Under Water

Securitization of mortgage loans has fueled a US housing bubble whose bursting has put one in four mortgages under water.

Andrew Lunsford, a retired state trooper who works for an insurance company, put 20% down when he bought his home in Las Vegas for $530,000 in 2004. Now (2009) his home was worth less than $300,000.

His home mortgage is said to be “under water”. In other words, he owes his bank (i.e., $530,000*80% = $424,000) more money than his home is worth ($300,000). If he could sell his home, he still owes the bank $124,000 (i.e., $424,000 - $300,000 = $124,000). He has in effect negative equity in his home that he has owned for 5 years. In a normal healthy housing market where housing prices increase 2% to 3% a year, he would have accumulated positive equity equal to his down payment plus 5 years’ worth of home price appreciation.

Through no fault of his own, Lunsford is caught in a housing bubble fueled by artificially inflated housing demand from subprime mortgage loans. Subprime mortgage loans refer to those loans where the borrowers normally would not have enough down payments or income to qualify for a loan. Responsible lenders normally would not grant loans to these borrowers for fear of being stuck with loan defaults.

But if these loans could be sold off to other investors at a profit, then lenders are tempted to be less careful in making subprime loans. Indeed, mortgage lenders could shift these subprime mortgage loan risk through the process of securitization.

Securitization involves pooling financial assets with a stream of cash flow and issuing new securities (i.e., coupon-yielding bonds) of smaller denominations backed by these assets. These asset-backed bonds are rated according to the default risk of the underlying assets with riskier bonds carrying higher yields.

The process creates liquidity by enabling once portfolio lenders to tap funding from the global capital market. Mortgages provided a large asset pool for such securitization. In retrospect, the risk of these mortgage-backed bonds was poorly understood even by the bond rating agencies. They were tempted to over-rate risky assets to keep their bond-issuing clients who pay their bills happy. To convince investors to buy these mortgage-backed bonds, investors could insure these bonds by buying default insurance on them. These unregulated insurance contracts are known as credit default swaps (CDS). Many issuers were too happy to sell these contracts just to earn issuing fees and the insurance premiums.

By tapping into a seemingly inexhaustible global funding source*, mortgage-backed securitization has fueled the US housing bubble. Borrowers who otherwise could not afford a mortgage were enticed into buying homes and more expensive homes than they could afford.

For a while, this bubble seemed to have no end in sight. But the need to create more mortgages to issue more mortgage-backed bonds sowed seeds of its own destruction.**

Mortgage defaults and foreclosures have driven home prices down by more than 20% in once hot housing markets. That is why Lunsford’s home is under water and his home equity was wiped out.

In the third quarter of 2009, the proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23% (about 10.7 million households), threatening prospects for a sustained housing recovery.