KMRC, a mortgage facility company, has been formed to facilitate the financing of Uhuru’s affordable housing plans. Among others, it will issue Mortgage Backed Assets in the Kenya capital markets. This is a laudable initiative that will deepen the capital markets. But Alas! Securitized mortgages contributed to global financial crisis. There is therefore need to learn from history, to prevent hubris, to get crediting ratings right, and to formulate efficient regulations.

By g.j

I will own a house, won’t I?

The Kenya Mortgage Refinancing Company (KMRC) has been formed to ensure affordable housing in Kenya. One of the thing KMRC is tasked to do, is issue mortgage backed securities. This is an off balance sheet financing effected by way of securitization of mortgages into mortgage-backed securities.

There is need to remember that these instruments played in the global financial crisis of 07/08. It would be helpful for KMRC and the National Treasury to review the preludes of this crisis in relation to the real estate. This way, as the country strives for affordable housing, it is done well, and a seed for a housing bubble is not planted.

2. Apres moi, la deluge

We take a refresher on the housing bubble and financial crisis. Freddie Mac and Fannie Mae, a United States equivalent of KMRC, supported the issuance of sub-prime mortgages. The investment banks, such as Merryl Lynch, Bear Stearns and Lehmann Brothers, as well as commercial banks and thrifts such as City Bank, Wells Fargo and Washington Mutual had packaged a large proportion of home loans and sold them off in bulk to securitization firms.

These firms would package the loans into mortgage-backed securities. Credit rating agencies would determine the riskiness of self-securities before they were sold to investors. In multiple instances, the securities were repackaged again into collateralized debt obligations to be sold to other investors.

These were often made up of the cheap and riskier proportions of the mortgage-backed securities. The pooling of such loans or mortgages is not necessarily a bad thing, because if executed successfully, this process can aid in diversifying risk when the risk of each loan are uncorrelated.

In the United States, economists thought that property markets in different American cities would rise and fall independently of one another. This means the mortgages themselves were not in any way linked to one another. The mispricing of risk also played a major role in the development of the global financial crisis.

3. Damn, the credit raters

The credit rating agencies were integral to the financial crisis. It is why Kenyan banks must be careful when Fitch, Standard & Poor, or Moody, announces their downgrades or otherwise. Credit rating agencies are institutions that rate a debtor’s ability to repay debt and determine the likelihood of default.

Essentially, ratings agencies exist to provide the markets with an estimate for debtor’s riskiness or credit worthiness by assigning each of these entities a credit rating. In the United States, because mortgage-backed securities and collateralized debt obligations were more complex and difficult to price than individual loans, investors often relied on ratings issued by these credit ratings agencies.

A significant portion of mortgage-related securities were given triple A ratings between 2000 and 2007. Any security assigned this rating is considered to be very safe. And as a result, when investors purchased tranches with high ratings, the investment was perceived to be safer because investor trusted the credit ratings agencies.

4. Waiter, serve me a CDO

By securitizing mortgages, lenders were shifting the risk of borrowers defaulting to the investors who were purchasing the securities. Given that investors were taking on the risk of default, they took out insurance on their mortgage-backed securities, called Credit Default Swaps, CDSs.

A Credit Default Swap is an insurance agreement whereby the issuer of the CDS agrees to compensate the investor if a credit event occurs. Credit event is a default, bankruptcy or any other situation which is recognized as affecting the creditworthiness of the borrower.

By way of an illustration, where an investor purchases a mortgage-backed security and the CDS, in the event that the mortgage is underlying the security default, this is considered a credit event.

And therefore, the insurance would have to pay out, compensating the investor for the loss of value associated with the default. CDS instruments were sold by many insurance companies, most notably the American International Group, AIG.

So, there were favorable ratings. With the fact that derivatives were backed by both real estate and insurance; it fueled demand for these instruments. Pension funds, banks, hedge funds and even individual investors purchased these products.

To meet the increasing demand, banks and mortgage brokers offered more loans. Banks that originated loans were able to extend even more loans using the funds generated from selling off mortgages to securitization firms. And given that the bank in effect sold the mortgage, it was able to extend new loans with the money that it received.

5. Things fall apart

More mortgages led to higher house prices. Banks had less incentive to monitor the quality of the loans they were extending, because none of them were kept on their balance sheets.

These developments were fueled in a low interest rate environment. This created an incentive for investors, including banks and hedge funds, to seek assets that offered relatively high returns.

Investors were attracted to these securitized products because they appeared to be safe by providing relatively higher returns in a low interest rate environment. The low interest rates made it attractive for market participants to borrow money to amplify their investments, which turned out to be a lucrative strategy to generate returns in excess of the cost of borrowing.

These mortgage-related securities were packaged, re-packaged and sold to investors around the world. And trillions of dollars in risky mortgages were embedded throughout the global financial system.

Lower interest rates work their way into the economy, and the number of homes sold as well as the prices they sold for increased dramatically, starting in 2002. At the same time the interest rate on a 30 year fixed rate mortgage was the lowest level seen in the prior four decade.

So the vulnerabilities that created the potential for the crisis were already building up in the years prior to it. But the actual crisis of 2008 was caused by the collapse of the housing bubble.

6. Waiting for Godot: Where is Ben Bernake?

The housing bubble was driven by low interest rates, accessible credit, limited regulation, and risky mortgages. This ignited a string of events, which led to a full blown crisis towards the end of 2008.

The demand for mortgages drove up demand for housing which home bidders tried to meet. With cheap loans available several people purchased real estate as investments. Investors assumed that property prices would rise and that they could later sell this property for profit.

But in 2004 the Federal Reserve started raising interest rates. By the end of 2004 the Feds Fund Rate, the Fed main policy instrument, was at 2.25%. By June 2006 it had increased to 5.25%. Because most of these mortgages had their rates adjusted periodically the cost of payments increased.

And many of the subprime borrowers were left with loans they could not afford. Ultimately, property owners were faced with payments they couldn’t afford. Defaults on mortgages increased and multiple properties foreclosed. The supply shop that followed in the real estate market caused housing prices to drop by roughly 4% between October 2005 and 2007.

This price decrease was so severe that it even made more sense for subprime borrowers to hold onto the homes they could no longer afford. The collapse of house prices and the slowdown in subprime lending that followed resulted in many financial institutions facing huge losses.

These losses in turn led to tighter credit conditions. And in early 2007 some mortgage lenders reported that they had stopped funding mortgages and accepting applications. While other larger subprime lenders reported larger than expected mortgage credit losses.

The repo market, the market for short-term borrowing, also faced difficulties at this stage. So institutions that relied on short-term funding through commercial paper and other unsecured short-term debt instruments began to face difficulties.

Investors became unwilling to fund them. On top of this, repo lenders became less willing to accept subprime mortgages or mortgage backed securities as collateral. Amid all this uncertainty, mortgage related securities became less liquid and, importantly, more difficult to value.

7. The tribulations of brother Bear Stearns

Bear Stearns, an investment bank, was one of the first major financial institutions to run into existential trouble. This was caused by two hedge funds. The High-Grade Structured Credit Strategies Fund launched in 2003. And the High-Grade Structured Credit Strategies Enhanced Leverage Fund launched in 2006.

These funds purchased mostly high rate mortgage spec securities or collateralized debt obligations. By borrowing in the repo market using high rate of transfers of collateralized stock debt obligations as collateral these funds used leverage to increase their returns. Bear Stearns asset management not only purchased CDOs, but also created and managed other CDOs.

The funds were popular and earned high returns between 2004 and 2006. However, they inevitably ran into trouble when the house prices started to fall and the value of mortgage backed securities was no longer clear. Bear Stearns’ strategy of relying on short-term leverage to finance their activities amplified their losses.

8. Things fall apart, the center cannot hold 

This led to the failure of both funds in June 2007, after which they filed for bankruptcy. When the Fed discussed the implications of this collapse they called Bear Stearns relatively unique. Several other funds were exposed to the same risks as those hedge funds, but they did not experience the same fate or scrutiny.

When credit rating agencies eventually issued comprehensive rating downgrades and credit watch warnings on a range of mortgage backed securities, investors panicked, fearing more downgrades would follow.

These downgrades, together with the problems faced by the Bear Stearns hedge funds, impacted the market significantly. Market prices fell quickly for two reasons. Firstly, repo lenders refused to take mortgage backed securities as collateral. And secondly, borrowers wanted to sell assets as quickly as possible to meet margin costs.

9. The Americanah lesson

Therefore, as KMRC will be collateralizing the mortgages, our financial markets have entered an advanced stage. We must learn from history, to avoid repeating it.  We must do it right.