Risk – Part 2

In the previous segment I talked about the risks in the sub-prime – read junk – mortgage market. As foreclosures mount, the inability to assess the future values of these loans as led to increased fear, fear that it could be worse than whatever the last risk assessment report was.

As someone who has been writing about the impending junk mortgage implosion, it is not surprising to see my predictions finally come true. But what has been even worse and even less gratifying is to see how widespread the aftershocks have been felt both in the credit markets, understandably, but in the equity markets as well.

The interesting part of this is to try to ascertain the part that risk plays in this whole situation. If you want to be completely honest about most of the activities in the financial world, they have to do with identifying risk and laying that risk off on someone else while keeping your profit.

With mortgages, perhaps they are originated by a mortgage broker like me, but we never own the loan so cannot be tagged with a potential loss. The company that funds the loan, whether it is a bank or a mortgage banker, takes a little risk because every day they are buying commitments to sell the loans that they are funding. They sell the loans a few days after they fund them.

The next stop is FannieMae, FreddieMac, or the Wall Street firm that bought the loan. Their job is to assemble the loans into pools and sell participations in those pools to investors. Again, these guys are playing hot potato too, and they want to lay off the risk on someone else as quickly as they can.

What are supposed to be a bunch of smart guys that are pricing these pools to reflect accurately the risk. FannieMae loans are underwritten to reliably strict standards and are sold at the lowest yield. They are sort of the T-Bill of mortgage investments. And the foreclosure rate on these loans is usually somewhere in the 1% range, meaning 99% are paid on time. But even if there is a foreclosure, surely most of the loan balance is paid off. That means that the losses are minimal.

That is not the case with the junk loans where the quality of the borrowers is lower and there is less equity to protect the lender. Everyone, in their heart of hearts, knew that the default rate was going to be higher. The only question was how bad it would be. That said, I’m sure that the salesman told the investors that they were high quality loans. For example, sub-prime sounds fancy, doesn’t it. How much harder would it be to sell the same thing when it has a name like “junk?”

In order to improve the PERCEPTION of risk, rating services examined the quality of the loans and assigned a quality rating to the mortgage pools. Note that a rating doesn’t change the actual risk of owning the loans, just the perception of its risk. My guess is that these guys were as far off base as the guys who originated the loans. I mean, it is obvious that many, many pools were far riskier than the rating services said they were. But you can’t sue a rating service.

Another aspect of this is that, theoretically, that once these loans, or rather the participations in the pools backed by the loans, are packaged and sold, the risks are spread so widely that the risk of loss to any one investor is minimal.

Let’s talk about final owners. Let’s assume that an insurance company needs to invest policy premiums to pay future claims. They invest a portion of their huge portfolio in mortgages, but, importantly, they are long-term investors and are perfectly happy waiting for the loans to pay off at some time in the future and collect interest payments in the meantime. Sure, there may be some defaults, but that was factored into the price they paid for the investment.

But what happened next was a re-concentration of investments in these pools, an act that increases risk. It’s a little different if you are a hedge fund or mutual fund that buys the mortgages for investors. Remember that these mortgages are not liquid. The hedge fund cannot call the borrower and ask him to refinance so you can have your money back. You are stuck with them.

It turns out that as these junk mortgages started heading south, some of the investors called the managers and asked for their money back. But with these pools of illiquid loans, there weren’t any buyers and they can’t be turned in to cash as is the case with a stock fund. When the funds were unable to raise cash, they announced that they would suspend redemptions. Of course, that injects even more fear into the equation.

Even worse, some hedge funds did a lot more than buy junk mortgages. They went out and borrowed money, a lot of money, so that these funds were leveraged. This is like what you do when you bought your home. You put down, say, 10% and borrowed 90%. If the value goes up 10%, you doubled your money. But if it goes down 10%, your equity would be wiped out.

That’s exactly what happened to two such funds assembled by Bear Stearns. The investors’ positions were wiped out. They lost everything. Some French and German funds faced liquidity crises too when the sponsors ceased redemptions. They got the jitters and that started spilling over into the equity markets.

The other problem is that funds did not buy loans or mortgage backed securities. Whenever you have any type of security, it is possible to dice it and slice it anyway you want. I’m making this up but you could sell half of a mortgage to one guy who would get interest payments in January, March, May and so forth and sell the other half to a guy who would get the interest payments during the other months.

This falls under the umbrella of what are called Collateralized Debt Obligations. It’s far too complicated to go into further here but it is covered well at Wikipedia. See the entry http://en.wikipedia.org/wiki/Collateralized_debt_obligation

This dicing and slicing exacerbates the problem because it makes it increasingly difficult to tell exactly who owns what, what its value is, and what the risks of owning it might be. The more uncertainty they see, the worse the crisis.

As the worries spread, it continues to spill over into the equity markets. As I write this, the value of the stock of Countrywide Financial, the country’s largest lender is half of what it was at the beginning of the year. A Merrill Lynch analyst actually talked about the possibility of bankruptcy. I doubt that is likely, but when you read this, check the current price under the symbol CFC.

That’s pretty sobering, but we’re not through. Stay tuned.