The Incredible Shrinking Mortgage Problem

Story Highlights:

• Many investors blame our financial system woes on lax mortgage lending standards in recent years.
• Mortgages end up in one of three places: held individually on banks' balance sheets, packaged into agency mortgage–backed securities (MBS), made into MBS or other structured debt instruments by financial firms.
• The products created by financial firms have been the most troubled, but that corner of the mortgage market is healing quickly with time.

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Have you ever opened the dryer to find a favorite shirt fits your miniature schnauzer better than it does you? Shrinking a few sizes can devastate an outfit, but for some things a Lilliputian quality is preferable. Waistlines, for instance. Most of us wouldn't mind seeing ours shrink a bit. And how about those pesky problem mortgages that have caused the financial world so much grief? Smaller is probably better there too. Unfortunately, it often seems mortgage problems have only grown. Despite massive efforts to get the economy back on track, foreclosure rates continue their incessant climb. To some, economic and stock market recoveries seem impossible until housing and mortgage problems abate. Although a housing market recovery isn't a necessary condition for an economic and stock market recovery, it will probably surprise many to learn mortgage issues are in fact easing despite increasing delinquencies and defaults.

Many investors blame our financial system woes on lax mortgage lending standards in recent years. Inarguably, many unwise loans were made and the resulting defaults have contributed to the current economic downturn. But as we've noted many times, mortgage defaults, though elevated, aren't large enough to cause the massive write-downs by financial institutions and tens of trillions of dollars of wealth destruction suffered by investors worldwide. Poorly applied mark-to-market accounting rules and inconsistent regulatory actions were more detrimental. But even if you still believe bad mortgages are the root problem, you'll be happy to know the most troublesome portion of the mortgage market is shrinking like a cheap cotton t-shirt.

There are basically three destinations for mortgages: They're held individually on banks' books, packaged into mortgage-backed securities (MBS) by government agencies (mainly Fannie Mae and Freddie Mac), or made into private label MBS or other structured debt instruments by financial firms. But mortgage problems aren't spread evenly across these three buckets.

Banks provision for expected losses on individual loans, so there's already money put aside if these mortgages go bad. Rising delinquencies and defaults hurt because banks must set aside more money, but they don't take big balance sheet hits thanks to those loan loss reserves.

MBS created by Fannie Mae and Freddie Mac are guaranteed by those entities (and by the US government now they're nationalized). So there's no real default risk for banks holding agency MBS since Fannie and Freddie absorb those losses.

The most troublesome portion of the mortgage market is private label structured debt because it's not guaranteed by government agencies, and this is where most of the worst subprime and Alt-A loans (requiring no income documentation) ended up. But the size of this market is shrinking rapidly. Since 2004, $4.3 trillion of mortgages have been securitized by financial firms. But there are only $2.0 trillion of these mortgages still outstanding thanks to refinancing, repayments, modifications, and past foreclosures. That's a 52% decline in the size of this overall market. Alt-A loans accounted for $1.3 trillion of the original securitizations, but the current amount outstanding is down to $775 billion. And the subprime component, the worst performing of the bunch, is shrinking even faster. Subprime mortgages made up $1.6 trillion of the original total, but the amount of securitized subprime mortgages outstanding has fallen by 65% to just $557 billion.

Standard & Poors estimates future losses tied to these assets will total $260 billion ($375 billion in a worst-case-scenario). That's not insignificant, but the impact on banks' balance sheets should be much smaller as most of these assets have likely been written down more than future losses warrant due to mark-to-market accounting. Already, worldwide write-downs have totaled nearly $1.4 trillion. And these potential future losses pale in comparison to the overall size of the mortgage market (about $11 trillion) and massive amounts of fiscal and monetary stimulus being deployed.

The bad news is there's little you can do to salvage your shrunken clothing, and a smaller waistline might require tedious trips to the gym. But time helps heal the mortgage market, so as time passes, the less problematic those legacy mortgages will be.