In contrast, a couple of decades ago when securitization was new, and banks did most of the mortgage lending, we had good old fashioned credit crunches. Credit would deteriorate, banks would tighten up their credit standards, and be forced to cut back on lending due to their deteriorating reserves. The credit crunch would soon ripple through the entire economy.
Now I'm beginning to wonder if Wall Street, in its exuberance, might have overlooked a crucial point, and failed to recognize that this new market structure could actually cause worse credit crunches than the old one. In the old structure, credit would tighten severely, but banks were still banks. They were in the business of lending, and so they would always keep lending to good quality borrowers no matter how bad it got. In addition, when liquidity really got tight, the Fed would get involved, strongly encouraging them to keep the lending engines turning and offering them dirt cheap borrowings from the discount window to entice them to do so with low risk profits.
Now here is the key point. Under the new market structure today, fixed interest fund managers are not in the mortgage lending business like the banks were. They have no compelling business or other persuasive reasons to remain in this market when the going gets tough. Cheap loans from the discount window are irrelevant to them. They don’t have to buy mortgages. They could just as soon hold treasuries. Envision what would happen if most of the world’s big fixed interest fund managers suddenly decide to go risk adverse, and sharply slow, or even stop purchasing mortgage securities. The entire global mortgage market would seize up. This would be a credit crunch of a higher order than has ever been seen.
Could this happen? Of course it could. Having been a fund manager for many years, I have often seen similar situations. A fund holds a particular type of asset which suffers from extremely large deteriorations in price. The Chief Investment Officer, ever mindful of the financial health and reputation of their firm, comes down and announces, “We are not buying any more of these until the dust settles”. End of story.
Even if not all fund managers, but just a large percentage of them react this way, a severe credit crunch will ensue. Can you image any CIO telling their traders to buy more mortgage securities in this environment today? There is just no one out there who is going to be willing, let alone big enough, to take up all the slack.
The very nature of the financial engineering which Wall Street has created in the mortgage backed market is contributing to the crisis. Whilst it is true these new structures have added great efficiencies to the market and lowered the cost of credit, it is also true that the resultant products are complex and opaque. In times of stress it is impossible to go out and “kick the tires” with these types of securities to determine whether true value exists. In addition, the way mortgages are packaged up and sliced into traunches that distribute losses primarily to the lower tiers, weakens over all mortgage sector liquidity. Sure, most managers would be willing to purchase the high credit quality upper tiers of a newly created security, but who wants to touch the lower quality tiers in this type of market environment? The whole structure of the security presumes there will be ready and willing buyers of the low quality tiers. When the low end of the market dries up, you can’t sell the higher quality tiers either. So the entire market just shuts down when the lower end fails.
Just this morning we had BNP Paribas suspend three funds because they couldn't get any prices for the securitized mortgage pools they own. And why aren’t there prices in existence for such securities? The reason is that there are no transactions taking place. The secondary markets in these securities have completely dried up.
Consider the BNP news further. If you can’t even get a price for these securities who is going to buying them? How could any financial firm with fiduciary responsibilities to its investors and shareholders prudently invest in these sorts of securities at all? And furthermore, if BNP can’t get prices for its mortgage pools, how can anyone else get prices for theirs? Why isn’t every fund around the world holding mortgages shutting their doors as well? Can they really be far behind doing exactly what BNP just did?
Just look around and you will see the mortgage contagion spreading, even to completely unrelated markets on the other side of the world. Last week one of the major Australian mortgage securitizers, Members Equity, was forced to abandon a $500m issuance of prime credit mortgages in a booming market where sub primes aren't even a factor. They were quoted as saying “There is a buyers strike.”
AIG also came out this morning and said that mortgage defaults are spreading to non sub prime areas of the mortgage market. How long will it be before buyers begin questioning whether any perceived value is worth the risk in this area of the market either? Further liquidity contraction is inevitable. The credit crunch has begun, and the new financial world model will be given a serious testing. Let’s hope the Fed is able to influence the results.