The Asset Securitization Crisis, Part I

I am in the process of creating a macro picture of the banking industry to assist me in consolidating and crystallizing my perspective of the near to moderate term. I will loosely follow the outline below and end up with a list of my personal bearish positions.

My analysts initially called this "Comparison of the S&L and Subprime Crises," but I was quick to remind them that the current crisis is subprime in the media's eyes only. This is, by far, a crisis of the asset securitization system and as I have harped since the beginning of this blog last September, it is the use of other people's money and off -balance-sheet vehicles that have prompted the abuses that we see today. Even with extremely low interest rates, we would not have seen the carnage that we have witnessed recently if those who originated the mortgages were to be held ultimately responsible for their performance.

The first section of the report is historical and plain vanilla. Most who have perused this blog for a while should be quite familiar with it, but I feel it makes plenty of sense to review it in order to remain grounded in factual reality in lieu of what we have seen in the media.

The Asset Securitization Crisis - What went wrong?

In the beginning, the part that everyone has heard before…

The dotcom bubble burst marked the beginning of housing bubble. The technology bubble bust of 2001 saw the US economy slip into recession prompting the US Federal Reserve to cut interest rates. The dotcom bubble burst cleaned up US$5 trillion in market value of technology companies after the NASDAQ Composite Index peaked at 5,132 on March 10, 2000. The dotcom bubble burst also resulted in a large influx of funds, fueling interest in the real estate market. The equity investors, having burnt their fingers in the dotcom crash, saw real estate as an attractive alternative and a safer investment opportunity.

Real estate’s share in total bank loans increased to 50% in 2002 as compared to 43% in 1999, and currently accounts for 56%. In addition, the real estate loans as a percentage of GDP increased to 20% in 2002 from 16% in 1999, and currently stand at 26%. The surge in realty loans and excessive focus on the real estate sector of the US banking industry lay the foundation of the housing bubble.

Historically low levels of interest rates supported growth in housing.

The US economy battling recession in the aftermath of dotcom burst was brought back on the growth track through an aggressive monetary policy which also helped fuel growth in the real estate sector. The US Federal Reserve lowered interest rates significantly from 6.5% in May 2001 to 1.75% by the end of 2001. Consequently, the national average contract mortgage rates came down to 5.34% in July 2003 from 8.01% in March 2000, prompting the rise in mortgage loans. The mortgage rates having reached an all-time low sparked a rise in the housing and construction activity and a surge in housing demand. The new housing annual starts grew at a CAGR of 5.7% from 2000-2005 depicting the increased construction activity during this period.

The US promoted consumer spending in order to bring the economy out of the technology crash. The US Federal Reserve not only made loans cheaper but also relaxed lending standards to drive the growth in the economy.

The rise in commercial and residential real estate loans resulted in construction and housing market boom

One of the primary reasons for the asset bubble creation is the increase in the loans toward the real estate sector which increased significantly during that period. Loans toward real estate in the US have grown at a CAGR of 11.7% in the period 1996-2006 to US$3,432 billion (during S&L crisis the real estate loan market had grown at a CAGR of 13.1% in 1976-1986). The construction and land development loan market has grown at a CAGR of 20.6% in the period 1996-2006 to US$499 billion in 2006. This implies the possibility that more supply was added to the market in this boom period than in that of the S&L crisis. The growth in construction loans saw an unprecedented rise in construction activity across the US attributable to the strong demand for housing. The increased construction activity and the housing boom along with low mortgage rates saw the US homeownership rates reach a peak of 69.2% in 2004, at levels not seen since 1965, as compared to 64% in 1994 – in the aftermath of the S&L crisis.

Source: FDIC

Increased speculative investments in the housing sector drove prices

The rising home prices and the cheap affordability and availability of mortgage loans saw real estate emerge as an attractive investment opportunity. The equity markets under the rapid capital gains spell of the dot com era and crash saw speculators move toward the real estate markets and drove home prices across the US. US home prices appreciated significantly in the 2001-2005 period owing to increased housing demand and emergence of the housing sector as an alternative investment. The S&P Case Schiller home price index appreciated 106.5% to 206.52 in August 2006 from a base of 100 in January 2000.

Source: S&P/Case Schiller

Click to read the full text of part 1 of this report.