End of "Financing on Steroids"

Securitization Pipeline Still Clogged

Buried in Thursday's Wall Street Journal -- the significant news always is -- was a stunning tidbit about the state of the securitization market (insecuritization market?). According to the Journal, securitizations of home loans totaled $19 billion in March, compared with $218.6 billion in March 2007 ("The Bank Loan Haircut," WSJ; 4/10/2008).

That's a rather astounding drop of 87%, and has important consequences for the housing market.

For the uninitiated, securitization is the process by which millions of illiquid mortgages get bundled together and re-sold as liquid, tradeable (theoretically) commercial paper. More than low interest rates, loose lending standards, or borrower greed and fraud, it was this phenomenon that arguably fueled the housing bull market (facilitated by the ratings agencies, which put their Triple A "seal of approval" on literally trillions of thus-securitized mortgages).

Securitization turned lenders' business model upside down. Instead of interest rate arbitrage -- paying depositors low rates and charging borrowers higher rates -- originating mortgage loans became a fee-and-commision business: make a loan, sell it (to a buyer who "securitizes" it and re-sells it to investors), then make another loan with the proceeds.

As the securitization boom accelerated, this process became turbo-charged: many of the biggest (and unregulated) mortgage lenders got their money directly from Wall Street, bypassing depositors altogether. However, the underlying principle was the same: borrow cheap, short-term; lend high, long-term. Huge amounts of leverage magnified this spread and the attendant investment returns (Bear Stears' leverage was rumored to be 30:1).

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"When you have to eat your own cooking, you tend to pay closer attention to the ingredients. Your appetite is also finite."
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In a nutshell, this is the engine that drove the munificent housing bull market the first half of this decade.

As the saying goes, anything that cannot continue forever . . . won't. The wheels on the securitization market chassis started to come off as increasingly marginal borrowers paid ever-higher prices for homes, using ever-junkier mortgage products (negative amortization loans, option-ARM's, etc.)

By the time signs of market saturation became apparent, literally $5 trillion (or more) of mortgage securities had been created (the actual amount in existence -- including derivatives tied to mortgage debt -- is the subject of much speculation, and is of no little interest to the Federal Reserve, investment banks, etc.)

As indicated by the March numbers, the clogging of the mortgage securitization pipeline means that mortgages are back to being long-term assets, held on the originators' books (rather than re-sold). In turn, that has inexorably raised lending standards -- equivalent to tightening credit.

Think of it this way: when you have to eat your own cooking, you tend to pay closer attention to the ingredients. Your appetite is also finite.

While this is long overdue and ultimately healthy for the housing market, in the short run it reduces demand -- no more "financing on steroids." That's great for (still) credit-worthy borrowers and prospective home buyers, but probably isn't what home sellers want to hear just now.