Economic Concerns Spill Over into Mortgage Market

Mortgage Market

During the last financial crisis, mortgage lending was at the forefront. This one is far broader. Mortgages are caught up in this big net as well, but not as much as some think.

Those who remember the financial crisis of 2008 will have a pretty good idea of how big of a deal the mortgage business is, given that it in itself caused a massive financial crisis and nearly took down our economy. Banks lost a huge amount of money during that time, by holding so much debt that turned bad, even though they should have seen this all coming far before it did.

Mortgage lenders essentially went all in on a bet that rates would not rise significantly, but the Federal Reserve had other plans. Perhaps the Fed bore part of the blame from this, as if they had the full story, they would surely have showed more restraint in raising rates during the time leading up to the financial crash, but no one did much diligence back then, and all the bankers were looking at was their profit numbers and the huge bonuses this lead to.

Many blame mortgage backed securities for this debacle, and while securitizing mortgage debt did serve to hide its poor quality for a time, that wasn’t really to blame either, as these things are in themselves very helpful, at least when they are as transparent as they are supposed to be. Mortgage backed securities allow us to manage the risks of mortgage lending more efficiently, they expand the lending market from what was traditionally limited to banks all the way to individual investors, and they also reduce the cost of borrowing for those seeking mortgages.

Where the problem arose with these was when lenders took on very high-risk loans and hid them within these securities, misrepresenting the risk as very small when it was actually huge. This all came down to needing rates to stay low, which you can’t count on. When they went up, low quality borrowers who should have never been given mortgages were unable to keep up with the payments, and this happened on such a massive scale that this brought down the housing market itself from all the foreclosures that resulted, indicating just how many people had mortgages that should not have.

Once the ship started to sink, mortgage backed securities, or MBS, which trade the same way that stocks and bonds do, declined in value massively, since they were worth far less with all of the defaulting going on. This is not a market that we want to see take a dive like this, and while that in itself would not cause a disaster as bad as we saw back then, this is a market that we want to maintain stability with.

All the MBS did really was to spread the risk around a lot more, right to the average person, due to so many funds holding them. If the banks had lost all the money on their own, that would have been preferable, as this just would have meant that the Treasury would have needed to conjure up more money for the bailout, and ordinary Americans as well as the American economy in general could have been more spared.

We definitely do not want to see MBS get hurt, and this is why the Federal Reserve, alongside everything else that they have done to support markets, stepped in and bought a massive amount of mortgage backed securities to stabilize this market.

The Fed does buy these securities quite often, as they feel the need, and after what happened in 2008, they are not about to risk any sort of crash or significant reduction in these asset prices. As a result of the 2008 crash, they bought $80 billion worth of them. The state of the MBS market back then was in as big of a crisis that we will probably ever see, and compared to back then, today’s mortgage situation is far less severe, but like the rest of thier moves lately, excess is a word that has been removed from the Fed’s vocabulary.

The goal here needs to be stabilization, and while a little buying was certainly a good idea, buying $200 billion, 2.5 times what they did when the house got bombed, is pretty disproportionate when you only have a few windows broken like we have now.

The risk with the coronavirus crisis is far less severe than it needs to be to threaten the mortgage market, unless you are perhaps of the belief that this will go on for a very long time. We need not even worry about that because if we shut down the economy for long enough to bring a large amount of foreclosures into the picture, this will destroy our economy on its own, and we will have much more to worry about than just foreclosures when everything collapses and the government cannot keep things together anymore.

There are real limitations to how much governments can do, and it’s not that they could just take the economy on its back for long periods of time, as some folks have suggested. It isn’t even a matter of how much we want to mortgage our future to pay for this, as we get to a point where this can’t be done. There is a reason why the Great Depression lasted 10 years, and it wasn’t that the government wasn’t afraid to spend a lot of money, it was because there is only so much that they can do when the economy itself is in shambles, as it was then.

We could get into a spot far worse than this was if we continue to constrain economic activity for long enough, and we need to be very careful here not to overdo this and pass the point of no return where the damage that we’re willing to cause is concerned. Even getting to the point where lenders would have no choice but to foreclose on a lot of these homes would be too far, although that would only be one of a great many things to worry about if we got to that point, unlike in 2008 when that was the whole deal, and one plenty bad enough.

In spite of the madness that has gripped the world over the COVID-19 risk worsening with each passing day, where some suggested that this was the biggest crisis humanity has ever faced and so many actually believing this massive hoax, the actual situation that is scaring so many people out of their wits will end soon enough, and long before we see the housing market crash like it did in 2008 or even close to that.

Still though, and not surprisingly since risk is being so greatly misrepresented with everything else, people are worrying about such a thing, and are particularly looking at Wells Fargo as they have the biggest mortgage exposure of all major U.S. banks.

These folks know little about banking though, and especially are unable to make the proper distinctions between someone who never should have gotten a mortgage in the first place and now can’t pay it back, like so many in 2008, and those who can pay it back if they are only allowed to work, but have had the ability temporarily taken away from them by public officials locking them out of their jobs.

The Risk to the Mortgage Industry is Pretty Minor Right Now

This is actually not that bad of a thing for mortgage lenders, because this particular situation isn’t even about losses, it is instead about deferrals, which actually improves the profitability of these loans by extending them without really increasing their risk. If you have 20 years left to pay and this becomes extended to 20 years and 3 months, banks still get paid in a timely enough way and collect more interest.

This does cost the bank a little more to service the debt, but the extra interest involved more than makes up for this. This is nothing like the old days with people laying pen to paper ledgers, as automation has greatly reduced administrative costs and deferring these payments is not really unwelcome. Banks have eagerly stepped up to do this with no persuasion needed, as the profit motive was enough by itself.

The fears that this will either cause a lot of defaults or hurt banks financially are therefore based upon a lack of understanding, the same way that the fear of this virus is. It is absolutely incredible to see how far we’ve gone with this virus, not only going off the deep end but dunking our heads underwater for as long as we can stand and still get enough oxygen to survive, from an event that really isn’t that significant.

Even Donald Trump has at least appeared to join this cult of horror, although this about face may be politically motivated. If he goes along with the 100,000 to 250,000 deaths that we are believed to see from this, and the numbers come in far less, which they certainly will since these numbers are so overblown, he’s surely going to claim some of the credit and perhaps give his campaign enough of a boost to buy him 4 more years.

People are also not bothering to tell us why 100,000 American deaths from a viral outbreak would be all that big of a deal in the first place. This is not a lot more than we see with the flu in some years. We got to 60,000 in the 2008 season, and this didn’t even make the back page, let alone all the pages from front to back. No one took a single measure against this, no one even took a single step away from anyone in fear, not even elderly people who probably should have.

This is not to minimize this many deaths, but we do need to realize that the treatment must be proportionate to the disease, and if this is just a little worse than the flu, our response also needs to be a little more, not more by an amount that boggles the mind.

With that said, how it could be even remotely reasonable that we would get even 100,000 deaths in the U.S. from this continues to be ignored. Trump was not long ago more on the side of reasonableness, but perhaps he saw a great opportunity to hang with the lunatics now so he can claim some of the glory when they turn the lights on with this finally, when reality overtakes absurdity.

This is very likely a great many more people in the U.S. that are currently infected than the tests have revealed, and all we need to do is look at the percentage of those testing positive among all tests administered. It’s about 25% right now, and while a lot of these tests are done on people with symptoms which would cause the percentage to be overstated, the true number is certainly a lot higher than the 0.5% that the current number of cases represent.

The truth lies somewhere in between, but we’ve tested enough asymptomatic folks that we can conclude with a lot of confidence there are at very likely millions of Americans infected already. If the actual rate were only 5%, that means that we would have over 16 million, which would be revealed if we could somehow test everyone in the country right now.

In people’s current state of mind, that would scare the hell out of them, but that’s only because no one is thinking at all right now. If 100 times more people have this than we think, the death rate is therefore 100 times less. It is supposed to be 10 times more deadly than the flu, but this would suggest that the flu is actually 10 times more deadly instead,

They tell us that their models are telling them that this many people will die, or more, but when you base your models upon ignorance rather than real statistical analysis, causing you to overstate the death rate by this much, as well as think that the number of cases we discover through testing each day actually represents new infections, that’s just beyond belief, as are the numbers that emerge.

It does not make any sense to base your predictions upon the growth of cases when you start by testing a tiny percentage of the population and then ramp it up more and more like we are doing. Whatever emerges from this is perhaps the ultimate case of statistical misrepresentation, by pretending that this is representing some sort of progression of the outbreak.

We are not even entitled to infer that there is a single new case when we discover 20,000 more on a given day, as all of these infections could have occurred on another day, perhaps even some time ago. This would only be valid if we tested everyone yesterday and then today, as that’s the only way to measure a progression, to compare comparable data.

The number of deaths is the only meaningful statistic here when we’re trying to decide how many people will probably die from this. After over 2 months, we’ve had 4,000 deaths, and while this number is growing, it’s not growing anywhere near as much as what would be required to get to even 100,000, or anything even close, when we look at how this virus has progressed thus far.

We’re just not seeing that many people dying from this from our experience with this virus, and we should find claims that we’re only 2 or 3 percent down the road after all this time, which would be required if these exaggerated death numbers were true, to be simply crazy. Even those with noses as long as Pinocchio’s are telling us that we are just 4-6 weeks away from the worst being over, and you don’t see things multiplied 25 or 50 times from where they are now anywhere near this quickly, except the movies, including this one.

The Shutdown Rattled Their Windows, Then the Fed Threw Big Rocks at Them

The bottom line here for the mortgage business is that people won’t be out of work for all that much longer, because there won’t be a need, nor could we do this for much longer than this without making the treatment itself the biggest challenge we have ever faced. We might even be there already.

The MBS market did need a little boost, as this is a real market like the stock market and sentiment does factor into things, and fear took its toll on these securities as well, to some degree.

It should not have been so difficult for the Fed to keep their response more in tune with the need, as they have a big staff and already monitor the repo market very closely on a daily basis. Instead, their reaction was more like helping homeless people not by giving them a place to live, but to throw a briefcase of money at them, far in excess of what they needed.

The Fed caused a big rally in mortgage backed securities as it turned out, by buying a truly reckless amount, and harming mortgage lenders by this. They are starting to speak out now and this has indeed cost them a damaging amount, even though people who don’t know much about the mortgage business may expect them to benefit instead.

The reason for this has to do with lenders locking in rates in advance for borrowers. It would be best for lenders if they did not have to do this, as this represents a meaningful risk for them, as if rates go up, they do not want to honor the lower rates at the time of application if they can avoid it. The difference represents a loss as they could have loaned the money out at the higher rate if not for this commitment.

If you refuse to do this for borrowers, they will just take their business elsewhere, to the bank down the street who will guarantee current rates. This part they really have no choice about, but they certainly do have some real choice in how they manage this risk, and they have made a very bad choice in today’s situation,

What lenders choose to do is to short MBS, where if rates go up, the value of MBS will go down and the profit they make from the short will offset their losses on the higher rates. If you are short something, you lose money when its price goes up, and when the Fed’s overbearance runs the price up as much as they have, you lose a lot of money.

While these lenders want to blame the Fed, and while it is true that if the Fed had not acted in such excess, they would not have this problem, they bear most of the blame themselves. They are crying over the margin calls they are now getting on these shorts, but only a fool would have stood by idly as this much money flew out the window, and they had plenty of warning,

Some may object to our ever being allowed to short mortgage backed securities, and there are some good reasons why we might not want this, but even better reasons to allow it as it turns out, because these lenders do need to offset their risk somehow. There are other ways to do this, but these shorts do provide a pretty efficient way of balancing off these risks, and they do need to be balanced off lest a crisis develop every time mortgage rates leap.

The real screwup that they made is not managing the risk of what actually ended up happening properly, and especially not managing it after it happened. How is it possible that a lender is still in these shorts after the Fed aimed a huge cannon at their ship and sank it? This seeks to manage one risk by taking on a bigger one. You would have to be crazy to do something like this, but that is not an obstacle it seems.

When people scramble to cover short positions as the price goes up, this puts the price up even more, and this is called a short squeeze. They are squeezing themselves here and have set margin calls as their threshold of pain, and may even be willing to put up the margin and put even more money at risk, compounding the problem.

The Fed has backed off in the face of these protests, and has pulled $10 billion off of the table now from their MBS fund, and we probably will also have to foot a lot of the bill arising from these bank traders losing their minds, much like they did 11 years ago. We cannot sit by and see a lot of these lenders become critically wounded from this, and the plan here was to help not hurt.

This is just another big expense that will be added to the colossal bill from this wretched paranoia, and perhaps the worst of the bunch. The Fed simply did not have to spend anywhere near as much as they did on stabilizing MBS, and should have known that this would happen if they drove up prices this much, causing a short squeeze of this magnitude and big losses from the very folks they are looking to protect.

Hindsight is 20/20, but foresight need not be so blind.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.