How Serious Is This Mortgage Crisis?
If you read the mainstream media headlines lately, you’d think the American money supply and credit lines for mortgages have all but dried up. Headlines even claim that borrowers with good credit and down payments will feel the effects.
It’s true the foundation of the risk mitigation that has driven mortgages for the past five or so years is at risk. However, this risk is based mainly on speculation at this point - speculation that all subprime mortgages are going bust.
The Washington Post ran a great story Sunday with the worst case scenario of this credit crunch. The conclusion?
The credit system is losing its, well, credibility. People no longer trust the triple-A ratings that many complex debt securities carry. The risk models used by rating agencies, hedge
funds and banks have also come under suspicion. The effects of subprime losses are being felt in unexpected places, including supposedly impregnable money market funds. Hedge funds and other highly leveraged investment vehicles are being forced to unwind. After years of excess, credit is beginning to contract.
There has been a “run on Wall Street finance,” said Doug Noland, editor of the online Credit Bubble Bulletin.
But no one knows how long it will last, or where it will end.
I’ll add no one knows how bad it will be either. Right now the markets are all moving on speculation.
To understand the credit crunch, it’s important to understand the various procedures and safeties our financial system has in place to keep credit flowing in an orderly and efficient pace. Our mortgage system is comprised of mortgage backed securities to provide liquidity to markets so lenders can lend and investors can invest. UrbanDigs in New York offers a very basic and thorough tutorial on how these financial instruments work.
Further, Pat at Transparent RE offers a basic tutorial on why this system of safeguards is suddenly not so safe.
After reading these two articles you should understand the analogy I am about to present -
The current mortgage lending crisis is like a buy/sell relationship between a collectibles store and a customer. The product, in this case, is a finely packaged box of gems, at least that’s what it is presented as. For years the customer of the store has been pleased with their purchases, so much so that they buy as much as they can and refer their friends from all over the world (China, Europe) to come and buy these packages. The collectibles store owner has been so desperate to meet demand, he hasn’t been looking too closely at what kind of gems are in the finely wrapped boxes.
One day recently, one of the buyers opened up their box and realized it wasn’t full of gold and gems, but was only partially full. The rest of the box contained worthless rocks. Soon they told their friends and some of them discovered the same thing. Others didn’t open the box and simply assumed it was full of rocks. Now nobody will buy the finely wrapped packages because they don’t know what’s in them. The collectibles store owner now has demand from the supply side, people wanting to sell him fine gems and must borrow from the bank to pay for these gems instead of using the profits from the sales to pay for them. If he doesn’t do this, he’ll go out of business.
If you haven’t guessed yet, the boxes of gems are the mortgage backed securities, the store owner is the big lenders, the buyers are the hedge funds and foreign investors and the rocks are the bad loans now coming to light.
So what is the solution to the current mortgage crisis? First of all, buyers need to more accurately know what’s in their portfolios. Through the recommendations of ratings agencies, too many loans have been packaged up as being good investments when they inherently contain more risk than originally presented.
As this adjustment is made and faith returns to the ratings of these securities, we’ll see demand for these instruments pick up. Treasury Secretary Henry Paulson, a Wall Street veteran, said today -
“Credit is being repriced, reassessed across our capital markets,” Paulson said in a television interview.
“As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk,” he said. “This will play out over time and liquidity will return to normal when the market has a better understanding, investors have a better understanding, of the risk-return trade-off.”
In the mean time Governments across the world are stepping in to assure markets continue to operate smoothly. By injecting needed capital to stave off speculative hoarding by lenders, reducing interest rates and even changing loan limits, central banks and regulators will do their best to insure orderly markets and enough mortgage capital to meet demand.
Whether this will be enough, nobody knows.