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By Ramsey Su

Once upon a time, during the reign of King Greenspan, sub-prime was the rule of the land. Someone asked his majesty what happened to the risks of these mortgages, to which the maestro replied, "the banks are very sophisticated and they know how to spread the risk around, so there is no need to worry" (not an exact quote, but that was his message).

Now we know the risk never went away, it was just hidden by despicable rating agencies and passed on to lazy investors who never did their own due diligence. Aside from a few hedge funds who catapulted to rock star status by betting against the loans, the country and the world paid a very dear price for Greenspan's dereliction of duty as the regulator.

There are three major changes since Greenspan's days: 1) the demise of private-label mortgage-backed securities (same as the dominance of agency MBS), 2) the rise of all cash transactions mainly from investors, and 3) Federal Reserve intervention via its QE operations. What happened to mortgage risk today? More importantly, pertaining to the real estate market: Are we are building a solid foundation or are we looking forward to another disaster?

Default Risk Disappears

Pertaining to mortgage risk and its effects on the real estate market, the cash transactions have to be considered as very positive. Even though they are not really cash, just financing from a different source, they are not directly secured by the underlying properties. Instead, they are an equity interest in the funds or public companies such as Blackstone or Silver Bay. There cannot be mortgage risk when there are no mortgages. If the single-family real estate market is to collapse in a similar manner as the bursting of the sub-prime bubble, the properties in the hands of Wall Street should be able to handle the losses. The value of these companies might suffer, but it should not trigger a wave of foreclosures to affect a declining market in a downward spiral. This type of investor is also more capable of absorbing a loss than a hand-to-mouth sub-prime borrower.

Default risk was probably the biggest flaw of the sub-prime bubble. It brought down all the borrowers who had no ability to repay the loans and investors who bought these loans strictly because the rating agencies told them they were AAA-rated mortgages. Ironically, default risk may have gone extinct. Borrowers no longer have to worry, because a mortgage is now an entitlement. In other words, if a borrower cannot pay it is the government's responsibility to try to modify the loan, offer incentives, or maybe even pay down the loan before finally foreclosing if all other options fail. By then, the borrowers will have been living rent-free for so long that all down payments will have been recovered and then some. For an investor, agency MBS are guaranteed by the treasury. It really does not matter anymore whether it is a mortgage product or a treasury product. They are one and the same.

Pre-Payment and Interest Rate Risk

What about pre-payment risk? With the lowering of mortgage rates, refinances have accounted for over 70% of all lending activities for the last few years. For the previous holders of agency MBS, it did not matter whether the borrowers prepaid voluntarily to take advantage of low rates, involuntarily via foreclosure, or refinanced with the assistance of one of the programs such as HARP -- the old high-yielding loans are continuously prepaid. Fixed income investors receiving prepayments have been destroyed. They have no choice but to accept much lower yields for similar instruments or be forced into higher risk investments. With rates so low, prepayment is probably not much of a risk factor going forward, but that may not be desirable. Rising interest rates would make the bond holders hope for prepayment.

The only major risk left is interest rate risk. Since the launch of QE3 on the week ending Sept. 19, 2012, the Bernanke Fed has purchased $563.5 billion in agency MBS. This is a pace of $862 billion per annum. The 30-year fixed-rate mortgage has gone from 3.38% in September 2012 to 3.7% as of this week. Clearly, if this trend continues, QE3 is not achieving the desired results in spite of practically purchasing all agency originations. There have been rumors recently that the Fed may be tapering its purchases. Are they suggesting rates are low enough?

Mortgage interest rates are in the hands of Bernanke or his successor. Interest rate risk, therefore, is mainly a policy risk because it is not influenced by the market but rather by policy decisions. In addition, refinance volume is now supported by programs such as HARP 1 and HARP 2. The Treasury can decide whether Freddie and Fannie should foreclose on defaulting borrowers, or forgive part of their loans as they are contemplating now.

Conclusion

In summary, mortgage risk nowadays is all about policy risk. It is policy that is supporting the market. Regardless of which way I approach the subject of real estate from, all roads lead me right back to government intervention. Considering the cost, who other than the Fed would believe QE can be for infinity. I conclude that the underlying risk is far greater today than it has ever been. If rates continue to increase, what can Bernanke do as an encore?

Average 30-Year Fixed-Rate Mortgage Rate Since 2008

Click to enlarge image.

Source: Federal Reserve of Saint Louis Research.

Source: Real Estate Mortgages - What Happened To Risk?