“The Big Short” is a movie that is currently in the theaters and has been nominated for an Academy Award. It very accurately describes what happened during 2006-2008 when the real estate bubble burst sending Lehman Brothers, Bear Stearns, AIG, Fannie Mae, Freddie Mac and many other banks and financial institutions into bankruptcy and/or bailout. It chronicles how a handful of investors and firms figured out that the US federal mortgage system, which was rated triple A and supposedly guaranteed, was about to fail. They shorted the US mortgage market by the use of “credit default swaps,” which are inexpensive insurance contracts on these mortgage pools of securities. As hard as it may be to believe, it’s happening again. Everything is lining up just like it did in 2007 and 2008, but this time it’s going to be worse, and the central banks are not in a position to intervene like they did last time.
Sub-prime mortgages were the catalyst for the 2007- 2008 collapsed real estate market. With the politically correct, but financially foolish, objective of making home mortgages more available to risky borrowers, these mortgages were given to people who couldn’t fully document their income and didn’t qualify for a conventional mortgage. These borrowers had to pay a higher interest rate because they were a greater risk. This in turn attracted investors, who got a much higher yield, but also took a much higher risk to get that yield. History documents this did not work and everybody involved lost money. The home owners defaulted on their loans and lost their homes, the investors and investment firms who invested in these supposed triple A mortgages lost their money, and the banks and Fannie Mae & Freddie Mac, would have defaulted had they not been bailed out by the US government with tax payer dollars.
All of this helped fuel a tidal wave of defaults during the housing crisis, and these types of mortgages subsequently fell out of favor. These sub-prime loans (also known as Alt-A loans or low-doc loans), gained prominence in the years leading up to the financial crisis, with lenders originating $400 billion at their peak in 2006, according to trade publication Inside Mortgage Finance. The Wall Street Journal reported that Wall Street firms want to bring back the low-doc loans, because investors are searching for a high yield in a low interest rate environment, so prominent investment firms like PIMCO, Neuberger & Berman, Legg Mason and others are once again pooling these high risk loans together to create high yields for their clients. The question everyone should be asking is: Why are we doing this again and why do these investment companies think they can manage the risk any better than Bear Stearns or Lehman Brothers could?
The other half of the equation that contributed to the 2007 real estate crisis was the lax standards of Fannie Mae & Freddie Mac, and their “too big to fail” attitude. The Wall Street Journal reported, Fannie and Freddie and their regulators just completed changes that will allow them to make loans cheaper and easier for risky borrowers. Fannie Mae and Freddie Mac said Feb 2nd that they have come to terms with lenders on how to resolve mortgage disputes, capping an effort that regulators hope will make loans cheaper and easier to get for some risky borrowers.
As the US high yield/junk bond market has tanked, investment companies are looking for alternatives for their yield hungry clients. So in addition to the above changes, they have become even more inventive. A group of hedge funds, convinced they have found the next Big Short, are looking to bet against bonds backed by sub-prime auto loans. Currently, cars are being sold to almost anyone who can breathe and sign their name, so investment companies again are pooling these high risk/sub-prime auto loans together and selling them to their clients. “Too many borrowers are likely driving away with cars they can’t afford,” said Janet Tavakoli, president and founder of Tavakoli Structured Finance. Tavakoli sounded alarms about the mortgage bubble before the 2008 collapse. (Bloomberg)