Sunday, November 25, 2007

A Lesson From the Subprime Mortgage Mess: Risk Never Dies

If you own municipal bonds, you might think you’re far removed from the subprime mortgage mess. After all, muni bond holders are probably the last vestige of the coupon clippers of yore, cautious, conservative, parsimonious with their tax liabilities, and about the last people who’d have an interest in illiquid, opaque, alphabet soup derivatives.

But the muni bond market has been shuddering lately, because insurers of muni bonds, such as MBIA, Ambac, CIFG, and FGIC, have subprime mortgage exposure. These companies insured billions of dollars of CDOs, derivatives contracts based on pools of mortgages. They have evidently been taking writedowns on account of their CDO exposure. That, in turn, has raised questions about their ability to stand behind their guarantees of municipal bonds. Guaranteed muni bonds are suddenly less valuable than they were a little while ago. Coupon clippers living in Beacon Hill are seeing dips in the value of some of their muni holdings because an investment bank in midtown Manhattan underwrote opaque and illiquid CDOs that purported to turn low-grade, high risk mortgage loans into AAA-rated investments that were bought with extreme levels of margin debt by a 34-year old hedge fund manager in Darien who has a very good resume but not much common sense.

This was made possible courtesy of the derivatives markets, the famed bazaar where risk could be bought, sold, swapped, insured, sliced, diced, stripped, mixed together and synthesized, all served with your choice of ketchup, mustard, mayonnaise, relish, pickles, onions, sauerkraut and horseradish. Holders of risk could, for a price, offload just about any can of worms they found too slimey to keep. From their perspective, risk could miraculously be eliminated.

But muni bond investors are spilling their tea on account of fly-by-night mortgage brokers selling impossible-to-repay option ARM mortgages to poorly educated home buyers in places like Detroit, Cleveland and Fresno. This illustrates a simple, but frequently overlooked, truth in the financial markets: risk never dies. All financial transactions involve risk of one sort or another. These risks can be and often are transferred. That’s what insurance is for, and that’s what the derivatives markets do. Transference of risk, though, doesn’t mean the risk ceases to exist. It’s still around, supposedly in someone else’s hands, but nevertheless maintaining a pulse and brain wave activity. If the risk blows up, somebody will take a loss. The only question is who.

When an insurance company insures a CDO, it will initially take the loss from a mortgage default. In the ordinary course of business, insurers maintain reserves to cover anticipated losses and can take mortgage defaults in stride. But, as we discussed before, the risks created by the subprime mortgage industry were enormous (see The insurers evidently didn’t have large enough reserves for the amount of risk that was out there. Perhaps they weren't aware of the enormous amount of dumb mortgage loans that were made, or how intertwined liabilities in the derivatives markets have become. Whatever the case, there was more risk than they were expecting.

If the Department of Motor Vehicles were to lower its standards and license a large number of poorly trained and unskilled drivers, the public (as well as auto insurers) would be outraged. Maybe there’s an argument that society is better off if more people can drive. Then, they could drive to where jobs are, and unemployment levels would drop. Auto manufacturers and dealers would probably enjoy increased sales. But this shouldn’t happen if it comes at great cost to the rest of us in the form of accidents and injuries.

Vast numbers of mortgage loans have been made that won’t ever be repaid. There is an argument that society may be better off if more people are homeowners. But that’s true only if it doesn’t involve great cost to the rest of us. The surfeit of subprime loans made in the last few years resulted from the illusion that the risks of these things could somehow be made managed or diffused. From the standpoint of mortgage loan originators, lending risk seemed to disappear. Since financial engineering made the risks seem to disappear, too many mortgage brokers and bankers apparently thought it would be okay to make enormous amounts of risky and downright lousy loans, especially if they got a lot of fee income in the process. Now, with losses from the subprime mess popping up in unexpected places, we are painfully reminded that risk never dies.

The dollar is declining, and foreign and American capital is gradually shifting into investments denominated in other currencies. This trend can only have been exacerbated by the subprime mess. After all, sudden investment losses, not currency fluctuations or balance of trade deficits, are the root cause of capital flight. The subprime mess has led to losses in the stock market, real estate market, bond market, derivatives market and now the municipal finance market. What’s next? All of these losses make the dollar seem like a lousy bet. The rating agencies are reportedly reviewing a number of bond insurers, and if they downgrade them, zillions of dollars of insured bonds will drop in value. Is there a good dollar-denominated investment still standing? Is it a wonder that capital is buying a ticket on the next plane to anywhere, as long as it’s out of the country?

Risk places stress on the financial system. The more risk that’s created, the greater the levels of stress. The challenge for the banking system and its regulators is to keep risk levels under control. That means constraining the amount of risk that’s created. With blowback from SIVs, guarantees on CDOs, proprietary mortgage-backed investments, LBO commitments, and the like, banks are learning the hard way that you can’t truly shift risk away, not when you create shiploads of it. There are too many interconnections in the financial system. This leads to the horrifying conclusion that, of all things, prudential lending standards will have to be imposed. But we’re living in a horror movie already, as risks that were thought to be long dead pop up out of every closet, attic and basement.

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