One of the great mysteries facing the market is whether the so-called “toxic assets” held by banks could really be worth as little as the markets are valuing them.
The market outlook for many mortgage-backed securities is bleak. The benchmark index of the market for securities backed by home loans shows that the top-rated mortgage-backed securities from 2007 are valued at only about 23% of their original value. Riskier securities with lower ratings are valued at less than 3% of their value.
Those kinds of losses are so extreme that some people wonder whether the market has become irrationally afraid of mortgage-backed securities. Others believe that a lack of financing for those interested in buying the securities is leading to a dearth of liquidity. Some combination of these views is held by the Obama administration. Indeed, they inform the core of the administration’s plans to reinvigorate the market by providing government financing for public-private partnerships.
At a very basic level, people want to know how these assets based on financing for housing could be worth so little. After all, houses are still worth something, right? So the assets must still be worth something.
Unfortunately, the market may not be as irrational as the Obama administration assumes, the problem may not be illiquidity and, because of the way mortgage bonds were structured, many of the assets really may be worth as little as the market believes.
The vast majority of home equity loan mortgage-backed securities issued between 2005 and 2008 were backed by sub-prime mortgages. Banks took thousands of mortgages and packaged them as mortgage bonds that were divided into tranches according to how safe they were. Typically, about 25% of these deals were subordinated bonds and the remaining 75% were AAA-rated senior bonds.
What makes the senior bonds safer is that they get paid first. The subordinated bonds only get paid if all the payments due to the tranches above them are made. Think of structured debt as a fountain of champagne glasses. When the champagne is flowing freely, the glasses all the way down to the bottom get filled. If the supply of champagne slows up, however, only the top glasses get filled.
Right now, mortgage-backed bonds from the boom years have realized losses of around five to eight percent of their original balances, according to mortgage market insiders. Serious delinquencies, when payments are overdue by 90 days, amount to 35 to 45% of the current balance of the deals. This means there is less champagne flowing into the fountain. Due to declines in housing prices, even foreclosures aren’t returning the expected amount.
Added together, these results can be catastrophic for the higher risk bonds. The champagne glasses at the bottom of the fountain just don’t get filled. And that’s how you get to a mortgage-backed security worth just 3% of its original value.
In short, just because most people keep paying off their mortgages, we can’t be confident that many bonds built on mortgages will not be worthless. Thanks to Wall Street’s structured finance practices, things just aren’t that easy.