In: Root » » Loans and mortgages
Re-Evaluating Risk It wasn't the mortgage losses per se that ignited the shock, but what they meant more broadly: Global investors had taken on too much risk, not simply in their subprime mortgage security holdings, but arguably in all their investments. The mortgage losses crystallized what had long been troubling to many in the financial markets; namely that assets of all kinds were overvalued, from Chinese stocks to Las Vegas condominiums to the British government bonds known as "gilts" (short for gilt-edged securities). The subprime meltdown was simply a catalyst for a top-to-bottom re-evaluation of risk: Were investors being adequately compensated for the risks they were taking? Many quickly concluded the answer was no. Global investors suddenly saw the entire U.S. housing and mortgage market in a new light. Although the number of homeowners struggling with mortgage payments was relatively small only a few million investors began to question the ability or willingness of all 52 million U.S. mortgage borrowers subprime, alt-A, and even prime to meet their obligations. The $11 trillion in U.S. residential mortgage debt outstanding had become a significant global financial influence, accounting for more than 8% of all the bank loans and securities in the world. In short, the world had made a huge bet on U.S. homeowners. In the mid-1990s, few overseas investors had ventured into the U.S. mortgage securities market. Those who did owned mostly debt backed by Fannie Mae and Freddie Mac, which was not much different than owning a U.S. Treasury bond. A decade later, foreign investors held some $3 trillion in mortgage securities, almost a third of all their U.S. financial holdings, including stocks. Some of this was backed by the U.S. government, but most was supported simply by the financial rectitude of the U.S. homeowner. This was seen as safe: Investing in an American household with a home and a mortgage wasn't supposed to cost investors any sleep much less their shirts. Investors also began looking critically at their other holdings, such as corporate bonds. It wasn't that businesses were defaulting on their obligations; the economy was still strong at the time. The problem was that investors were receiving returns that suggested no firm would ever default again. The rates were razor-thin compared to the potential risks. The difference between rates on risk-free Treasury bonds and on low-rated or junk corporate bonds narrowed to an all-time low in spring 2007. It is this interest rate difference the spread that measures how much compensation investors receive for the risks they take with their money. Not only wasn't there much of a spread in the prices of corporate bonds, but many bonds came with terms considered remarkably loose by historic standards. Traditionally, firms that issue bonds have to meet strict conditions, maintaining a certain level of cash flow or other financial benchmarks, to assure investors they can meet their interest payments. If the benchmarks aren't met, creditors have the right to demand their principal back. But in the 2000s, investors were so eager to throw their money around that many bought so-called "covenant-lite" bonds, which had fewer conditions and benchmarks for issuers. Terms became so easy that some businesses were allowed to make interest payments on their bonds by issuing additional bonds rather than paying in cash.
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