Lending Markets: Where’s the money for the second round?

Where we are today - a brief recap:
Residential and Commercial mortgage backed securities (MBS) made up for about 75% of the liquidity that made loans including mortgages readily available. This is where the big banks would buy mortgage papers and sell them through investment banks to investors as securities. The combined value of these securities was way higher than the combined asset values held as collateral. This enabled the lending banks to not only not wait the term of the loans to be recapitalized but continuously expand the lending market. They were able to issue loans at a much higher rate than what the deposit holdings would have allowed them to do. Now, this entire industry of mortgage backed securities has evaporated removing almost 75% of the vehicle that made liquid capital available for lending.

Why the rise?
Sub-prime rose to 20% of the overall mortgages in 2006. Was it really the private sector listening to the government and making loans to people who may not qualify due to equal housing opportunity and urban revitalization programs or was that the feel good story that covered the workings of the MBS market? Let's look at what's good for an investor in the MBS market. When an investor buys an MBS he or she is looking for a stream of income that’s created as the borrower pays back the interest and a portion of the principal every month. The investor gains the most if the buyer pays for the full term of the loan. The investor gains less if the borrower prepays the loan cutting the overall interest that the bank would have collected, improves his or her credit and re-finances to a better loan with a lower interest rate or rapidly pays the principal down lowering the interest paid on balance. In effect anything good for the borrower is bad for the investor. The investor is looking for people who are probably stuck in jobs that have no growth, barely make their payments and don’t receive big bonuses. These are the borrowers from whom the investor can make the biggest returns. This promise of seemingly secure higher returns attracted a huge volume of MBS investors in a short time. So it was imperative for the industry to look for non-quality or sub-prime borrowers.

Why the fall?
Did the investors not realize that the segment of population that they were going after could be prone to defaults? May be, may be not. First, before the mess, foreclosures were pretty rare. People would loose their homes last. What they missed was the accounting method that forced foreclosures to pollute perfectly good mortgages. Before Fannie Mae’s revised guidelines foreclosures were excluded from comps that were used to appraise the value of a home as foreclosures are not “arms-length” transactions. However, mark to market laws required assets to be valued at their current market value which for many of the pools had to be derived from the value of the lowest foreclosure in that pool making the pool worth a lot less on paper than it is really worth. To me this problem is unreal. However, as MBS investors realized that the assets based on which their securities were generated could have questionable value, they started bailing in mass numbers causing a rapid fall in security values and therefore further distressing the underlying asset. Now, Fannie Mae is requiring foreclosures to be included in the comps making this unreal problem real.

Will the bailouts work?
At the peak in early 2007, the first lien debt amount was almost 8 trillion dollars and about 75% of it was securitized between Fannie Mae, Freddie Mac, Ginnie Mae and the non-agency ABSs (asset backed securitizers – or a BSsers!). Only about 25% of it was held by deposit banks doing business the old fashioned way. Now the MBS investors are almost gone and are not likely to come back especially if we keep talking about how “toxic” these assets are. Given the negativity around regulatory agencies, rating agencies, management agencies and investment banks and the discussion of how difficult or almost impossible it is to value these assets why would investors trust the system again?

By way of the TARP and the stimulus package the government can provide some liquidity to ease current lending. But without the underlying industry that converted the loans back into liquid capital rapidly lending cannot return to “normal” levels. It is like adding gas to a car that has lost its engine.

So what can we do?
Given the enormity of the commercial banks and the securitization industry, running a lending market with just deposit banks will shrink our economy down to levels that will not be acceptable to most Americans. We must address the unrealness of the toxicity of these assets and mark it as most commoners would do – a foreclosure is not worth the same as a normal “orderly” sale in any neighborhood. There must be an aggressive effort on the part of the banks to make foreclosures readily available to investors and home owners who have the means to convert that into a positive asset and limit the damage to the neighborhood. The clash between the wants of the investor and the wants of the borrower needs to be reconciled. Finally, banks must republish their asset values once the corrections are made and begin to instill confidence in the securities market.

None of this addresses the other elements of this perfect storm we are in with the recession, loss of jobs and the challenge from global markets and global trade but we got to start somewhere and the TARP is not it! Hope our leaders do understand the core issues or else as Scully said, “Brace for impact.”