Wednesday March 19, 2008
Red Alert
Okay. So where did all the sub-prime mortgages go? What value, if any, do those kinds of mortgages have today? And which specific banks, funds and portfolios are contaminated with bad paper?
Strap yourself in, folks. Because a lot of worthless mortgage-backed paper may be in your portfolio right now.
According to the U.S Treasury, there were $35 billion of sub-prime mortgages issued in 1994. That annual number jumped to over $625 billion by 2006. And many of these loans were so-called “hybrid” mortgages, which helped propel real estate speculation to absurd heights.
A hybrid mortgage is adjustable-rate debt with, typically, a 30-year tenor and periodic interest rate adjustments. “Hybrids” often permit borrowers to buy a house with little or no money down and give borrowers a rock-bottom, very low initial rate of interest followed by a “reset” or substantial interest bump-up in 3, 5 or 10 years.
Many hybrid mortgages even permit payments of interest only and no re-payment of principal for some period of time.
In the heyday of the housing bubble, then, these kinds of mortgages enabled borrowers to buy properties they could otherwise never afford. Unbridled rapaciousness seized the country. Banks took on outlandish risk. Borrowers took on impossible-to-repay debt. And both borrowers and lenders expected real estate prices to escalate forever, altogether ignoring basic risk and cash-flow fundamentals.
The problem, of course, is that once they reached the critical “re-set” adjustment, many borrowers simply could not — and cannot — afford the higher, “bumped up” interest cost. As a result, massive defaults are taking place across the country.
This cancer quickly spread. The banks which issued these hybrid and sub-prime mortgages often sold off the risk. They sold these mortgages to “mega-lenders” like Countrywide. Wall Street also helped bundle and off-sell this debt as “mortgage-backed securities” to hedge funds, mutual funds, money market funds, and new investment structures known as “SIVs”.
A “SIV” or “structured investment vehicle” is a financial structure that we are going to hear a lot more about. It is a structure that borrows short-term money to buy and hold long-term collateralized assets such as sub-prime loans, hybrid mortgages, and other kinds of collateral-backed assets. Many banks created these structures. Their assets are often not carried on the institution’s balance sheet. They don’t show up! So it is difficult to ascertain the overall size and financial health of the institutions behind these SIV structures.
We do know two things about SIVs. First, many banks set them up. They include Citibank, Standard Chartered, HSBC, Societe Generale, Bank of America, Sun Trust Bank, and a host of others.
Second, there is growing and justifiable concern about the assets that SIVs hold. Let’s be clear: most of the mortgage-backed and collateral-backed assets held by SIVs are highly rated “Aaa” or “AAA” paper. That’s fine. But many of investments in SIVs are sub-prime or hybrid mortgages that are going belly up. And the house of cards that greed built is now tumbling down.
Fearing that many SIV assets are becoming worthless, the banks and investors which once gave money to fund banks with SIVs are turning off the tap. And this has plunged many institutions into a liquidity crisis.
IKB, a German bank, was one of the first casualties of the crisis. Believing that its SIV holdings were in trouble, investors stopped giving IKB funding. That caused the institution’s collapse.
Many other banks with SIVs or large positions in mortgage-backed securities are also having a hard time renewing or obtaining funding. They are unable to obtain funding because lenders believe — rightly or wrongly — that the institutions may be sitting on billions of worthless paper and represent high risk. On the other hand, these same banks and SIVs are unable to sell off their mortgage-backed assets without triggering colossal losses.
The crisis spread in the U.S. in 2006 and 2007. Some U.S. banks talked of creating a “super bailout fund” to prevent funding turmoil, but that fizzled in December 2007. In early 2008, Standard Chartered withdrew its pledge to support “Whistlejack”, its own SIV, and appointed a receiver for the $7 billion failing fund. Among others, Orange County California reportedly had $80 million invested in Whistlejack.
Meanwhile, U.S. and foreign banks began writing off large amounts of problem, mortgage-backed paper. For example, Citibank has thus far written off some $20 billion of mortgage-backed holdings. However it is not clear how much more Citibank and other banks need to recognize as losses.
I believe that the write-offs collectively taken by all banks are small potatoes in comparison with the expected total size of the SIV and mortgage problem. The situation is precarious.
Today, many financial institutions have investment structures holding immense volumes of mortgage-backed assets of dubious value. As more and more hybrid mortgages go through their “interest re-set”, more and more defaults are likely and more SIV and fund content will depreciate or prove worthless.
Clearly, many more billions of dollars of write-offs have to take place before the SIVs, banks and funds holding mortgage-backed securities return to financial health.
In the meantime, the Fed has attempted to shore up public confidence and avoid a melt-down by cutting interest rates and by extending financing directly to those institutions which are having a hard time obtaining day-to-day funding otherwise.
So what does this mean for you? It means that it’s time to exercise great caution with your savings and take — right now! — defensive posture.
Bad mortgage collateral appears to have contaminated a number of otherwise wholesome investments: (1) bond funds, (2) money market funds, (3) hedge funds, and (4) the special investment vehicles and portfolios of many banks. The funds and structures holding this paper are in jeopardy. You should, therefore, take defensive action:
1. Check the content of your bond funds, money market funds, and hedge funds today. If you hold bond or money market or hedge funds from any financial group, call that group’s “information hot line” and ask whether the fund has hybrid-backed or mortgage-backed content. If it does, cut your holdings.
2. Cut investments in U.S. as well as non-U.S. bank stocks. The equities of many financial institutions are going to experience great whiplash due to SIV problems and, unfortunately, due to “guilt by association”. Most banks are certainly not in danger of collapse. Let me repeat: most banks have perfectly sturdy balance sheets and are not in danger of collapse. However, their stocks are likely to experience severe turbulence as more and more investors and pension funds come to understand the need for major write-offs industry-wide. Steer clear of bank stocks.
3. Increase your holdings of TIPS [“Treasury Inflation Protected Securities”] or TIPS funds — but only hold them in tax-sheltered accounts such as IRAs or 401(k)s to avoid paying taxes on the inflation adjustments. The Fed’s interest rate cuts are fueling inflation. Other factors are as well. However, our government officials and financial overseers have been so asleep at the wheel that we now find ourselves painted into a nasty a corner: the repair of one problem [the credit crisis] is now fueling another [inflation]. So you need to protect yourself from bad collateral, the likelihood of massive write-offs, as well as the likelihood of stock and fund turbulence. But you also need to protect yourself from sharp inflation ahead.
4. Step up non-U.S. investments. Many fiscal and financial weaknesses are converging. They include (1) the immense debt of the federal government, (2) a weakening dollar, (3) lower dollar interest rates, and (4) the unstable state of this country’s financial institutions because of the mortgage and SIV mess. Collectively, these factors may cause foreign investors to shun U.S. investments until we return to financial sobriety. Don’t get me wrong — U.S. investments belong in your portfolio! But we’ve reached a point where massive write-offs and real economic corrections are needed — not to mention a radical overhaul of the layers of federal and state oversight of banks and funds that allowed this problem to become so severe in the first place. Until the U.S financial system returns to good health, increase your non-U.S exposure.
My book Cash-Rich Retirement recommends other ways of avoiding speculation and investment whiplash. It will help you, too. But the immediate point is this: it’s time to pay close attention to the content of your investments and to avoid damage that the housing bubble and outright greed are sure to cause in larger doses. We’re in a nasty predicament. It will take years to sort out these problems. For the next six months at least, be defensive and be cautious. And gear up for larger inflation, the “side effect” of the cure we’re taking.
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