The stock market has been squirrelly ever since a leveraged section of the financial world stumbles in March. What is borrowed must be paid back. Computer assisted financial leveraging schemes are falling apart forcing margin calls on these games of structured debt.
In the crisis following the Muslim attacks on New York and Washington DC, the new Republican Administration makes a decision to put lots of money into the American banking system. The primary intention is to stabilize business operations. It is also believed a positive secondary benefit of abundant liquidity will be a rise in home ownership. Mortgage loans are available at historically low interest rate levels and Americans seize the opportunity to fulfill the American Dream. Republicans believe home owners are the most tax sensitive segment of the population and, therefore, more likely to vote for promises of lower taxes.
The market responds exactly as expected. Private business is driven by competition to meet the consumer demand for enough cash to have the good life immediately. Big house, big debt, big deal. The surge in mortgages creates an oversupply of collateralized debt obligations (CDO) and specifically mortgage backed securities (MBS). Groups of assembled mortgages become a bond with a calculable cash payout and are sold as investments on the value of that payment.
In theory, asset backed instruments should have high stability because there is real property serving as full collateral behind the promise to pay. Wall Street firms quickly figure out they can use mortgage backed securities the same way they use any financial instrument. An age old trick is to borrow money at a intereset rate lower the yield rate of a bond purchased with those borrowed funds. The borrowed money is paid back from the cash flow of the purchased bond and the left over coin is all profit. The more base dollars the more the more coin a half point rate difference delivers so Wall Street grabs up the MBS with gusto. The math is simple and computer programs can divvy up an aggregate pool of mortgage interest any number of ways. It all works fine as long as the all the rates remain basically stable.
This is a high finance game and inevitably greed creeps in. The higher the spread between the cost of borrowing and the yields of mortgage backed securities the more profit is produced. Wall Street soon becomes willing to pay handsomely for all high yield MBS. These high yield bonds are created by bundling up mortgages paying the highest interest rates. High interest rate loans, however, go to high risk borrowers like real estate speculators or individuals with poor credit. As the demand from the leverage players grows for these “sub-prime” MBS bonds, the market works to produce more of them.
The way to sell more sub-prime loans is to fund more sub-prime loans. This means finding people willing to sign for the money and underwriters instructed and willing to approve them. The conventional 30 year fixed rate mortgage is supplanted by exotic loans designs with features like adjustable rates and interest only payment periods. The desire to create high interest loans even triggers a willingness to fund 100% financing on home purchases. These "no down payment" loans depend entirely on the value of the property which in turn drives appraisal inflation. In the real world, no appraiser jeopardizes their lender relationships by reporting back that a property is not worth what someone is willing to pay for it.
Then on February 27, 2007 the sub-prime market simply goes away. Freddie Mac announces they will no longer purchase sub-prime loans and within hours all of Wall Street follows the same path. The calculated yield and actual yield on many MBS is diverging because of increasing levels of payment default. It turns out that people who can’t make their payments, don’t. Plus when speculators loose their bet on home price appreciation, they just walk away leaving the property to cover the debt.
When the cost of the borrowed money exceeds the linked investment return, holders of high risk mortgage backed securities start loosing money and the house of cards begins to topple. The economy consists of cash, credit and assets with price established in buy and sell transactions. A significant issue with MBS is they are historically purchased as long term holdings and there is no active market for them. In private holdings, a bundle of $40 million dollars worth of mortgages with an aggregate yield of 7.25% should have a price that reflects the value. A public market would establish a price as the bond yield decays, but since no one is willing to buy these bonds the firms simply have no way of assigning an accurate value to these holdings. This indeterminate value simply freaks accountants out.
The collapse of leveraged financial positions in effect forces a margin call on MBS holders. Without a quick way to liquidate mortgage backed bonds for cash the firms are forced to sell other assets. The volume of stocks sold to raise cash pushes stock prices down on numerous days over the summer. The only good news is the volatility in the stock market is largely due to liquidity issues, or in other words the need to convert things to cash, and the Federal Reserve is actually quite capable at correcting liquidity imbalances.
Government issued currency ultimately depends on the faith individuals have in the financial system. Our financial system in practice either creates and destroys ephemeral money numbers on a daily basis. Billions of paper dollars are going to be lost but the actual tangible assets are all intact. It’s not like the oil supply to America is suddenly cut by a third. A $200,000 financed home re-sold for $150,000 is somebody’s bad fortune and someone else’s great deal. A $100 stock that retreats to a trading range in the $70’s still has considerable value.
The free market only guarantees that risk and reward remained grounded in real behavior. Our financial system knows how to deal with greed, so if politicians stay out of the way, the overall economy will eventually digest and discard this period of excess in the housing sector. The next big wave of adjustable rate mortgage re-sets are reportedly due in November so the days of market turmoil may keep happening from time to time till the end of the year. Hold on.