Vol. 5 Num 1137 Fri. August 10, 2007  

Letter From Europe
The complex world of mortgage market

A few years ago, the mortgage market was not at all complicated, at least in principle. Buying a house was and still is probably the single most important investment an ordinary person makes in his whole lifetime. Besides providing a home for him and his family, it obliges an ordinary citizen to save money on a regular basis.

In many countries, it also gives him certain tax advantages. The mechanism to formalise a mortgage contract was simple. After checking the credit background of the borrower, a bank, a building society, or a mortgage company used to lend a substantial amount of money (could be as high as 90% of the total value of the house) to him on the security of the house/property bought by him.

There were several other variable factors in each operation, for example, the repayment period (10, 15, 20 or even 30 years), the interest rate (fixed or floating), the nature (first mortgage or second mortgage) etc.

Thus, under the law, the debtor, or borrower, became the mortgagor, who charged or transferred his property in favour of, or to, the creditor or lender, who became the mortgagee. Until a few years ago, the mortgagee used to maintain the loan in his balance sheet.

The history of the loan repayments used to be examined on a quarterly, six-monthly, or annual basis to see if a provision for bad or doubtful debts should be made against the loan. Thus, every mortgage loan came under regular scrutiny.

If the default rate became exceptionally high, the regulator used to limit the capacity of the mortgagee to issue fresh mortgage loans. The intention was for the balance sheet of the mortgagee to show a true and fair view of its financial situation.

Now the mortgage market situation is completely different, and definitely much more complex. The banks still give mortgage loans, but they no longer carry them in their balance sheets. Most of the mortgagees now sell these loans in the secondary market.

Since the loans disappear from the balance sheet of the mortgagee, the need to assess whether a new provision should be made against the loan or the existing provision be adjusted disappears. On the face of it, the balance sheet of the mortgagee looks clean to the regulator. Therefore, he is under no obligation to take any action against the mortgagee.

This is probably the principal reason why sub-prime mortgages came in to being. Since the risk is passed on to the secondary market almost immediately after the formalisation, there is greater incentive for some of these banks to give loans without really making sure that the borrower will be able to make regular mortgage repayments.

For example, during the period 1994 to 2005, some 3.2 million Americans were able to buy homes thanks to these sub-prime mortgages. The lenders loosened the loan standards to such a level that loans were often given to people with no income, no job, and no assets.

The mortgage loans are not sold individually. Instead, ever-innovative financiers have found a way to trade them as complex derivatives. They are classified by the credit rating agencies according to their risk factor, and bundled together as blocks of CDOs (collateralised debt obligations) or mortgage-backed securities.

The fundamental difference between the old individualised mortgage portfolios of a bank and the CDOs is that it becomes very difficult under the new system to know the real value of the debts at any particular moment.

It is postponed until the CDOs are sold in the open market or the credit rating agencies change their classification, as they (the agencies) have done recently by downgrading a huge number of them. Since the investors do not make provisions for bad debts on a regular basis, they do not know what they are really worth until one of these two situations takes place. Meanwhile the bubble keeps on growing.

When it bursts, as it has now, because of the downgrading of a large number of these securities, it sends shock waves across the entire financial market. On August 6, one of the largest independent US loan providers, American Home Mortgage, filed for bankruptcy court protection.

In Germany, a government-owned group had to come to the rescue of IKB Deuetche Industriebank with a $4.8 billion bailout. A co-president of Bear Stearns had been forced to resign when it became clear that the two Bear Stearns hedge funds that had invested heavily in securities backed by sub-prime mortgages were worth virtually nothing.

These are only a few examples. According to some experts, the worst is yet to come. What has been discovered may only be the tip of the iceberg. Many fear that there are hidden losses of many billions of dollars in these CDOs.

Stock markets around the globe have reacted negatively to this mortgage market crisis. House prices are falling and activity in the construction industry (for housing) is slowing down. With the tightening of the credit market, several important leveraged buyout (LBO) deals have been put on hold.

On August 6, the United States dollar fell to a record low against the euro because of fears that these sub prime mortgage losses would slow the US economy and force the Federal Reserve to cut interest rates. But the question is: Will such an action alone be able to fix the mortgage mess?

True, the Fed has the capacity to repair the banking system, as it did in the 90s, by lowering interest rates. But since the risks have been spread well beyond the banks and into other parts of the financial market, some experts feel that specific regulatory measures will be required to fix the mortgage mess.

Chaklader Mahboob-ul Alam is a columnist for the Daily Star.