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Mortgage menace and more...

May 9, 2008

Shelter providers run for cover
The results declared by some of the largest mortgage lending companies in India (particularly HDFC) did not signal any alarming slowdown in the demand for home loan, nor has there been any perceptible damage to the financials of these companies. This is notwithstanding the fact that real estate prices in some pockets have certainly seen some cool off. The same, however, does not hold true in the case of their US counterparts.

  • Read our view on HDFC

    At a time when prices of housing units in the US are finding it difficult to seek stability, the regulators, administration officials and lawmakers are looking at two giant mortgage companies - Fannie Mae and Freddie Mac - to keep the housing market afloat. Further, with most 'non-housing finance companies' that had crowded up this space over the last couple of years, now abandoning the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80% of all mortgages bought by investors in the first quarter of 2008. That is more than double their market share in 2006. These companies, which were formed by government but are currently owned by investors, suffered more than US$ 9 bn in mortgage-related losses in 2007, and the same is expected to multiply this year.

    It must be noted that both Fannie Mae and Freddie Mac do not lend directly to house buyers. Rather, they buy mortgages from banks and other lenders, and thereby provide fresh capital for home loans. The companies keep some of the mortgages they buy, hoping to profit from them, and sell the rest to investors with a guarantee to pay off the loan if the borrower defaults. However, if Fannie Mae or Freddie Mac were to fail, the pinch on the US taxpayers pockets would be much harder that that witnessed in the Bear Stearns' case.

    Because of the widespread perception that the government would intervene if either company failed, they can borrow money at lower interest rates than their competitors. As a result, they have earned enormous profits in the last decade and handsomely rewarded their shareholders (from 1995 to 2005 each company's stock grew more than 500%).

    But as per Economist, with mortgage defaults and foreclosures rising, their combined cushion of US$ 83 bn, the capital that their regulator requires them to hold, underpins a colossal US$ 5 trillion in debt and other financial commitments. Given this, the health of the strongest mortgage providers in the US seems to be in the dire need of the 'Fed pill'.

    The hazard of innovation...
    Innovation can be good, unless adapted without foreseeing the downsides. The same can be said about the innovations in the global financial markets that are now opening up a can of worms. Use of innovative credit instruments and complex layering of risk diffusion have reduced information costs, but at the same time they have also forced the investor or risk taker to become progressively remote from the ultimate borrowers where the actual risks reside. With a host of intermediaries in the form of mortgage brokers, special investment vehicles (SIVs) and hedge funds, the identification and location of risks in the whole chain is becoming increasingly challenging. According to the IMF's estimates, potential losses to banks from exposure to the US sub-prime mortgage market and from related structured securities, could be of the order of US$ 440 bn to US$ 510 bn, which would put significant pressure on the capital adequacy (CAR) of the US and European banks.

    Further, the inability to judge the risks on the innovated products has also brought the role of rating agencies under scrutiny. The issues such as small number of rating agencies and the possible conflict of interest clearly suggest that the reliance only on rating agencies for risk assessment needs to be avoided.

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