The big financial news this week-end is Bear Stearns’ decision to put $3.2 billion into its struggling hedge fund to try to stave off collapse of both the fund and the larger mortgage securities market. An academic paper, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions,” presented early this spring at the Hudson Institute suggests that the mortgage market has been structurally realigned, and that the whole system is far riskier than rating agencies, regulators or investors have recognized. If the paper is right, Bear Stearns has taken the financial equivalent of striking up the Titanic band to play “Nearer My God to Thee.”
Everyone acknowledges that subprime mortgages are riskier than prime mortgages and that more defaults were to be expected. But what do all those defaults mean in a world in which no lender keeps its own mortgage paper? Now that there is a very active, very profitable, and VERY complex market for purchasing, bundling and trading mortgage securities and their derivatives, what will be the effect of sharply rising defaults?
The conventional wisdom among the don’t-worry crowd has been that the new complexities of the mortgage market will provide a level of diversification that will insulate the economy from the impact of defaults. Yes, lots of people will lose their homes, but they are the only ones who will suffer. (We’ll put aside the morality of that view so we can stay on point about the market.)
Along come Joseph Mason and Joshua Rosner with their paper. They have some fascinating empirical data about the interaction among various parts of the new, restructured mortgage market. The authors give a very detailed explanation of how all the pieces of this complex mortgage market are linked and — here’s the key — how at each stage, the risks associated with default become more obscured. The cumulative effect is that the financial markets have hidden both what is wrong with these mortgages and how deeply dependent the economy is on the continued successful repayment of these mortgages.
The authors conclude:
The structural changes witnessed in the mortgage markets have interacted with complex MBS and highly CDO volatile funding structures to place the U.S. housing market at risk. Equally as important, however, is that housing market weaknesses feed back through financial markets to further weaken financial instruments . . . . This feedback mechanism can create imbalances in the U.S. economy that, if left unchecked, could lead to prolonged economic difficulties.
What are those “economic difficulties”? The authors explain that the collapse of housing markets will be followed by bad trouble in the construction industry, the building industry, and the home products industry. These industries, they point out, are key industries for overall economic performance in the US market. Worse yet, as these industries decline and more people are laid off or lose overtime, mortgage defaults, of course, will continue to rise.
A lot of people got richer off speculation in mortgages. Now the question is how many more ordinary families — people who work at Home Depot or people who stretched to buy houses at inflated prices or people whose jobs depend on a strong economy — will get a lot poorer.
