We’ve all heard that this is a liquidity driven selloff and I think most understand that the sub-prime mortgage industry has provided the catalyst for this lack of liquidity. As banks and hedge funds alike purchase mortgage backed securities, mortgage lenders continue to write new loans and pocket the underwriting fees knowing that they will be able to sell these securitized loans to free up capital to start the process again.
The problem for mortgage originators comes in when there is no willing buyer for the loans they have written and suddenly the company does not have the capital to lend out any more money - lately, home buyers have found out at the last minute that the loan they have been promised isn’t available.
So why does this very specific portion of the market have such a drastic effect on the broader indexes and potentially on the global economy? The answer lies in the recent history of our globalized markets. As stability characterized the mature markets over the past few years, managers have been willing to take more and more risk to enhance returns. As this trend continued, leverage became more and more accepted and liquidity became king as money poured into all kinds of asset classes.
Mortgage backed securities were one of the most popular as it was well known that rising home prices would provide ample collateral, and investors such as hedge funds could borrow seemingly unlimited capital at say 4.5% and invest those funds in MBSs yielding 6.5%.
Now that housing prices have begun to drop, and foreclosures on houses have picked up, light is being shed on the finance industry in general and the mortgage industry specifically and there are some ugly things being uncovered. Many mortgages have been written without proper documentation to homeowners who should never have qualified for the loans in the first place. Properties pledged as collateral turn out to be worth less than originally thought (and less than the financing balance) so investors in the loans are not as well protected as expected. Issuers of credit are taking it on the chin and now have less appetite for risk and less capital to lend even to high quality borrowers such as stable corporations.
Now the prices on securitized mortgages are dropping and funds who leveraged up borrowing cheap funds to invest in higher yielding MBS and this is kicking off margin calls. The funds may not be able to meet the margin calls because they can’t sell the MBS for enough to pay off their loans. Banks and brokerages who lent the funds margin capital are at risk because they may not get the lent funds back. That is part of the reason you see (MER), (NYSE:GS), (NYSE:BSC) and (LEH) dropping.
As the vicious cycle continues, funds are now liquidating whatever they can to meet the margin calls. So if there’s no market for MBS, they have to sell what is available to sell and now we start working on (NYSE:KO), (NYSE:HD), (NYSE:GE), and (NYSE:IBM). Before too long, the entire market is under pressure because of the contagion that is present as liquidity is sucked out of the system.
The bad news is that there are very few places to hide. Volatility makes even short selling difficult because violent swings both down and up stop traders out of positions and wreak havoc on anyone committing serious capital. The good news, however is that the final outcome will be some incredible values for those left standing when the smoke clears. It will not be unusual to see moderately diversified unleveraged accounts increase triple digits the year or two after the carnage is complete. The key is making sure you are around to play when the game gets fun. For now, damage control is key. Make a list of stocks to watch - even dabble by buying or shorting small lots to stay involved. But leave the majority of your capital safe until the risk is lower and the reward is ready to be taken.
Full Disclosure: Author does not have a position in the stocks mentioned.