The world is full of people desperate to know what Gretchen Morgenson thinks about the market in mortgage-backed securities, or MBSs. The problem is that her column last week on the subject is hidden behind the Times Select firewall. So we can all be very grateful that she has now rewritten it, at even greater length, and republished it under a “News Analysis” slug. (No firewall!) The headline? “Crisis Looms in Market for Mortgages“.
Or, you know, we can ignore it, on the grounds that Morgenson adduces no evidence whatsoever that any crisis is looming at all. For one thing, she doesn’t seem to understand the difference between two entirely different types of investment: equity in subprime mortgage originators, on the one hand, and debt backed by pools of subprime mortgages, on the other. It’s certainly true that originating subprime mortgages does not seem to have been a very good business to invest in over the past year or so. But Morgenson never connects the dots and explains why that means that the market in subprime MBSs is likely to implode.
Morgenson also talks at great length about the enormity of the market in MBSs, but never stops to point out that the vast majority of that market is in bonds issued by Fannie Mae and Freddie Mac, and that no one has any worries whatsoever about those securities crashing.
Here’s a bit of typical overheated prose:
Wall Street firms and entrepreneurs made fortunes issuing questionable securities, in this case pools of home loans taken out by risky borrowers… Regulators stood by as the mania churned, fed by lax standards and anything-goes lending.
But here is Morgenson’s own graph, showing the practical effects of that churning mania: MBS issuance more than $1 trillion lower in 2006 than it was three years earlier. It’s very hard to look at this graph and see any evidence of a bubble: rather, it seems that private-sector MBS issuance has been rising only to make up for a large drop in issuance from Fannie and Freddie.
Morgenson’s most substantive problem is that there’s a ticking bomb in the MBS market, in the form of investors failing to mark their securities to market. First she says they don’t, then she says they do, and then she says they don’t — let’s see if you can make more sense of it than I can.
Owners of mortgage securities that have been pooled, for example, do not have to reflect the prevailing market prices of those securities each day, as stockholders do. Only when a security is downgraded by a rating agency do investors have to mark their holdings to the market value. As a result, traders say, many investors are reporting the values of their holdings at inflated prices…
Years ago, mortgage-backed securities appealed to a buy-and-hold crowd, who kept the securities on their books until the loans were paid off. “You used to think of mortgages as slow moving,” said Glenn T. Costello, managing director of structured finance residential mortgage at Fitch Ratings. “Now it has become much more of a trading market, with a mark-to-market bent.”…
Interestingly, accounting conventions in mortgage securities require an investor to mark his holdings to market only when they get downgraded. So investors may be assigning higher values to their positions than they would receive if they had to go into the market and find a buyer. That delays the reckoning, some analysts say.
Of course, Morgenson is missing two crucial points here. The first is that here simply isn’t a market in most MBSs tranches — that’s why so much of the recent activity has concentrated on MBS indices rather than the underlying securities. The liquid, mark-to-market activity that Costello is talking about is entirely in Fannie and Freddie bonds, not in individual tranches of securitized subprime mortgages. You can’t mark subprime MBS tranches to market daily for the very good reason that most such tranches simply don’t trade on a daily basis.
And the second point is that if you actually look at the prices for those subprime MBS tranches when they do trade, guess what? They haven’t actually fallen much in price at all. If investors were marking to market, it really wouldn’t make much difference. As Josh Rosner told me, the problem is not that existing MBSs are likely to default or drop in price. A default is much like a prepayment, from an investor’s point of view, so investors only really care about default rates when they start approaching prepayment rates. And they’re nowhere near those levels.
Anyway, here’s my favorite bit from Morgenson’s article. Before you read it, ask yourself what a scary loan-to-value ratio for subprime mortgages would be. 125%? 100%? 95%?
The rapid rise in the amount borrowed against a property’s value shows how willing lenders were to stretch. In 2000, according to Banc of America Securities, the average loan to a subprime lender was 48 percent of the value of the underlying property. By 2006, that figure reached 82 percent.
There you go: 82%, in the year universally considered to be the laxest year in the history of subprime mortgages. Now do you understand why investors aren’t particularly worried about default?
Invidiously, Morgenson even hints darkly at nefarious conflicts of interest at the ratings agencies, saying that they might be soft-pedalling downgrades to save their own hides. I don’t think they are. Mortgage pools are designed to be able to withstand a temporary drop in house prices or rise in default rates. I look at the tiny number of MBS downgrades and take comfort in it. I’m perfectly happy to concede that subprime mortgage originators who were active this time last year are going to be in a lot of trouble now. But I’m nowhere near convinced that there’s any real problem in the market for the securities based on the mortgages they originated.