Banks Pay the Price for Risky Mortgage Bets

Major banks are suffering enormous losses on investments tied to home mortgages. For years, Wall Street made handsome returns betting on mortgage-backed securities. But those securities are opaque and contain risks that investors were either unwilling or unable to recognize.

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MELISSA BLOCK, host:

We heard earlier from the chairman of the president's Council of Economic Advisers, Edward Lazear. One of the other things he said today was that the nation's credit crunch has gotten worse in the last couple of weeks. The problems began in the subprime mortgage market and they've been magnified by the way Wall Street packaged those loans.

NPR's Scott Horsley has this report on how banks got into so much trouble.

SCOTT HORSLEY: For years, the subprime mortgage market was built on a faulty assumption: that home prices would keep climbing.

David Olson, who runs the mortgage research firm Wholesale Access, says lenders were willing to make high-risk loans with the false confidence that if worse came to worse, the borrowers could always sell the house and get their money back.

Mr. DAVID OLSON (Managing Director, Wholesale Access Mortgage Research & Consulting, Inc.): That was the mantra they said over and over again. Up until about a year ago, people were still saying prices never fall. And here they are.

HORSLEY: Home prices are falling. The National Association of Realtors says the average price on October was down about 5 percent from a year ago. There goes the safety net for both lenders and borrowers. Many people who bought homes or refinanced lately now owe more than their homes are worth.

Mr. OLSON: Some people took $405,000 loan just last year and now they have the house for sale at $330,000. They are 75,000 underwater. They're going to be very tempted just to walk out in that loan.

HORSLEY: More and more borrowers are doing just that. Foreclosures are way up from a year ago, and that's meant mounting losses for Wall Street firms. Bank of America says it might write off $3 billion in the fourth quarter. Morgan Stanley warns of a $6 billion charge. And Citigroup says it could take a hit of up to $11 billion. What's striking about those losses is not only how big the numbers are but how imprecise the estimates are.

Equity analyst Jamie Peters of Morningstar says the banks can't even say for sure how deep a hole they're in.

Ms. JAMIE PETERS (Equity Analyst, Morningstar): A lot of their write-downs at Citigroup and the others have talked about are actually write-down on very complicated securities backed by subprime mortgages. Right now, a lot of them are trading at 50 cents on the dollar.

HORSLEY: Those prices are a moving target though. Questions about the value of the mortgage-backed securities have caused some wild gyrations on Wall Street.

Ms. PETERS: And these products are incredibly complicated. Not even people who made them seem to be able to find out what they were really worth. They made a lot of money by creating these products, but now they're making a lot of paying because they weren't quite sure what they're really worth.

HORSLEY: To understand why, you have to know a little bit about how the so-called secondary mortgage market works. Wall Street banks take whole bundles of mortgages and carve them up into securities, sort of like a butcher shop carving up a side of beef. Some of the cuts, or tranches, are high-priced tenderloin, others are just flank steak.

Finance professor Joseph Mason of Drexel University says the Wall Street butchers can trim the fat from the least risky securities, but they can't get rid of it all together.

Dr. JOSEPH MASON (Associate Professor of Finance, Drexel University's LeBow College of Business): Some of the securities created can be safer than the underlying risk of the pool. But by definition, if some are safer, some have to be more risky. There's nothing created by this process. In other words, there's no free lunch.

HORSLEY: That's okay, so long as everyone buying the various securities knows what they're getting. But what's happened in the subprime debacle is more like a meat grinder, where the risk of hard to predict mortgage defaults has contaminated whole batches of securities.

Dr. MASON: We've sliced and diced risks far too finely. And because of that, we're not sure which tranches will pay, which won't, and we can't be sure of the underlying value of the tranches at issue.

HORSLEY: That's why investors are turning into financial vegetarians, weary of buying anything that might have come in contact with subprime mortgages. When investors stop buying, Wall Street has less money to lend and all of this has put a crimp in the nation's credit market that extends well beyond subprime mortgages.

Scott Horsley, NPR News.

BLOCK: So should banks that misjudged risks could get a bailout or would that be encouraging bad behavior in the future? You can get both sides of that debate at npr.org.

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