Mortgage-Backed Securities Return, but Are We Really Ready?

All roads from the real-estate meltdown lead to crumbled mortgage-backed securities. And after a three-year respite from these investments, the industry is starting to go down that path once again.

The big question is whether financial institutions -- and investors -- have learned anything. What everyone is wondering is whether this move is a logical and positive outgrowth of a recovering industry.

"Are we ready for this again?" asks Boston University economics professor Laurence Kotlikoff. "Absolutely not. We still don't have any checks or balances put into place to make sure we don't end up in the same situation."

Last week, Redwood Trust (RWT) rolled out the first private-label security investment backed by new, high-end home mortgages. The Mill Valley, Calif. -based investment firm plans to sell $222 million mortgage-backed securities backed by jumbo residential home loans. Quick primer: Mortgage-backed securities represent the claims on the principal and payments on a large number of mortgages that have been assembled into a pool through a process called securitization.

Investments That Led to Collapse

The last time the industry offered these securities was in October of 2007. Investors recall that when the economy turned sour, homeowners in non-traditional mortgages began defaulting on their payments. This dragged down the country's biggest financial institutions that poured money into these lucrative mortgage-backed investments.

The fallout spurred an unprecedented $700 billion taxpayer-funded bailout and was cornerstone of a national recession. Its victims included Wall Street stalwart financial firms Lehman Brothers and Bear Stearns, not to mention the countless homeowners who lost their homes through foreclosures.

Kotlikoff, author of 14 books including Jimmy Stewart is Dead and Spend 'Til the End, likened the situation to the Tylenol cyanide deaths in 1984. Following that incident, Tylenol-maker Johnson & Johnson instituted safety seals on all of its products, now a standard in the industry.

"Take it from me, there still aren't safety seals for mortgage-backed securities," Kotlikoff says.

Checks and Balances Still Missing

There are some proposals being floated to offer some guidelines for these investments. The Securities and Exchange Commission has recommended that firms that put together and sell the investments must hold a certain percentage on their own ledgers. This move spreads out the exposure and may lead to more checks and balances.

While acknowledging that the wounds from the sub-prime collapse have not completely healed, analysts see the limited reintroduction of mortgage-backed securities as a good sign that the real estate market is showing some health. In particular, the offering by Redwood Trust is a probably a good bet, they say, and it could mean the lowering of mortgage rates for home buyers.

"We're still not back to normal, but the market has improved," says Greg McBride, senior financial analyst at Bankrate.com. "This is a positive development, and a huge step in the right direction."

Sign of Return of Real Estate Market?

McBride says the proof can be found in the details of the offering. The company's focus on jumbo home mortgages is safer than the sub-prime mortgages which saw overflowing defaults. Plus, there will be a direct impact for high-end home buyers who have had a hard time getting financing.

Jumbo mortgages cover loans over $730,000, and Redwood said the loans in this offering are closer to $1 million.

Steven DeLaney, managing director and senior analyst with JMP Securities, admits that nothing is a sure thing, particularly given what's taken place in the real estate industry. However, he says Redwood's offering is at the opposite end of the spectrum than the risky sub-prime loans.

"This is a good place to start, with an investment by a firm that has a strong reputation with the banking community and has offered consistent returns over a long period of time," DeLaney says.