The future of mortgage backed securitisation lies within the technology embedded in the tba and bond markets and the institutions governing the debt markets. The interest rates are determined by the market, based on risk adjusted expected return. The pricing of the risk, is at the core of the Great Recession. During the boom, the interest investors charged was not sufficient to cover the risk they were taking-hence mispricing of all forms of credit eventually led to the collapse of the bond markets. This occurred as investors experienced defaults on home mortgages in boom markets.
When house prices decline, borrowers can no longer sell their house in the event of an income shock. Subprime mortgages, option arms, 2/28s and exotic products were originally created to supply credit in predominantly low income areas, operating as a low cost alternative to the FHA. These products were used as 'structured finance' for borrowers who had every intention of selling the house for a profit. Responsible subprime lending fills a need, analogous to the way FHA operates in the market. However, creative financing also helped stimulate demand (feedback loop), as the prices rose - a psychological melt up from the positive feedback in house price appreciation.
Globalised bond markets' growing desire for yield pushed the race further and further to the bottom -in terms of risk adjusted returns. Competition from Wall Street fueled the securitisation machine . As supply of homes exceeded the demand, house prices naturally fell. When the bond markets recognized the risk they were holding, a swift psychological shift led to the downward spiral, exacerbated by credit default swaps and high leverage. High leverage- margin calls beget more margin calls- forced selling on the way down. The dramatic psychological shift in the market is also known as the liquidity run. Institutions were afraid to lend to other institutions. The market pendulum now demanded too much interest to compensate for the mark-to-market losses. Credit froze.
When a hurricane hits Florida or Louisiana, a governor calls a state of emergency to solicit Federal funding. Citi, Bank of America, MS, Wachovia, were all essentially insolvent. They needed 'everyone' to take fresh capital to instill confidence in the system (TBTF). The market recognized the Fed and U.S. Treasury were willing to do whatever it took to save the Financial System. Stress tests, the Fed, the Treasury, the FDIC all acted as an insurance mechanism in the event as failure--government as lender of last resort. The market became more about psychology and theoretical perceived capital, such as in human resources and in the political system. The political capital, is the sum of the capital provided by the market, plus all faith and credit in the political system.
When house prices decline, borrowers can no longer sell their house in the event of an income shock. Subprime mortgages, option arms, 2/28s and exotic products were originally created to supply credit in predominantly low income areas, operating as a low cost alternative to the FHA. These products were used as 'structured finance' for borrowers who had every intention of selling the house for a profit. Responsible subprime lending fills a need, analogous to the way FHA operates in the market. However, creative financing also helped stimulate demand (feedback loop), as the prices rose - a psychological melt up from the positive feedback in house price appreciation.
Globalised bond markets' growing desire for yield pushed the race further and further to the bottom -in terms of risk adjusted returns. Competition from Wall Street fueled the securitisation machine . As supply of homes exceeded the demand, house prices naturally fell. When the bond markets recognized the risk they were holding, a swift psychological shift led to the downward spiral, exacerbated by credit default swaps and high leverage. High leverage- margin calls beget more margin calls- forced selling on the way down. The dramatic psychological shift in the market is also known as the liquidity run. Institutions were afraid to lend to other institutions. The market pendulum now demanded too much interest to compensate for the mark-to-market losses. Credit froze.
When a hurricane hits Florida or Louisiana, a governor calls a state of emergency to solicit Federal funding. Citi, Bank of America, MS, Wachovia, were all essentially insolvent. They needed 'everyone' to take fresh capital to instill confidence in the system (TBTF). The market recognized the Fed and U.S. Treasury were willing to do whatever it took to save the Financial System. Stress tests, the Fed, the Treasury, the FDIC all acted as an insurance mechanism in the event as failure--government as lender of last resort. The market became more about psychology and theoretical perceived capital, such as in human resources and in the political system. The political capital, is the sum of the capital provided by the market, plus all faith and credit in the political system.
