Risk Managing securitized mortgages

Risk Managing derivatives and securitized mortgages
Our views:
The US housing sector started facing problems way back in the eighties . Thousands of housing mortgages faced foreclosures due to inability of the borrower to repay the loans. Many of the smaller Banks who had financed the loans reported liquidity problems and hundreds failed especially in the manufacturing belts where the housing and real estate sector had boomed due to great demand in the seventies. The Federal Insurer “FDIC” report stated that around 10% of US Bank failed in a 10 year period 1985-1994 terming it the worst in the post war US history. The housing mortgage defaults were posing a major risk for the banks.

How was the risk to the Banking industry mitigated? The financial wizards who had long seen the failure of conventional methods to mitigate risk , devised a radically new derivative called the “credit default swap” to raise the valuation of the mortgages. They argued that if the market value of the security was up, the fact that some of the mortgages were not paid for and foreclosed would not matter. The Bank would benefit from the market value of the derivative more than the loss due to unpaid mortgages. Hence the housing mortgages were bunched together and the combined value of such bundles were priced on the basis of their future projected earnings and the derivative found its way to the markets.

At that point of time very few understood the complex derivative and not many challenged its introduction other than the legendary investor Warren Buffet. Buffet rightly predicted that the mortgage risk would mutate and grow and derided derivatives as the financial weapon of mass destruction. However by the time his warning came the market took a fancy to Wall Street’s innovative instrument the newly packaged security that could be sold to the investor at fancy prices. The bull run had begun.

Such was the bull run during the 2002-2005 period that the financial bigwigs were swamped with demand and began issuing the derivatives without even having time to do the background paperwork for the securitization. Such was the rush for profits, that these “credit default swap” derivatives during that period, were issued by the Wall Street biggies even before closely assessing the actual positions they held. When things got out of control Tim Geithner, then with the Federal Reserve pressed the top 15 financial firms who were issuing the derivatives to build an electronic network for recording of these instruments which was completed only by the third quarter of 2006. By then the damage was done. The market values had spiralled out of control and the price of both the securities as well as real estate surged beyond expectations.
By then, some financial institutions were already reporting problems about the subprime mortgages underlying these high priced securities. AIG's Financial Products unit, one of the largest issuers of credit-default swaps, stopped offering that insurance, and few others followed suit. Thus instead of becoming a risk distribution & risk management vehicle the “credit default swap” securities became a potential risk themselves triggering initial speculation and collapse of the markets thereafter.

We could be wrong. Tell us if we are & why? We encourage diverse opinion even if it is from commercially interested groups opposed to our thinking.