Wall Street can’t cage its mortgage monster
WHEN the rocket scientists on Wall Street outsmart even themselves, very bad things can happen.
The 1987 stock market crash was fueled by an institutional investment strategy that its creators ironically had termed “portfolio insurance.”
The collapse of the giant hedge fund Long-Term Capital Management in 1998 was triggered by a sequence of market events that the fund’s engineers believed couldn’t occur in literally billions of years.
Today’s version of Frankenstein turning on its creator is the mortgage loan mess. Wall Street in recent years has taken a simple concept -- bundling mortgages and selling them to investors as interest-paying bonds -- and concocted an alphabet soup of securities so incredibly complex they defy understanding by all but a handful of PhDs.
That complexity now is coming back to haunt the buyers of those securities, who for the most part are hedge funds and other big investors, not individuals. If you aren’t sure what it is you own, you can’t be confident about the thing’s value. And in financial markets, if confidence dies, little else matters.
For months, Wall Street’s standard line about the massive volume of mortgages made to high-risk borrowers since 2003 was that rising delinquencies on those so-called sub-prime loans were a manageable problem.
What’s more, the line went, the trouble would be “contained” -- meaning, it would be limited to the highest-risk loans and wouldn’t spread up to better-quality mortgages or to better-quality mortgage-backed bonds.
Those assertions were all but blown away last week, after brokerage Bear Stearns Cos. on Tuesday disclosed that investors in two of its hedge funds that owned mortgage-backed securities had lost virtually all of their money.
It wasn’t that the bonds became completely worthless overnight. Rather, the funds were victims of their heavy use of borrowed money to boost their bond bets. The use of debt, or leverage, magnifies an investor’s gains when a portfolio is rising in value but also magnifies losses when the portfolio declines.
Still, leverage alone wasn’t the problem. In its letter to clients, Bear Stearns reminded the rest of Wall Street what was happening with investors’ perceptions of mortgage-backed bonds, even those purported to be of high quality.
Its funds were obliterated, the brokerage said, in part because of “the unprecedented declines in valuations of a number of highly rated -- AA and AAA -- securities.”
For a AAA-rated bond, a serious decline is a drop in the market price from $1,000 to $950 in a matter of days. It may not look like much, but for a security that had the highest possible credit rating, that’s a disaster.
Investors are losing faith in mortgage bonds up and down the quality chain because the major credit-rating firms -- Standard & Poor’s, Moody’s Investors Service and Fitch Ratings -- this month have begun to warn that loan delinquencies may be worse than what the firms had anticipated.
As they have cut their ratings, or put securities on “watch” for possible downgrades, the rating firms have helped unleash a torrent of fear.
Now, some owners of the riskiest mortgage bonds might like to sell, but the reality is that very few securities actually are changing hands.
Why is that? Because buyers are balking. After the biggest boom the housing industry has ever experienced, the bust could be unprecedented as well. So gauging how much of a loss a mortgage bond ultimately will experience -- in other words, how many loans backing the security will go bad -- is a difficult exercise for a potential buyer.
This is the peculiar problem of mortgage-backed securities. It isn’t enough to know how many struggling homeowners will be forced into foreclosure. A bond investor also has to figure whether the foreclosed homes can be sold at prices that will cover the mortgages. And the investor has to guess how long the workout process could take.
Certainly, most Americans will make their mortgage payments, as they always have. But the $1.5 trillion in sub-prime mortgage bonds sold from 2003 through 2006 tells you that a huge number of high-risk borrowers were financed in that period. Some of those loans already have failed; more assuredly will fail.
What’s more, in the sub-prime loan market it’s now clear that fraud played a big role in the ease with which loans were granted as the housing boom peaked in 2006.
So what are investors supposed to believe about the underlying paperwork that describes a mortgage and the home that secures it?
“You cannot model [a bond for] the effects of fraud,” said Andrew Lahde, head of Santa Monica-based Lahde Capital Management, which has been betting this year that mortgage bonds would plummet. “Fraud by definition is deception.”
The difficulty in evaluating mortgage-backed securities has left potential sellers and buyers far apart. As many traders have described the situation in the last few weeks, a seller puts a bond up for sale hoping to get 80 cents on the dollar, only to find that potential buyers are offering no more than, say, 40 cents.
In this environment, “no one believes that AAA is AAA,” which just echoes down the rating scale, said Janet Tavakoli, head of Tavakoli Structured Finance Inc. in Chicago and an expert on mortgage securities.
The seller then pulls the bond off the market. He hasn’t realized a loss, but his anxiety level only rises because he’s still stuck with the security in a worsening market.
As confusing as things are for mortgage bonds, it’s worse for Wall Street engineers’ crowning achievement in fee-generating securitization: collateralized debt obligations, or CDOs.
A CDO is, in effect, a bond backed by other bonds. And in a wondrous bit of alchemy, a CDO creator can take a pool of bonds backed by mostly sub-prime mortgages and turn it into securities that have AAA credit ratings.
It’s all in the slicing and dicing of the underlying portfolio. In theory, the holder of a AAA-rated CDO slice owns a security that has almost no chance of losing principal.
But what, exactly, is backing that CDO slice? That’s the question that many yield-hungry hedge funds and other big investors failed to ask in the boom years, said Christopher Whalen, an analyst at research firm Institutional Risk Analytics, which provides risk analysis to financial firms.
Now, “as mortgage default rates go up, investors are going to find out that what they own is not what they think it is,” he said.
That is likely to be the unfolding story of the rest of this year and the first half of 2008.
The fire sale in mortgage securities has yet to begin. But it’s coming. The implications for the rest of financial markets aren’t clear, but when confidence is shaken in one market there usually is collateral damage.
Once again, Wall Street’s rocket scientists have created a monster they can no longer control.
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