You’d think Wall Street would have learned its lesson…
But nearly a decade after the last financial crash of 2007–2008, the hunger for risky mortgages is back.
Earlier this month, $210 million worth of bonds stuffed with risky mortgages were given a AAA rating. It’s one of the first times since the banking crisis that such a product has been awarded a prime grade.
If this sounds eerily familiar, it’s because it is.
These very same financial products – junk mortgage bonds with an irresponsible rating – were part of what triggered the 2008 crash.
The new bonds in question are backed by “unqualified” mortgages. These are loans secured with a simple bank statement. No tax returns. Very little vetting.
Even Moody’s – the ratings firm that stubbornly held riskier, also known as subprime, mortgage bonds at AAA before the crash – considers this type of loans risky.
Yet the mortgages are now finding their way into AAA bonds. Which means they could soon be in your pension pot and other retirement savings.
The message is simple. Wall Street is quietly opening the door to risky mortgages again.
The parallels to 2008 here are scary. Let’s take a look at mortgage-backed bonds in a little more detail to explain why.
The basic premise behind these financial products is fairly straightforward. Banks take thousands of mortgages and wrap them up into a bond package. Investors purchase the bond and receive a profit from the mortgage payments. Since most people pay their mortgage predictably and regularly, it’s (theoretically) a safe investment.
So safe, in fact, the bonds were given AAA ratings before the crash. Because they kicked out a higher yield than Treasury bonds, they were bought by pension funds, mutual funds, and even governments.
Of course, the bonds are safe only if homeowners pay their mortgages.
The problems started when banks began stuffing these bonds with subprime mortgages.
Subprime mortgages were handed out to those with poor credit and even those without an income, job, or assets. This was known as a NINJA (no income, no job, and no assets) mortgage.
With low interest rates and soaring house prices, it was assumed that borrowers could pay back the loans easily. So the AAA ratings stuck.
Of course we all know what happened next. Interest rates began to rise, putting pressure on repayments. House prices slowed, and the defaults began.
Those AAA bonds were now filled with failing mortgages. They were worth peanuts, dragging down the value of pension and mutual funds. The domino effect kicked in and carved out the recession.
Bottom line: There were two major catalysts for the 2008 crash. Number one, a willingness to lend to those who couldn’t afford it. Number two, false ratings of financial packages that were basically junk.
Flash forward to 2016 and both these factors are back. Risky mortgages and questionable ratings have returned.
Despite new rules and regulations to deter risky lending, “unqualified” loans are sold to borrowers who simply “state” their income.
The two ratings firms at the center of this fiasco are DBRS, Inc., and Fitch Ratings, and this isn’t the first time they’ve rated risky bonds. DBRS, for example, has rated bonds with unqualified mortgages as high as A.
Both the ratings firms and the lenders have been quick to defend themselves, maintaining that the mortgages are at a prime level. Fitch, for example, claims the average credit score of the mortgage borrowers is 712.
The lenders, which include Sterling Bank & Trust, Lone Star Funds, and Lendsure Mortgage Corp, explain that these “unqualified” mortgages are typical. They regularly approve mortgages, they say, to those who cannot prove regular income. This could be business owners, for example.
This may well be true, but it looks like a slippery slope to us.
It means lenders are increasingly skipping their steps of due diligence. They’re approving mortgages without full documentation or full confidence in repayment.
Worse, Wall Street is merrily packaging these risky loans into new bonds. And ratings companies are giving them a seal of approval.
The Slippery Slope
Don’t get us wrong. There isn’t another housing collapse right around the corner. But the dominoes are lining up in the same place.
And if you think no one is crazy enough to buy these bonds, think again.
The world’s largest asset manager, Black Rock, recently launched a European exchange traded fund (ETF) that tracks US mortgage-backed securities. They are pouring money into AAA bonds that now contain risky, unqualified mortgages.
Worse, with Trump in the White House, we may see lenders unshackled yet further. He has vowed to dismantle the restrictions on banks. We may see many, many more unqualified mortgages emerging yet. And many more AAA bonds filled with them.
Lastly, the Fed has tentatively begun raising interest rates. Of course this won’t have an immediate impact on mortgage rates. However, what happens when mortgage rates do catch up?
What happens when that 4% repayment turns into, say, 8%, and borrowers can’t afford the repayments? What happens when homeowners start defaulting and the bond yields dry up?
We can’t help but think of the following quote, often attributed to Einstein:
“Insanity is doing the same thing over and over again and expecting different results.”
The same wheels are in motion. Can we really expect a different result?
Many investors and savers aren’t waiting around to see what happens next. They already lived through it once. They know the smart thing to do is take control of their own money.
Start a self-directed IRA and have a say over what assets make it into your pension pot. Purchase a store of gold that cannot be manipulated. Or go overseas where lenders are held to higher standards.
Of course, we may get lucky. Things may take a different turn. One can always hope. But as Einstein implied, it would be insane to expect a different outcome.