From a small northwestern observatory…

A few days ago, I kicked off this series with some comments about the asset side of the residential market.  Today, I’ll discuss the finance side of that market.  Later on (parts 3 and 4) I’ll talk about the asset and financial side of the commercial market.  Keep in mind that these markets are all very different, albeit intertwined.

A quick caveat — don’t use ANY of this to answer Econ 101 exam questions.  I’ve over simplified nearly all of this to make it readable.

If you watched the really excellent HBO movie, Too Big to Fail, you saw and heard the actors talk about huge losses in “real estate”.  While many of these players actually owned real estate assets (see my commentary about Archstone), the real thing that brought them down was their ownership of real estate derivatives.  Now, this may sound like I’m side tracking, but it’s very helpful to understand how we got here, if we’re going to understand how to fix it.

Imagine John and Jane America go to Main Street Bank (MSB) and borrow $100,000 to buy a house.  In the course of a year, Main Street Bank may make 100 of such loans, totaling $10,000,000.  In a typical pool of 100 loans, two of them will go bust, resulting in $200,000 in “paper” losses to MSB.  Now, before you start feeling sorry for the depositors and shareholders of MSB, it’s important to note three things:

1.  This was a fairly predictable set of losses.  Hence, every borrower paid a slight premium on their loan to “share the burden” of everyone else.

2.  The bank has the house as collateral.  While foreclosure sales rarely fully compensate the bank for the losses, they really do cut the pain down to a small headache, and then #1 above kicks in.

3.  Many mortgages have private mortgage insurance, etc., to compensate even further.

Hence, in a normal year, a small number of foreclosures is expected and manageable.  However, the period leading into this recession was anything but normal.  House prices peaked, and actually started tumbling downward, meaning that #2 wasn’t working very well.  The losses started bankrupting the PMI companies, thus making #3 ineffective.  Finally, foreclosure rates got up to huge levels. 

Still, you might say, these numbers should have been reasonably manageable, right?  Well, not so quick, partner.  Now we need to introduce two new concepts:  the mortgage backed security (MBS) and the default swap.  An MBS is a really strange, hybrid, derivative instrument.  Fully explaining it here is nearly impossible, but let’s take a stab.  Remember the $10m in mortgages?  (In actuality, we were usually dealing with pots of loans that were ten times that big.)  Let’s say the average yield on that pool was 6%.  Now, I’ll chop and dice that pool three ways.  First, I’ll sell $5 million of it to widows and orphans, and promise them AAA safety by giving them first crack at the principal and interest.  However, their yield will only be, say, 4%.  Next, I’ll sell some speculators the next $2.5 million of AA rated paper, and give them the NEXT crack at the payments but only a 5% return.  The last $2.5 million will get all the residual returns, which should work out to an 11% yield if nothing goes wrong (see numbers 1 – 3 above).  However, everything went wrong, and these last slices of the pie went down the tubes.

Now, if you’re Lehman Brothers, you take that last slice, and sell IT off  in slices to investors.  However, you promise THEM AAA security by entering into a credit default swap.  Essentially, you’re getting Bear Stearns to guarantee YOUR pools, and you guarantee theirs.  To find out how that worked in reality, go see the movie.

Unfortunately, so much of our investment banking establishment was hinged on these derivatives, and the underlying asset values went so far down, that the system totally broke down.  It’s very close to broken today, which is why getting low-down-payment loans is nearly impossible now-a-days (in effect, the default rate on 80% LTV loans is nearly zero, so that’s the only part of the system that’s working fairly well now). 

Fannie-Mae and Freddie Mac had Congressional mandates to buy tons of these mortgages.  While they were not in the MBS and credit default swap business, they were in the business of borrowing money to invest in loans.  A default rate of 6% or more might have been manageable if the values of the underlying assets hadn’t fallen by 20% – 40% in some parts of the country.  Note that 6% of several trillion dollars is a lot of money when the short-sale only recovers 60 to 80 cents on the dollar.  There is also a huge shadow inventory of properties (by some estimates, 5 million homes with a potential loan overhang of a trillion dollars) that haven’t yet even been foreclosed on but the loans are either non-performing or in serious arrears.

How do we fix it?  The system depends on a complex network of institutional trust coupled with complex insurance and hedges (essentially, a credit default swap was an insurance policy).  Most of that system is irreparably broken.  Following the Savings and Loan Crisis of the late 1980’s, the nature of residential mortgage lending was significantly changed in the U.S. and many other countries.  This situation is far, far more complex than that one, and probably calls for the same level of overhaul we saw in the Great Depression, when the very nature of home mortgages was completely stood on its head.  Unfortunately, we’ve wasted several good years with no settlement in sight.  My guess is that the rest of this decade will be wasted, at the pace we’re currently seeing.

Any good news?  I think so.  There are some great private sector minds who are currently realizing that the Federal Government is NOT going to step up to the plate with a solution like it did in the 1930’s.  Hopefully, the pace will pick up as the market starts realizing that it needs to find new financing instruments to satisfy the demand for housing and restore health to this sector of the economy.