Liquidity and Its Importance in the Bond Market
In years passed a borrower would visit their bank to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend to the next guy
What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, Fannie Mae (FNMA), Ginnie Mae (GNMA), and Freddie Mac (FHLMC) were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is capable or repaying the loan, willing to repay the debt, has the cash to close, and the value is in the property is OK, the loans and thus the bond will perform as expected.
During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% financing to those with weak credit, and high risk exotic loans (Option ARM's). In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses flattened out and moderated in 2006.
Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetites for this risk has waned. To attract investors in this environment, rates had to increase substantially. Bruised credit loans that were in the mid 7% range just a few months ago are now in the 11-12% range.
"Conforming" loans sold to Ginnie, Fannie, and Freddie remain largely untouched in the recent credit rout because the investment qualities of the loans are well known. The foreclosure and delinquency rates are well within acceptable standards lending support to these products as their interest rates have fallen in the recent weeks.
The fact remains that a qualified borrower is a good investment from a bondholder perspective. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current subprime issue will determine when that change occurs.
We are in for a ride... Stay tuned for more details, or visit www.JoeMetzler.com
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