Don’t Look Now, but They’re Back: Bad Mortgage Debts May Surface Once More

by Michael Blim

Ben Bernanke met the press this past week with no good news to report. Rather he admitted that “we don’t have a precise read on why this slower pace of growth is persisting. Some of the headwinds that have been concerning us, like the weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues, may be stronger and more persistent than we thought.”

And how. The US economic recovery now almost two years old is the weakest of economic bounce backs over the past one hundred years, according to Richard Milne in the June 25 Financial Times, and economic policy elites like Bernanke are mightily perplexed. Output growth continues to falter, and unemployment will remain as high as seven to seven and a half percent through 2013. Instead of figuring out what to do next, Bernanke et.al. find themselves spending most of their time defending what they have already done as saving America and the world from something much worse.

As the economy slows once more, and the housing market worsens, the chances of really bad knock-on effects increase. You may recall that the collapse of the value of mortgage-backed securities (MBSs) triggered the panic that sent the world economy reeling. Well, those bad securities, some half a trillion dollars worth, are still sloshing around in Wall Street basements, still able to help take us under should the economy start to tank once more.

The securities whose worth relies upon millions of sub-prime mortgages and loans made to homeowners on wildly over-valued houses have been passed around the financial system once more, as bottom-feeding hedge funds have been churning resale markets to increase their prices and take speculative profits. The once high returns of six to eight percent that MBSs offered have made them worth the gamble, and by picking them up at fire sale prices, some funds have been able to even double their money.

It remains a tricky game of pass the parcel. As long as someone other than the speculators were willing to eat the losses of the face value of the MBSs, say the Federal Reserve, Fannie Mae and Freddie Mac, and commercial banks, the game offered pretty good rewards at reduced risks. If the economy slows down, and the housing market, already stalled, deteriorates further, the game can become deadly serious. As Aline van Duyn of The Financial Times explained in a fine column on June 18, the securities can turn toxic once more, risking the money that was borrowed to buy them up, and putting into jeopardy a whole set of hedge funds for whom adding a little bit of high-yielding poison has given them an edge and a growing share of the investment market.

So-called “macro” hedge funds, the riskiest kind according to Magnum Funds, that make bets in any markets that are affected by macro-economic shifts, have included mortgage-backed securities in their investments. They are a big and growing segment of the hedge fund market with currently $380 billion under management. They try to lay off the extreme risks in their portfolio by betting on commodities, currencies, stocks and securities at the same time, hoping that diversification will make money and limit exposure to losses in any given sector.

This strategy and its execution may sound familiar, as van Duyn points out, because it is directly analogous to the reasoning used by the creators of the sub-prime mortgage crisis that got the world economy deep in the hole three years ago. Originators of MBSs mixed lower-yielding, ostensibly good mortgages with the higher-yielding bad ones to create a good-yielding product with what seemed to be manageable downside risk. When the bad ones failed, the ensuing panic and recession destroyed the value of many good mortgages as well, and the bonds became worthless, and the money used to buy them lost.

Once again, a leading segment of the financial markets en masse has made a big bet and borrowed money on mortgage-backed securities whose foundations are suspect and likely to deteriorate along with the housing market. Believing again in the alchemy of mixing the good with the bad to produce higher profits, this time, spreading the risks across markets constitutes the good, and taking risky and even bad assets once again as tolerable as mixing good and bad mortgages. The macro hedge funds, however, seek out high risks wherever they go, from junk bonds to commodity futures, and use derivatives to magnify their chances for higher profits. If the MBS resale market starts sliding, there is some reason to think that other markets will be falling in sync too, as all of them will be responding to the same economic bad news. Like the 2008 crash, there are the makings of a perfect storm: risky assets have been tied together throughout the financial system and a lot of money borrowed at little or no cost to make huge bets that given underlying economic fundamentals could all go sour at the same time, endangering the hedge funds and the banks and private equity firms that lent them the money.

Our world financial system continues to careen wildly through space and time, nothing if not emboldened by the cheap money released since 2008 to make the crisis go away and by the desperate search for higher yields released by the deflating effect of the same cheap money on yields. The question is not whether another crisis if probable, but how probable.

In parallel fashion, the Greek financial crisis goes its way, with banks in major European nations, and the European Central Bank itself, uniformly vulnerable to losses from Greek default or asset devaluation.

What frightens the world economic elite about Greece is that like the mortgage-backed security crisis of 2008, Greek default would spread panic throughout the financial system, triggering losses across the board in all of the financial markets, and precipitating solvency crises among banks and other sovereign bond holders.

Back in the US, given high unemployment, low consumption, little or no economic growth, and the continued deterioration of the housing market, a slump or a mini-crash in the now highly speculative mortgage-backed securities market would not be surprising. Would it once more prove dangerously contagious as it did in 2008? Would it trigger insolvency among the “macro” hedge funds and the banks that lent them the money? Or would something like a Greek-induced panic turn out to be the trigger for an MBS market crash?

These are the imponderables facing the economic policy elite and ultimately all of us. No one knows if or from where a bullet may come, or if it can be dodged in time. In all, it makes the road to Sarajevo albeit in retrospect seem obvious.