DÉJÀ VU?? – Mortgage Bonds 2016
Are they making the same “dumb” mistakes as they did in 2007-2008”?
After the debacle of 2007-2008, you would have thought Wall Street learned their lesson?
When it comes to GREED, they really did not learn their lesson?
The appetite for risky mortgages is back and forgetting what happened almost 10 years ago.
What has happened you ask? Recently $210 Million worth of bonds filled with high risk mortgages were given an AAA rating by one of the major rating agencies. Yes, the same agencies that were bought and paid for in 2007-08. The rating agencies that gave AAA ratings to high risk mortgage bonds while the delinquency rates were skyrocketing in these bonds.
OH NO, HERE WE GO AGAIN!!!
This one of the first bond issuance we have seen since the banking crisis, in which this batch of mortgage bonds has been awarded a “prime rating”. If you remember in 2007-08, the so-called rating agencies kept the AAA grade on the mortgage bonds even when the delinquencies were rising at an alarming rate, but rating agencies refused to downgrade those bonds. Why? Greed. Wall Street paid the rating agencies to rate these bonds and they needed the rating to stay at AAA level to sell these worthless bonds and get their money back. During this time, Wall Street unloaded as much of the “junk” as they could before they lost too much money. Amazingly enough no one from any rating agency, who took the bribes, was ever prosecuted or went to jail. Only one person from Wall Street went to jail. ONLY ONE!!!
Sounds all too familiar doesn’t it? These new bonds are the very same financial products, junk mortgage bonds, given a prime grade “again”. The new issues in question were backed by unqualified mortgages. These loans were underwritten with a simple bank statement, no tax returns and little or no verification.
Sooner or later, these bonds will find their way into your pension fund or other retirement accounts. Wall Street is again quietly opening the door to risky mortgage debt.
Mortgage Backed Bonds
Let’s take a look at mortgage-backed bonds in a little more detail and show you the parallels to 2008.
The basic premise behind these products is straightforward, financial institutions take thousands of mortgages and place them into a large pool or package called a bond package. Investors purchase these bonds and receive a profit from the monthly mortgage payments. Since most people pay their mortgage on time, it is theoretically a safe investment, at least in theory.
Before the crash these bonds were considered safe and the rating agencies, gave them their highest rating of AAA. Because they produced higher yield than Treasury bonds, these mortgage bonds were bought by pension funds, mutual funds and government agencies for the yield.
Maybe the old sayings, “if it is too good to be true, than it usually is” and caveat emptor (let the buyer beware) should apply to Wall Street.
Interest rates began to increase which began to put pressure on mortgage repayments (homeowners paying their mortgage payments). Housing prices slowed and defaults began to increase. Those AAA rated bonds were then filled with defaulting payments, creating failing mortgages in turn affecting the overall rating of the mortgage bond. Since the default rate in the pool was rising, the credit rating should have been downgraded from AAA. It wasn’t! The higher the default rate, the lower the credit grade should be. For example, the highest grade is AAA and it goes down from there- AAA to AA to A, then BBB, BB and so on.
All mortgage bonds and servicing portfolios expect a certain default ratio on their portfolio, pool or bonds. In some cases, depending on the type of mortgages in the pool, the default rate could have been underwritten with a default rate of 2-3%. When the default rate is set to establish the credit rating, the bond is rated based upon those defaults. If the pool/bond performs worse than the default rate applied to the bond, the value of the bond diminishes.
In 2007-08, there were two major catalysts for the meltdown. 1. A willingness of the banks to lend money to borrowers who were not able to make their contractual payments and 2. Fraudulent ratings of the mortgage loan pools/bonds which in reality were “junk”.
Both of these factors exist today. Risky mortgages and questionable credit ratings are back.
Despite all of the new legislation to deter risky lending, unqualified loans are being given to borrowers who simply state their income with no verification.
This is not the first time these rating agencies have given prime ratings to risky bonds. Lenders and rating agencies are quick to defend themselves maintaining the mortgages are at a prime level. For example, they claim the average credit score is 717. Using a credit score as the primary indicator to determine whether the loan is a prime level is wishful thinking and distorting the overall credit of the mortgage and pool to establish a higher rating. The credit score is a snapshot in time of a borrower’s credit worthiness and does not take into account a number of human behaviors as well as current or potential market conditions.
Were you aware when they underwrote the bonds in 2007-08, not one rating agency took into account future market conditions. They underwrote those loans as if the interest rates, market conditions and the overall economy would remain the same for the next 20 – 25 years.
THIS MISTAKE COULD HAVE BEEN AVOIDED!!!
These are supposed to be the best educated and brightest people reviewing these pools. Common sense told some this would never last. Real Estate values increased over 100% and in the same time frame incomes only went up 3%. And they wonder how they missed the crash. Loans are underwritten by a machine from information input by a human with a cursory review by an underwriter. I think we have that backwards. I could go into great detail about underwriting based solely upon a credit score, but I will leave that for another time.
History might be about to repeat itself and not in a good way!
Wall Street is once again packaging risky mortgages into bonds and the rating agencies are giving them the needed AAA prime grade they need to sell these bonds.
Where are we headed?
Don’t get me wrong. I am not advocating another housing collapse just yet, but the stars are beginning to line up in the same manner as they have before. If you think no one will make the same mistake and buy these bonds, think again. One of the world’s largest asset managers recently launched a European exchange traded fund (ETF) which tracks US mortgage backed securities. Money is pouring into these AAA rated bonds that now contain risky, if not potentially toxic mortgages.
The new administration has vowed to dismantle the restrictions on banks. Most take that statement literally rather than review the current legislation, which in many ways has created this current circumstance. The current legislation shored up some concerns and in turn left a number of areas over regulated, while exposing areas with not enough regulation. Lawmakers either go too far or not far enough. Depends on which lobbyist they are beholden to. Finding loopholes in this current legislation appears simple enough. Just look at our antiquated tax system. Over legislating can be just as bad if not worse than under legislating. Let’s see where this administration takes this.
Lastly, the Fed has started raising interest rates and mortgage rates are beginning to rise. What happens to these bonds when the interest rates catch up? Take into consideration when a 3% default turns into a 5% or even 7% and the borrowers are no longer be able to pay their mortgage payments. History has proven as mortgage default increase, bond yields dry up and more risky mortgages are added to loan pool sales. Bond sale history is on the verge of repeating.
The same wheels are in motion. Can we really expect to see a different result?
Joseph R. L. Passerino, Managing Director | Broker
BRE # 00631090