by Calculated Risk on 8/20/2005 10:53:00 PM

The Los Angeles Times reports: Wall St. Waits to See What Will Be Repaid

The financial services industry has made it possible for millions of Americans to stop thinking, "I can't afford that."

Now, Wall Street is beginning to wonder how many people really couldn't afford what they bought in recent years on incredibly cheap credit.

One-percent mortgage loans, zero-percent car loans, home-equity loans for more than what your property is worth — all of this has been the cushy financial reality for U.S. consumers in this decade. No house, car or vacation has been out of reach, thanks to a network of eager lenders and the global army of investors who've supplied them with capital at rock-bottom rates.

In the midst of any wild party, however, some people do things they later come to regret. And while talk of a housing bubble has been incessant over the last year, only now are the money handlers on Wall Street beginning to worry about payback — that is, how much of the credit extended in this borrowing extravaganza won't be paid back.
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Home mortgage and equity line-of-credit debt has swelled from $4.8 trillion at the end of 2000 to nearly $8 trillion now. And behind every borrower there's a lender.

Which raises the question: How fast will investors in financial company stocks and in mortgage-backed bonds rush to sell, if they begin to sense that a wave of loan defaults is inevitable?

Richard X. Bove, a veteran banking industry analyst at the firm of Punk, Ziegel & Co. in New York, last week sent clients a research report with a chilling title: "This Powder Keg is Going to Blow."
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The biggest threat of upheaval is in the mortgage-backed securities market itself.

That market, worth nearly $4 trillion, has provided much of the capital for the housing boom. Instead of holding on to the loans they make, many lenders package them and sell them to investors worldwide via mortgage-backed bonds. The bond owners get the loan interest and principal passed through to them.

The genius of the mortgage-backed securities market is how it has been sliced and diced by investment bankers. There's a piece of a mortgage to match every investor's need — long-term and short-term paper, high yield and lower yield, insured and uninsured.

But the increasing complexity of the securities also raises the risk that some investors will feel they can't be sure exactly what they're holding, particularly in the case of bonds backed by the new wave of adjustable-rate mortgage loans. If investors begin to worry that they won't be repaid, their rush for the exits could be thunderous.

"Securitization shifts risks from banks to other investors, but this does not necessarily mean less systemic risk [to the economy and markets] because we don't know how these relatively new market participants will react in a declining market," Joseph Abate, a senior economist at brokerage Lehman Bros., said in a report to clients Friday.

Food for thought (or concern). If investors pull back, yields will rise and a housing decline will be a self-fulfilling prophecy. But where will those investors move their money? Ten year treasuries yielding 4.2%?