The Mortgage-Backed Credit Slowdown-And the Rules That Caused It

By Flowers, Edward | Review of Business, Spring 2008 | Go to article overview

The Mortgage-Backed Credit Slowdown-And the Rules That Caused It


Flowers, Edward, Review of Business


Abstract

The U.S. credit crisis in sub-par, mortgage-backed securities that began unfolding in July of 2007 now appears to be spreading to Europe, (1) where housing prices are falling and economic forecasts are for slower growth. (2) The crisis is spreading to stock markets in Asia, as well. (3) The crisis has already caused the layoff of 42,000 employees in New York City's financial industry and has threatened the growth of the city's economy, (4) where 20 percent of Manhattan salaries are earned by financial industry employees. The tightening of mortgage credit and corporate loans (5) now threatens to slow the U.S. economy as well. Although bank lending since midsummer grew at the fastest rate in more than 30 years, that credit is now tightening as banks cut back their lending and increase their loan loss reserves. These new reserves (6) will come from earnings, so this tightening will turn the recent banking boom into a bust. (7)

Cheap Mortgage Financing

This credit crisis was caused by an ingenious U.S. mortgage financing system which has been so efficient at providing mortgage financing that it has given what amounts to a subsidy of up to $100,000 to each household that owns an upper middle class home. This subsidy comes to mortgagees in the form of cheaper mortgage financing and tax deductions on mortgage interest payments. But now the credit markets associated with this financing system are frozen because the collateralized debt obligations (CDOs) of banks have been contaminated by a small number of sub-par mortgages. Although the sub-par component of this mortgage market is estimated to constitute only one to two percent of the total--an estimated $600 billion of a total mortgage market of about $30 trillion (8)--it has been sufficient to make most mortgage-backed securities both unmarketable and unpriceable.

Housing Prices Plunge

The sub-par mortgage problem reached crisis proportions when housing sales plunged eight percent in September to the slowest annual pace in a decade. (9) Thomas Zimmerman, head of mortgage credit research at UBS in New York, estimated that should house prices fall another 10 percent over the next two years, the losses due to defaults could wipe out as much as 16 percent of the $600 billion of the sub-prime-backed securities issued in 2006. Although in August of 2007 such losses were equivalent to less than one percent of the total, (10) Zimmerman's scenario is entirely possible. As housing prices fall, the ability of a mortgagee to refinance the escalating payments on an adjustable rate mortgage (ARM) becomes more difficult.

Mortgage Defaults

In this frozen mortgage financing market, purchasers of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) can no longer be certain that their securities are not backed, in part, by some sub-par mortgages. These mortgages have already begun to default and as a result of the clauses and formulas in the CDO agreements, the interest payments on these bonds are beginning to be cut off. (11) These defaults threaten the liquidity of both the funds that hold these securities and the banks that guaranteed the assets in these funds.

Structured Investment Vehicles

There are approximately 30 funds that hold the bulk of the MBS and CDOs. These funds are called structured investment vehicles (SIVs) and account for the approximately $320 400 billion of sub-par mortgage backed securities. These SIVs were created by two former Citigroup bankers, Nicholas Sossidis and Stephen Partridge-Hicks, who called their first SIV the Gordian Knot. (12) These funds used short-dated commercial paper and medium-term notes (13) to finance the purchase of assets such as credit-card debt and mortgage securities from the banks that originated them. (14) The banks then shared in the profit from the spread of mortgage-backed asset sales over the SIV's cost of financing, through fees that they charged the vehicles.

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