Market Meltdowns: Then and Now
In my last post comparing the Savings and Loans Crisis in the late 1980s to the current Subprime Mortgage Crisis, you might have gotten the impression that the two events are just about the same. All you have to do is replace junk bonds with mortgage backed securities.
Unfortunately, that’s not entirely true and there is a case to be made that this crisis is going to be much more significant in the history of our markets. It may not be reasonable for us to assume that a year or so of doldrums is all that we’ll experience before jumping back on the bull much like the short recession in 1990-91 before the unprecedented market run of the mid to late 1990s.
Why might this market meltdown be different? The key lies in the difference between junk bonds and mortgage backed securities. Junk bonds were just one type of security. They were packaged together and sold to known recipients. The biggest buyers of these high-yield bonds were savings and loan companies, thrifts, and insurance businesses. Government regulators knew where the poison was and worked quickly bring balance back to the markets.
Deregulation in the 1990s has created a whole array of complex and poorly understood securities. Collateralized debt obligations, credit default swaps, Klio funding, and a whole host of other types of financial instruments have risen to popularity. Most of these instruments break up thousands of underlying mortgages and repackage them into pretty securities with all sorts of different investment grades and supposed risk-return characteristics. This means that defaulting mortgages don’t just affect one buyer or one security anymore, but instead can have impact on a whole slew of banks and individual holders.
To illustrate, we’ll take the example of interest only and principal only mortgage backed securities. The payback on a mortgage can be split into two types of cashflow – interest and principal repayment. One mortgage can then be split into two securities, one which returns to the investor interest payments and the other which returns principal payments.
Conventionally, a standard mortgage pass through, a security which passes interest and principal repayments of a mortgage onto the holder, will fluctuate in value inversely to interest rates. As interest rates go up, the mortgage’s value declines since cash flow payments are discounted at a higher interest rate. Optional principal prepayments likely fall as well as the homeowners are more burdened by the new higher interest rates. Interest only and principal only mortgage securities, however, do not necessarily follow this trend. Furthermore, one IO or PO security is often created out of a package of hundreds of mortgages making it even more difficult to analyze for true underlying value. And, since the same mortgages aren’t necessarily used to create one IO or PO, an investor is hard pressed to find a way to put together an IO and PO to try to recover the value of the original mortgages. When markets are hit with uncertainty and poor liquidity, these complex securities are a quintessential recipe in which the sum of the parts doesn’t equal the whole. Rather than add value, these new derivative products destroy value the moment they are created.
As you can see, derivative securities have added layers of complexity in the investment process. While initially designed as tools to diversify risk, investment banks and hedge funds latched onto these new and poorly understood securities and turned them into one of the greatest short-term profit engines we’ve ever seen. Rampant speculation and short term success created avenues for which these securities reached every nook and cranny of the system. Unfortunately, as the truth about the risk characteristics of these securities has come to light, the market for them has disappeared, few fund managers are willing to even attempt to value these securities, and those left holding mortgage backed securities are facing open markets unwilling to pay anything for them. This means that these companies will be taking huge unrealized losses on their MBSs and their only hope is to wait out payment of the underlying mortgages. A truly daunting idea in a housing market where defaults are mounting, home prices are falling, and the life of these mortgage is likely to be longer than anyone expected just a few months ago.
So, with these insidious securities all over the financial system and an inability for regulators to target the problem, are we facing a truly horrific economic downturn? Well, it’s hard to say. The good news is that innovation in financial products and derivatives has not come unaccompanied. In just the last few months, we’ve seen a dramatic shift in the Federal Reserve policies used to manage the economy with some truly innovative new practices of their own. The discount window has been opened to investment banks in addition to commercial banks. The Term Auction Facility has been created to improve usage of the Fed’s lending program. We’ve even created dollar backing to support the MBS market through the Term Securities Lending Facility. As far as economic meltdowns go, we’re in uncharted waters. Only time will tell whether the Fed has created effective tools to target and combat the problems created by the subprime meltdown and the proliferation of mortgage backed securities.
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