For most of the past decade, mortgages have been the Street’s golden goose. More than $1.5 trillion of mortgages just like yours have been packaged into bondlike securities by investment banks and government-sponsored companies with nicknames like Fannie Mae, Ginnie Mae and Freddie Mac. Strong demand from banks, life insurers and individual buyers has turned traders of mortgage-backed securities into multimillionaires. But as interest rates tumble and refinancing soars, Wall Street is learning that the golden goose can bite. Says David Bullett of Teachers Insurance and Annuity Association, “It’s caused quite a ripple in the market.”
In the bond market, lower interest rates are good news. But mortgages are a different animal: as rates fall, homeowners can easily refinance and pay off their old loans. An investor who jumped at a mortgage-backed security touting 10 percent interest over 30 years may suddenly find himself getting the principal back, with no investment around offering a similar yield. To minimize that risk, big buyers spend millions on mathematical models to predict how many mortgages will be prepaid each month. But the models misfired badly as interest rates dropped faster than anticipated. “Prepayments were much heavier than most firms were expecting,” says Gregg Patruno of First Boston Corp.
The prepayment boom has hit hardest at some owners of collateralized mortgage obligations, an exotic variant on mortgage-backed securities. One type of CMO gives the owner the right to the interest payments from a bundle of mortgages; some other buyer gets rights to the principal. If a mortgage is prepaid, however, interest payments stop, and the interest-only investor gets less than he bargained for. The value of these so-called IO strips has plummeted since mid-July. The question, says Nikko Securities mortgage trader Steve Maher, is, “Where are all the IOs?”
The answer, ironically, may be that much of this paper, which brokers have promoted heavily to individual investors, is still in the investment banks’ own vaults. None of the big houses admit to major losses; analyst Alison Deans, who follows the financial industry for Smith Barney, says that losses are widespread but not catastrophic. That means that despite a banner year-629 issues of mortgage-backed securities have raised $249 billion since January, according to Securities Data Corp.-mortgages won’t do much to strengthen Wall Street’s bottom line.
Is Wall Street merely getting its just deserts? If you’re still looking for a loan, you’d better hope not: the roiling secondary market has caused some investors to shy away from mortgages. “People are selling mortgage-backeds and buying treasuries,” laments Felix Beck, chairman of Margaretten & Co., a mortgage banker. That makes borrowing more costly: experts figure the already low rate on a 30-year loan would be about 0.25 of a percentage point lower had all those prepayments not upset the market. Borrowers, it seems, must pay a price to save the golden goose.
