"Lenders may be using ARMs to offset future rate risk, but what about future asset values? Is it worth originating loans today which may sink lenders tomorrow? A large number of foreclosures won't look good on anyone's books, reason enough to tighten ARM loan standards." Wrong-Way Borrowing Threatens Borrowers, Lenders, RealtyTimes.com, June 7, 2005

If you remember the good old days of the foreclosure crisis, say about six months ago, the problem was subprime loans, a blip on the financial radar and not a worry for you or your neighbors.

After all, explained John Robbins, chairman of the Mortgage Bankers Association, about half of all subprime foreclosures get worked out and the ones that fail involve only .25 percent of all homeowners.

"As we can clearly see," Robbins told the National Press Club in May, "this is not a macro-economic event. No seismic financial occurrence is about to overwhelm the U.S. economy."

Today worries about foreclosures and their impact suggest a financial melt-down of far greater proportion. As Secretary of the Treasury Henry Paulson explains, the unfolding mortgage crisis is "the most significant current risk to our economy."

What's changed in the past six months is not merely that we have more foreclosures in Miami and Las Vegas, instead lenders, investors and hedge fund operators have begun to realize that their assets are at risk.

Is this a "seismic" problem? You bet. The gamble could not be larger and now the stakes have been raised by $80 billion in an effort to prop up the market for mortgage securities.

The Mortgage Marketplace
"In today's world, property is local but loans are as mobile as the wind," says James J. Saccacio, chairman and chief executive officer of RealtyTrac, the leading online marketplace for foreclosure properties. "The mortgage that finances your home may well be sold and re-sold many times before it's fully repaid. Not only is it possible for a series of investors to own your loan, those investors can be anywhere. Mortgage ownership now moves across national borders with electronic speed and no customs checks."

In basic terms, mortgage loans are packaged together to construct residential mortgage-backed securities (RMBS). Interest from the loans is used to create income for RMBS investors. The money paid by investors to buy RMBS securities is used to fund a new round of mortgages. The result is more money available for mortgage financing, more money means more supply and the result is both greater liquidity and lower rates.

The rate of return for an individual RMBS depends the loans included in the package. For instance, an RMBS with only mortgages from prime borrowers with strong credit would have a relatively-low rate of return because there's little risk. Alternatively, an RMBS with lots of subprime mortgages requires a higher yield because such loans are more risky.

The value of an RMBS reflects the rate of interest it produces and the risk of the underlying loans, something determined by independent ratings agencies such as Moody's and Standard & Poors.

Why is so much international money available for U.S. mortgages? A lot of places in the world have iffy economies and a strong potential for political strife. If you're wealthy, you want to move assets out of such regions and into the safest and most stable economy you can find.

Investors worldwide have a lot of choices regarding where to put their money, but what could possibly be safer than investments secured by American homes in a country where the government will not take your property without compensation? What's the one bill Americans are most likely to pay?

But What If The Assumptions Are Wrong?
In his speech before the National Press Club, Robbins essentially laid out the traditional case for international investment in the U.S. Yes there will be foreclosures, but some level of foreclosures is normal and expected — that's why RMBS investors get higher returns when their securities are backed by a large percentage of subprime loans.

Combine historic RMBS rates of return with a lively marketplace for such securities and at any time we have some sense of what to bid for an RMBS and the value of RMBS securities that we hold. But, if our assumptions as investors must be changed, it then becomes necessary to also re-think what we're willing to pay for an RMBS -- and what our holdings might be worth.
 
The RMBS marketplace is immense. Just for 2006, says Sheila C. Bair, chairman of the Federal Deposit Insurance Corporation, "approximately 75 percent of the estimated $600 billion of subprime mortgages originated in 2006 were funded by securitizations."

If you take a careful look at those subprime mortgages you can see that not only were they issued to individuals with limited credit, they also were largely composed of toxic loans.
 
"Almost three-quarters of securitized subprime mortgages originated in 2004 and 2005 were '2/28 and 3/27' hybrid loan structures," says Bair. "Most of these borrowers are having difficulty making the payments on these loans after the "reset" to higher payments — often an increase of thirty percent or more — that occurs after the initial two or three years of loan payments. According to one study, the interest rates for an estimated 1.1 million subprime loans will reset in 2007 and an additional 882,000 subprime loans will reset in 2008. Fewer and fewer of these borrowers are able to refinance because of the slowing rate of housing appreciation, higher interest rates and the problems faced by subprime lenders."

In other words, investors worldwide who bought safe and secure RMBS securities during the past few years may now see the value of their assets decline because original foreclosure projections were too conservative — more people are losing their homes than expected. No less important, the same loan formats causing so much havoc among subprime borrowers are also present among prime borrowers, those with the best credit, and ALT-A borrowers, individuals with credit between prime and subprime.

The extent of changing valuations, if any, cannot be known in advance. What is known is this: There were a number of steps taken in the past few months to shore up the value of RMBS securities.

"We expected lenders in 2007 to reverse the liberalization of underwriting criteria, to limit exceptions to these criteria, and to strengthen quality control procedures for newly originated subprime loans," says Michael Youngblood, a securities analyst with Friedman, Billings, Ramsey.

Instead, in a report issued during late September, Youngblood reported that "the credit performance of the subprime residential mortgage-backed securities (RMBS) issued in 2007 deteriorated sharply in August 2007 from the prior month." Well-publicized programs, policies and edicts designed to reduce marketplace risk were not effective. Between July and August, said Youngblood, foreclosure rates for adjustable subprime loans jumped 44 percent. Viewed another way, an RMBS may be worth less than originally thought.

Securities Versus Derivatives
So far we've seen that RMBS securities are widely traded and easy to value. This is not the case with derivatives.

A derivative is a hedge or bet which says that the value of a commodity, index, turnip seed or whatever will reach a given value in the future. The idea is to use a derivative to hedge or balance other marketplace bets to prevent large-scale losses.

Very smart people with advanced degrees in mathematics and physics argue that derivatives not only limit losses, they can be used to generate profits. The value of derivatives is based on economic models with certain assumptions, however if those assumptions change then derivative bets can be wildly inaccurate.

You can buy securities on margin and leverage your investment, but the leverage associated with derivatives is far greater. A hedge fund, for example, might take $1 billion in capitol and then borrow several times that amount, say $5 billion, from lenders. That $6 billion can then be used to buy derivatives worth hundreds of billions of dollars. Given so much leverage, a slight price movement can produce massive profits — or massive losses. For instance, the IMF has reported that in 1998 a U.S. hedge fund, Long-Term Capitol Management, held derivate contracts worth approximately $1.3 trillion. At the time the company had $4.8 billion in capital.

Mark To Market
While RMBS are traded on commodities markets, derivatives are not. You only know the value of a derivative when it comes due, perhaps in six months or a year. This creates a problem: How do you know what your derivative is worth today?

If you have a derivative tied to the movement of an RMBS you can value your security by using the "mark to market" method, that is, giving it a value today before the investment is finally cashed-in, perhaps at a higher or lower price. But what if the market for RMBS securities slows? It then becomes harder to value derivatives.

"The U.S. subprime mortgage market is small relative to the enormous scale of global financial markets. So why was the impact of subprime developments on the markets apparently so large?" asks Ben Bernanke, chairman of the Federal Reserve.

"To some extent," he continued, "the outsized effects of the subprime mortgage problems on financial markets may have reflected broader concerns that problems in the U.S. housing market might restrain overall economic growth. But the developments in subprime were perhaps more a trigger than a fundamental cause of the financial turmoil. The episode led investors to become more uncertain about valuations of a range of complex or opaque structured credit products, not just those backed by subprime mortgages. They also reacted to market developments by increasing their assessment of the risks associated with a number of assets and, to some degree, by reducing their willingness to take on risk more generally."

$80 Billion
In October several major banks agreed to raise between $80 and $100 billion to support the RMBS market. This is a curious effort for several reasons.

First, if a major chunk of the U.S. economy is troubled you might think that lenders would actually want to put up some or all of the money themselves. This is not the case. As the New York Times reports, "the plan calls for the banks to create a new financing vehicle to try to restore confidence and reduce the risk of a market meltdown by propping up an important part of the debt markets. But the banks hope to take minimal risk and avoid actually investing any of their own money." (See: 3 Major Banks Offer Plan to Calm Debts in Housing, October 16, 2007.)

Second, the banks are propping up securities they don't actually own.
So why has such a huge fund been announced?

The market for mortgage securities and related instruments has been impacted by the mortgage meltdown.

"The effort to create a backup fund began about three weeks ago, when the Treasury secretary, Henry M. Paulson, called a meeting in Washington that included the chief executives of Citigroup, Bank of America, JPMorgan and other big banks," according to the New York Times. "With Wall Street firms having almost no luck finding buyers for mortgage-backed securities and derivatives, Mr. Paulson wanted to see what could be done to relieve the bottleneck."(See: Banks May Pool Billions to Avert Securities Sell-Off, October 14, 2007)

If the value of mortgage-related securities declines or if trading slows, that means the value of related investments can decline. Those derivatives are highly-leveraged investment instruments which have been bought with funds borrowed from major banks and other large sources of capital.

By supporting the RMBS marketplace, banks are shoring up investments that rely on massive borrowing. Banks, in a round-about-way, are looking after their own interests.

Whether the banks will be able to raise $80 billion is unknown at this writing. Is $80 billion actually needed? That will not be the case should market values and activity rise on their own. Or, in the worst possible case, what if $80 billion is not enough to stem the tide of a generally-declining market? In that event the result could be massive losses, higher interest rates and — as Mr. Paulson says — significant damage to the economy.
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Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.