Friday, March 23, 2007

Victim of Real Estate Bust: Your Pension

Friday, 23 March 2007 Written by Garrett Johnson
Part 1
It's the dirty little secret of Wall Street.
"U.S. lenders will make about $2.8 trillion in home-mortgage loans this year, according to the Mortgage Bankers Association. The MBA estimates that about 80% of these loans will end up in mortgage-backed securities. Mortgage-backed securities outstanding at the end of the first quarter totaled $4.61 trillion, up 61% since the end of 2000. In the same period, total Treasury securities outstanding grew 35% to $4.54 trillion.
Who buys those mortgage-backed securities? Pension funds have been one of the largest buyers for many years now.

What is a Mortgage-Backed Security?
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans.
These are usually packed and sold in bulk, and then are often resold. Quite often the person buying them has no real idea just how safe these mortgage loans are. Are they a bunch of subprime, house-flippers with no downpayments? There is usually no way to tell by the time the MBS has been sold and resold. The banks that originally made the mortgage loans don't care about the quality of the mortgage because they have already made their profit and off-loaded the risk to the pension fund, or insurance company, or foreign investor that bought the MBS.

How did we end up in this condition. Jim Jubak explained that the coming Baby Boomer retirement is a prime culprit. State and local government budgets are stretched thin. So do they raise taxes to pay for the coming flood of retirees? That's poltiically unpopular. So they change their investment strategy to get better returns, and that requires more risk. However, with so much cash moving towards higher yielding investments, that pushes down the returns for those riskier investments. Pension funds that should be investing in low-risk treasuries are investing in agency bonds. When agency bond yields are too low then they invest in MBS. And so it goes until pension funds are investing in MBS from subprime lenders.
The spread between the yield on high-yield bonds -- known as junk bonds -- and relatively safe U.S. Treasury bonds has averaged 5.24 percentage points since 1986...The spread is now a paltry 2.88 percentage points. The trend toward less yield for higher risk has been in place pretty much without interruption since the third quarter of 2001, when spreads maxed out at better than 10 percentage points.
It's well known that loan standards have been beyond loose in recent years. What isn't always known is that this has been true for more than just the sub-prime market. The next step up from subprime, known as Alt-A, has been the epicenter of this risky financing.
In 2006, according to UBS, interest- only loans, 40-year mortgages and option-adjustable-rate mortgages comprised more than 75 percent of Alt-A issuance. These loans often have little documentation of a borrower's income and rack up higher mortgage debt against the value of the underlying collateral (i.e., the house). UBS said that 76 percent of adjustable-rate interest- only loans written in 2006 had low documentation, while 57 percent had loan-to-value ratios greater than 80 percent. No surprise, then, that 3.16 percent of these loans are already delinquent by two months or more.
If you think we've already seen the worst of the RE Bust, think again. The resetting of subprime loans (i.e. when the "teaser" rates expire and they readjust to standard market rates) won't peak for another 10 months. Alt-A's peak for resetting is nearly two years off.

Even the IMF has noticed that America's real estate market is out of control and a danger to the overall economy. I think Bill Fleckenstein said it best.
As the credit bubble in real estate dies a dramatic, not-pretty death, a very simple truth has resurfaced: It's not a viable business when you lend money to people you know can't pay it back.
Of course the damage will be spread far and wide, and some of it will require a federal government bailout. How big of a bailout? No one knows because no one is counting.
The city of Charlotte does not count foreclosures. Neither does Mecklenburg County. Nor the state of North Carolina. Nor the federal government.

Even the Federal Housing Administration, which insured many of the failed loans, didn't track the concentrations. The Observer on Sunday profiled Southern Chase, a neighborhood of 406 houses in Concord built by Beazer Homes USA. Seventy-seven buyers lost their homes to foreclosure. Forty-five of the failed loans were insured by the FHA. [...]

None of the government agencies contacted by the Observer plans to start tracking foreclosures.

Part two to follow.

Garrett Johnson,

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