Monday, February 12, 2007
housing damage widening
"The national inflation picture has been clouded in the past few years by large swings in energy, commodity, and housing prices. As these markets normalize, and as we gain a clearer picture of the underlying inflation trend, we may see that some inflation risks remain. In that case, some additional policy firming may be needed - depending, of course, on the outlook for both inflation and economic growth."
hopes for a nascent recovery in housing cannot have been encouraged here -- and indeed tranches of commodified housing mortgages (known as CDOs and tracked by bond index ABX) are tanking. this graph shows the ABX relating to high-risk (BBB) mortgages originated in the second half of 2006, which are now selling at 89 cents on the dollar on default fears. but in some ways more disturbing is the deterioration in CDOs reflecting better credits -- such as AA bonds (100 cents) and A bonds (96 cents) in the same timeframe, both of which have taken a sharp turn down.
could this indicate the beginning of a capital flight from mortgage debt? certainly the press is reporting that wall street is nervous.
The once booming market for home loans to people with weak credit -- known as sub-prime mortgages and made largely to minorities, the poor and first-time buyers stretching to afford a home -- is coming under greater pressure. The evidence can be seen in rising default rates, increasingly strained finances at mortgage lenders and growing doubts among investors.
Now, Wall Street firms, which had helped fuel the growth in the market by bankrolling and investing in sub-prime mortgage lenders, have begun to pinch off the money spigot.
Several mortgage lenders have recently collapsed. While the failures so far are small in number, some industry officials are concerned that they could be the first in a wave. The sub-prime sector, which produced loans worth more than $500 billion in the first nine months of last year, could shrink significantly.
Wall Street firms were attracted to such lenders because they helped feed a pipeline of securities backed by the mortgages, a market bigger than the one for U.S. Treasury bonds and notes. Merrill Lynch, for example, backed $67.8 billion in residential mortgages in the first nine months of 2006, up 58.4 percent from the period a year earlier.
But an increasing number of borrowers are defaulting on sub-prime loans earlier now than they did a year ago, often within six months of having taken the loan out, shaking Wall Street's confidence in its sub-prime partners.
Nearly 1 million homeowners nationwide either lost their homes or missed monthly payments from July to September, according to the Mortgage Bankers Association.
In a December report, the Center for Responsible Lending estimated that nearly 20 percent of those who took out risky mortgages will lose their homes nationwide. In California, more than 21 percent are likely to default, with a foreclosure rate as high as 25 percent in some areas.
In one indication that investors are losing their taste for mortgages, hedge funds that specialize in mortgage-backed securities had an outflow of $1.8 billion in 2006, down from an inflow of $1.8 billion in 2005, according to Hedge Fund Research. It was the only category of hedge funds to have a negative flow for the year.
``We have been and continue to be cautious about the sub-prime market -- its lending standards, decline in home price appreciation, other deteriorating credit fundamentals,'' said Jim Higgins, chief executive of Sorin Capital Management.
Mortgage lenders as small as Ownit and as big as Wells Fargo sit in the middle of housing's food chain that starts with individual home buyers and can end with investors in exotic credit derivatives on the other side of the world. Smaller lenders like Ownit use money provided by banks like JPMorgan and Merrill Lynch to make loans that it receives from mortgage brokers who interact with and help fill in the paperwork for people buying homes or refinancing existing loans.
Once completed, the mortgages are sold to Wall Street banks that package hundreds of loans at a time into bonds that are sold to investors and traded in financial markets.
The bonds are sliced into different layers of risk and many investors typically accept lower returns in exchange for guarantees that they will be paid ahead of people in the lower-quality portions of the securities if borrowers default on mortgages. Investors also shield themselves by requiring mortgage companies like Ownit to buy back mortgages that incur ``early payment defaults,'' an industry term for loans that have turned bad quickly.
In recent months, banks have sought the safety of these protective measures and grown pickier about the kinds of loans they will buy after noticing that a growing number of borrowers who took out loans in 2006 were falling behind on payments just a few months after they had been issued.
and that confirms rumors from elsewhere in the mortgage broker chain that merrill lynch is making margin calls to "mortgage warehouse borrowers" to whom it has lent working capital.
In some quarters it's being called a liquidity crisis, the likes that haven't been seen in the subprime sector since 1998. On Friday, National Mortgage News Online reported that Merrill Lynch was making margin calls on certain warehouse customers, asking these non-depositories for more capital. Meanwhile, we're told that higher-ups at Merrill are questioning why it bought First Franklin -- and why it paid so much money for it. Will heads roll at Merrill? A spokesman there told us that yes, margin calls are occurring, but the company is more than happy with First Franklin. We're also told that some Wall Street firms are getting ready to trim back their warehouse lending operations. Which Wall Street firm will be the first to run screaming from the industry, shouting, "What have I done? What have I done?" Stay tuned…
with the ABX indeces of even moderate risk levels turning down -- and the higher risk end falling apart -- a rout may be on. some few economists are starting to predict recession, noting that the recent bounce in housing was ephemeral and weather-related -- but a rapid unwinding of mortgage exposure would probably bring on a credit crunch that would quickly seal this fate as inevitable.
it is important to note that high-yielding american mortgage debt is on one end of a large number of carry trades -- it may pay to keep an eye on yen-dollar trading. as carry trades unwind, all those who sold yen (the most important carry trade currency) to buy higher-yielding dollar assets will be coming back to buy yen and pay down loans. recent weakness in the yen indicates that this is not yet happening.