Thursday, September 22, 2005

offshoring risk

another mechanism by which american leadership on the global stage is gaining, not shrinking. the world finances US growth in the same way that the US finances NY growth, enabling wealth concentration for the latter. the fundamental human trait involved is envy, which through time has been the most useful evolutionary adaptation to compel organisms to seek greater fitness. envy is often confused for greed.

Mortgage Risk: a Hot Export --- What if Home Loans Blow Up? Much of the Pain's Been Sent Overseas By James R. Hagerty and Ruth Simon

WHEN THE AMERICAN housing boom winds down, some of the first howls of pain are likely to be heard in Europe and Asia.
That is because investment banks have been moving more of the risk of defaults on home mortgages to foreign investors, leaving less with U.S. lenders and investors.
This change comes amid concern among U.S. bank regulators about frothy house prices and about lenders' heavy promotion of loans that allow borrowers to afford pricier homes by delaying repayments of principal. The offshoring of such risk also comes as Fannie Mae and Freddie Mac -- formerly the main holders of credit risk in the U.S. mortgage market -- are playing a smaller role in that area.
Lenders wrap home loans into securities known as mortgage bonds, and foreign investors are gobbling up some of the riskiest ones, says Daniel Ivascyn, a portfolio manager at Pacific Investment Management Co., or Pimco, even as "many sophisticated investors at home" shy away from the riskier types of these bonds.
The vehicle for this shift of risk is the fast-expanding market for collateralized debt obligations, or CDOs, pools of debt instruments that are a rich source of fees for investment banks and money managers. CDOs are investment vehicles created by investment banks and others that sell equity and debt to investors. The proceeds are used to buy an array of bonds and other fixed-income assets. More and more CDOs are being created to buy U.S. mortgage-backed securities and other types of asset-backed securities.
Issuance of this type of CDO in this year's first seven months totaled about $35 billion, compared with $49.7 billion for all of 2004 and $23.1 billion in 2003, according to Bear, Stearns & Co.
Gyan Sinha, a senior managing director at Bear Stearns, says CDOs are an easy way for foreign insurers, pension funds and others to put money into the vast U.S. mortgage market. CDOs wrap a variety of mortgage securities into one package, sparing the investor from having to research each individual security.
CDOs, in turn, are the biggest buyers of the riskier types of mortgage securities, Pimco's Mr. Ivascyn says. If defaults reduce the amount of cash available to pay holders of a mortgage-bond issue, the holders of the lower-rated, higher-risk portions absorb losses before holders of the investment-grade portions suffer.
Mortgage defaults have been exceptionally low in recent years largely because soaring house prices allow borrowers who get into trouble to refinance or sell their homes easily. But defaults are likely to surge when the housing market cools.
French insurer AXA SA is among the major European investors betting that U.S. mortgages will continue to perform well in the long term. Alexandre Martin-Min, head of CDO investments at AXA's fund-management arm, acknowledges the risks in the U.S. housing market. But, he says, when some investors are scared by such risks, opportunities arise for those who believe that the yields more than compensate for the perils.
Mr. Martin-Min says he invests only in CDOs managed by experts he knows personally and trusts. AXA, he says, frequently invests in CDOs managed by Ellington Capital Management of Greenwich, Conn., and BlackRock Inc., a New York fund manager.
Some CDOs and hedge funds are using insurance-like products known as credit-default swaps to bet on how high mortgage defaults may climb. Sellers of default protection under these swap contracts collect fees for agreeing to compensate buyers of the protection if defaults reduce the value of a certain mortgage bond. Credit-default swaps have been a common form of insurance for corporate bonds for years. Now dealers are making them available on mortgage securities.
CDOs, largely held by foreign investors, are emerging as big sellers of this default protection. In effect, the CDOs are betting that defaults will remain fairly low. The buyers of credit protection under these swaps -- frequently hedge funds -- are betting that defaults will surge, or at least that investors will demand higher yields for holding mortgage bonds. These swaps allow hedge funds, banks, money managers and others to take bigger positions in mortgage credit than they could before, says Roy Cantu, a senior trader in asset-backed securities at Barclays Capital, a unit of London-based Barclays PLC.
Not all U.S. mortgage risk flows overseas, of course. Banks and other mortgage lenders in the U.S. still hold a large share of it. Mortgages and related securities accounted for 35% of assets at U.S. commercial banks and savings institutions in the second quarter, up from 31% in 2000, according to the Federal Deposit Insurance Corp. Banking regulators don't know exactly how much of the credit risk lenders carry on their books and how much is held by other investors at home or abroad. But most of the mortgage-backed securities held by banks are guaranteed by Fannie or Freddie, which means the banks don't hold the credit risk on these issues, according to Barbara Ryan, an associate director with the FDIC.
Another chunk of the risk goes to U.S. real-estate investment trusts -- such as Redwood Trust Inc. and Impac Mortgage Holdings Inc. -- that invest in mortgage securities. Hedge funds also often invest in the tranches of mortgage securities that bear the brunt of the default risk. Among hedge funds active in this type of investing are Ellington, Clinton Group Inc., MKP Capital Management LLC and Highland Financial Holdings Group.
Until the past couple of years, Fannie Mae and Freddie Mac either bought or guaranteed most U.S. mortgage loans that weren't retained by banks and so shouldered the lion's share of the credit risk. More recently, though, Fannie and Freddie have lost market share, partly because regulators have clamped down on them in the wake of their violations of accounting rules and partly because the market has become more competitive. Their purchases of single-family mortgages originated last year dropped to 34% from 53% in 2003.


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