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Notes to myself, possibly of interest to others.
-- Bill Northlich

Thursday, August 21, 2008

Why is the mortgage process not working?

Why are mortgage rates above 7% for jumbo loans, while the Federal Reserve discount rate is 2.5%?

Why are loans hard to get, even for people with excellent credit scores?

For that matter,

Why are investment banks going out of business (Bear Stearns)?

Why are commercial banks going out of business (IndyMac)?

Before addressing the "why's" above, note that the Fed and Treasury are (finally) putting lots of plans in place to address the "credit crunch", aka the "credit crisis". A major plan is the recent housing bill which includes allowing the Government Sponsored Entities (GSA's) FHLMC/FNMA) to borrow potentially unlimited amounts from the government. See the post below; there will be more about these fixes to follow in a later post.

The short answer to the mortgage "why's":

Since about 1986, mortgage loans have been securitized. Since the late '90's, almost all debt has been securitized. Securitization means that the debt is packaged by investment banks in various ways and sold off into the world financial system, leaving the originator with more cash than he started with, free of the worry of managing and holding the loan. This has enabled an efficient movement of debt through the banking system, and thus a much more efficient conducting of business, not only business related to real-estate, but all business. More about securitization to be presented in a following note.

Now, securitization does not work. The ways that investment banks have packaged and sold off loans do not work any more. The mechanism of securitization has never been very well stress-tested. In recent stressful months, this mechanism has indeed not worked as advertised. The securitized loans which were designed as "AAA" rated securities have, under stress, been revealed to be of much lower quality. Again, see the securitization discussion, to follow.

Without securitization, a loan originator has to hold (and service) the loan himself. Actually, loan service can be a profitable business, but holding a loan can be a drag on the way banks have gotten used to doing business over the last 10 or 15 years. In fact, many banks have set up their business models to be loan originators only, relying on an infinite supply of investors willing to buy pieces of the original loans, and a robust plumbing system of investment banks very eager to make very good money providing the securitization and sale of the loan pieces, otherwise known as "tranches".

If a bank must hold a loan on it's own books, the bank knows it can not make money originating the loan at anywhere near the Fed discount rate. The main sources of "risk", or expense, on a loan for a bank are:

  1. The risk that the borrower might not be able or willing to make the payments. This is of course the only area that most people focus on when dealing with mortgate banks and rates.
  2. The risk that the interest rate charged may not be enough to cover events currently unforeseen, such as rising inflation, recession, etc. If a bank makes only 2% on a loan, a period of rising inflation might easily take away all a bank's profit on a 30 year loan over a period of 10 years, even the loan is for 30 years.

In this discussion, risk #2 above is very important. In the era of securitization, most of the risk of unforseen events could easily be passed on to investors who bought loan pieces, which can be called "loan securities". One feature of one of loan securities is that they act a lot more like stocks than the original loans. Although the markets are quite thin, the loan securities can be bought and sold similarly to stocks. If inflation goes up, for example, the market value of the loan securities may go down. In fact, these loan securities are not really bought and sold so much, as kept on the books of financial institutions as collateral against the institutions' operations. For example, insurance companies are required to keep certain amounts of capital as collateral against losses. The companies hope never really to need to tap the capital, but it is there, generating income, and thought to be safe and solid. It is important for the bookkeeping of an insurance company to be able to point to the loan securities and say "see, there are the securities and they are worth so and so".

Loan securities have traditionally been quite stable, and highly rated by Moody's, S&P, etc. In the stressful last six months, the mathematics behind loan securities has not stood up, which means a great number of the loan securities highly rated by the rating agencies have been revealed to be of mediocre quality, and so these securities, held by banks, insurance companies, etc, are worth far less than they were assumed to be worth. More on this in a later post.

So there we have the whole picture. To summarize,
  • Since the late '80's, loan originators could originate loans and quickly sell them to investment banks or their surrogates, which bundled loans into securities and sold the securities off to other investors.
  • Since securitization does not work any more, loan originators must now keep the loans on their books.
  • In order to make any money doing this, they need a return significantly above the federal discount rate to account for the newly introduced uncertainty due to inability to sell loans.
  • Right now, the margin banks are charging above the Fed rate is 4-4.5%. This may rise in the near term.
Of course, in the "old days" banks held loans all the time. This ain't the old days no more...

The housing bill noted above will allow FHLMC/FNMA to, for a while, aggressively buy loans from originators, thus putting in place a temporary substitute for loan securitization. The government's hope is that this will buy time to allow other free-market processes to gradually take over from the old securitization process. This may or may not work, but at least it is a positive step.

Stay tuned for an simple intro. to securitization, why it does not work now, and how that affects lots of institutions/banks/etc.

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