Mortgage Meltdown and the Grand Unified Theory of Risk in Financial Markets
The financial news the past few weeks has been dominated by the meltdown in subprime mortgages, and the aftershocks that's having throughout financial markets.
For those not following the story, here it is in a nutshell: During the real estate boom, few mortgages went bad at least partly because increasing prices let homeowners refinance to get out of trouble. This led mortgage lenders to be willing to make riskier and riskier loans, since it seemed that the risk of default was low. The trend to writing riskier mortgages accelerated toward the end of the boom, as mortgage companies tried to keep their profits up in what was a fundamentally slowing market.
As a result, there's a lot of really high-risk mortgages out there right now. But unlike 50 years ago, today's mortgages aren't held by a local bank. Instead, they're combined with other high-risk mortgages, sliced into little bits (called "tranches") and sold like bonds in the financial markets. A basket of even the riskiest mortgages will yield both high quality tranches--which get paid back from the first dollar the borrower repays--and low-quality tranches, which get repaid last (and are unlikely to ever get repaid). The riskiest tranche is often called the "equity tranche," or more informally (and accurately) "toxic waste."
Dividing up mortgages like this is nothing new: stock brokers were selling unsuspecting customers Collateralized Mortgage Obligations (CMOs) way back in the 80's. After a bunch of them went bad, most brokers realized that these very complex securities are unsuitable for nearly all individual investors, and today most are held by sophisticated investors like pension funds and hedge funds.
(CMOs were a big part of the Series 7 exam for a stockbroker's license back when I took it in 1996, but our trainer basically told us that we'd never see one in real life, since no sane individual investor was buying them by that time.)
There's a slightly new wrinkle these days, which is taking the toxic waste from a bunch of CMOs and recombining them and reslicing them into a new set of Collateralized Debt Obligations (CDOs) which have both high risk and low risk tranches. That lets some of the toxic waste get recycled and makes it somewhat easier for financial markets to swallow risky mortgages. The net effect of all this pooling and slicing is that little bits of risky mortgages are held in all sorts of places you wouldn't expect to find them: low-risk bond funds, conservative pensions, money-market funds, and the like. That's because the high quality tranches are--at least in theory--more like a highly rated bond issued by General Electric than a bunch of option-ARM mortgages issued to guys who never had to prove their income.
But because real estate has been strong the past several years, the actual riskiness of some of these securities has never been tested. It's all hypothetical. And now that the mortgages are starting to get into trouble, the supposedly risk-averse investors who bought this recycled toxic waste are getting very nervous.
Hence the meltdown: writing high-risk mortgages depends on the ability to slice them up and sell the parts to risk-averse investors who wouldn't otherwise touch them. As default rates go up, those investors are now starting to think that the whole thing is a house of cards and they're avoiding even the safest tranches. That makes it hard to refinance, which was how troubled borrowers were avoiding default during the boom, so more borrowers are forced to default. That makes the mortgages even riskier, and continues the cycle.
Grand Unified Theory of Risk
This is the third financial meltdown I've seen in my professional career: the first was the asian monetary crisis of the late 90's, the second was the bursting of the dot-com bubble, and now the mortgage meltdown. All three had the same characteristic, which I will boldly proclaim to be my Grand Unified Theory of Risk in Financial Markets:
During a financial boom (or bubble), investors' tolerance for risk increases continually until a crisis ends the boom and restores normal risk tolerance.
The cycle is akin to a relaxation oscillator (think of a toilet tank which fills gradually, then suddenly empties when flushed). The stages are:
Improving Fundamentals. The boom starts when a market (be it for stocks, bonds, foreign currency, mortgages, or whatever) goes up for a sustained time because of improved fundamentals. This is normal, until:
New Investments. The boom becomes self-sustaining when investors who wouldn't otherwise be involved in the market notice the good performance, and start investing new money. This increases prices across the board, and everyone's happy as long as the prices don't get out of whack with the fundamentals.
Increased Risk. As the prices in the market keep going up, they start becoming disconnected from fundamentals. The risk level begins increasing, but nobody notices at first because the market persistently goes up. More enthusiastic commentators proclaim that the market will keep going up forever, or that (against common sense) risk levels are actually lower than before. Some of those who have been investors since step 1 can't figure out the prices and sell; others are enjoying the party too much and stay invested until:
Crisis. As long as the market continues to attract new investments, it will keep going up and becoming more risky. At some point, though, there will be a change in the fundamentals (or simply no new investors to be found), and prices will drop. This exposes the high level of risk in the market, which causes the more skittish investors to pull out. The decline accelerates, forcing out more and more investors, until prices eventually reach a level (perhaps months or years later) which attracts investors back in based on the fundamentals.
At this point, the mortgage market is solidly in the Crisis stage, and the only question is how far things will fall and how much collateral damage it will cause. Things will eventually stabilize, but mortgages will be much harder to obtain for marginal borrowers, real estate prices will drop (at least in many markets), and the more exotic mortgages will likely disappear completely--at least until the next real-estate bubble.
The other thing I've observed is that there's always a bubble going on somewhere in the world. In our global economy, there's a lot of "hot money" sloshing around, and what's coming out of the mortgage market right now has to be going somewhere else. I'm just not sure where yet.