct 25, 3:33am  

speaking of inflation, it looks like another interest rate reset:

Reserve chief throws on inflation anchors

oh, wrong reserve, wrong country, heh

tipped to increase int rates on nov 8 -- inflation is at the top end of the comfortable range ~ 4%. last time it happened in the 90s, they tacked about 3% onto interest rates all at once...

apart from higher fuel costs flowing into everything, i suspect the housing boom and high mortgages as being the culprit also -- high repayments mean cost of goods and services also go up -- followed by upward pressure on wages. any concurrence from the econ experts here?

92   DinOR   2006 Oct 25, 3:33am  

Person,

I'll agree. That's my whole point. The "employer dependent" stranglehold is what I try to break with each plan I set up! I tell these guys (many of whom have served on boards etc.) you're all big boys here and there's no crying if you lose! If it's publicly traded and legal for ret. accounts you got it! If I see someone doubling down after they just doubled down, I'll give them a call but everyone is free to follow their fancy. It's really revolutionary! More people should try it.

93   Peter P   2006 Oct 25, 3:38am  

GOOG worths this much if and only if people believes that it will worth a lot more sometime in the future.

Forget fundamentals. They are invented by unicorns.

94   Claire   2006 Oct 25, 3:40am  

Stock market sounds more and more like legal gambling to me....

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