The Wall Street Journal today ran a story, “Mortgage Bond Pioneer Dislikes What He Sees,” featuring Lew Ranieri’s comments on the mortgage securities market. For those of you too young to remember, Ranieri effectively created the mortgage securities market at Salomon Brothers in the 1980s, as head of its mortgage-backed securities department. He and his team (noted for their large girths and correspondingly large appetites) were profiled, less than flatteringly (they were the original “big swinging dicks”), in Michael Lewis’ book Liar’s Poker. Ranieri went on to head his own firm, Ranieri, Wilson & Co. (with Ken Wilson, a well regarded Salomon investment banker) and has been successful both as an investor and advisor.
There’s more to this piece than meets the eye. Superficially, it reads like an archetypal “Wall Street greybeard takes dim view of risky new practices” story. But the issues Ranieri highlights suggest that the strong possibility that there may be less capital available for mortgages, which points to higher risk premia, hence higher rates, which would be a negative for the housing market.
Here are the key factoids from the article. Mortgage paper is a whole lot riskier than it used to be (in the old days, the big risk was prepayment risk, but now with the keen appetite for more yield, subprime and other risky credits have become a bigger portion of the market). What is worse, the risks are much less apparent to investors because more of them are buying them through collateralized debt obligations (which are pools of the securities, which were already pools of underlying mortgages). And these securities were difficult to model even before adding the CDO layer.
Ranieri says he thinks the rating agencies aren’t up to properly analyzing the CDO paper, and I’ve heard that confirmed in the marketplace. A hedge fund manager yesterday told me he was considering buying a triple A rated tranche of a CDO (mind you, it was the bottom tranche, with 40% of the pool ahead of it from an equity standpoint). This investment was trading at 270 basis points over Treauries. As he noted dryly, “Either S&P is wrong or the market is wrong,” and it was pretty clear he wasn’t going to bet against the market.
But other investors have put their trust in the ratings, and Asian and European investors have been happily buying up risky CDOs. So why is this bad?
The Financial Times has been sounding the alarm about the expolsive growth of this market, seeing it as a sign of excessive liquidity and a cause of overly lax credit conditions. The one bit of good news is investors probably won’t dump the securities in a correction, so they probably won’t create or feed a panic if things were to get worse. But by currency and sophistication (many of the CDO investors are European and Asian institutional investors), they aren’t natural buyers of this sort of paper. So if (when) they get burned, it will be a long time before they come back.
That means less investment funds available for mortgages, which means higher rates (note this is independent of what the Fed does; Treasuries can remain the same but mortgage spreads will widen). Yet another reason to be less than optimistic about the prospects for a recovery in housing this year.
From the WSJ story:
As a star Wall Street trader more than two decades ago, Lewis Ranieri helped create a vast new business: selling bonds backed by millions of Americans’ home-loan payments.
Today, that business has gone through what Mr. Ranieri calls a “staggering” transformation, and he doesn’t like some of what he sees. The rumpled 60-year-old says he is worried about the proliferation of risky mortgages and convoluted ways of financing them. Too many investors don’t understand the dangers….
The problem, he says, is that in the past few years the business has changed so much that if the U.S. housing market takes another lurch downward, no one will know where all the bodies are buried. “I don’t know how to understand the ripple effects through the system today,” he said during a recent seminar….
The industry he helped to create is immense, and its investors scattered across the globe. As of Dec. 31, there were about $7 trillion of U.S. mortgage securities outstanding, easily exceeding the $4.3 trillion of U.S. Treasury securities.
Until the past few years, the business was dominated by Fannie Mae and Freddie Mac, the two government-sponsored providers of funding for home loans. But they have lost their dominance amid accounting scandals. At the same time, investors in mortgage-backed bonds became lulled by the real-estate boom into buying loans that would have been unthinkable a few years ago.
The housing boom kept loan losses unusually low, because borrowers who got into trouble could easily sell their homes for a profit or refinance into a cheaper mortgage. Many “subprime” borrowers (people with weak credit records) bought homes with no down payments. More than 40% of subprime borrowers last year weren’t required to produce pay stubs or other proof of their income and assets, according to Credit Suisse Group. At the same time, some lenders have become more reliant on computer models to estimate the value of homes.
“We’re not really sure what the guy’s income is and…we’re not sure what the house is worth,” says Mr. Ranieri, who now runs his own investment businesses in Uniondale, N.Y. “So you can understand why some of us become a little nervous.”
In recent months, amid a surge in early defaults, lenders have become much more cautious, insisting on down payments and doing more diligent checks of a prospective borrower’s income. Those changes are too late to save many loans granted in 2005 and 2006.
During the boom, investment banks promoted new instruments that made it easy for more investors to dabble in mortgages. Chief among these is the collateralized debt obligation, or CDO. Money managers set up CDOs, which raise money by selling notes and shares to investors. The proceeds are used to buy a wide variety of mortgage securities. The target market: insurers, pension funds and other investors that lack the time or expertise to choose individual mortgage securities. Instead, they can buy into a CDO, just as a stock-market investor gets immediate diversification by buying a mutual fund.
CDOs, which are particularly popular with Asian and European institutional investors, have become huge buyers of the riskier slices of mortgage securities, the high-yielding portions that suffer some of the first losses if mortgage defaults are higher than initially expected.
One concern, Mr. Ranieri says, is that it isn’t clear exactly which investors hold lots of the riskiest slices and whether they understand those risks. Investors in CDOs don’t get as much information about the collateral backing their investments — thousands of homes scattered across America — as do traditional, specialist buyers of individual mortgage securities, he says.
Adding to the complexity: CDOs also often invest in other CDOs, putting another layer of opaqueness between investors and their collateral.
CDOs aren’t bad, per se, but can bring mortgage exposure to “a much less sophisticated community,” Mr. Ranieri says.
CDO investors rely heavily on ratings from firms like Standard & Poor’s to guide them, but Mr. Ranieri says he believes the rating agencies are struggling to keep up with the rapid changes in mortgage finance. “It’s almost overwhelming,” he says.
Officials at S&P, a McGraw-Hill Cos. unit, say they are keeping up with the changes and have more than 100 analysts monitoring CDOs.
Mr. Ranieri isn’t predicting Armageddon. Some of the riskier new types of mortgages probably will perform “horribly” in terms of defaults, leading to losses for some investors. But, he says, the “vast majority” of mortgages outstanding are based on sounder lending principles and should be fine.