The current crisis in mortgage backed securities affects everyone, including the financial and real estate markets of the Cayman Islands. Although the local mortgage industry is unique, the problem is not, however, limited to specialist areas such as the hedge fund and banking industries and the knock-on effect may be seen in the gradual fall off in real estate sales to both foreign and local buyers as less money circulates around the system.
This article provides a brief review of what is meant by "sub prime" and how the issue is relevant to business in the Cayman Islands.
Sub Prime Defined
In simple terms, the creator of a sub prime residential mortgage-backed security (RMBS) buys loans from all over the US, often from several different lenders. Several thousand loans go into one mortgage-backed security. Because the security combines the specific risks of all the individual loans into a single pool, its investors as a whole are less exposed to the potential problems of any one borrower.
The residential mortgage-backed security, in its usual form, repackages and redistributes the income from the loans among different classes of bonds. In theory, highly rated bonds are the first to receive income and the last to suffer any losses, but they also offer the lowest return. Low-rated bonds are intended to pay a better return, but are also among the first to take any losses if borrowers renege on the loans in the pool.
As many as 150 mortgage-backed bonds (or other mortgage-linked investments) may be packaged into a single Collateralized Debt Obligation (CDO). Much like an RMBS, the CDO then issues new bonds, each with its own level of risk and return. The pieces of the CDO with middling ratings like A or triple-B are often sold off to other CDOs and the cycle continues.
Investment structures of the type described above make it hard to identify where the risk actually lies and have exacerbated the current panic as banks desperately attempt to shore up their credit ratings and stem the flow of write downs related to their off balance sheet transactions.
Previously, banks and other mortgage providers were careful to ensure that the property was correctly valued and that the borrower had a good credit history and enough income to make the mortgage payments thus allowing for timely repayment.
Over time, financial institutions became more specialised. Some focused on originating loans, and others specialized in raising the capital to fund the loans. Those institutions that were good at raising the capital started buying the mortgages from those that were good at originating them. Thus began the development of the secondary mortgage market.
The Federal National Mortgage Association, commonly known as Fannie Mae, was created by US Congress in 1938 to buy mortgages from banks as private companies did, but with taxpayers' dollars. Fannie Mae had a great advantage, given that it could borrow money from the federal government more cheaply than private institutions could obtain their money. Thus Fannie Mae was able to quickly nearly monopolize the secondary mortgage market.
In 1968, the US federal government started requiring Fanny Mae to raise capital in the private markets. It was commonly accepted that Congress would not let Fannie Mae fail for want of funds and private suppliers of capital were willing to charge Fannie Mae less than other competitors because they rightly felt the risk was less. Fannie Mae thus became a virtual monopoly in the secondary mortgage market. But rather than break it up and make it truly private, members of Congress, as is their want, did the wrong thing in 1970 and sponsored another company, "Freddie Mac," to be the competitor (which has the same implicit federal guarantee).
With their competitive advantage, the duopoly of Fannie Mae and Freddie Mac grew larger and larger by buying more and more mortgages. The originating financial institutions continued to let standards slip because they had two ready and undemanding buyers for all the new mortgages they could write. By 2002, the Federal Reserve Bank was offering virtually unlimited amounts of money to the banks at rates sometimes even below inflation, thus the housing boom was artificially bolstered by the issuance of 100 percent mortgages to un-creditworthy borrowers.
The originating banks could pass off these "sub prime" mortgages to Freddie Mac and Fannie Mae, who would put them in "pools" that, in turn, were sold to investment funds and the public as "hi-grade" investments, as described above.
The banks that were good at originating mortgages liked this arrangement because it gave them a ready market to resell their mortgages at a profit. As would be expected, over the years credit standards slipped because those who ran Fannie Mae were not using their own money but the taxpayers' money and were able to excuse their own increasingly sloppy behavior as doing a "social good" by making it easier for people to buy homes who were not really creditworthy.
With portfolios of almost $3 trillion, capital of $65 billion, and no obvious end to the fall in home values, the continued solvency of Fannie Mae and Freddie Mac remains in question. Freddie Mac recently shocked Wall Street with a quarterly loss of over $2 billion, and in their subsequent discussion with analysts, Freddie's management indicated more and larger losses could be expected.
There is an argument that even if Fannie and Freddie are insolvent, they will not become illiquid; the capital markets will continue to fund institutions they believe are backed by the federal government. Thus, it will be tempting for all concerned simply to wait for things to improve leaving the U.S. taxpayer ultimately on the hook if the risks don't pan out.
Since no one can predict where the bottom of the housing market may be, it is important to recognize that a loss of, say, 3% on portfolios of $3 trillion would easily wipe out what is left of their capital.
The legal disputes that are bound to ensue will be daunting and well-nigh endless. In the best case, new management will be put in place that will reduce the losses. The more likely outcome is eventual government recapitalization.
The recent US class action complaint brought by Norfolk County Retirement System against Countrywide Financial Corporation (Countrywide) on behalf of stockholders shows the precarious position in which lenders may find themselves without the exercise of due care. Following a review of recent filings with the US Securities Exchange Commission and public statements issued by Countrywide, lawyers for the stockholders claim that investors were misled into believing that Countrywide operated strict and selective underwriting and loan practices before witnessing the selling of over $1 trillion of stock by insiders with the company continuously stating that business and prospects remained bright.
Mounting Credit Fears
With the inter-relation of the Cayman Islands to the US economy and our dependence upon the health of the US Dollar, it is not hard to extrapolate to see how we may soon sneeze in sympathy with our cousin's cold and as the slow down in the US economy begins to affect the performance of local markets in the Cayman Islands.
It is not easy to forecast with certainty the exact nature of the ripple effect predicted. We have yet to see a fall off in requests for financial services. No public figures currently exist to substantiate market movement, however several local laws firms have reported a drop in certain areas of securitization work and an increase in the area of insolvency. Similarly, some of the larger US law firms are seeking to profit through the creation of specialist units focusing on National Credit Markets and Sub prime Lending Task Force groups.
One thing that can be guaranteed is the resilience and diversity of local financial service providers. Although it is true to say that the US provides much of our business and we rely on the US economy for stability and growth, still we undertake much business with Europe and the Far East where the effects of the sub prime crisis have yet to permeate with equal magnitude (UK and Spanish housing markets providing the exception).
Colossal losses by major US banking institutions have forced a flee to sovereign investment funds such as that offered by the Kuwait Investment Authority and the Dubai Investment Group eager to break into and gain a foothold in Western financial markets.
It is clear that the crisis remains global in scope with Japanese banks reporting similar write downs and UK banks having to pay out on two structured investment vehicles by bringing them back in from the cold and firmly onto the company's books.
Underlying these debt trends have been buoyant housing markets and favourable financing conditions. These developments have been reinforced in several countries by financial liberalisation and innovation, both of which have facilitated the access to credit of borrowers who were previously denied it and relaxed financing constraints on first-time homebuyers.
Traditionally, mortgage lenders in the Cayman Islands have been conservative and have developed a healthy loan book as a result, with no off balance sheet lending. With this in mind and, also due in part to the finite numbers of available beach front properties, the oscillations of the US real estate markets may have limited impact on the overall success and return rates of the local market.
What may be of greater concern is the affect of the US slow down on the local economy of the Cayman Islands as a whole. We rely on revenues raised through tourism as well as the provision of financial services and it may be in the aftermath of a slow down and the fall off in cruise ship numbers that a new strategy may need to be introduced to entice European visitors attracted by the warm climate and the advantageous exchange rate.
Current global trends suggest a possible decline in the fund industry in the Cayman Islands. However, to date, investment fund formation in the Cayman Islands continues apace and has now approached the 10,000 mark for registered hedge funds. Whether this may be due in part to the formation of new funds formed to soak up the spillage of the earlier troubled funds remains unclear.
US Federal Bank Chairman, Ben Bernanke has recently been quoted as saying that problems in credit markets are tenacious. Recommendations to the Board of Governors of the Federal Reserve System on the Budget favour the quick implementation of a fiscal stimulus package so as to ensure effects on the aggregate spending levels are felt without delay.
There recently followed a one-two punch by Washington aimed at jolting the US economy with easier credit and extra money in the form of an interest rate cut of three quarters of a percentage point and a further adjustment of half a percentage point a few weeks later, both extraordinary maneuvers.
The US central bank has signaled that it is ready to err on the side of boldness in fending off a possible recession. It has left open the possibility of additional rate cuts with up to $161 billion in additional funds expected to be injected back into the US economy during 2008 through tax rebates for individuals and tax breaks for businesses.
Luckily, with or without government intervention, the market almost always corrects for and adapts to previous mistakes. The future may bring the development of a new breed of mortgage backed securities, more transparent and better balanced. Such securities will once again become attractive to fund managers and the world economy will find itself at the beginning of yet another boom cycle ensuring buoyant times for the Cayman Islands financial industry that will no doubt reinvent itself to take advantage of market movements.
With thanks to Richard W. Rahn, Chairman of the Institute for Global Economic Growth.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.