Mortgage Liquidity Crisis: HSH's Thumbnail Outline (HSH Associates)

This is an expanded article based on the discussion which appeared in HSH's Weekly Market Trends Newsletter dated August 24, 2007.

First things first: what we\'re seeing in the markets isn't so much a credit crunch as a liquidity crunch. Liquidity is created when loans are bought and sold easily, and quickly, and at terms agreeable to both buyer and seller. The credit quality of the loans of course plays a role, but it's not the only factor. More important is that buyer and seller both agree on an equitable price.

Right now, money is available for many kinds of credit, and, yes, perhaps even for risky credit. However, it probably isn't available at a price which can produce profits, or in sufficient volume to satisfy everyone involved in the process. At present, certain loan 'paper' can only be sold at prices which guarantee a loss to the seller, which leaves little incentive for the seller to even try to offer them for sale.

To successfully originate a mortgage, many masters must be served. The price of the money and terms of the deal must be low and easy enough to attract mortgage borrowers; at the same time, it must be high enough and 'tight' enough to provide profit for the firm who originated the loan, and ultimately provide profit to the investor whose money is at stake. Investors may hold those individual loans (or bundle them into securities) which can be bought and sold. Selling generates cash to make more loans, or the profits from those sales can be returned to the parties involved in the transaction, or both.

The investor in the loan(s) (or MBS purchaser) rightfully expects that the loans involved will perform (be paid back) in a certain way. This allows him to ascribe a value to them, either individually or collectively. Among other factors, some of that value is created by the terms and rates on the loans, and, based on those conditions, a rating can be placed on a security developed from the loans. These valuations are crucial, for in order to buy and sell loans, both buyers and sellers need to know what they are buying and selling so at least a baseline price can be developed and negotiated from there.

It's a great system, as long as nothing goes awry. But something did: as already-originated or securitized loans began to perform more poorly than expected (think 'unexpected defaults'), investors became concerned that the instruments they held weren't as valuable as they originally thought.

Usually, even loans or securities which are expected to perform poorly can be bought and sold, too, but are offered at lower prices or have higher rates of return to the investor. As long as the investor is getting what they expect, everything is OK.

A loan that began as a 'good quality' loan but had started to exhibit payment qualities of a poorer quality loan can become hard to sell at full value. After all, the next buyer is unlikely to want to pay a dollar for an investment which performs like one worth 95 cents.

From a buyer's standpoint, buying those loans or securities at a steep discount can help ensure profitability even if the loans do perform worse than they expect over time. However, from a seller's standpoint, this can bring instant loss, a generally unacceptable condition, as they initially paid full price for a loan or security which now can only be sold for less than the original value.

In short, new or potential buyers of these mortgage loans and securities began to refuse to pay the full-face price for them, based on the fear that the investment's performance might be worse than expected. These new buyers began shunning these investments or demanding discounts, discounts steep enough as to ensure losses by the seller, who paid 100% on the dollar for the loan or security in the first place.

As a rough analogy, if you're the owner of an expensive car that doesn't run very well because it has too many faults, you might not be able to sell it for 'book value', once those faults are factored into the price. Worse, the only buyers around are offering much less than that -- because they fear it may be a lemon. If you need cash badly enough to remain 'liquid,' you'll have to sell at the price the market will bring, even if you lose money on the deal, because no sale means no cash at all. Such, broadly speaking, is the current state of the credit market.

In such a market, unless there is a requirement to sell -- to satisfy other investors in a fund, for example -- the seller simply cannot sell at the buyer's "market clearing" price. A seller who must sell will face instant losses; those who don't need to sell immediately may decide to wait until conditions improve, or only sell the bare minimum needed to raise cash while containing losses to just a part of a portfolio. Some may look to borrow money from others (or against other assets) to help provide cash. Without fresh cash to lend or distribute, they are effectively out of the market.

Amidst this, usually-reliable buyers of loans or securities refuse to buy not only existing assets, but refuse to purchase also any new ones, unless the yield (interest rate) is high enough to provide profitability and the terms tight enough to help limit potential losses. Where money remains available, it is offered at much less liberal terms.

That creates its own set of problems. Once the rates are lifted high enough, or the terms become tight enough, the borrower who wants a specific loan either refuses to take it -- or can't afford to get it. What's a mortgage lender to do? If he can't make new loans, or can't make enough of them to quickly bundle and sell -- and can't (or can't profitably) sell loans or securities he already owns -- a mortgage operation will simply close up shop, or otherwise sort of hibernate by not offering certain products (or any product), or may only run a bare-bones shop for plain-vanilla loans until conditions improve (as some lenders have done).

• A seller of mortgage paper hopes to be able to sell at a profit, or at least break even.
• Buyers won't pay what sellers are asking, and sellers can't sell at prices buyers are willing to pay, so new cash can't be generated, crimping liquidity.
• Without liquidity, rates and terms rise and tighten for new loans, so potential homebuyers either balk at those conditions or can't afford a new loan, and
• the smaller volume of new loans made makes it harder to produce securities profitably.

As we've stressed in our weekly MarketTrends in recent weeks, this isn't strictly a "subprime mortgage" mess. Uncertain valuations of loans already on books is the order of the day, and virtually all products which are commonly securitized may ultimately be affected. Although lots of products are funneled through Wall Street, not all loan products are (or are right away) -- and not all are necessarily subject to any form of instant impact.

Certainly, a finance company which is merely a conduit for Wall Street -- like a BNC Mortgage, which Lehman Brothers closed in August, or a National City unit which made only home equity loans -- can see troubles quickly; however, loans that can be made and held on lender books for at least a while shouldn't see the same trouble, at least not yet. Lenders making more traditional consumer and home equity loans for their books don't need to sell or securitize them as they are originated; they can write loans from their own in-house funds, at least until they run out of cash and must sell in order to keep lending. At that point, some loans will have be sold, but markets may be functioning better at that point in time than they are right now.

There may even be a sort-of silver lining for consumers: to help keep cash coming in to lenders, you may see higher yields available for certain deposit investments. If so, you'll need to act fast -- it's a limited-time offer, valid only until buyers and sellers of MBS and ABS see more eye to eye and 'fix' the liquidity crunch.

As well, there has been one little-discussed and unforeseen benefit to the credit/liquidity mess: lower Treasury yields -- significantly reduced from their levels of just a few weeks ago -- means that rates on ARMs coming due to adjust will be lower than many borrowers might expect.

Yields for one-year Treasury Constant Maturities -- a very popular ARM index -- have dropped sharply from around 5% in late July to 4.44% last week. Factoring in a typical 275 basis-point margin, a borrower who faces an interest rate adjustment based on that index will see a rate of perhaps 7.25%, a savings of a half-percent or more over what they might have seen just a few weeks ago. Of course, those ARMs are probably rising from much lower levels, but any trimming of higher rates -- and increase in monthly payment -- will surely be welcomed.

There are some tenuous signs that the market logjam is easing a bit. At least some buyers and sellers are finding common ground, and the Federal Reserve has eased borrowing conditions at its Discount Window for firms which would like to raise cash but can't find any buyers (or buyers who will pay a price high enough to help keep the seller in business). While it's way too soon to even suggest that the market is improving, it's reasonable to say that we may have found at least a level platform for now.