Subprime Mortgage Industry: Black Swan or Stupid is as Stupid Does?
Since the advent of securitization as a widely available financing tool to finance mortgages, the industry that was created around it has experienced a wild boom and bust cycle. The boom of the early to mid 1990s was followed by a miserable bust, just as the dot com industry was beginning to overheat, in the late […]
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Written by randomfool on March 5th, 2007 with
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Since the advent of securitization as a widely available financing tool to finance mortgages, the industry that was created around it has experienced a wild boom and bust cycle. The boom of the early to mid 1990s was followed by a miserable bust, just as the dot com industry was beginning to overheat, in the late 1990s triggered by a black swan event in the bond markets resulting from a global recession. Since the shakeout that followed the late 1990s bust, the industry has been in another crazy boom cycle with mortgage companies growing dramtically, adding riskier and riskier products to their mix and helping to fuel a real estate boom. However, the spoiler of just about every party like this is mean reversion and the real estate and mortgage industry boom of the last few years is now inevitably dipping back into the bust phase of the cycle.
No subcategory of mortgage companies makes more money during a boom and struggles more during a bust (i.e., is as volatile) as the subprime mortgage industry. Subprime, or mortgage companies that make loans to people who cannot get loans through banks or other such channels, have been printing money over the last few years. Fueled by a seemingly endless appetite among investors for for bonds that are secured by subprime mortgages, subprime mortgage companies have been growing dramatically since early in the decade. Subprime mortgage companies now are not just struggling (almost all of them are struggling), but they are going bankrupt and closing their doors just like their predecessors did in the last 1990s. In the last few weeks, Ownit and ResMae have file for bankruptcy protection while New Century, Accredited and NovaStar have reported disappointing earnings or are suffering rating agency downgrades or even worse.
So, is this a black swan event or are these companies just not subject to any real rational limitations and taking stupid risks with shareholder money? It’s the latter. The crash in 1998 was more of a Black Swan event. You can read about it in amazing detail in When Genius Failed. When Russia decided to devalue its ruble in the midst of a global recession in 1998, no bond investor wanted anything but U.S. Treasury bonds. Thos that were willing to invest in riskier bonds wanted a lot more money, so the “spread” (or the difference in price) between Tresuries and the bonds that mortgage companies sell in securitization transaction “gapped out” and the mortgage companies were left holding hundreds of millions of dollars in mortgages, that they had borrowed to make, without a way to sell them.
This time, though, it’s different but its the same basic underlying problem. Subprime mortgage companies have been growing and growing while all the time making riskier and riskier loans. They had no idea just how risky their business models were but they mortgage company down the street was all to happy to make the next riskier loan so they all jumped in. Since mortgage companies are not regulated like banks are, they are free to take whatever risk they want limited only by the appetite for the bonds in the bond market and the shareholders’ willingness to finance them. In 1998, subprime companies relied to aggressively on a certain type of accounting for securitizations and nobody realized how vulnerable they were to a shock like the Russian economic crisis. Everyone had convinced themselves that risks were controlled and that because the market was willing to finance the risk that everything was OK, but it wasn’t. The dot com boom experience was based on the same human failing…we set aside everything we knew about risk and justified it by just calling it a “new economy”.
Now, mortgage banks are filing bankruptcy, laying off people and destroying shareholder value. The bond markets this time are fine but management, fed by Wall Street, just shifted their reckless behavior to another easy target: underwriting. Just like they piled on non-cash earnings in the late 1990s which, now in retrospect, obviously would come crashing down at some point, they lately have been making loans to people who should never be given someone else’s money and they are going down because of it.
The timing of the eventual collapse is clearly random (and it happens quickly). However, the crash was very much predictable and not random.
Written by randomfool on March 5th, 2007 with
no comments.
Read more articles on General Folly and Randomness and Business.