Dismal Science: Mortgages and Musical Chairs
Financial crises usually come from left field. But that doesn't stop swamis from searching for the next trigger. Right now, the prospect of rising interest rates is focusing swamis on trouble in the bond market. Not a bad bet, since the past few years of falling rates have produced a ton of complicated ways to extract profits from fixed- income securities. Also not a bad bet since a forecast of higher rates is driving investors to unwind positions -- presenting a perfect moment to expose flaws in hedging and other strategies.</br></br>So it's hardly surprising that concentration of risk is Topic One. Consider, for example, a recent speech by the new head of the Federal Reserve Bank of New York. In lovely Fed-speak, Timothy Geithner blended concerns about the increasing vulnerability of the financial system to the growth in Fannie Mae and Freddie Mac and the high degree of concentration in the market for interest-rate options.</br></br>Mr. Geithner was vague in the extreme, but the details of his concern are laid out in a report from Credit Suisse First Boston. Here are the mechanics of a possible crisis scenario in which the particular nature of risk in the mortgage market becomes concentrated in the market for interest-rate options.</br></br>The chain of transmission starts with the mortgage market. (Bear in mind that, at some $7 trillion, this market is enormous.) Mortgages are of course wondrous financial instruments. They allow people, even those with humble means, to own a big asset -- a house -- without having to pay the full price up-front. But mortgages have an almost as wondrous property -- they give home buyers the opportunity to pay off before maturity. This prepayment option allows homeowners to transfer interest-rate risk to mortgage holders.</br></br>Holders of mortgage securities borrow money to buy those securities. If all goes according to plan, holders buy securities that yield more than they pay on their debt. However, when interest rates fall and homeowners prepay, mortgage holders find that cash flows have changed. What was a nice deal of, say, receiving 6% on mortgages and paying 5% on debt could become a less comfortable arrangement of receiving 5% on mortgages and paying 5% on debt. Not good. Or say that interest rates go up; then homeowners keep their mortgages and holders could find themselves getting 6% on assets but paying 6% on debt. Also not good.