Wednesday, May 18, 2011

Jason Zweig's Questionable Home Mortgage Hedging Column

In this past weekend's edition of the Wall Street Journal, Jason Zweig wrote in his The Intelligent Investor column about hedging your home mortgage. I think it may be time for him to change the name of that column.

First, this is hardly a new idea. I've thought about it for decades, as I'm sure have many other intelligent, educated people who've worked in the financial sector. Why would you not consider how to hedge the value of what, for most people, is their largest asset purchase, when it reaches a lofty value?

My own ideas have included simply selling it to someone while simultaneously leasing it back. Zweig's column mentions a few firms that purport to offer value insurance for about 1.5% of value.

Frankly, that's obviously very cheap if you have had to buy into a housing market that's frothy or even merely tight and probably, at least currently, overvalued.

Of course, your home isn't just another asset. You live in it and it's probably the most ill-liquid asset you'll own. If you get a hedge on it wrong, it could have life-altering consequences beyond those of an IRA gone wrong. Plus, for real estate exposure, there are other ways to invest, if that's what you want.

Perhaps you shouldn't buy into overheated markets, and go long on undervalued ones. Simple and effective, without the major risk I'll get to shortly.

Leaving aside the regulatory hurdles, consider the challenge of making this a truly ubiquitous product. That is, consider it while recalling what happened to AIG due to its financial products unit which sold so many derivatives which were meant to function as hedges.

To me, the primary issue is counterparty risk for something so massive. Sure, it may be feasible for someone to offer home value hedging just for Syracuse, New York, as one firm mentioned in Zweig's article does.

But US home ownership is a large chunk of value. I don't have my fingers on the exact number, but it's very large. So ask yourself this.

What exists as a countervailing asset that can be reliably expected to fund a massive drop in US residential real estate values?

These sorts of bets typically come unglued when reality overwhelms prior expectations, resulting in a "black swan" event that transcends stress tests.

We're not talking about real estate values dropping by 3% or 10%. Let's talk 30% and more.

What other US-based asset class will be likely to remain able to pay off a 50% decline in the value of all US residential real estate?

Long ago, during the first great collateralized mortgage frenzy, when Lew Ranieri ran his famous group at Salomon Brothers, I discussed this issue with my boss, Gerry Weiss, SVP of Corporate Planning & Development. He had sent me to a CMO conference in Manhattan, and wanted to debrief me from my two-day experience.

In short, I said that the repackaging of cashflows into CMOs by the fixed-income wizards, who were suspiciously silent on things like 'negative convexity,'  which would affect the duration and value of longer-lived tranches, could not, by themselves, magically eliminate risks of mortgage lending.

In effect, in exchange for a few percentage points of fees to create, sell and service the CMOs, investment banks were simply recutting and spreading existing risk while extracting a fee.

Risk is conserved- it can't be eliminated. It can be hedged, assuming a perfect, reliable counterparty.

Thus, while many unwashed thought the CMO craze made the world safe for mortgage risk, all it really did was pay Wall Street investment banks to allow troubles S&L's to liquefy their damaged mortgage loans while simultaneously allowing investors to more finely select mortgage risks subject to duration and other factors.

So when I read Zweig's piece, the first thing that came to mind was, just who will be a reliable counterparty for a substantial portion of the value of all US residential real estate?

How will that work? What source of asset value will be either unaffected by, or move in opposition to, the value of US residential real estate at a time of huge value reduction of the latter?

Granted, should such a ubiquitous residential real estate hedge become available, it might provide some minor relief for a family which, due to one of the parents' careers, moves every 5-7 years. But that's a steep price for such short-term coverage.

But for the worst case scenario involving residential real estate hedges, beyond holding an instrument that purports to be that hedge, a reliable party with an asset that will perform on that hedge have to both exist amidst an expected turbulent financial and/or economic environment.

It's not the "greatest idea never sold." It's a mirage.

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