The past three months have been terrible for global mortgage finance. First, shocked hedge-fund investors recoiled at the horror and reality that their higher-yielding investments also have higher risk attached to them. Then, many secondary mortgage market investors stopped purchasing mortgage securities backed by subprime and alternative-A mortgages due to record losses and an inability to accurately price the credit and collateral risks. This caused an unprecedented and as-yet-unresolved liquidity crisis.
In the primary mortgage market, lender loan pipelines continued to fill with unsalable or unprofitable loans; lenders began slashing loan production, tightening underwriting guidelines and eliminating loan programs altogether. Nevertheless, many warehouse lenders terminated mortgage bankers' credit lines. These mortgage bankers went out of business because they could not sell the loans and lacked the capital to internally fund these loans. Even Countrywide Financial Corporation, Calabasas, California, whose mortgage banking division is arguably the most successful mortgage bank in the history of U.S. mortgage finance, stunned investors by tapping an entire $11.5 billion credit line. It also accepted a $2 billion strategic investment from rival Bank of America, Charlotte, North Carolina, because it was having difficulty selling short-term debt to fund new mortgages.
Flaws in securitization and CMOs
Unlike U.K. and European mortgage funding, which relies on retail bank deposits and covered mortgage bonds issued by mortgage lenders themselves, U.S. mortgage funding relies heaviest on securitization. Retail deposits and Federal Home Loan Bank advances are important but secondary long-term funding sources. Short-term warehouse lines of credit are also critical to many mortgage lenders selling loans into the secondary market.
In addition to pooling loans into mortgage-backed securities (MBS), firms restructure MBS into collateralized mortgage obligations (CMOs). CMOs stratify credit and prepayment risk into tranches with different risk and yield relationships. Unrated and high-yield subordinate tranches collateralize the higher-rated tranches. These tranches were retained in portfolio or sold to hedge-fund investors that misjudged the risks. This repackaging of risks worked well for years, until subprime mortgage lending underwriting guidelines loosened significantly while lending volume tripled during the past four years.
This summer, as rating agencies began to downgrade MBS and CMOs, investors wrote down MBS and CMO values and investor demand for new subprime, alt-A and jumbo mortgage loans disappeared quickly. These developments also called into question the value of rating agency ratings, which some investors had relied on too heavily.
How secure is securitization?
So what will happen to the primary mortgage market? Is securitization to blame, and are CMO structures for subprime loans dead? The short-term answer today appears to be yes, but in the long term securitization will be alive and well.
The important question is: When will subprime, alternative-A and jumbo mortgage securitization come back next year, and in what form? There is a primary mortgage market answer and a secondary market answer.
In the primary mortgage market, U.S. lenders need to diversify their funding sources. In fact, surviving mortgage lenders have done just that. Countrywide Bank and Pasadena, California-based Indymac Bank have converted to federal savings bank charters to obtain access to Federal Home Loan Bank advances. Bank of America and Seattle-based Washington Mutual have issued covered mortgage bonds. Lenders are also focusing on generating more loan volume from their retail distribution channels and de-emphasizing wholesale distribution. …