Sunday, August 12, 2007

Floyd Norris: Three Columns; August 10, 11, & 12

In a Credit Crisis, Large Mortgages Grow Costly

Published: August 12, 2007

When an investment banker set out to buy a $1.5 million home on Long Island last month, his mortgage broker quoted an interest rate of 8 percent. Three days later, when the buyer said he would take the loan, the mortgage banker had bad news: the new rate was 13 percent.

“I have been in the business 20 years and I have never seen” such a big swing in interest rates, said the broker, Bob Moulton, president of the Americana Mortgage Group in Manhasset, N.Y.

“There is a lot of fear in the markets,” he added. “When there is fear, people have a tendency to overreact.”

The investment banker’s problem was that he was taking out a so-called jumbo mortgage — a loan greater than the $417,000 mortgage that can be sold to the federally chartered enterprises, Freddie Mac and Fannie Mae. The market for large mortgages has suddenly dried up.

For months after problems appeared in the subprime mortgage market — loans to customers with less-than-sterling credit — government officials and others voiced confidence that the problem could be contained to such loans. But now it has spread to other kinds of mortgages, and credit markets and stock markets around the world are showing the effects.

Those with poor credit, whether companies or individuals, are finding it much harder to borrow, if they can at all. It appears that many homeowners who want to refinance their mortgages — often because their old mortgages are about to require sharply higher monthly payments — will be unable to do so.

Some economists are trimming their growth outlook for the this year, fearing that businesses and consumers will curtail spending.

“In the last 60 days, we’ve seen a substantial reduction in mortgage availability,” said Robert Barbera, the chief economist of ITG, a brokerage firm. “That in turn suggests that home purchases will fall further. Rising home prices were the oil that greased the wheel of this engine of growth, and falling home prices are the sand in the gears that are causing it to grind to a halt.”

At the heart of the contagion problem is the combination of complexity and leverage. The securities that financed the rapid expansion of mortgage lending were hard to understand, and some of those who owned them had borrowed so much that even a small drop in value put pressure on them to raise cash.

“You find surprising linkages that you never would have expected,” said Richard Bookstaber, a former hedge fund manager and author of a new book, “A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.”

“What matters is who owns what, who is under pressure to sell, and what else do they own,” he said. People with mortgage securities found they could not sell them, and so they sold other things. “If you can’t sell what you want to sell,” he said, “you sell what you can sell.”

He recalled that the crisis that brought down the Long-Term Capital Management hedge fund in 1998 started with Russia’s default on some of its debt. Long-Term Capital had not invested in Russia’s bonds, but some of those who owned such bonds, and needed to raise cash, sold instruments that Long-Term Capital also owned, and on which it had borrowed a lot of money.

It appears that in this case, securities backed by subprime mortgages were owned by people who also owned securities backed by leveraged corporate loans. With the market for mortgage paper drying up, and a need to raise cash, they sold the corporate securities and that market began to suffer.

The Wall Street investment banker who wanted a jumbo mortgage had a good credit score, and is not a subprime borrower. But private mortgage securities are now hard to sell, leading to his problem. In the end, he was able to get a mortgage with a lower interest rate, but it will adjust in five years, possibly to a much higher level.

The size of the rate increase he faced is unusual. But all jumbo lenders have raised rates. reports that conventional 30-year mortgages cost about 6.23 percent now, less than they did a few weeks ago, due to a decline in Treasury bond rates. But the average jumbo rate is now 6.94 percent. The spread between the two rates rose from less than a quarter of a percentage point to more than two-thirds of a point.

Jumbo mortgages are most important in areas with high home prices, most notably on the East and West coasts. “In California, it has shut down the purchase market,” said Jeff Jaye, a mortgage broker in the Bay area. “It has shut down the refi market.”

The problems with subprime mortgages erupted as home prices began to slip in some markets, making it harder to refinance mortgages. There were reports that a surprisingly large number of loans made in 2006 were defaulting only months after the loans were made.

Many of those mortgages had been financed by securities, highly rated by credit agencies, that suddenly seemed less secure than they had. Hedge funds that owned those securities, and had borrowed against them, were asked to put up more money to secure their loans.

Two Bear Stearns hedge funds were forced to liquidate, and investors lost everything. Investors shied away from buying new mortgage securities, and several lenders went out of business, unable to finance the mortgage loans they had promised to make.

With the credit gears clogged, there has been a sudden lust for cash at many levels of the financial system. Last week banks in Europe and the United States tried to borrow so much money that central banks had to step in to keep interest rates from rising.

“What I suspect is that there is a demand for credit by institutions that don’t want to sell the securities they own, because the bids are so low, and the banks are extending credit to them,” said William L. Silber, a professor of economics and finance at New York University and the author of the book “When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of America’s Monetary Supremacy.”

Fannie Mae and Freddie Mac, the government-sponsored enterprises, can still purchase mortgages and issue securities, guaranteeing that the underlying mortgages will not default. Those guarantees are still accepted by investors, and borrowers who meet their standards — meaning they can get so-called conforming mortgages — still can borrow. But those who want larger mortgages, or cannot make down payments, face a harder burden.

Homeowners with adjustable mortgages can refinance them at any time, so long as they qualify for a new loan, so some facing a payment increase may be able to wait it out and refinance later, if the market improves.

There have been sudden changes in the mortgage market before, but this one may be both more severe and more damaging than those in the past.

In past years most borrowers had 30-year mortgages with fixed rates. If such borrower kept his job, he usually could meet the monthly payments, even if the value of the home had declined so much that he could not et a new mortgage.

Now, however, many mortgages call for sharply rising monthly payments after a few years, and borrowers were given loans without regard to their ability to meet the higher payments. Lenders assumed the mortgage could be refinanced, and that rising home prices would assure repayment of the loan. It became common to offer homebuyers loans to finance the entire purchase price of a home.

In June, banking regulators ordered that adjustable-rate loans be given only to borrowers who could afford the rate at which it was likely to be reset, meaning that many borrowers would not qualify for refinancings even if their homes had not lost value. Such a rule three years ago might have prevented the crisis, Mr. Barbera said, but imposing it now may worsen the problem.

Investors made the mistake of assuming that housing prices would continue to rise, said Dwight M. Jaffee, a real estate finance professor at the University of California, Berkeley. “I can’t believe these sophisticated guys made this mistake,” he said. “But I would remind you that lots of investors bought dot-com stocks.”

He added, “When you are an investor, and everybody else is doing the same thing and making money, you often forget to ask the hard question.”

And that is how a problem that began with Wall Street excesses that provided easy credit to borrowers — and made it possible for people to pay more for homes — has now turned around and severely damaged the very housing market that it helped for so long.


Ignore the Last Few Weeks. It’s Been a Heck of a 25 Years.

Published: August 11, 2007

IT has not been the best few weeks ever for stock market investors, but it has been the best 25 years.

As stock markets gyrated this week, the United States stock market was approaching the 25th anniversary of the beginning of the great bull market. The Dow Jones industrial average hit bottom on Aug. 12, 1982, at 776.92, during a recession and with interest rates very high.

The accompanying charts give views of just how good the intervening period has been, not only in American stocks but in those of Germany, Britain and Japan as well.

The first chart shows the compound annual return of the Dow over 25-year periods from the period that ended at the end of 1925 up through the period that ended last month. One line shows the gain in the index measured in dollars, while the other shows the gain after adjusting for inflation.

The figures do not include dividends, which makes them lower than numbers often cited, but they also do not take into account taxes or the transaction costs involved in adjusting a portfolio of major stocks as the members of the Dow index change. They show how well such a portfolio has held its value relative to inflation during various periods.

Over the long period of a quarter-century, there have been periods when stocks were poor stores of value. One such period ended in the summer of 1982, just as the bull market began. Over the previous quarter century, the value of the Dow, adjusted for inflation, had declined by more than 3 percent a year — meaning that it had lost more than half its value.

But as can be seen from the chart, in the next quarter-century the value zoomed. The compound return was 11.8 percent a year before considering inflation, a little below the record set in the 25-year period that ended in late 1999, just before the technology bubble burst and the market nosedived. But taking inflation into account, the 8.5 percent compound annual gain has been the best ever.

The other charts show the total performance of indexes over the past quarter-century, from Aug. 12, 1982, for most of them and from July 31, 1982, for the FTSE All-Share index in Britain (daily prices are not available for the FTSE All-Share index that far back, so monthly figures were used, starting at the end of July 1982).

The best of the lot is the German DAX index. In local currency, it has risen about the same as the Standard & Poor’s 500-stock index in the United States. But the German currency — first the mark and now the euro — has outpaced the dollar most of the time. In dollars, that index is up about 2,500 percent.

The performance of both the Nasdaq composite — a star when the tech bubble was growing and a laggard thereafter — and the Japanese Nikkei 225 provide ample evidence that what goes up can come down, and painfully so. At the end of the 1980s it looked as if nothing could match the Japanese index, and at the end of the 1990s the same could be said of the Nasdaq index. Both are now lower than they were when they were the stars.


A New Kind of Bank Run Tests Old Safeguards

Published: August 10, 2007

A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough.

For a long time, that all seemed to be safely relegated to the past. But now the runs are back — and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.

“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”

This problem has plagued the United States at regular intervals. The Panic of 1907 was halted only when the banker J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.

Then the Depression, with a wave of bank failures, led to the establishment of deposit insurance. With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.

But a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.

Left to deal with the run are the institutions that were created to deal with the old system’s problems — notably the central banks like the Federal Reserve and the European Central Bank. But, in contrast to their close involvement with the banking system, these banks have little regulatory oversight of the securities that are in trouble and may not even know who is holding them.

At the heart of the new system was a decision to have loans financed directly by investors, rather than indirectly by bank depositors. Investors, ranging from hedge funds to wealthy individuals, had confidence in the arrangement because most of the securities were blessed as very safe by the bond rating agencies, like Moody’s and Standard & Poor’s.

The highly rated securities pay relatively low interest rates, but until now there were many willing to own them or to lend money to those who did own them. But there is no reason to hold them if there is any question about their safety — just as there was no reason to keep deposits in a bank that was facing a run amid rumors about its safety.

A result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit. The problem first gained widespread attention when two hedge funds run by the brokerage firm Bear Stearns collapsed and a third Bear Stearns fund had to suspend redemptions as investors sought to get out even though there was no evidence that the fund was in trouble.

“The third Bear Stearns fund announcement was the key,” said Robert Barbera, the chief economist of ITG. “You have to believe that in the hedge fund and mutual fund complexes, there is a decision that is building that says, ‘I want to hold some Treasuries to have a cushion if I see redemptions.’ ”

The basis of the system was a belief that securities backed by bad credit could be very safe — so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages or of loans to highly leveraged companies.

So far, none of those highly rated securities have failed to make their interest payments on time, but that fact is not enough to make anyone want to buy them. The rating agencies have downgraded some securities, and they are tightening their standards for new ratings.

Early this week, stock market investors around the world tried to reassure themselves that nothing was really wrong, and financial stocks bounced back after suffering sharp declines last week. Analysts argued that profits remained strong, as does world economic growth.

On Tuesday, the Fed declined to lower the federal funds rate, saying that despite financial market volatility and a decline in the housing market, “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

But that comforting outlook did not help the credit markets recover, or persuade anyone to buy the newly questioned securities — at least at anything like the prices people had assumed. No one wants to sell the securities at very low prices — and in many cases they have borrowed heavily against them. So the markets have dried up.

Yesterday, BNP Paribas, a major French bank, said it could no longer value three investment funds that it managed, whose assets had been invested in highly rated securities that were backed by dubious mortgages.

“The complete evaporation of liquidity in certain market segments of the U.S. securitization market,” the French bank said, “has made it impossible to value certain assets fairly, regardless of their quality or credit rating.”

Adding to the problem is that the questionable securities are widely owned and sometimes have been repackaged to form the basis of other securities. European banks and funds own paper tied to subprime mortgages, and it is not clear who else does, or how investors will react.

Banks that are worried about their own liquidity decided this week to increase their reserves, which they can do by borrowing from other banks. Loans on such rates rose as a result of the added demand. Both the federal funds rate — the rate on loans of reserves between American banks — and the London Interbank Offered Rate leaped sharply yesterday.

The Fed — which conducts monetary policy by focusing on the fed funds rate — was forced to inject money into the system to bring the rate back down to its targeted level. And the E.C.B. lent almost 100 billion euros ($130 billion), to European banks.

If the current panic is just that — unreasoning fear — then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.

On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.

Yesterday, stock prices fell in Europe and kept declining in the United States, amid speculation over what other owners of the securities might surface as having problems. But American stock prices remain well above the levels they fell to in February, after a sudden drop in the Chinese stock market, and many stock investors still think all will work out acceptably.

The central banks, while clearly crucial to dealing with the loss of faith in the new financial system, lost influence under that system. Loans could be arranged by nonbanks, not subject to bank regulators, and the regulators were hesitant to impose rules that would not apply to all lenders. The lenders sold securities to finance mortgages that let people borrow at rates that — temporarily — were far lower than the Fed envisioned. That delayed the impact of the Fed’s attempts to raise interest rates in 2005 and 2006.

“That is important because it means the decline in the housing market is likely to continue,” Mr. Barbera said. If the American economy does continue to weaken, the Fed may feel forced to reduce interest rates sooner than it had expected, even if that move threatens to hurt the value of the dollar.

Prices in the futures market for federal funds show that just a few weeks ago investors thought there would be no Fed easing this year. Now they seem to think such a move is highly likely, and some expect it as early as next month.

But the Fed’s influence is limited when lenders are suddenly risk-averse. “The impetus of lowering interest rates may not help, if they don’t let you borrow in the first place,” said Kingman Penniman, the president of KDP Investment Advisors.

The new financial system is not the one the Fed was created to deal with, but it is the one it must try to handle.


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