The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage.

FBR’s Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That’s a leverage ratio of 19 to one.

But last year’s subprime meltdown has undermined confidence in the home loans that back these mortgage securities. Now the banks that finance most of these leveraged mortgage investments have started to pull back and impose margin calls, demanding more cash or collateral to back their loans.

This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices.
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“The immediate impact is that [interest rates on] 30-year fixed-rate mortgages will have to increase relative to Treasuries,” FBR’s Miller wrote in a note to clients on Friday. “That is why we are experiencing pressure on mortgage rates despite the downward movement on the 10-year bonds.”

Rates on 30-year fixed mortgages usually follow the movement of 10-year Treasury bonds, but this relationship has broken down as de-leveraging in the financial system takes hold.

The difference, or spread, between yields on “agency” mortgage securities backed by Fannie and Freddie and those on Treasuries rose to a 23-year high this week, Miller noted.

“It is the leverage game playing havoc with the system,” he wrote.

There are two ways to resolve the problem. Either inject $1 trillion of new capital into the mortgage market, or allow prices of mortgage securities to fall (and interest rates on home loans to climb), Miller said.

The mortgage market won’t be able to raise $1 trillion, so prices have to fall, he warned.

“There is no quick fix here,” the analyst said. “It will take about six to 12 months for the pricing pressure to alleviate on these mortgage assets.”

Parenthetically, I would just note that the rating agencies continue to be a farce. How could MBIA – — which recently had to pay 14% to borrow money, and whose debt still yields over 13.5% — ever possibly be considered AAA?

If the ratings agencies are to have one shred of credibility again, ever, they might as well start now. But of course, just like every other aspect of the sanity that some of us might like to see break out, it seems to be politically unacceptable for anyone in a position of real responsibility to act like an honest adult.
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The specter of municipal-bond downgrades is a function of a much larger problem: the unwinding of the credit bubble, which had the housing bubble at its epicenter. The credit bubble that has burst is going to continue to shrink the availability of credit, and the housing bubble that has burst is going to continue to unwind. The United States is not going to escape without a serious recession, which is the outcome preordained by the housing/credit bubble.

As to when folks will confront that reality, let me say this: It takes many years for a certain psychological mindset to take root, and resistance to change is always formidable. Yet when the dominant trend finally changes, that new trend remains in place for a long time.
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In any case, the determination to suppress the destructive downside of capitalism and ensure permanent prosperity is a terrible idea that will not work. Permanent prosperity, after all, is what socialism was supposed to be about, and we’ve all learned that theory doesn’t work. I continue to find it a sad irony that Wall Street — the alleged bastion of capitalism — would cling so dearly to the hope of socialism.

For now, the FDIC is looking to bring back 25 retired employees with experience in the bank closures of the 1980s and 1990s. No, it’s not just a reunion of hard-nosed accountants who closed banks and savings and loans in notorious Friday night raids and liquidated their assets.

This is a real search for tough, experienced “lone rangers,” who set upon a bank or thrift institution on a Friday to take over as much of the assets as possible and open the following Monday with full assurances for insured depositors and firm answers for uninsured depositors. The latter group will get 100% on their insured deposits, probably 50% on the uninsured portion and “well, we can talk about it, and we’ll send you some more later.”

This week Fed Chairman Ben Bernanke put it bluntly: “There probably will be some bank failures.” Regulators have some real work ahead of them. The FDIC had 76 banks on its problem bank list at Dec. 31, down from 136 problem banks in 2002 and 213 banks in 1990. This past year’s three failures were the first since 2004. Apparently the FDIC expects to have a busy year.

State and local government bonds fell 4.17 percent through yesterday, including reinvested interest, based on Merrill Lynch & Co. data. That’s the most since July 2003, when they tumbled 4.59 percent. Florida had to pay 5.35 percent yesterday to sell 30-year fixed-rate general obligation bonds, almost three- quarters of a percentage point more than at its Feb. 6 sale.

The $330 billion auction-rate market froze after dealers stopped purchasing the bonds when buyers failed to bid. Their lack of support has spread to the broader tax-exempt market, sending yields soaring. Borrowers from California to New York City plan to convert the securities to longer-term debt, raising concern that a flood of bonds will overwhelm already sparse demand from banks and hedge funds.
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The auction-rate turmoil and slump in municipal bonds are the latest examples of how the fallout from subprime-mortgage delinquencies has spread, touching a market whose credit quality is typically second only to the U.S. government.
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Failures [at auctions] have increased as subprime-related losses at bond insurers led investors to question their creditworthiness and to shun securities carrying their backing, and banks refused to step in and buy unwanted bonds as they had in the past.
Dealers including Goldman Sachs Group Inc., Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales, allowing some yields to rise to 20 percent. Investors and borrowers never knew the extent that banks propped up auctions because of scant public disclosure of bidding.
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While households hold most of $2.6 trillion in U.S. municipal securities, either directly or through funds, rising demand from banks, hedge funds and other institutional investors dominated the market in recent years.

By borrowing at variable rates to buy higher-yielding long- term debt, they helped absorb the record $430 billion sold in 2007 and drove state and local debt to outperform Treasuries and corporates three straight years through 2006. Since then, municipal bonds gained 1.3 percent and their taxable counterparts rose 9 percent, Merrill data shows.

The unwinding or attempts to unwind such trades by hedge funds may be exacerbating the declines, investors said.