Debt markets: The American dream turns into a nightmare

JEFFREY KIRSCH, CEO of American Residential Equities (ARE), is an extremely busy man. Not that he has ever been a slacker; it is just that his line of work is booming – his company liquidates underperforming mortgage loans. In the past 10 years, Kirsch has bought and liquidated something like $1 billion of loans. However, now he envisages liquidating a much larger amount over a much shorter time horizon.

If Kirsch is right, the prospect is of millions of homeowners being forced on to the streets, an outlook that is bound to loom large in the fast-approaching US presidential elections. Senator Hillary Clinton has already proposed a $1 billion fund to help homeowners avoid foreclosure. Pressure is building for the Federal Reserve to come to the rescue with rate cuts. Amid accusations of predatory lending practices at originators, there is talk of the need for extensive forbearance – which would allow borrowers to delay onerous monthly payments. A number of calls from Federal politicians have urged the Office of Federal Housing Enterprise Oversight to act to allow the agencies, Fannie Mae and Freddie Mac, to help support the market in some way. State laws are being passed to protect borrowers from themselves and from unscrupulous lenders. Lawsuits are being prepared, with state attorneys seeing an opportunity to make a name for themselves.

The US structured finance sector is being tested to the extreme. Despite the fact that over-enthusiastic lending is hardly a new phenomenon, some are blaming securitization for the excesses in sub-prime lending. Certainly the CDO and hedge fund bid for the riskiest parts of RMBS capital structures changed the economics of the business – providing cheap credit to borrowers of meagre means is easy when someone else is on the hook. That distribution channel has withered for loan originators and structurers of RMBS – putting the whole financing of a huge market at risk. Not only has non-agency issuance ballooned in recent years, this private label market was recently characterized by loans with a high number (approximately 60%) of adjustable rates. These loans would typically be refinanced when the so-called teaser rate periods, typically two/three years, end. But hundreds of billions of dollar-worth of loans could struggle to find new lenders willing or able to commit new funds – it is uncertain whether their existing lenders will foreclose or be willing to negotiate new terms.

Without serious amounts of good fortune or heavy intervention, the future looks bleak – for millions of homeowners and for the financial markets. How did it come to this and where do the markets – in housing and structured finance – go from here?

Back in 1995 the sub-prime mortgage-backed market was approximately $65 billion – within 10 years it had ballooned to nearly 10 times that size. Issuance reached a record $600 billion in 2006. Over the same time period, US homeownership expanded from 60% of households to a little less than 70%. This expansion was driven by selling mortgages to marginal borrowers. The growth of this mortgage market attracted more and more players, which hit the profitability of originators who – in the face of slowing growth rates on the back of rising interest rates – failed to maintain tight lending practices. A lot of poor underwriting in previous years had been masked by strong house price appreciation. Just as a receding tide exposes the skinny dippers, so falling (or just stable) house prices in the past year have uncovered a mess that has had an adverse impact on the wider international financial markets.

It has now been approaching nine months since the term sub-prime crept out of US mortgage and structured finance circles and entered the wider financial services vocabulary. The causes of the sub-prime crisis are now widely understood (see Euromoney December 2006, Have Wall Street banks gone subprime at the wrong time?) but the question that needs answering is what will happen to the US residential market and the financing industry that was built upon it in the near term.

This was a highly significant business. According to data from Dealogic, the new issue fees from the US mortgage-backed business in 2006 amounted to $3.17 billion, and this does not include revenues earned from sales and trading and proprietary position-taking. Nor does it take into account the profits booked from the cash ABS CDO business, which has thrived in recent years. Estimates for outstanding sub-prime securitized paper range from $1 trillion to $1.2 trillion. The wider residential mortgage market is about $10 trillion – making it the foundation of global fixed-income credit markets.

Continued US economic growth must surely be linked to a robust housing market and there are many reasons to be concerned, not least because the withdrawal of credit that is taking place might well be intensified as a result of new state and/or federal regulations aimed at protecting borrowers from predatory lending.

Opportunity knocks

But amid the doom and gloom not all players will be losers. Those that are well positioned – that is, cash rich, and knowledgeable – will make substantial profits in the coming months, because when financial markets are dislocated the mispricing of credit risk is to be expected.

"These are hedge funds, wealth management firms, even a small investment banking house – a whole myriad of players wanting me to explain what they own" Jeffrey Kirsch, American Residential Equities