Housing Hot Potato III – The Secondary Mortgage Market
Until now, my Housing Hot Potato series has focused on the mortgage-origination process, and the games played in that arena. In Part I, I discussed the mortgage broker, who originates the loan, then brokers it to a mortgage banker or commercial bank, which in turn sells it. Commercial banks, as I mentioned in Part II, also have the option of holding the loan, since they take in deposits. If a commercial bank does hold the loan in its portfolio, this is the last stop for the “hot potato.” This rarely happens, however, and that is where the game of hot potato really gets interesting.
The Big Picture (with Pictures) – Conforming Loan Secondary Market
For the sake of simplicity, we are going to limit the secondary market players to Fannie & Freddie, even though other players exist. Why? Because financial markets and ratings agencies have interpreted Fannie and Freddie’s GSE (government-sponsored entity) status to mean that there is an implied guarantee by the United States Treasury.
This can be seen in the narrow spread of Fannie/Freddie debt over Treasuries, and the AAA rating their securities carry. The ability of Fannie and Freddie to issue debt (i.e. borrow money) at rock-bottom rates has distorted the secondary mortgage market. Fannie and Freddie enjoy a pricing-power advantage that effectively makes them the only game in town.
As the pictorial shows, the mortgage bankers and commercial banks sell the loan to either investors or secondary market players (Fannie and Freddie). Investors can buy it at this point, but very few do, as their interest lies not in single loans but in a pool of loans securitized by Fannie and Freddie. By combining loans into a large portfolio, one of the benefits Fannie and Freddie offer is geographical diversification (limiting exposure to any one local real estate market). But perhaps even more valuable to an investor is the fact that once Fannie and Freddie have packaged the loans, any defaults or delinquencies results in zero loss of principal to investors who have bought Fannie and Freddie paper. This risk lies with Fannie and Freddie, at least in theory.
In the Land of the Blind – The One-Eyed Man is King
Central to my thesis is that due to Fannie and Freddie’s unique makeup as private government-sponsored entities, the system holds more risk than the average market participant realizes. This risk come in two forms: 1. Sound underwriting and risk management can be compromised. Fannie and Freddie’s ability to issue debt so cheaply forces other secondary market players to take on more risk if they want to play. 2. Similarly, investors rely less on investment analysis and more on the Fannie/Freddie guarantee. Investors could buy a loan from a commercial bank or mortgage banker, but they wait for Fannie and Freddie to stamp their guarantee on it. If the unfathomable happens and Fannie and Freddie run into trouble (i.e. property values decrease, unemployment rises, unexpected interest rate shocks), investors believe the federal government will make good on Fannie and Freddie’s debt by paying 100 cents on every dollar of principal. Investors pay in the form of lower yield, but do so willingly in exchange for what they perceive to be zero credit risk.
The Real World
Let’s take a moment to work through a real-world example. When I bought my house, an independent mortgage broker originated the deal and brokered my conforming loan to Washington Mutual. The loan was fixed for 30 years at 6.25%. At the time, Fannie Mae probably announced that it would buy any conforming loan for 6.0%. So why would Washington Mutual sell the loan to Fannie for such a small profit? Well, let’s remember there are two parts of any mortgage loan – the right to receive payments and the physical task of collecting the payments, or what is called “servicing” (receiving monthly mortgage payments, managing tax and insurance escrows, monitoring delinquencies, managing foreclosures and making payments to investors). While the servicing part might not be as glamorous as receiving payments, it is a time-tested moneymaker. Furthermore, Washington Mutual still hopes to make money from the float –the amount of time between when I pay it and when it pays Fannie Mae.
Once Fannie buys my loan from Washington Mutual, it has two basic options -- issue agency securities backed by nothing but the guarantee of its credit, or pool the loan with other mortgages and offer MBS (mortgage-backed securities) to investors. Given the large number of originations and refinancing at the time, my loan was probably pooled into an MBS. The yield on the mortgage-backed securities was probably around 5.60%. In this example, Fannie would make a spread of .40% (income 6.0%, minus cost of funds 5.60%, equals .40%). At this point, it might seem as though the game of hot potato had stopped, but wait…what if I refinance?
In 2001, our friends at the Federal Reserve cut rates 11 times to ease the fallout from the popping of the equity bubble. In November of 2002, the Federal Reserve again cut rates, this time by 50 basis points. That move sent a shock through the bond/mortgage market, igniting a rally in the already-strong housing/refi market, thus starting the game of hot potato all over again. In this example, the reverberations from this shock included the opportunity for me to refinance my loan at a lower rate with no points. The investors of Fannie’s mortgage-backed security pool, which included my loan, still received their principal back, but now had to reinvest it in a lower-interest-rate environment. Likewise, the volatility in the bond market forced Fannie to expand its hedging activities at a cost to its net income.
Just the 'Cliff Notes,' Please.
The bond market, in all its wisdom or rashness, has priced Fannie and Freddie’s debt just a tad riskier than Treasuries. This has forced other secondary mortgage market players to lower lending standards in order to compete. At the same time, investors have become complacent about risk, believing that if the economy weakens or falls prey to an exogenous event, the government will swoop down with a Fannie/Freddie debt bailout. This attitude results in yet another risk to the system: Fannie and Freddie’s overpowering size and the difficulty (market impact) it has when hedging out its interest rate risk.
The Smaller Picture
Although much smaller in size (only about 10% of the market), the subprime secondary market is an important indicator of where the conforming market may be heading. More and more loans are originating with both high LTV (loan-to-value) ratios and high mortgage-payment-to-income ratios. Although the subprime market doesn’t have the implied guarantee of the government, someone still has to securitize the loan. Let’s see how this works:
Subprime Loan Secondary Market
The origination process for subprime loans is basically the same as for conforming, except that the mortgage broker, mortgage banker and banks specialize in subprime lending. In the prime/conforming arena, Fannie and Freddie buy any loan that meets a certain preset standard. In the subprime arena, the loans need to be sold to someone who will securitize them (Fannie and Freddie’s job in the conforming world). In an example like the one above, that is done by a mortgage REIT (Real Estate Investment Trust), or an investment bank, just two of the many ways a subprime loan can get pushed to the public.
An investment banking firm purchases mortgage loans from mortgage banks and sells them to SPE (special purpose entities). They then invite investors to buy ownership interests in the SPE, which pay interest over a specified term, with the investment bank’s name adding a sense of security. Knowing that there is a risk in the loan, the bank often mitigates this with recourse agreements, or by purchasing insurance.
If the loan goes to the mortgage REIT instead of the investment bank, the REIT securitizes the loans and pays a dividend to the investors in the REIT. Remember, this is subprime, so think of a company like NFI, not NLY.
'What, Me Worry?'
Now that we’ve seen how both the subprime and conforming secondary market mortgages work, we can look to the future and ask “Where do we go from here?” and “What’s wrong with this picture?”
Well, as long as the economy and housing prices keep rising, the answers are “nowhere” and “nothing.” It’s a system that appears to work. But what happens when we get to a period where both the economy weakens and housing flattens? We can then imagine that the subprime market will experience a rise in the foreclosure rate. We can also imagine that the conforming market will probably be able to hold relatively steady, except for growing a case of price paranoia.
But what would happen if we threw another variable into the mix? What if we found out that the investment banks, the very ones that give people a sense of security, were found to have an equity interest in some of the mortgage banks from which they acquired the loans? In that case, what motivation would an investment bank have to really check the quality of the originations? Likewise the REIT that securitizes its own loans and can play games with gain-on-sale accounting isn’t going to slow down the pace of originations to worry about quality, is it?
It seems to me that if the regulatory environment allowed this all to continue, then we would eventually have to contend with a lot worse than just rising foreclosures in the subprime market, and housing price paranoia for the general public. And when big players push their weight around to hide conflicts of interest, and play games with assumptions we all take for granted, those games suddenly get a lot more serious.