High risk lending makes a return

A frantic search for strong investment returns is resulting in high risk mortgages making a comeback.

In a story carried in the New York Times, it details how banks that created cocktails of risky mortgages and loans during the boom — the kind that went so wrong during the bust — are busily reviving the same types of investments that many thought were gone for good.

It has been known for some time there were rumblings in this area of the mortgage market. In fact, it would not be a surprise if this does not become a high growth area internationally as traditional banks refrain from lending to erstwhile strong mortgage candidates.

What is driving the trend in the US is the same investor optimism that has seen the stock market rise to new heights in recent weeks. The property market in the US is improving at a faster rate than many had predicted. Record low interest rates have also created an opening for those in the hunt for better returns and property is again proving to be an old reliable.

The revival of so-called structured financial products is a by-product of the fact that they have largely escaped new regulations, which were supposed to prevent a repeat of the 2008 financial crisis.

Several banks are developing types of structured products faster than they did before the market collapse. According to the New York Times report for example, banks have issued “$33.5 billion in bonds backed by commercial mortgages, slightly more than they did in early 2005, when the real estate market was flying high.”

So far, it appears that banks are limiting the level of risk they are prepared to consider in order to keep potential investors on board. Managed and contained risk is as far as this new phase in the return to high risk lending may go for now. However, this is precisely where the market was in the pre-2000 age, before non-bank lenders entered the market with their outlandish risk profiling models.

While the retail sale of high risk loans is one part of the equation, it is the pooling of them that is more interesting as the basic principle behind the products remains the same. This is where a pool of loans — it could be home mortgages or commercial loans — are mixed together into bonds, ranked by varying levels of risk. If the underlying loans go bad, the bonds at the bottom of the pecking order suffer losses first, followed by the next lowest, and so on up the chain. It is only after enormous losses that the top-ranked AAA bonds lose money.

Only time will reveal how far the creators of high risk loans are prepared to push the boundaries in their quest for positive returns. But we do know several ingredients for a return already exist in abundance: mortgage lending has never been so low, the appetite for loans has never been so high and the search for positive returns across the globe has never been so frantic. As with all vacuums, the lending vacuum appears as if it may be filled by those prepared to take calculated risks.

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