US housing market is different this time - it's worse (From UK)

MoneyWeek ^ | 12/8/2006 | Cris Sholto Heaton

[RobRoy]

“It’s different this time,” are four of the most alarming words an investor can hear. Very rarely do things turn out differently; history shows that normally they go wrong in almost exactly the same way they did last time round the cycle.

But when it comes to the US housing market, there are reasons to expect that things will be different this time. But not in the way that optimists expect – instead the difference is that the damage could be more far-reaching than ever before.

Plenty gets written about the vast scale of this real estate bubble, the world of pain that housebuilders, realtors and overstretched buyers are finding themselves in and the likely impact that falling prices will have on the American consumer’s willingness to run up debt at the mall.

What’s sometimes overlooked is the other end of the equation: the huge amount of risky loans that have been issued to fuel this bubble and the question of who will be left holding the baby when it all blows up... In the modern mortgage market, loans often don’t remain with the bank that issued them. Instead they're parcelled up into bond-type structures called mortgage-backed securities (MBSs) and sold on to investors. The buyers range from hedge funds and pension funds to the Chinese government diversifying its dollar assets away from Treasuries.

This process - called securitization - looks like a winner for all involved. The mortgage lenders get rid of the risk of more borrowers than expected defaulting on their payments. The buyers get a higher interest payment from the MBSs than they would from a corporate bond with a comparable credit rating (this is because individually the mortgages are riskier, which means they pay a higher interest rate; but if you collect enough together, you reduce the risk of too many defaulting, which makes for an improved credit rating). And the investment banks collect a fat fee for arranging the deal.

MBSs aren’t a new development. The first ones appeared during the 1980s and played an important part in the Savings and Loans crisis. The banks persuaded S&Ls to turn their mortgage portfolios into MBSs and sell them, then use the proceeds to buy MBSs issued by other S&Ls. That may not sound like great business acumen, but it should be borne in mind that the S&Ls were run by near-amateurs working on the time-honoured 9-6-3 business model: lend money at 9%, take deposits at 6% and be on the golf course by 3pm.

Since then, the scale of the MBS market has expanded enormously. And one segment that has grown particularly strongly in recent years is subprime mortgages - loans granted to borrowers who are a higher credit risk.

Banks charge higher interest rates for subprime loans, making them a very profitable segment during boom times. So as the housing bubble inflated, subprime originations soared from around $100bn six years ago to over $800bn last year. In the process, lenders lowered their standards, throwing money at people who wouldn’t have even qualified as subprime in previous years.

The problem is that when the housing market or the broader economy turns down, delinquencies (late payments) and default rates on subprime mortgages shoot up. And that seems to be what’s happening now. Investment bank UBS reports that nearly 4% of subprime mortgages issued and bundled into MBSs this year are 60 days or more behind on their payments. While that may not sound too alarming, it’s the highest rate in over a decade - almost one percentage point higher than in the 2001 recession - and the economy as a whole isn’t even officially in trouble yet.

These delinquencies don’t bode well for the performance of this crop of MBSs in years to come. Typically, delinquencies and defaults pick up from year three of an MBS’s life; high delinquencies in year one are generally a sign that higher-than-usual defaults can be expected later on (because people who struggle to meet payments from the off are likely to struggle even more in subsequent years). That means that many investors who have bought subprime MBSs may soon find high default rates eating into their returns.

In theory, this will mostly affect investors who have bought bonds with lower credit ratings, but in practice even investors who bought higher-rated bonds may take a hit. Nobody really knows how subprime MBSs will perform during a falling housing market, because there’s so little historical evidence to assess them. One Merrill Lynch report reckons that a 5% fall in house prices could see defaults rise to double digit rates, which would be enough to hurt some investors who’ve bought seemingly-safe A-rated paper, the analysts reckon.

And of course, not many MBSs would actually have to cut payments; just the increased threat of it could send their prices tumbling. As happened with the S&Ls, plenty of investors will then find that they didn’t understand the risks they were taking on. But this time, the scale will be much greater.

Still, at least the lenders can take comfort in the fact that they’ve got all the risk off their books, can’t they? Not quite. MBS buyers may have been very reckless recently, but they’re not completely stupid. Usually the lender must buy back mortgages that go bad within the first few months. That could prove a trap for reckless lenders. This week, Ownit Mortgage, a formerly fast-growing subprime lender in California, shut its doors after apparently running out of cash to meet its repurchase obligations. It’s unlikely to be the last firm to meet that fate.

[RobRoy]

I didn't connect the dots on this whole thing until I got something like the 20th offer for my daughter to get a credit card, all within a month of her 18th birthday.

She never received a one. ;)

[EVO X]

Amazing how times have changed. When I was 18 you couldn't get credit without a job, etc.