What Do Spinal Tap’s Keyboardist and the U.S. Mortgage-Lending Market Have in Common?

Marty DiBergi: “If I were to ask you what your philosophy of life, or your creed… what would that be?”

Viv Savage: “Have… a good… time… all the time.”

The Next Bowl of Punch

The popping of the technology-and-telecom bubble left America’s new, retail shareholder class punch-drunk. It also educated that base to the enticing possibilities of asset bubbles. Bonds are hard to understand and there’s been no democratization of technology supporting the retail ownership of fixed-income instruments. (Though we would argue that the availability of such technology, and the popularization of bond-trading at the retail level, should better have preceded the widespread use of equity platforms designed for Brenda and Eddie; but that’s not how it happened.)

So punch-drunk, but ever optimistic, the newly empowered retail shareholder class went looking for another bowl of punch.

Americans understand home ownership; we don’t need to be sold on the idea; and no new technology is necessary to participate. What could be less unlike the Internet than your very own bricks and mortar? It’s a house — it’s your house; it’s “safe as houses” (to quote an expression that our butler, Baines, informs us may have arisen from the bursting of Britain’s railway bubble in the 1840s).

“Mortgages — Get Your Red-Hot Mortgages!”

The historically low level of federal-funds rates following the market collapse of 2000 is the baton that connects the Internet and housing bubbles. And what could be more different than the shady machinations of Wall Street analyst-hucksters than owning a home — when you can’t even trust a Methodist church trustee from Texas like Kenneth Lay? There’s no sugar-sweet, click-per-view or pay-per-click multiple math going on; and your grandparents probably never rented anything (unless, like Baines, you’re British and of a certain age; then even your parents may have rented lots of things, from rooms to radios). Enticed by the possibilities of asset bubbles, and with the age-old quality-seal — financial, cultural — that homeownership carries (unlike, say, Pets.com), the distance from “stocks are exploding!” to “home prices are exploding!” was shorter than Bernie Ebbers’ perp walk (Baptist deacon).

A man goes into Countrywide Financial (CFC), the largest mortgage-lender in the country, and applies for a loan for a house. Though the mortgage is for a little more than he can afford, home prices are up “countrywide” since the start of the decade. CFC is a fairly prudent mortgage lender — not unsophisticated, not a loan shark. It issues the mortgage for many reasons, none of them having to do (in our tailor-made example) with the applicant’s credit-worthiness.

Specifically, it writes the mortgage because: (i) it needs to meet analysts’ expectations on a quarterly basis, (ii) posting growth numbers competitive with the industry’s and (iii) growing its market share; (iv) it needs growth to justify senior-level bonuses and to fund its 401(k) plan; and (v) it sees hungry demand on the part of institutional investors for mortgage-backed (as well as other collateralized) securities, which it therefore has no problem moving. This is a hypothetical example designed to capture the spirit underwriting (and securitizing) U.S. mortgages for the last couple years. And again, none of these reasons have anything to do with the credit-worthiness of the borrower, as may be further evidenced by the $30 billion in option ARMs (adjustable-rate mortgages) carried by Countrywide alone. So far, so bad.

You Can’t Stop the Avalanche as It Races Down the Hill

The structured-finance group of an investment bank such as Lehman Brothers (LEH) uses quantitative models to prepare a prospectus for a collateralized-debt offering — specifically, a private placement of residential mortgage-backed bonds — which it pools with similar instruments (as measured by expected risk) and markets to pension funds, endowments, and hedge funds around the world.

The quant models use inputs from rating agencies regarding recent market default rates (as well as other inputs) to price the various tranches. The run-up in housing prices has driven strong performance from these kinds of offerings, and, by extension, (i) the risk appetite from institutional investors for more such instruments; (ii) the willingness of mortgage lenders (and the ratings agencies themselves) to satisfy this demand; (iii) a greater number of loans to riskier borrowers to (iv) finance the purchase of more homes at inflated prices which, because of the asset-price inflation (which provides earlier buyers with more of an equity cushion), (v) makes for a greater number of new-home buyers and (vi) offerings that are seemingly less risky at the margin.

The brokerage industry that creates these investments — which includes players from Moody’s (MCO) to Goldman Sachs (GS) — and the institutional investors who purchase and price them in the secondary market, therefore all use inadequate risk assumptions in their valuation models: They are mostly look-back models, not crystal balls, which is fine inasmuch as there are no crystal balls. But are the super-duper, sophisticated quant models even “looking back” at the right time period? They tend to look at the recent trend, not the previous cycle or the one before that. In fact, they tend not to incorporate cyclicality as such; neither do their users. Eventually, subprime mortgages account for about one-seventh of all outstanding U.S. mortgages. Why not? The recent trend has been strong. The more layers of securitization we have, the more margin for error creeps into the analyses and pricings.

And You Just Can’t Stop My Knife and Fork When I See a Christmas Ham

Commercial paper is boring; at its first mention, our eyelids tend to flutter, consciousness itself threatening to slip away. That is as it should be — money-market fund managers use these short-term (e.g., several days to several months), corporate IOUs to juice the returns available from higher-grade, but longer-term, instruments like Treasury bills. But when the quality of the underlying assets comes into question, as it is in connection with the mortgage lenders and their creditors, the market for commercial paper and longer-term corporate bonds dries up in a flight to quality. Money-market funds are at risk of “breaking the buck,” or closing at less than net asset value, which puts not only the funds’ investors but its managers at risk (for their jobs). Everybody just wants T-bills, as seen by the one-day price-spike last week — the largest of the decade. As a result, T-bill yields are pushed so far below the target rate that nobody knows how to price risk even in the short term. Liquidity dries up as algorithmic-trading systems, which now probably account for over half of all daily share volume, migrate to quality, to liquidity.

The Fed indicated that it viewed inflation as a continuing risk; then, ten days later, in response to the above, lowered the discount rate 50 basis points to 5.75%, extended such loans’ duration from one to 30 days, and indicated with a wink that it would accept mortgage bonds backed by the chartered agencies (Fannie Mae, Freddie Mac, Ginnie Mae) as collateral. The country’s four biggest banks, having been granted a special (and temporary) exemption allowing them to use the funds, up to a certain limit, to finance securities purchases through their brokerage arms, borrowed unneeded billions at above-market rates from the discount window, so that smaller banks in need of funds wouldn’t feel “uncool” for doing the same. (Then everyone gets a greaser haircut and breaks into a conspicuously well-choreographed “You Can’t Stop the Beat.”) Easier access to discount-window funds encourages banks to lend or extend credit terms, regardless of whether they actually belly up to the window. Market participants react positively to the symbolic gesture; but we’ve still got all those adjustable-rate mortgages out there.

You Can Try to Stop the Seasons Girl, but You Know You Never Will

None of this is to suggest that more cyclical quant models (or users incorporating cyclicality in their thinking to a greater degree) would abolish booms or busts, in the MBS or any other market. Rather, it suggests three questions: how deep will the subprime contagion spread, and by what means? And what role should we expect the Fed to play under any scenario?

As to the first: most of the outstanding ARMs have yet to reset, so most of the damage has yet to be felt by consumers or the banks that will be forced to foreclose on them. Jim Cramer is rightly advising folks, under certain circumstances, to walk away from their homes, and many will. The banks no more want to own these assets than a private consortium wanted to bail out Long-Term Capital Management nine years ago. The total value of loans currently facing foreclosure is 20 times bigger than the losses represented by the LTCM debacle (which totaled $4.6 billion in the final accounting).

The second two questions are structural, and their answers may inform not only the current crisis, but the next, inevitable one. The Fed is clearly taking steps to promote the smooth functioning of market and credit systems while avoiding the appearance of rewarding speculators. But it has already effectively lowered the cost of credit by allowing the actual fed-funds rate to deviate substantially from the target, in addition to the other, more specialized means discussed above, and through repo injections. It may be that moral hazard is hardwired into a centrally banked, fiat-money economy in a manner that poses an escalating risk — but we will have to leave discussion that for another time.

The President assured the market, as Bernanke had, that there would be no federal bailout; that there will be FHA reforms and new government programs promoting refinancing at the retail level; that the tax code can and will be modified in light of “subprime, all the time.” “You can try to stop my dancing feet, but I just cannot stand still.” ♦