Abaci's Common Sense Investing

The subject has attracted so much attention and press coverage that I almost felt guilty not to write something about it. However I'd not repeat what you probably have heard but instead fill-in a few details which I hope will help you understand the situation better.

The mortgage market in the US is the most advanced in the world and it's long evolved from a pure lending market, where banks and homeowners are the participants, into a free-flowing capital market where everyone can be a part of it, be it commercial banks, investment banks, mutual funds, pension funds, wholesale and retail investors. For this day we have the US academics to thank, who came up with the exotic math to tackle all kinds of uncertainties in this world, and property market is only one area of application.

Anyone who'd want to know more about the inner-workings of the mortgage market, but not too much technical details, can read Liar's Poker by Michael Lewis. It's a hilarious story about the daily life of a group of greedy and over-aggressive mortgage bond traders. The fictional story took place in the 80s but I don't think things have changed much since, other than that there are now more exotic products.

Like HSBC management has explained, Household Finance was too eager to lend to sub-prime borrowers as, like everyone else, they thought they could always securitize and sell those mortgages to others. Nobody was expecting to hold the mortgage for long, in spite of its higher interest. They all aimed for making capital profit, i.e. lend/buy mortgages at say 10% and then securitize and sell for 8% (similar to what HK developers did with REIT to get rid of its rental properties). After the mortgages have been sold the process repeats itself, like a wholeseller selling and restocking. If they 'turnover' the mortgage book often enough they'd sure make big bucks in the end of the year. Mortgages have become a merchandise, a hot one indeed with the rising and buoyant housing market. The overall market grew by the day and that attracted more liquidity. Of course, the low interest cost environment throughout the world also added fuel to the campfire.

Once a big enough pool of mortgages is obtained, you can slice it anyway you want and start selling, as far as your imagination can go. It can be done by location, e.g. Westcoast, Silicon Valley, or even beachfront (my wild guess); by average maturity, e.g. 5 years, 10 years, 20 years; by timing of cashflow, e.g. interest only (IO) which a holder only receives interest throughout, and principal only (PO) which works like a zero coupon bond; by level of credit protection which works sort of like preferred and common shares (higher class bondholders have priority over lower class bondholders in receiving interest). Closer to present there's a new market for credit derivatives where insurers underwrite default risk for a fee and then, guess what, further securitize those policies, bringing in yet more investors. In nice words it's said mortgage securitization allows every John Dole to participate in the growth of the US housing market, and in investment opportunities that didn't exist before, and that all the different varieties merely reflect investors' needs and tastes. Most importantly, the originators should be rewarded for their ingenuity. Soon came the convenient disregard for the classic listing question: 'should' the issue be floated as opposed to 'can' the issue be floated.

With the mortgage market functioning much like a stock market, it's no surprise there will be extended bull and bear runs. Obviously now is a bear market where liquidity has dried up and sellers/lenders are fighting for the nearest exit. And probably some witty traders, if their hands are not burnt yet, are trying ways to further 'short' the market knowing most participants don't have the capital to defend their positions. This will cause an oversold market which don't reflect longer term fundamentals.

What are the fundamentals?

A property market dropping by say 15-20% can result in many negative equity homes and many more near worthless bonds, but these don't necessarily lead to massive default, just like a listed company can go by its business without minding its share price. The key factor remains repayment ability. How fragile are the sub-prime borrowers? Are there more property-flippers or those making lower but honest income? Is the job economy gonna be affected eventually? These are all important considerations, and there are many more, but my lack of timely knowledge of the state of US market has precluded me from writing further.