Wall Street’s short memory: A return to risky mortgages

In a resurgent real estate market, Wall Street is back to its old tricks, weaving together the same type of complicated financial instruments and mortgages that wreaked havoc during the housing bust, the New York Times reported.

Investor optimism coupled with a strong real estate market and the Federal Reserve’s policy of maintaining low interest rates has allowed banks to revive these instruments, known as structured financial products. The safest of these investments can offer interest rates almost twice those paid out by U.S. Treasury securities, according to RBS securities, which was a previous player in the structured financial products game. But these investments have once again managed to avoid the scrutiny of government regulators. 

“All of this seems like a fairly quick round trip,” Manus Clancy, a managing director at Trepp, a research firm that focuses on commercial real estate, told the Times. “You are seeing a fair number of sins being forgiven.”

Indeed, so far this year, banks have issued $33.5 billion on commercial mortgage-backed bonds, a slight increase from levels seen in 2005, when the real estate market was booming, according to Thomson Reuters data seen by the Times.

Banks are attempting to put investors at ease through steps designed to make this generation of structured products safer than its earlier iteration, but regulators and credit rating agencies have cautioned that the extra protections are already easing up.

“The players in the business are generally the same as they were before,” Tad Phillips, a commercial real estate analyst at Moody’s rating agency, told the Times. “Because it’s the old players, they know how to push the boundaries.”

And the makeup of these structured products remains as labyrinthine as it once was. A pool of loans — whether home mortgages or corporate loans — are mixed together into bonds ranked by levels of risk. If the core loans default, the riskiest bonds take the first hit, and so on and so forth. The bonds at the top of the totem pole could remain unscathed until enormous sums of money are lost.

Last time around, when real estate prices dropped unexpectedly, investors took a tremendous hit from these types of structured products and the ripple effect was felt throughout the financial system. At the time, investors complained that the complexity of these products had made the risk less apparent. [NYT]  –Hiten Samtani