Jan
16

Securitized Mortgages – Still a Problem in Credit Markets

admin on January 16th, 2009
The following was originally written to be distributed to the members of Central Oklahoma’s Realtor’s Commercial Alliance (RCA), based on presentations at the National Association of Realtor’s 2008 Annual Conference in Orlando.

The problem of securitization of mortgages (so called toxic securities) is still a significant issue for both residential and commercial real estate markets.  The current freezing of the credit markets can be traced to the securitization of mortgages (both commercial and residential) whose securities received higher credit ratings than they should have.  When the mortgage default rate of the securities increased from the normal 0.5% to just under 20% for the so-called sub-prime group, the market value of the securities significantly dropped. 

This drop in market value for some mortgage backed securities has lead to catastrophic situation for Lehman Brothers as well as other financial institutions.  How these situations were created and what we can do about it was a topic of the National Association of Realtor’s November 2008 Annual Meeting in Orlando.

Federal Housing Finance Agency

On November 7, 2008 at the National Association of Realtor’s annual meeting in Orlando, James B Lockhart, III, Director of the Federal Housing Finance Agency, gave an update on Fannie Mae, Freddie Mac, and the Federal Home Loan Banks

 The Federal Housing Finance Agency is a newly created independent federal agency created by the Federal Housing Finance Regulatory Reform Act of (July) 2008 as the successor regulatory agency resulting from the merger of the Federal Housing Finance Board and the Office of Federal Housing Enterprise Oversight, with expanded legal and regulatory authority.

On September 7, 2008, FHFA director Lockhart announced he had put Fannie Mae and Freddie Mac under the conservatorship of the FHFA, in effect, nationalizing the quasi-government financial institutions.  Lockhart said that one of his first actions was to eliminate funding for Fannie and Freddie’s lobbying efforts – it seems that they were the largest political spenders in DC…

Securitized Mortgage Problems

The issue of “toxic mortgages” that have been securitized and sold as AAA securities is still a current problem adversely impacting credit markets.  For example, the November 23 issue of the New York Times, in a front page article, suggested that a primary source of CitiGroup’s financial trouble could be traced to its lack of oversight of its $43 billion portfolio of mortgage related assets, and subsequent $65 billion in losses, write-downs for troubled assets, and charges to account for future losses.  At current stock market prices, CitiGroup is worth $20.5 billion, significantly less than its $240 billion stock market value two years ago. 

It is assumed that the reason its current mortgage related losses are larger than its mortgage related portfolio is that CitiGroup was very involved in moving mortgages off its balance sheet into mortgage backed securities – securities which CitiGroup guaranteed payments of some loans that were placed in the mortgage backed securities. 

Home Mortgage Market:
Missing Feedback Loop

Lockhart identified one significant long term problem with the current system of securitizing home mortgages; that the system currently is missing a feedback loop that is currently found in the commercial market.  

Commercial Securities Scenario Mortgage Backed Securities Scenario
  • Current management prepares to issue securities backed by mortgages or other assets
  • Bank selects a wide variety of mortgages from their portfolio to be included in a mortgage backed security offering
  • Rating Agency evaluates both the company’s management (to make a judgment on the ability of the company to repay loan) as well as the collateral that secures the loan
  • Credit Agency gives the package a AAA, or other near investment grade rating (regardless of the underlying quality of mortgages)

 
  • If the company has bad management, the rating agency will lower the bond’s rating, increasing the company’s future cost of capital

 
  • If the mortgages as a group have a greater default rate than anticipated, rating agency is reluctant to reduce rating because:
    • They may not get future work
    • If rating is reduced below investment grade, banks will, based on mark-to-market accounting, need to decrease the book value of the securities they hold on the asset sheet, which may in-turn cause them to contract their loans
    • If a market is established in these subprime – investment grade securities, and their actual value is found to be 75% less than book value, a bank’s capital may disappear and a conservator may need to be appointed.
  • With increased borrowing costs, the company’s profit martin will decrease
  • With uncertainty in the value of mortgage backed securities, that may be used in inter-bank loaning, banks stopped loaning to each other, effectively stopping the credit market
  • With decreased profits, management will be impacted; either management will improve performance or they will be replaced
  

  • O O P S

 

 Additionally, is evidence that many banks kept what was perceived to be the safest securities for their own account, placing the weaker mortgages in mortgage back securities offerings, but still maintaining AAA credit ratings on the packages. 

 What’s Next?

The mortgage backed securitization model for both commercial and residential mortgages did not have the feedback loop of regular commercial securities.  To unplug the credit market, the Federal government needed to prop up the balance sheets of banks with significant mortgage backed security exposure on their balance sheets

The resulting lack of trust seems to have destabilized markets and turned what started out as a supply side recession (caused by excess inventory) into a Demand Side recession (caused by lack of demand for products and services) as evidenced by many the number of businesses can not afford (or can not obtain) working capital loans.  The net result of this credit contraction is that businesses are also contracting.  For example many retail organizations are closing locations because of the difficulty of obtaining credit to finance inventory.   

The Collateralized Mortgage Backed Securities markets (both commercial and residential) need to be unfrozen. As long as there are toxic loans, both commercial and residential, inter-bank loans will be problematic, and the banking industry will be at risk. As long as the banking industry is at risk, credit will be constricted, and we will remain in recession.

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