Mortgage Industry Trends

The talking heads on CNBC don't understand the problem that has afflicted the mortgage industry. Bernake doesn't appear to understand either, though I could very well be wrong.

It goes without saying that the President doesn't understand what is going on. I don't think anyone expects him to be able to understand the inner workings of a rather niche market.

Its also likely that none of his advisers understand, either- and I say that partly because of what the president said the other day, and partly because what we've seen from this White House is that cronyism is the key to advancement, and the louder you can say yes, the more likely you are to be a member of Bush's inner circle.

But I digress.

Its actually quite simple. And, if you're like Peter Cugno, we can blame the smart people on Wall Street.

At its simpliest, Wall Street found a way to slice and dice mortgages through MBS & CDOs in such a way, that they could sell them to all kinds of investors looking for long term above average returns with low risk.

I wonder what the genius got paid for finding a way to sell a subprime pool of loans as a Triple A rated securitiy.

Pension funds, hedge funds, give me your cash, and while you are at it, this game is so safe, you really ought to borrow some money and leverage your returns!

But the party couldn't last forever- at some point, this bubble needed to burst, or at least sag. So many area's of the country became unaffordable for many of the people that lived there, and we developed a positive feedback loop: money poured into real estate, values went up, it became easier to borrow, both more and under risker terms (2/28's, neg ams, stated/lite doc loans).

Once things started to go sideways, the Street players like Merrill and Bear Stearns tried to play musical chairs and pushed back on originators the loans that were holding back the perfect ratings on their "Frankensteinian" financial instruments. Eventually, these originators started to buckle under the pressure, and one by one, they cry uncle.

The carnage has been the slow motion variety, like some action film or fireworks display- you keep thinking, that must be the finale, there can't be another villan to blow up or star burst to explode. But no- there is more. It continues unabated, like the Black Death moving from town to town.

The talking head on CNBC, Larry Kudlow, doesn't seem to understand what has happened. He talks about bailing out subprime mortgage banks. They're mostly all gone. That isn't the problem. The problem is that Wall Street sold subprime mortgages as triple rated securities to pension funds and other institutional investors, and these bets are going sideways. The first guys that stuck their head up out of the fox hold, like the Bear Stearns head funds and BNP hedge funds, got them shot off.

The other guys that are too scared to stick their head up- they're not sure what they own. None of these investors understand what a mortgage is, how it works, what is stated, what is a mortgage broker. They understand numbers and spreadsheets and Wall Street sold them numbers and spreadsheets.

But Wall Street's formulas have turned out to be wrong. Partly, its been a function of trial and error. They don't have the experience to properly assign risk- they did try. And partly, its greed. Everyone who wrote the mortgages and the structures going sideways- they're set. They got paid. There were residuals for them. Perhaps for some of the guys originating the loans for securitiezation might have a small piece left that will pay off over the long term.

And now the world wakes up and wonders what did I buy? What is it worth.

With any other asset, you go to Yahoo Finance and plug the ticker symbol in. But funny thing about these CDOs & MBSs. Not a lot of people trade them. So, if your investors have asked for their money back, and your a hedge fund, you might have to tell them that what you thought was a $1MM asset that you paid $1MM for, is now worth considerably less. Try 0. Zero. Lots of Zeros. $0,000,000.00

Because no one wants to buy that crazy triple A CDO or MBS. Partly because no one knows what they are really worth. I mean, everyone is sure its not worth what you paid. And no one wants to buy it because they can't turn around and sell it.

There is plenty of cash in the market. Plenty of capital.

The people who need the government bail out are the consumers who want a mortgage, but don't fit neatly into the Fannie Mae/Freddie Mac conforming bucket. The mortgage banks that wrote these loans. They're gone. Out of business. Wall Street can wait for things to improve. They have plenty of other things to do to generate fee income and other income from M&A, trading and corporate finance activities.

How best to do this? I'm not sure that lowering the overnight Fed Funds rate is going ot do the trick. I doubt it would hurt and it might help.

In an ideal world, the government would create a special purpose vehicle similar to Freddie & Fannie Mae to go out and buy MBS & CDOs. Bush wanted to privatize Social Security- what better way to match an asset with a desire to park money long term. Perhaps if you don't pay your mortgage, perhaps you could be penalized by not paying out social security or adding a year to your work life. This is interesting.

But, I think the most we can hope for is that the Ofheo will in a reasonable fashion authorize Freddie Mac and Fannie Mae to go into the market and make addional purchase beyone where they are today.

That is perhaps bailing out hedge funds, pension funds, institiutional investors and mortgage professionals. No one says the GSEs have to bid high for any asset they want to buy- they are for proffit.

But, they will be bailing out American home owners and those who dream of home ownership.