hurricane ginnie: what happened/where to put your money

Tuesday, October 07, 2008 | 02:12

what happened?
our current credit crisis can be credited to two words: greed and securitization.  don’t understand what securitization is?  that’s alright… os x leopard’s spell check doesn’t either, but i’m going to attempt to explain why we’re all screwed anyway.

securitization, although not appearing heavily in the media until recent months, has been around for decades.  here are the basics from a mortgage-backed security (MBS) example (the root of our current crisis): as a loan originator, it is difficult to find someone to purchase the debt of a single mortgage.  they would have to figure out the risk on each individual loan and service each mortgage.  it would be much easier to sell a basket of mortgages as a single security that are marketed as “diversified” for lower risk and where you would still service the loans.  you could “charge” for the service through this basket and they would provide cash up front for streams of payment plus interest in return later.

this was a no-brainer for mortgage lenders.  you could sell tens of thousands of mortgages as a single recurring-income product (payment coming from monthly payments from mortgage borrowers) and as a result these payment receivables would be moved off of your own balance sheet in exchange for cold hard cash in the full amount of the loans, rather than monthly payments, to help you continue your business operations without waiting the 15 to 30 year life of the mortgage.  furthermore, your MBS basket of mortgages could undergo various methods of “credit enhancement” making it even more attractive to a buyer since it has a high credit rating.  in 1970, the Government National Mortgage Association (GNMA) a us government-owned corporation, also known as ginnie mae, was the first organization to buy mortgages from their originators and convert them in to securities.  securitization was born!

fast forward to the middle of the ’00s… the economy is raging, having recovered from the internet bubble burst endured just a few years earlier.  investment banks are looking to make money as always, but interest rates are still at historical lows so traditional debt securities just won’t do.  however, real estate prices have been growing at a frantic pace, surely fueled by low interest rates, and everyone knows real estate prices will never fall. what’s a greedy i-bank to do?  capitalize on real estate and get in the mortgage business of course!

so now you’re an investment bank in the business of selling baskets of mortgages.  more mortgages originated means more mortgages to package and sell, so really you should have everyone and their dead mother buy a home.  even if they have terrible credit and have no income, it doesn’t really matter.  in fact, you can tell borrowers they can pay a low introductory payment and just sell their home for a profit before their payment adjusts to a higher payment for a quick buck… because real estate values will never fall.

in fact, these higher risk borrowers are even better.  you can turn your MBSs into what is called subordinated debt.  you can lump high quality mortgages in with these lower quality mortgages in the same security, with different levels, or traunches, to invest in.  each traunch will have a different interest rate based on the risk of the underlying mortgages in them.  of course the higher risk mortgages will pay out a higher interest rate for the increased risk exposure.  and since you’re an investment bank and you’re here to make money you obviously want to receive a higher interest rate so you’ll take the majority of the high-risk mortgage paper… and you’re not really worried about these lower quality mortgages anyway, because if the borrower can’t pay you just repossess their house and resell their home for a profit.  because real estate values will never fall.

it’s early 2007.  real estate values fall. to top things off, those introductory rates and payments on mortgages are starting to reset to the higher rates and already overspent americans are now unable to keep up with their mortgage payments.  the perfect storm of hurricane ginnie has finally reached shore and if you’re an investor there’s a sudden realization that you’ve been duped and your high credit-grade MBS might not be such a healthy investment after all.  you’ve been “lied to” and there is now zero trust in the financial system.  even if you have money to invest you’re a lot pickier now and you’re not sure if the other guy is going to make good on his promise to pay you back, even if it has the highest possible rating, and the result: a credit crunch and a sharp fall in the value of risky assets for which there is now very little demand for… and if you’re holding on to extra risky assets like high-risk traunch MBSs there is now no demand… you’re F’d.

securitization, first kicked off by a united states government entity, has screwed you over.  let’s recall that you’re an investment bank looking to make money… and guess what?  you’re holding the majority of those nearly worthless high-risk mortgages because they had a high interest rate… and your other investors are still expecting payments.  you’re F’d, with a capital F.  any coincidence Lehman’s former CEO’s name is dick Fuld?  go ahead, switch the last two letters of his last name with his first.  i dare you.

where to put your money
i have generalized and oversimplified a lot of the nuances of the current financial crisis for the sake of easing explanation, but what does this scenario mean to you when you take out all the financial engineering talk?  if you’re not a subprime borrower and you’ve still got a job and a roof over your head that hasn’t been wiped out by the greed-driven securitization storm, just keep doing what you’re doing.  as john cochrane, finance professor at the university of chicago gsb notes on his website, you don’t have to be worried about this being the great depression 2.0. back in the 30’s, hedge funds, private equity firms, sovereign wealth funds, and warren buffett and their trillions of dollars weren’t even in existence.  oh wait, nix the buffett.  today they can come to the rescue (and profit) just as j.p. morgan almost single-handedly rescued the entire american banking system in 1907.

ride it out.  do what you’ve been doing, keep investing as you’ve been investing.  learn from the victims of hurricane ginnie and shore up your own finances.  don’t take on payments you can’t handle and don’t buy things you can’t afford.  don’t take risks that don’t need to be taken. it’s that simple.  and when the storm passes you’ll be just fine and if you can find and invest in the companies that survive and thrive in the storm, you may even end up better than you ever imagined.

posted in finance