The Mysterious Magic of Financial Engineering

Less than two years ago, during his extended farewell tour, former Fed Chairman Alan Greenspan spoke glowingly about evolving credit markets in general and subprime lending in particular. This speech was delivered in April of 2005, just as risky mortgage lending was shifting into high gear.

With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.

Last fall, the Federal Reserve Bank of Chicago deemed the recent housing boom a product of "wealth creation technology" in the mortgage lending business. After the continuing fallout in subprime lending that now threatens the rest of the economy, housing continues to be a topic of discussion at the Chicago Fed, but references to this new technology were not to be found in recent literature.

How quickly times change.

How quickly everyone comes to their senses when the bottom line is materially impacted.

How quickly the euphoria of a speculative bubble changes to finger pointing.

In the current issue of The Economist, they weigh in on subprime lending calling it the "mysterious magic" of "financial engineers" - clearly a more accurate characterization aided by the passage of time. In the process, they provide one of the better images depicting the current state of technological innovations in mortgage lending lauded by the Federal Reserve not so long ago (the loan originator is in the middle).

Bleak houses
America's riskiest mortgages are set to pop. Where will the shrapnel land?


LAST March, ResMAE, a mortgage lender catering to risky borrowers, cut the ribbon on its new headquarters in Brea, California. The sprawling, 135,000-square-foot building dwarfed the company's 458 local employees. But it fitted the firm's outsized ambitions. Less than a year later the company, rather than its ribbon, was facing the chop. This week it said it had filed for bankruptcy and was selling its assets for a diminutive $19m.

ResMAE is one of over 20 casualties among America's “subprime” mortgage lenders, which serve borrowers with spotty credit histories at higher interest rates. This end of the market took on $605 billion of new mortgages last year, more than a fifth of the total. But as interest rates have climbed, these loans have soured and the shares of bigger subprime lenders, such as Countrywide Financial and IndyMac, have sagged.

Does the rot run deeper?
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Some banks do get caught holding the live grenade. FDIC reckons that depository institutions hold $3 trillion of mortgages. Much of this is higher-quality stuff, but not all. And even banks eager to securitise their loans sometimes retain the “residual”—the most risky slice where losses hit first. CreditSights, a research firm, notes that Bear Stearns holds about $6.8 billion in residuals, although only a fraction is below investment grade. Banks that write mortgages are also contractually obliged to buy back securitised loans if their underwriting is shown to be shoddy or if the loans sour too quickly. That is what felled ResMAE and is hurting Accredited Home Lenders Holding, a San Diego lender.
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Should loan losses climb, investors in mortgage-backed securities will also get burnt, especially those holding the riskier, higher-yielding bonds. Financial engineers worked their mysterious magic with these securities, turning the junkiest mortgages into high-grade, sometimes AAA-rated, securities. They could do this only with the blessing of credit-ratings agencies, which made a profitable business out of rating these securities. But critics say the agencies got complacent, and doubt the pooled loans were sufficiently diverse, or sliced up with sufficient art truly to have dispersed risk. One possible blind spot is that the dodgiest mortgages all behave similarly in times of stress. Another is that it is hard to avoid heavy exposure to mortgages from California, the biggest market in America, where alternative products were popular.

No one quite knows in whose hands these little bombs will ultimately explode. The hope is that the risks are widely and thinly spread. The fear is that they all sit in the lap of a few big hedge funds. But the real casualties may be homeowners, who often took out risky loans they could barely afford or did not understand. The FDIC has already tightened rules on underwriting negative-amortisation loans, and the Senate has begun to hold hearings on predatory mortgage lending. With Democrats now in charge of Congress, there is a fair chance the politicians will act. The Eliot Spitzer of the housing downturn may be about to start his charge.

The mysterious magic of financial engineering will always define this era.