Monday, August 27, 2007

Understanding The Credit Crunch

Everyone has heard about the problems in the credit markets today. With all the press and airtime given to this topic I was surprised by a question from a client recently asking for an explanation. Sadly, while the problem has been discussed widely, the root of the problem has gone unexplained in the popular press.

To understand the credit problem you must first understand a little about how the bond market works. Nearly all bonds are sold out of a dealers inventory, like shirts sold at a department store. The bond dealer buys bonds, marks them up, and then resells them at a profit. Unlike stocks which trade actively everyday on the various exchanges, there are hundreds of thousands of different bond issues, and very few trade on a given day. So unlike stocks where everyone can see the value because the prices are published throughout the day, bonds are valued by using computer models. If you have bonds in your portfolio the value published each month on your statement reflects an estimate of the bonds value on that particular day. If you try to sell a bond, the price you receive could be higher or lower than the estimate your custodian provided on your statement. When dealing with bonds backed by mortgages, current and projected default rates are a factor in estimating the bonds value.

Mortgage backed bonds are created when banks and mortgage brokers pool large groups of mortgages and sell off smaller pieces to institutional and individual investors around the world. Very few mortgages are kept in house by banks, as this would tie up too much of their capital. Your mortgage has probably been sold off in this manner too. Banks and mortgage bankers make their profits from fees charged to originate the mortgage, and from fees received to service those loans. Your personal mortgage is probably part of a large group or tranche of mortgages owned by many different investors.

The current credit crunch probably began on June 20 when Merrill Lynch, a lender to a couple of Bear Stearns hedge funds investing in sub prime mortgages, asked for bids on some of the holdings held as collateral for loans made to the hedge funds. Suddenly, a large block of mortgage backed bonds had to be priced to market rather than priced to (computer) model. With a background of a weak housing market, and adjustable rate mortgages that were resetting at higher rates, the bids Merrill Lynch received from other bond dealers were significantly lower than the models had estimated. Merrill Lynch had issued a margin call, and sold the bonds off in a weak market.

This news caused others to question the value of mortgage backed bonds. Like dominoes, mortgaged backed bonds fell in value as more and more were offered for sale and bond dealers, hesitant to risk their own capital, we reluctant to buy them at any price. Suddenly awash in supply, the demand shrank to nearly nothing. It became like a run on a bank, a self fulfilling prophesy. The run was not contained to the sub prime segment of the market, it cascaded quickly to include any bond backed by any type of mortgage. Even Thornburg Mortgage, a company who specialized in jumbo mortgages, with very low default rates found it impossible to to find financing for its portfolio. The financing required to keep the mortgage market liquid suddenly ground to a halt. The only jumbo loans being issued were those that banks could afford to keep in their inventory, and they came with hefty interest rates.

What has happened to cause this credit crunch began with sub-prime mortgages, but the sub prime segment is not very important to where we are now. The challenge facing the credit markets now is how to restore faith and liquidity to this huge part of our economy. Without mortgage availability the housing market will plunge, taking along with it all the appliance sales, furnishing sales, legal services, etc that are part of this important sector of our economy. Without a housing industry our economy will surely slip into a recession or worse. The cries for an interest rate cut have been loud and often, yet when the federal reserve acted it was with a cut at the discount window not the fed funds rate.

The reason for this could be two fold. The Federal Reserve does not want to be seen as bailing out Wall Street. With the beginnings of this credit crunch so closely tied to predatory lending practices and hedge funds, the public perception is that the problem is contained there and it would be inappropriate for the government to in any way bail out bad business practices. Secondly, the federal reserve may believe that lowering interest rates will not solve the problem. Lower rates can make housing more affordable and even save some unfortunate individuals from foreclosure, but until the root problem of liquidity in mortgage backed securities is solved the specter of a housing collapse is more than just a nightmare scenario.

The stock market seems to be pricing in a rate cut from the Fed. So we are set up for a major disappointment should the fed forgo a cut at its September meeting. Again, this may be what chairman Bernanke wants. He does not want to bail out Wall Street, but if a stock market decline is unavoidable, he certainly wants that decline to be orderly in nature and not a fear driven plunge like we witnessed in the weeks preceding the latest Fed action. The Fed has been injecting liquidity into the banking system on an almost daily basis. More probably should be done. Allowing Fannie Mae and Freddie Mac to purchase mortgage securities over the current $417,000 limit should be a first step. This would allow banks to begin selling jumbo loans from their in- house portfolio and provide further liquidity. Yet, so far the politicians who could make this happen have failed to grasp the true nature of the problem, instead referring to such a move as a bail out.


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