John Mauldin talks about the US Mortgage Market

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In an excellent article today on safehaven.com John Mauldin writes about the US mortgage market including how we ran into the subprime problem because of global liquidity and the dubious tactics used to designate subprime mortgage bonds as investment grade. He also talks about the housing market and what home sales data mean for the market in the upcoming months.

This is one of the more illuminating, sweeping articles I have read and encourage you to head on over to read it.

Some interesting tidbits from the article "The US Mortgage Market – Overexposed and Overrated" by John Mauldin. Contact the author at John@FrontlineThoughts.com. (emphasis mine in all instances).

On how the subprime market was fueled by questionable securitization and rating tactics on Wall Street (one of the most illuminating insights in to the RMBS process I have read):

Then the investment bank starts slicing smaller parts of the pool and eventually
ends up with the final 4% getting a below-investment-grade BBB rating. Again,
this is all a good thing as it allows investors to buy the risk they want and
makes for a more liquid real estate market. But then we start to get cute with
alchemy. Not content with turning lead into gold, we start trying to do the
magic on sewage.

Because investment banks then combine all these BBB tranches into yet another
pool called a Collateralized Debt Obligation or CDO. The rating agencies have
sophisticated models which tell them that with the increased diversification,
87% of these former BBB bonds can now be sold as AAA or AA investment-grade
bonds. Only 4% is considered actual BBB debt, and 5% is the "equity" portion.
So we have taken an original security that is not investment-grade and turned
all but less than 9% into an investment-grade bond. Not just lead into gold,
but nuclear waste into gold. Only on Wall Street.

If you ever wondered how or why people decided to lend money to subprime borrowers or where the money all came from this article does an excellent job of explaining the process. It is amazing to me that Wall Street, by slicing and dicing debt, can turn subprime mortgages in to investment-grade bonds.

On foreclosures:

A Wall Street firm reported in May that the foreclosure "shock cone" is widening:
while total foreclosures, at all stages, are up 60-70% over last year so far,
foreclosure notices – the front end of the process, when a mortgage is typically
90 days delinquent – are 127% higher so far than in 2006. It said that foreclosed
homes being resold by banks or lenders are hitting the housing market with
an average price drop of 30% nationally. (EIR)

This is a very important piece of the housing problem that guarantees that there will be problems for the next few years. Foreclosures take a long time to get started and even longer to work their way through the system. It can take near a full year to complete a foreclosure on a property. So while foreclosure data seems high now its only really going to kick in to high gear next year and 2009 when some of the riskiest loans (those written in 2005 and 2006) begin to adjust and people walk away from homes that they can’t afford and have zero equity in.

This idea of the "shock cone" is an excellent way of thinking about how the foreclosure process will spread through the housing market and impact prices for the next few years.