The Great Recession of 2008 is most famous for the massive default rate we saw with mortgage backed securities. Don’t look now, but this problem is back, and in a big way.
While just about everyone who was around during the financial crisis before this one, an economic downturn severe enough to not just be called a recession or even a big one but the great one, is familiar with the term mortgage backed securities, or MBS, there are still quite a few people who aren’t entirely sure what these things are other than they are some sort of financial derivative that are complicated enough to confuse just about everyone.
While there are some very complex derivatives out there that even confuse the principles of these trades, where people and organizations buy these securities and aren’t even that sure what they bought and especially how much risk that they are taking on, mortgage backed securities aren’t really of this sort.
The easiest way to understand this type of derivative is to think of them like we would a bond fund, with the fund itself buying and holding many types of bonds and then selling shares in the fund, where we buy a piece of the revenue stream that these financial instruments generate.
The bond fund is well diversified so a certain amount of defaults won’t impact the fund much as these losses will simply be spread around. If you owned one of these bonds instead of the entire basket and it defaulted, you could be out your money, but with the basket, as long as the default rate doesn’t go too high, while defaults will put your return down, the risk of losses can be kept more reasonable that way.
That’s not the biggest reason why mortgage backed securities exist, and the investors that buy them aren’t deciding on whether to buy these mortgages individually or as part of a package containing a great deal of mortgages, because they aren’t looking to own mortgages otherwise, although the diversity involved does make these securities more attractive risk-wise than if they were taking on fewer of them and would be exposed to individual default risk more.
Mortgage backed securities and other derivatives that package debt together actually has a bigger purpose, which is to make it easier and more efficient for people to borrow. They don’t just make it easier to get mortgage financing, they also make the economy as a whole healthier, as the size of our economy is measured by how much lending there is out there, and mortgage backed securities allow us to essentially borrow more when institutional investors buy so much from traditional lenders, allowing them to take the proceeds and lend it out again.
This functions in a similar way to what the Fed does when they want to stimulate the money supply by putting interest rates down, as their goal is to see these lower interest rates stimulate more lending. As more money gets loaned out, people spend more, and the greater spending that results is how this grows our economy. When we can tap into the lending capacity of mutual funds and pension funds in financing mortgages, this results in our overall lending capabilities being significantly increased.
We saw just how much power the additional lending that can be fueled by mortgage backed securities has during the last recession. The appetite for mortgage backed securities at the time exceeded the ability of the mortgage market to satisfy so much that this resulted in mortgages being handed out like candy to just about everyone, including a lot of people who did not even have the capacity to make the payments on them.
This created what turned out to be a Ponzi scheme where all it took is a rise in interest rates to set the wheels of collapse in motion, which caused a cascade of defaults so severe they took down the world economy enough to cause the biggest recession since the Great Depression.
While mortgage backed securities defaults aren’t the cause of this current recession, as there is a lot more to worry about this time around than just this market, if we punish our economy as severely as we have, the widespread damage that we see will certainly extend to the lending market, because a poorer economy means that the capacity for people to make payments can be reduced in a way that is plenty painful.
Commercial MBS Are Taking the Big Hit This Time
Whereas residential mortgages took the brunt of the hit during the residential housing crisis last time, a different type of mortgage backed securities is taking most of the bullets this time, commercial mortgage backed securities, or CMBS. Given that our lockdown and stay at home orders have impacted commercial ventures in particular, especially those in the hospitality industry who have really seen their businesses shrink, it only makes sense that these securities will be much more affected from this downturn of such an unusual cause and nature.
Mortgage backed securities pay out periodic interest like bonds do, where the income stream that this lending generates gets passed on to investors. Like with bonds, if mortgage backed securities cannot meet their interest obligations, this places them in default, just like your missing payments on your own mortgage will cause your defaulting. These securities cannot just defer their payments like we can though, as there is only do or not do, there is no try in this world.
Residential mortgage backed securities haven’t seen their default rate move up by that much, currently only going from 0.41% in May to 0.59% in June, according to securities rating firm Fitch Ratings.
The overall default rate with mortgage-backed securities overall has leapt from 1.46% in May to 3.59% in June, the greatest one month increase since Fitch started tracking these things 16 years ago, which includes the period called the Great Recession when they collapsed.
If residential mortgage backed securities still only has a relatively tiny default rate but these securities have an overall rate 6 times higher, that alone tells us that the other type, CMBS, is taking a real hit, and that is certainly the case, especially with ones that focus on sectors that have simply been hammered.
This big increase in defaults is being led by the hotel sector, where all these months of people not staying in hotels much is really taking its toll. Defaults among CMBS in the hotel market exploded from 2% in May to 11.49% in June. The retail sector has also been hit hard, both in terms of their business declining so much and their CMBS defaulting in turn, a number that has grown from 3.82% in May to 7.86% in June.
Mixed-use CMBS are also now at an above-average default rate among mortgage backed securities, rising to 4.17% now. It’s their mixing in these distressed property types that has caused this, as those focusing on office space leasing is only up to 1.92%, with industrial spaces being impacted the least over this time, with only a 0.67% default rate now, only a little higher than residential MBS defaults.
With our seeing a reversion toward restricting businesses again due to the rise in COVID cases that the U.S. has seen lately, this situation is expected to get worse before it gets better. Just being able to open again isn’t enough if you still cannot create enough business to keep your head above water, if you can only run at half capacity for instance and this is beneath your ability to be profitable.
Things Are Expected to Get Worse Before They Get Better
Fitch’s forecast going forward is not very pretty, as the range that their analysts foresee by the end of the third quarter has the overall mortgage backed security default rate in the range of 8.25% to 8.75%, which are very disturbing numbers.
Melissa Che, Fitch’s senior director of CMBS, is concerned that the level of defaults may rise enough to place notable downward pressure on property valuations. This may not spill over too much to the residential side, but certainly affects the ability to refinance commercial properties and will place surviving CMBS under more pressure as they watch so many properties get liquidated and see this affect their ability to stay afloat.
Just like default rates on residential properties prevented so many from saving themselves by just refinancing, where they no longer had the equity to do it and were already in the red due to plunging property values, this has the same effect on commercial mortgage backed securities, lowering the commutable value of this paper due to their equity being so reduced.
Derivatives are different than just holding traditional loans, as the value of derivatives is determined by the market essentially, derived from the value of the asset but also subject to market forces. We drove residential mortgage backed securities right into the ground during the Great Recession, which resulted in an overreaction that took us well below their actual value, and there were some that stepped in and bought these distressed assets for a song and did quite well with them.
We might think that only big institutions need to worry about this all that much, as individual investors generally don’t invest in CMBS, but many of us have pensions or invest in mutual funds that hold CMBS, and the reach of this is much bigger than it appears.
Mortgage backed securities have always been promoted as low risk, similar to bonds, and this just added to the shock of their collapsing the way that they did in 2008. Many thought that banks and other large financial institutions took the direct hit, with our being punished by the reverberations in the economy that this caused, but many were impacted directly, and many are still prone to the impact of this latest crisis directly.
There’s not much that we can do about our pension fund being subject to these losses, and we certainly aren’t entitled to assume that these funds learned their lesson the last time. It was claimed that these securities are actually similar in risk to bonds after we cleaned up the subprime lending fiasco, but as we now see, these investments are considerably riskier than bonds and even more so than stocks.
Stocks have substantially come back, while the trouble with CMBS has only begun. It is both amusing and sad that the added risk of mortgage backed securities has been missed once again, although to be fair, no one expected us to lose our minds over a pandemic and be willing to visit our economy with such destruction as a means of managing this health crisis.
This was not hard to see coming once this twisted economic nightmare became reality, because if you are depending on payments continuing to be made by enterprises that we have so badly wounded, you will simply become disappointed.
Mortgage backed securities have become simply toxic investments once again, especially when we consider the very low returns that they pay, returns that really cannot bear much risk at all, let alone fantastic amounts of it. To make sense of taking on higher risk, we need to be compensated for it on the return side, and when your returns are very low at best and the risk can explode like this, this is the last place you should want your money, especially when it is happening.
Seeing all this recent heavy smoke coming from CMBS should alarm people who hold this type of investment in their portfolio, even though they should have seen this coming when they were bombarded 5 months ago now.
What makes mortgage backed securities so utterly terrible is their inability to handle tail risk like this, and while that doesn’t mean that they aren’t worth investing in at all, at best, we need to run as fast as we can the other way when crises hit. The time to run was quite some time ago, but if you are still in this stuff, with more pain on the way, it’s time to walk away from what has turned against us in such an alarming way, and hopefully come away with a valuable lesson.