Sunday, August 24, 2008

From the Ground Up

(WP) With bank loans scarcer, a handful of Web sites help borrowers tap individuals for cash.

Steve Lubs was looking to get rid of his $8,000 in credit card debt, but his high interest rate had him bogged down. He tried getting a loan through a bank to pay off the balance but couldn't find one with an interest rate lower than 12 percent.

That's when he turned to Prosper, one of several peer-to-peer lending networks that connect people who need a cash infusion with those who have money to lend. About 70 people have pitched in with $100 to $300, totaling the sum he needs to get out of debt, at a rate of 8 percent.

"When it comes to borrowing, it's a bargain," said Lubs, an engineer who lives near Columbia.

Rather than turning to the traditional sources of loans -- banks, mortgage lenders, credit unions -- many cash-strapped consumers are borrowing from friends, family members and even strangers and are getting favorable terms and rates. And people with money to spare see lending it to others as a better investment than socking it away in a low-yield savings account or playing the volatile stock market.

"Worthy borrowers used to have lots of options, but those have dried up," said Chris Larsen, chief executive of Prosper, where about 780,000 users have exchanged $160 million since the lending network launched 2 1/2 years ago.

Getting a loan isn't as easy as it once was, as interest rates have climbed and credit standards have tightened. At the same time, demand for loans is rising. High gas and food prices make it harder to save and pay off existing debt. Home-equity lines of credit are harder to come by, leaving many people short on the costs of home improvement and other expenses. Some people also find it difficult to use traditional lending to finance a car or a graduate degree.

As a result, several peer-to-peer lending networks have sprung up, with names like Zopa, Virgin Money and Lending Club. Some, such as GreenNote and Fynanz, offer loans exclusively for students.

But using such networks can be a gamble for both lenders and borrowers. Loans made through some networks are not insured by the Federal Deposit Insurance Corp. Some networks are affiliated with credit unions or banks, which are regulated by the federal government.

Lenders run the risk losing their investment if people don't pay them back.

The networks supervise the loan agreements by checking credit histories. But if a borrower defaults on a loan, a lender's only recourse is to report the borrower to collection agencies. And not all networks are licensed to make loans in all states.

For borrowers, replacing existing debt with a new loan could lead to deeper financial problems. Personal-finance advisers say borrowers could find themselves in a worse financial hole if they use the networks like just another credit card.

Borrowers must be creditworthy, and both borrowers and lenders must divulge private information such as bank accounts and driver's license numbers to get started, raising privacy concerns among some observers.

Prosper lets people borrow or lend up to $25,000, typically by piecing together 50 to 100 small loans. The process is similar to the way an eBay auction works: Borrowers set the maximum interest rate they're willing to pay, and lenders compete to make the best offer. Users looking to borrow money can share how they plan to spend it, whether it's to buy a house or to pay for a wedding.

They can also invite friends to join. "If you get a friend to bid on you, it increases other people's trust in you," Larsen said. "That's where the social capital comes in."

Prosper oversees the process. It checks credit scores for both borrowers and lenders, verifies bank accounts, and then sets the repayment terms.

At first, about 30 percent of the users had blemished credit records that prevented them from qualifying for more traditional loans. But a wider variety of borrowers have joined the network in the past year, Larsen said.

"People looked at peer-to-peer networks as a place you go when you couldn't go anywhere else," he said. "Now it's become one of the new alternatives that's still open."

Lubs has also used Prosper as an investment by loaning small amounts of money -- typically $200 to $1,000 -- to people looking to borrow funds. He has 37 outstanding loans to network borrowers, totaling about $9,000. He said he's been earning an average annual return of 19 percent on the total amount, which is better than what he gets on his investments in the stock market and real estate.

"This is my primary method of investing," he said. "It's the best opportunity I have to increase my rate of return."

Carson Evan of Alexandria used Virgin Money to lend his younger sister $17,000 to pay off her credit cards. With her interest rates, she would have needed 15 years and $70,000 to pay off that debt. Instead, she can repay her brother's loan over five years at 3 percent.

"I know I could be getting a better return on it someplace else, like the stock market," Evan said. "But this was the right thing to do."

He said making the loan through Virgin Money took the awkwardness out of lending to a family member. Rather than paying him back directly, his sister writes a monthly check to Virgin Money, which then wires the money to Evan.

"It added an air of legitimacy to it," said Evan, a 29-year-old software engineer. "It's better if she's not writing the check directly to me, to pay back her brother, even though she is."

John Vyge, principal with Hillebrand Financial Planning in Dulles, said using a social lending network to correctly document a loan between family members or friends can minimize the chances of the relationship being damaged by a disagreement over the terms or repayment.

But he's still skeptical about the concept of peer-to-peer loans.

"My concern is people are depending on these loans instead of building a sound financial plan, like having an emergency fund," he said. "People can just use these sites as another credit card to fund a vacation or anything else under the sun."

People who use such sites to lend money are mostly protected from losing their money, he said, because the sites check credit backgrounds and keep borrowers on a structured repayment track. Those who fail to pay run the risk of being reported to collection agencies. Diversification is also possible. Lenders can distribute money in a variety of amounts and at different rates.

Konrad Berk of Towson is one lender who is willing to take the risk. He's invested a little less than $10,000 in loans to strangers through Prosper. Each loan is for no more than $50, allowing him to create a diversified portfolio of interest rates.

After he secures an interest rate of, say, 11 percent on a loan, Prosper takes a cut, and a default agency does as well. After accounting for those fees, his return wouldn't exceed 9 percent, he said.

In the 10 months he has loaned money through Prosper, a few borrowers have missed payments -- several in a row, in some cases.

"You don't know how a given default situation will work out in the future," he said. "A borrower could resume payments or stop paying altogether." He said he has accepted the fact that he may not get paid back for a few of the loans.

Still, Berk said he likes the "social benefit" of peer-to-peer lending networks. "I feel like I'm contributing," he said.

Virgin Money focuses on facilitating loans between people who know each other. Chief executive Asheesh Advani started the company in 2001 as CircleLending before it was acquired in 2007 by Richard Branson's Virgin empire. The company has overseen $350 million in loans.

Virgin Money borrowers are considered to be in default if they are more than 60 days late on a payment, Advani said, and the default rate is about 3 percent. If a borrower misses a payment, lenders can choose to add an extra payment to the end of the loan, spread it over the life of the loan or double up on the next payment. They can also choose to forgive the payment.

"In my view, the flexibility is the secret sauce to peer-to-peer lending," Advani said. "Especially in today's jobless, growthless economy, people tend to have shorter-term jobs or are unemployed, but they are perfectly good credit risks."

Some students have turned to similar social networking sites to fund their educations. Carmina Alvarado, a graduate student at Santa Clara University in California, raised the $3,000 she needed for summer school through GreenNote, a two-month-old company that helps students secure private loans by tapping into their social circles.

A financial-aid counselor recommended the service to her when she realized she'd need to find a private loan to pay for summer classes. "At first I didn't know if this was for me because I didn't feel like I had a strong network of people I could e-mail," said Alvarado, 23.

She then started reaching out to former professors, friends and family members. Her sister contributed $100. So did her boyfriend's mother. A woman she used to do volunteer work for loaned $150. A cousin contributed $1,000. The remaining balance -- $1,650 -- came from total strangers.

Unlike typical private education loans, which carry interest rates of 12 to 20 percent, GreenNote loans carry terms similar to federally subsidized student loans. Many loans have a rate of about 6 percent, and some are lower. Borrowers have a six-month grace period after graduating before they have to start making payments.

Alvarado's loan has an 8 percent rate, and she has 10 years after graduating to pay it back. She said she thinks people are less likely to default on a loan from individuals, rather than institutions, even if they don't know their lenders.

"It's more personal -- people who are lending me the money really believe in me, and that motivates me a lot," she said. "They're investing in me, and I'll do the best I can because I don't want that to go to waste."

Akash Agarwal, GreenNote's founder and chief executive, said the system helps students build credit. It can hurt them, as well: If they default, GreenNote will report them to a collection agency.

"You're being underwritten by the social connection," Agarwal said. "The pressure to pay back a loan is pretty visible because you know where the money is coming from -- it's coming out of someone's pocket, not some bank warehouse."

Saturday, August 23, 2008

Mortgage Shopping, Incognito Sites Require Fewer Personal Details to Generate Quotes

(WP) Even though mortgage lenders have raised the bar on what it takes to qualify for a home loan, shopping for a loan online has gotten easier, if not necessarily less confusing.

Where mortgage-scouting Web sites traditionally required users to enter personal information to generate rate estimates, the newest sites offer a way to comparison shop for a loan under a blanket of anonymity.

This can help allay concerns about turning over personal information online or being hounded for weeks by mortgage lenders soliciting business.

But do these rates hold up once names, credit scores and other personal details enter the picture?

"My gut instinct is that there will be a wide disparity about what rates are quoted on these sites and what they actually end up with, and not necessarily due to the borrower," said Robert Statnick, chairman of the California Mortgage Bankers Association. "All the sites may not collect all the data that's necessary to give an actual price quote."

The lenders do collect the data they need to figure out what to charge for a loan, but these sites have made it possible to delay that step to give a borrower time to shop incognito. and Mortgage have embraced this concept in the past year, though that's where their similarities end.

Mortgage Marvel bills itself as the mortgage-shopping version of travel sites Orbitz or Expedia.

The site, which launched in the spring, is operated by Mortgagebot, a Milwaukee-based provider of online loan-origination technology for banks and other lenders.

Like the online travel sites, Mortgage Marvel lets users enter details on the kind of mortgage loan they need and the site rounds up real-time rate and lender fee quotes from hundreds of lenders.

The site boasts that users don't need to punch in personal details to get real rates instead of teaser rates used to bait visitors. The catch: Users must have a credit score of 720 or better.

Mortgage Marvel says it can make this claim because it's tapped directly into 250 banks and credit unions' automated loan pricing databases. (It gets a fee every time a user fills out an application with a lender on the site.)

The site requires users to enter three pieces of information: the loan amount, the property's value and its Zip code. Users can toss in a few more variables, including specifying whether they're hoping to buy a condo or a detached home, whether they would prefer a 30-year, fixed-interest rate loan or an adjustable-rate mortgage.

The site then displays a list of any lenders offering quotes on the loan.

But that's where anonymity ends. To find out whether a borrower qualifies for the rate, he must fill out an application, providing personal information to the lender.

"It's easy, reliable, accurate and fast -- there's no bait-and-switch," said Dan Welbaum, chief marketing officer for Mortgagebot.

Zillow's Mortgage Marketplace page also doesn't ask for identifying information other than an e-mail address.

Instead, Zillow relies on the honor system, counting on users to fill in accurate information about their personal financial profile, such as their credit score -- unlike sites that ask for a Social Security number to run the credit check themselves -- annual income, money in savings and so on.

Zillow users are also asked to enter how much money they want to finance, as well as preferences on their loan type.

The site broadcasts this information to its roster of more than 3,300 participating mortgage brokers and lenders, which then e-mail loan rate quotes.

After selecting a broker, borrowers submit a formal application with personal information.

Zillow says loan queries will garner six rate quotes, on average, with 97 percent of all queries receiving at least one rate quote.

With several brokers vying for a sale, it's not hard to imagine that some might have incentive to low-ball their quotes in hopes of luring business.

Zillow, which makes its money by selling ads on the site, encourages participating mortgage brokers to "stick to your quote."

Spencer Rascoff, chief financial officer for Seattle-based Zillow, said the company guards against low-balling by encouraging consumers to give brokers ratings, much like the reputation rankings sellers rack up on auction giant eBay.

"All those [dubious] loan requests, they can be flagged by the community," Rascoff said.

Zillow's online forums buzz with posts from users discussing favorable and negative experiences with brokers. The site also highlights which brokers have amassed the highest positive ratings.

Since launching its mortgage search product in April, Zillow has reviewed hundreds of red flags and barred more than a dozen lenders for employing bait-and-switch tactics with their loan rates, Rascoff said.

That system has worked well on eBay, where a bad reputation can make it tough to unload even the most-prized items.

While not handing out personal information willy-nilly may be a relief, experts say it's best to keep shopping away from the computer.

"There is a plus in not having to give personal information, but you still have to ask yourself who's in and who's not included in the system," said Gail Hillebrand, a senior attorney for Consumers Union, the publisher of Consumer Reports.

"Just like some of the big travel sites don't have Southwest," she said. "You have to ask the same question. Who else is out there?"

Friday, August 22, 2008

The subprime turmoil: What's old, what's new, and what's next

The subprime crisis is the joint product of perverse incentives and historical flukes. This column explains why market actors made unrealistic assumptions about mortgage-backed securities and how various regulatory policies exacerbated the problem. The crisis will necessitate changes in monetary policy, regulation, and the structure of financial intermediation. (Charles Calomiris @ Vox)

The financial system is working through a major shock. It started with problems in the subprime mortgage market but has spread to securitisation products and credit markets more generally. Banks are being asked to absorb more risk moving off-balance-sheet assets back onto their balance sheets when their ability to do so is reduced by massive losses. The result is a bank credit crunch as the scarcity of bank equity capital is forcing banks to limit exposure to new risk.

Origins of the turmoil
There are both old and new components in the origins of the subprime shock. The primary novelty is the central role of “agency problems” in asset management.

In previous real estate-related financial shocks, government financial subsidies for bearing risk seem to have been key triggering factors, along with accommodative monetary policy, and government subsidies played key roles in the most severe real estate-related financial crises. While the subsidisation of borrowing also played a role in the current US housing cycle, the subprime boom and bust occurred largely outside the realm of government-sponsored programmes.

Investors in subprime-related financial claims made ex ante unwise investments, which seem to be best understood as the result of a conflict of interest between asset managers and their clients. In that sense, sponsors of subprime securitisations and the rating agencies whose unrealistic assumptions about subprime risk were known to investors prior to the run up in subprime investments were providing the market with investments that asset managers demanded in spite of the obvious understatements of risk in those investments.

The subprime debacle is best understood as the result of a particular confluence of circumstances in which longstanding incentive problems combined with unusual historical circumstances. The longstanding problems were (1) asset management agency problems of institutional investors and (2) government distortions in real estate finance that encouraged borrowers to accept high leverage when it was offered. But these problems by themselves do not explain the timing or severity of the subprime debacle. The specific historical circumstances of (1) loose monetary policy, which generated a global savings glut, and (2) the historical accident of a very low loss rate during the early history of subprime mortgage foreclosures in 2001-2002 were crucial in triggering extreme excessive risk taking by institutional investors. The savings glut provided an influx of investable funds, and the historically low loss rate gave incentive-conflicted asset managers, rating agencies, and securitisation sponsors a basis of “plausible deniability” on which to base unreasonably low projections of default risk.

What is the evidence for this? How do we know that asset managers willingly over-invested their clients’ money in risky assets that did not adequately compensate investors for risk?

Detailed analyses by Joseph Mason and Joshua Rosner, by the IMF, and by others describe in detail why the assumptions that underlay the securitisation of subprime mortgages and related collateralised debt obligation (CDOs) were too optimistic. These facts were known to sophisticated market participants long before the subprime collapse.

Consider, for example, rating agencies assumptions about the underlying expected losses on a subprime mortgage pool. They assumed a 6% expected loss on subprime mortgage-backed securities pools in 2006 a number that is indefensibly low. Expected losses prior to 2006 were even lower. Independent observers criticised low loss assumptions far in advance of the summer of 2007.

The 6% assumption is not a minor technical issue. It was hugely important to the growth of subprime mortgage-backed securities in the four years leading up to the crisis. It goes a long way toward explaining how subprime mortgages were able to finance themselves more than 80% in the form of AAA debts, and more than 95% in the form of A, AA, or AAA debts, issued by subprime mortgage-backed securities conduits.

So long as institutional investors buying these debts accepted the ratings agencies’ opinions as reasonable, subprime conduit sponsors and ratings agencies stood to earn, and did earn, huge fees from packaging loans with no pretence of screening borrowers.

Where did expected loss estimates come from?
How were the low loss assumptions justified, and why did institutional investors accept numbers ranging from 4.5% to 6% as reasonable forward-looking estimates of expected pool losses?

Recall that subprime mortgages were a relatively new product, which grew from humble beginnings in the early 1990s, and remained small even as recently as several years ago; not until the last three years did subprime origination take off. Given the recent origins of the subprime market, which postdates the last housing cycle downturn in the US (1989-1991), how were ratings agencies able to ascertain what expected losses would be on a subprime mortgage pool? A significant proportion of subprime mortgages defaulted in the wake of the 2001 recession. Although the volume of outstanding subprime mortgages was small, a very high proportion of them defaulted; in fact, only in the last quarter has the default rate on subprime mortgages exceeded its 2002 level. The existence of defaults from 2001-2003 created a record of default loss experience, which provided a basis for the 6% expected loss number.

Of course, this was a very unrepresentative period on which to base loss forecasts. Low realised losses reflected the fact that housing prices grew dramatically from 2000 to 2005. In a flat or declining housing market the more reasonable forward-looking assumption for a high-foreclosure state of the world both the probability of default and the severity of loss in the event of default would be much greater (as today’s experience demonstrates). The probability of default would be greater in a declining housing market because borrowers would be less willing to make payments when they have little equity at stake in their homes. Loss severity would be greater in a declining housing market because of the effect of home price appreciation on lenders’ recoveries in foreclosure.

This error was forecastable. For the most part, the housing cycle and the business cycle coincide very closely. Most of the time in the past (and presumably, in the future) when recession-induced defaults would be occurring on subprime mortgages, house prices would be not be appreciating. This implies that the loss experience of 2001-2003 (when house prices rose) was not a good indicator either of the probability of foreclosure or of the severity of loss for subprime mortgage pools on a forward-looking basis. Anyone estimating future losses sensibly should have arrived at a much higher expected loss number than the 4.5%-6% numbers used during the period 2003-2006.

Another reason that the expected losses were unrealistically low relates to the changing composition of loans. Even if 6% had been reasonable as a forward-looking assumption for the performance of the pre-2005 cohorts of subprime borrowers, the growth in subprime originations from 2004 to 2007 was meteoric, and was accompanied by a significant deterioration in borrower quality. Was it reasonable to assume that these changes would have no effect on the expected loss of the mortgage pool? The average characteristics of borrowers changed dramatically, resulting in substantial increases in the probability of default, which were clearly visible by 2006 even for the 2005 cohort.

Of course, investors could have balked at these assumptions as unrealistic, precisely because they were based on a brief and unrepresentative period. Why didn’t they? Because they were investing someone else’s money and earning huge salaries, bonuses, and management fees for being willing to pretend that these were reasonable investments. And furthermore, they knew that other competing asset managers were behaving similarly and that they would be able to blame the collapse (when it inevitably came) on a surprising shock. The script would be clear, and would give “plausible deniability” to all involved. “Who knew? We all thought that 6% was the right loss assumption! That was what experience suggested and what the rating agencies used.” Plausible deniability was a coordinating device for allowing asset managers to participate in the feeding frenzy at little risk of losing customers (precisely because so many participated). Because asset managers can point to market-based data and ratings at the time as confirming the prudence of their actions on a forward-looking basis, they are likely to bear little cost as the result of investor losses.

Official input and managerial incentive problems
Various regulatory policies unwittingly encouraged this “plausible deniability” equilibrium. Regulation contributed in at least four ways.

    • Insurance companies, pension funds, mutual funds, and banks all face regulations that limit their ability to hold low-rated debts, and the Basel I and II capital requirements for banks place a great deal of weight on rating agency ratings.

By granting enormous regulatory power to rating agencies, the government encouraged rating agencies to compete in relaxing the cost of regulation (through lax standards). Rating agencies that (in absence of regulatory reliance on ratings) saw their job as providing conservative and consistent opinions for investors changed their behaviour as the result of the regulatory use of ratings, and realised huge profits from the fees that they could earn from underestimating risk (and in the process provided institutional investors with plausible deniability).

    • Unbelievably, Congress and the Securities and Exchange Commission (SEC) were sending strong signals to the rating agencies in 2005 and 2006 to encourage greater ratings inflation in subprime-related collateralised debt obligations!

In a little known subplot to the ratings-inflation story, the SEC proposed “anti-notching” regulations to implement Congress’s mandate to avoid anti-competitive behaviour in the ratings industry. The proposed prohibitions of notching were directed primarily at the rating of CDOs and reflected lobbying pressure from ratings agencies that catered most to ratings shoppers.

Notching arose when collateralised debt obligation sponsors brought a pool of securities to a rating agency to be rated that included debts not previously rated by that rating agency. For example, suppose that ratings shopping in the first generation of subprime securitisation had resulted in some mortgage-backed securities that were rated by Fitch but not Moody’s (i.e., perhaps Fitch had been willing to bless a higher proportion of AAA debt relative to subprime mortgages than Moody’s). When asked to rate the CDO that contained those debts issued by that subprime mortgage-backed securities conduit, Moody’s would offer either to rate the underlying MBS from scratch, or to notch (adjust by a ratings downgrade) the ratings of those securities that had been given by Fitch.

    • Changes in bank capital regulation introduced several years ago relating to securitisation discouraged banks from retaining junior tranches in securitisations that they originated and gave them an excuse for doing so.

This exacerbated agency problems by reducing sponsors’ loss exposures. The reforms raised minimum capital requirements for originators retaining junior stakes in securitisations. Sponsors switched from retaining junior stakes to supporting conduits through external credit enhancement (typically lines of credit of less than one year), which implied much lower capital requirements. Sponsors that used to retain large junior positions (which helped to align origination incentives) no longer had to worry about losses from following the earlier practice of retaining junior stakes. Indeed, one can imagine sponsors explaining to potential buyers of those junior claims that the desire to sell them was driven not by any change in credit standards or higher prospective losses, but rather by a change in regulatory practice a change that offered sponsors a plausible explanation for reducing their pool exposures.1

    • The regulation of compensation practices in asset management likely played an important role in the willingness of institutional investors to invest their clients’ money so imprudently in subprime mortgage-related securities.

Casual empiricism suggests that hedge funds (where bonus compensation helps to align incentives and mitigate agency) have fared relatively well during the turmoil, compared to other institutional investors, and this likely reflects differences in incentives of hedge fund managers, whose incentives are much more closely aligned with their clients.

The standard hedge fund fee arrangement balances two considerations: the importance of incentive alignment (which encourages profit sharing by managers), and the risk aversion of asset managers (which encourages limiting the downside risk exposure for managers). The result is that hedge fund managers share the upside of long-term portfolio gains but have limited losses on the downside. Because hedge fund compensation structure is not regulated, and because both investors and managers are typically highly sophisticated people, it is reasonable to expect that the hedge fund financing structure has evolved as an “efficient” financial contract, which may explain the superior performance of hedge funds.

The typical hedge fund compensation structure is not permissible for other, regulated asset managers. Other asset managers must share symmetrically in portfolio gains and losses; if they were to keep 20% of the upside, they would have to also absorb 20% of the downside. Since risk-averse fund managers would not be willing to expose themselves to such loss, regulated institutional investors typically charge fees as a proportion of assets managed and do not share in profits. This is a direct consequence of the regulation of compensation, and arguably has been a source of great harm to investors, since it encourages asset managers to maximise the size of the funds that they manage, rather than the value of those funds. Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.

Propagation of the turmoil
When it comes to the shock’s spread, much is familiar. As usual, the central role of asymmetric information is apparent in adverse selection premia that have affected credit spreads and in the quantity rationing of money market instruments. But there is an important and favourable novelty the ability and willingness of banks to raise new capital. As of mid-June 2008, financial institutions had raised over $300 billion in new capital to mitigate the consequences of subprime losses.

This novelty is especially interesting in light of the fact that the subprime shock (in comparison to previous financial shocks) is both large in magnitude and uncertain in both magnitude and incidence. In the past, shocks of this kind have not been mitigated by the raising of capital by financial institutions in the wake of losses. This unique response of the financial system reflects improvements in the US financial system’s diversification that resulted from deregulation, consolidation, and globalisation.

Another unique element of the response to the shock has been the activist role of the Fed and the Treasury, via discount window operations and other assistance programmes that have targeted assistance to particular financial institutions. Although there is room for improving the methods through which some of that assistance was delivered, the use of directly targeted assistance is appropriate and allows monetary policy to be “surgical” and more flexible (that is, to retain its focus on maintaining price stability, even while responding to a large financial shock). Unfortunately, in the event, the Fed threw caution to the wind in its Fed funds rate cuts, driving long-term inflation expectations significantly higher over the past year. The Fed could have, and should have, maintained financial stability through surgical interventions and provided less inflationary monetary stimulus than it did in the form of rate cuts.

Near-term implications: monetary policy, regulation, and restructuring
Dire forecasts of the near-term outlook for house prices and attendant macroeconomic consequences of subprime foreclosures for bank net worth and consumption reflect an exaggerated view of downside risk. Inflation and long-term inflation expectations have risen substantially and pose an immediate threat. Monetary policy should focus on maintaining a credible commitment to price stability, which would ensure the continuing stability of the dollar, encourage stock market recovery, and therefore assist the process of financial institution recapitalisation.

Regulatory policy changes that should result from the subprime turmoil are numerous, and they include reforms of prudential regulation for banks, an end to the longstanding abuse of taxpayer resources by Fannie Mae and Freddie Mac, the reform of the regulatory use of rating agencies’ opinions, and the reform of the regulation of asset managers’ fee structures to improve managers’ incentives. It would also be desirable to restructure government programmes to encourage homeownership in a more systemically stable way, in the form of down payment matching assistance for new homeowners, rather than the myriad policies that subsidise housing by encouraging high mortgage leverage.

What long-term structural changes in financial intermediation will result from the subprime turmoil? One likely outcome is the conversion of some or all standalone investment banks to become commercial (depository) banks under Gramm-Leach-Bliley. The perceived advantages of remaining as a standalone investment bank the avoidance of safety net regulation and access to a ready substitute for deposit funding in the form of repos have diminished as the result of the turmoil. The long-term consequences for securitisation will likely be mixed. In some product areas with long histories of favourable experiences like credit cards securitisation is likely to persist and may even thrive from the demise of subprime securitisation, which is a competing consumer finance mechanism. In less-time tested areas, particularly those related to real estate, simpler structures, including on-balance sheet funding through covered bonds, will substitute for discredited securitisation in the near term and perhaps for many years to come.

1 Of course, either through external enhancement or voluntary provision of support to their conduits, sponsors may still be taking an effectively junior position, and of course, many did so by absorbing losses that otherwise would have been born by other investors.

Thursday, August 21, 2008

FDIC Mod Plan: Welcome to the Real World

(Tanta @ Calculated Risk) I'm going to go out on a limb here and suggest that the FDIC's plan for modifying IndyMac loans is, overall, a great thing. I am glad it is happening and I truly look forward to snickering over the results.

Housing Wire has a post up this morning encapsulating the main angry responses to the FDIC's plan. Plus one response voting for the "No Big Deal" option, which I think is really the wisest one (I'm sure it comes from an industry insider):

    If the FDIC follows its stated plan, which is to maximize loan value or recovery value, a good chunk of these mods won’t go through anyway, despite the press given to it. The FDIC will find out what every other servicer already knows: for one thing, the majority of borrowers will simply ignore the offer. For another, those that do step up will give credible proof that they cannot afford their homes unless the FDIC were to undercut home value by 40 or 50 percent from current levels. And the FDIC didn’t say it was going to modify blindly here, so this is not a big deal.

The fact is that Sheila Bair has spent a lot of time and energy in the last year or so castigating mortgage servicers for not doing enough to modify loans and prevent foreclosures. So now, being the proud owner of the former IndyMac Bank, Bair has a great opportunity to show the rest of us how it's done.

And so what
innovative plan did the FDIC think up that has so far eluded every other mortgage servicer out there?

    The goal of this streamlined loan modification program is to achieve improved value for IndyMac Federal by turning troubled loans into performing loans and, thereby, avoiding unnecessary and costly foreclosures. Accomplishing this goal will reduce the costs to the FDIC of the failure of IndyMac Bank and provide improved returns to investors in securitized mortgages.

    Some mortgages serviced by IndyMac Federal are subject to additional contractual terms governing loan modifications. While additional steps are necessary to comply with those contracts, IndyMac Federal will work to expedite approvals for modifications to help eligible homeowners keep their homes.

    IndyMac Federal will only make modification offers to borrowers where doing so will achieve an improved value for IndyMac Federal or for investors in securitized or whole loans. Modification offers will be provided consistent with agreements governing servicing for loans serviced by IndyMac Federal for others. The modification program does not guarantee a modification offer for IndyMac Federal borrowers.

Translation: the FDIC has discovered no magic way to get around securitization rules or the basic calculus of maximizing recoveries to the investor (that is, doing a mod only when it is "less loss" to the investor compared to foreclosure). They will, however, "work to expedite" this process. Because of course no one else has tried that yet.

Oh, but the FDIC's program is "streamlined," you see. What does that mean?

    Once a borrower has provided financial information to an IndyMac Federal customer service representative, IndyMac Federal will evaluate whether a loan modification may be available and, if so, provide a proposed offer to the borrower by mail.

    Once a borrower has received a proposed modification offer, all it takes for them to bring their mortgage current and qualify for a final modified mortgage is to

    1. sign and return the enclosed Modification Agreement along with a check for their modified monthly mortgage payment and

    2. provide verification of their income to confirm that they qualify for the proposed modification.

    The borrower must then continue to make timely payments at the modified monthly payment amount and comply with all other terms of their mortgage agreements. If the borrower’s verified income information demonstrates that they do not qualify for the proposed modification, IndyMac Federal will contact them to discuss alternatives that may help them keep their home.

This is a whole lot faster than the way servicers have been doing mods, you see, because the FDIC goes ahead and draws up the modification agreement based on "stated" income information given by the borrower. Then the mod is mailed out, and all the borrower has to do is sign it, write a check, and, um, finally provide the documentation of the income used to qualify for the mod. If it turns out there are some, um, issues with that, then the FDIC will, um, do something else. Does this mean that the FDIC risks wasting a bunch of time and energy drawing up modification agreements that it will be unable to accept because when it finally sees those income docs, it realizes that the borrowers still don't qualify? Well, yeah. But the borrowers won't be made to wait weeks and weeks for a mod offer, unlike with those lousy private mortgage servicers. The actual ratio of successfully executed mods might be more or less the same, but nobody had to spend three weeks listening to hold music.

Do I know where the FDIC is going to get the staff to do all this lickety-split? No. But you see, the FDIC wants to do mods, unlike those lousy private mortgage servicers who just don't care and are evil. As an empirical test of the belief that attitude trumps experience and headcount, this is a public service.

So I think everyone should just quit griping and let the FDIC rip on this one. Since they've promised to use the "maximize value" test here, if they actually manage to get more successful mods done than anyone else has, they will have minimized losses to the FDIC and private investors and we can all congratulate them for that. If, as I fully expect, they don't do any better at making a silk purse out of a sow's ear than anyone else can, maybe Sheila Bair will quit pontificating about a subject that remains a lot harder than she thinks it is. That, too, we could all get behind.

Subprime Mortgage Bonds Lead `Extinct' Credits, Moody's Says

(Bloomberg) -- Subprime mortgage-backed bonds lead credit products rendered ``extinct'' by the collapse of the U.S. housing market, according to Moody's Investors Service.

Collateralized debt obligations packaging loans and structured investment vehicles will also disappear as investors refuse to buy debt linked to U.S. housing market losses, Jennifer Elliott, Moody's group managing director in the Asia- Pacific, said today at conference in Melbourne.

``These are products that have just disappeared and we certainly don't expect to be coming back,'' Hong-Kong-based Elliott said. ``There is an overwhelming level of investor concern about what will happen in credit markets, as opposed to what has happened, that is impacting issuance.''

The worst U.S. housing slump since the Great Depression has triggered more than $504 billion of writedowns and losses at the world's biggest financial companies, many of which sold and invested in securities based on American mortgages. Subprime mortgage bonds made up almost half of the world's home loan debt securities prior to the housing collapse, Elliott said.

Structured investment vehicles, which operated by selling short-term debt to buy higher-yielding assets, have been forced to wind down or have defaulted after the seizure in credit markets cut their funding avenues. Investors are also avoiding CDOs, which package mortgage-backed bonds and use the income to pay investors.

``We have seen far more contagion of risk than anyone anticipated,'' she said.

RMBS Sales Plunge

Sales of bonds backed by U.S. commercial and residential loans have fallen about 90 percent this year from the same period in 2007, Elliott said. Derivative-based securities have also plunged 90 percent and high-risk, high-yield bonds sales have been cut by 70 percent.

``We are not seeing much happening at the moment and yes it is the height of the vacation season in U.S. and Europe, but I think it is deliberate nothing is being done,'' Elliott said. ``We haven't had any real bad news for a while and that makes me nervous for the beginning of September.''

Housing Wire comments:

Her remarks underscore an issue that’s received little attention this far; the idea that where credit markets are headed has as much to do with wiping out certain vehicles as does what’s already taken place over the course of the past year.

And, certainly, market conditions suggest neither CDO nor private-party RMBS issuance is likely to return soon. Thus far in August, there has been absolutely zero non-agency MBS issuance after just $700 million issued in July, according to trade publication Asset-Backed Alert; the non-agency MBS market essentially disappeared in October of last year.

The publication also reported that worldwide CDO issuance has all but dried up, as well: just 1.5 billion in CDO issuance has been recorded in August so far, compared to the $21.8 billion recorded one year ago. In July, just $6.1 billion in CDO issues were pushed out the door, compared to $14.7 billion in June and $35 billion one year earlier.

“We have seen far more contagion of risk than anyone anticipated,” Elliot said, according to the Bloomberg story. (You think?)

Factors pushing change
In particular, pending accounting changes regarding the off-balance sheet treatment of securitizations via two previously obscure (and equally obtuse) accounting standards known as FAS 140 and FIN 46R seem likely to reduce issuer enthusiasm and make it tougher, if not impossible, for issuers to manage large-scale securitization efforts.

Further, analysts have suggested that as much as $5 trillion would need to come back on the balance sheets of various financial institutions as a result of the proposed changes.

Treasury secretary Henry Paulson, as well as Fed chief Ben Bernanke and FDIC chairman Sheila Bair, have begun pushing covered bonds as an alternative to securitized trusts. The move to establish a covered bond market in the U.S. — until recently, a vibrant covered bond market existed in Europe — comes as regulators likely have reached to the same conclusion as Moody’s regarding the future of much of structured finance surrounding mortgages.

Wednesday, August 20, 2008

FDIC Releases Details on IndyMac Loan Mods; Questions Remain

(Housing Wire) We’ve reported earlier that Federal Deposit Insurance Corp. chairman Sheila Bair was planning to use IndyMac Federal Bank — that’s the FDIC-led replacement for failed IndyMac Bank, which was closed on July 11th by the Office of Thrift Supervision — as a test case for her push towards greater loan modifications. On Wednesday, Bair formally outlined details of the program; it’s an effort to at least in part improve the selling profile of the bank to a prospective future buyer.

But it left industry participants we spoke with asking plenty of questions, mostly centered on second liens and secondary market investors.

The bottom line: borrowers with IndyMac-owned loans — those whole loans held in portfolio and controlled completely by the bank — could be involved in some extensive loan modification work, second liens notwithstanding. For those borrowers whose loans were sold off and securitized, the picture is far less clear.

The FDIC said it would focus on actively modifying loans for delinquent and severely delinquent borrowers, employing so-called “affordability modifications” en masse; in other words, the FDIC will look to write down loans to roughly whatever levels the borrower can afford, a strategy that has long been advocated by consumer groups but panned by industry representatives.

In the program details, the FDIC said it would look to put borrowers with various Alt-A loan products into “affordable” mortgages that would reduce their payment load down to a 38 percent debt-to-income ratio, including principal, interest, taxes and insurance — even if that means writing off principal, or reducing rates well below current market rates to get there.

Borrowers looking to qualify for the program would need to document their income and provide proof of primary residence, the FDIC said.

“I have long supported a systematic and streamlined approach to loan modifications to put borrowers into long-term, sustainable mortgages—achieving an improved return for bankers and investors compared to foreclosure,” said Bair in a press statement. “The program we are announcing today will provide affordable mortgages for eligible borrowers primarily in the so-called ‘Alt-A’ market.”

The FDIC said it will send an estimated 4,000 modification proposal to borrowers this week, with many more coming in the weeks ahead. IndyMac holds a $200.7 billion servicing portfolio, and roughly $21 billion of that total is in the form of whole loans owned by the bank; the rest is servicing on loans that have been sold or securitized.

HW’s sources suggested to us that pushing through the kind of loan modifications Bair touted in her press statement may likely prove to be much more difficult than most think, regardless of who owns the loan.

“I doubt the investors at the lower end of the RMBS deal chain will simply agree to be wiped out because the FDIC says so,” said one source, a mortgage consultant. “Something tells me investor groups are preparing their legal docs already, if so.”

Same thing for second lien holders, said a senior bank executive, commenting under condition of anonymity.

“We’re talking Alt-A here, which means we’re also talking second liens,” said the source. The FDIC statement on loan modifications at IndyMac didn’t address second lien positions, which would likely be wiped out in the event of a borrower refinancing.

Taken together, all that’s really known at this point that the FDIC’s move will impact some borrowers and not others; but which, and under what circumstances, remains as unclear today as it was when Bair first announced a halt to foreclosures on IndyMac-owned loans in the wake of the FDIC’s assumption of the bank’s deposits.

Related docs: FAQ on IndyMac/FDIC loan modification program, Bair’s remarks on the program

(Calculated Risk) From the FDIC: Loan Modification Program for Distressed Indymac Mortgage Loans. A couple of excerpts:

What loans are eligible?
The streamlined loan modifications will be available for most borrowers who have a first mortgage owned or securitized and serviced by IndyMac Federal where the borrower is seriously delinquent or in default. IndyMac Federal also will seek to work with others who are unable to pay their mortgages due to payment resets or changes in the borrowers’ repayment capacities. This streamlined approach applies only to mortgages for the borrower’s primary residence. As with all modifications, borrowers will have to demonstrate their financial hardship by documenting their income.
What modification options will be available to borrowers?
Under the IndyMac Federal program, eligible mortgages would be modified into sustainable mortgages permanently capped at the current Freddie Mac survey rate for conforming mortgages (now about 6.5%). Modifications would be designed to achieve sustainable payments at a 38 percent debt-to-income (DTI) ratio of principal, interest, taxes and insurance. To reach this metric for affordable payments, modifications could adopt a combination of interest rate reductions, extended amortization, and principal forbearance.
This seems to provide an incentive for IndyMac borrowers to stop making their mortgage payments until they are "seriously delinquent or in default". Then the borrower - especially Alt-A borrowers who stated their income originally - would apply for a loan modification based on their actual income. The borrower could then receive an interest rate reduction and principal forbearance.

Note: I didn't see any restriction on borrowers that overstated their income originally.

Tuesday, August 19, 2008

FHA Share of Mortgage Apps Soars: MBA

(Housing Wire) Ginnie Mae is on a hot streak. The government-insured share of mortgage applications tripled in the past year according to data compiled by the Mortgage Bankers Association and released Monday afternoon; relying on the group’s weekly application survey, the MBA said that of all mortgage applications accepted during the month of July 2008, 29.1 percent were for government-insured loans (mostly FHA) compared to 8.4 percent in July 2007.

News of the MBA data follows an HW story last week that found Ginnie Mae fixed-rate mortgage-backed securities issuance trumped similar issuance volume from Freddie Mac (FRE: 4.39 0.00%) in July, and was running ahead of both Freddie and Fannie Mae (FNM: 6.15 0.00%) to-date in August. Roughly 97 percent of FHA-endorsed mortgages are securitized via Ginnie Mae.

The government-insured share has been increasing since February 2007, the MBA said, but only since the beginning of this year has the share really exhibited significant increases; up from 9.4 percent in January. The MBA suggested that interest in government-insured mortgages still has room to run, however, relative to a record share of 43.8 percent of mortgage applications in February 1990.

Data from the U.S. Department of Housing and Urban Development show that the level of conventional to FHA refinance applications had increased 317 percent on a year over year basis in July, the bulk of which the MBA suggest was likely from borrowers looking to get out of subprime ARM products.

That said, not all FHA originations are subprime; the level of conventional to FHA refinance endorsements has increased 260.8 percent on a year over year basis, as well.

The MBA suggested growth in FHA originations was a strong impetus to push forward with proposed FHA modernization, including risk-based pricing; the recently-passed housing legislation that included a $300 billion expansion of FHA’s authority to underwrite refinancing for troubled borrowers effectively outlaws the practice. Democratic lawmakers have criticized risk-based pricing for loans as discriminatory against minorities, who tend to comprise more of the subprime credit category.

Sunday, August 17, 2008

Wingin' it at the IRS

(Tanta @ Calculated Risk) I have had occasion before now to compliment Michelle Singletary's personal finance column, The Color of Money, in the Washington Post. I don't read a lot of "personal finance" stuff because, frankly, most of it is drivel. But even in a better field of competition, I think Singletary's work would stand out as a combination of no-nonsense advice and original reporting.

Today she takes on the subject of the new $7,500 tax credit for first-time homebuyers. What started out as an attempt to explain the tax credit to potential homebuyers ends up being an interesting report on the extent to which the IRS has no particular plan at this point for managing this thing.

Since this is a loan from the IRS, will the IRS be sending an annual loan statement to taxpayers?

The details of how the IRS will collect this money or inform people have not been worked out. Smith said a line would probably be added to the standard 1040 tax form to indicate that the credit should be paid as part of your tax liability.

Can I pay off the loan early?

The IRS hasn't yet come up with a system to accommodate an early payoff. . . .

Will this be a debt that has to be settled at closing if you sell the house?

This debt isn't tied to your home but rather to you as a taxpayer. The outstanding loan will probably not be required to be paid at the closing table, Smith said. . . .

If there is not a lien on the property, how will a settlement company know the debt is due when a homeowner sells?

It probably will be up to the homeowners to inform the IRS that a sale has occurred and that they need to pay off the loan balance, Smith said.

It's this last answer that I see as an oversight nightmare for the IRS.

Let's say a homeowner sells and realizes a $7,000 profit. However, he or she still has $6,000 left on the first-time home buyer loan. This means the homeowner will have to set aside the bulk of that gain -- $6,000 -- from the sale to satisfy the tax debt, which would be due in the tax year of the sale.

If the person isn't financially disciplined and spends the money, he or she could end up with a hefty tax liability.

"We have to look at all the issues involved with this credit and figure out the best controls," Smith said.

No kidding.
I don't exactly expect any elaborate bureaucracy like the IRS to have all its operational and procedural ducks in a row within a couple of days of the passage of this kind of "stimulus" legislation, which by definition can't exactly wait for all the details to be ironed out before passage (or it is too late to "stimulate" the market). On the other hand, the work eventually has to get done, unless the IRS is willing to promise to not penalize people who don't handle this correctly. You can't exactly make it difficult for people to know when and how much to pay you and then turn around and slap them with penalties and fines if they don't follow the rules. The IRS can tell itself it's got years to figure this out, since the first installments won't be due until the 2010 tax year for people buying this year. But that inability to handle prepayments on sale of the property is going to mess that plan up.

If we had a dime, of course, for every story we've read lately that tells us that your average first-time homebuyer either doesn't read mortgage documents or manages to understand approximately every tenth word of them, including "the" and "and," we would be rich enough to fund a study comparing the relative comprehension on the part of the public of mortgage documents versus the tax code. If we had another dime for every story we've read about mortgage servicers making it difficult for people to prepay loans, refusing to provide clear payoff statements, fouling up servicing transfers and proofs of claim and generally making it an insurmountable challenge for people to know what they actually owe and where to send the damned payment, we would also be rich enough to buy the IRS a loan servicing platform it could manage not to use correctly, just like everyone else.

But no one is handing out dimes, so we will just have to send the IRS a cheap homemade housewarming present: a little note welcoming it to the neighborhood, Love, The Mortgage Industry.

F.D.I.C. Retirees Ride to Rescue in New Era of Bank Failures

(NY Times) Before he retired from the Federal Deposit Insurance Corporation three years ago, Gary Holloway was cleaning up the remnants of the savings and loan crisis two decades earlier.

His nettlesome problems included selling leaky gas stations in Florida and the Thomas Ranch in California, also in need of a petroleum cleanup. What Mr. Holloway and his co-workers were really doing was working themselves out of jobs. The F.D.I.C. closed offices and slashed its staff in the 1990s as the savings and the loan mess wound down after hundreds of failures through the 1980s.

Activity slowed, with just 29 bank failures in the five years ended in 2004. So after 30 years with the agency, Mr. Holloway retired for a laid-back life of fishing and golfing in rural Spicewood, Tex.

At the F.D.I.C., what followed was nothing — literally. From 2005 through the end of 2006, not a single bank failed, the longest such stretch since 1993.

But in March of this year, the agency came calling for Mr. Holloway. With the credit and housing crisis in full bloom, the number of troubled banks was again on the rise. A onetime colleague asked if he would return for a year to help sort out the bad loans of banks that the F.D.I.C. was shutting down.

Mr. Holloway, 57, leapt at the chance. Now, he is on the road with a SWAT-like team that swoops in to handle collapses, sort through loans and reassure the public that their deposits are safe. The work is exciting and rewarding, and he says he just might sign on for another year.

The agency, it turns out, is operating more like the rest of America, with a just-in-time work force that grows and contracts based on its needs. The F.D.I.C., which had a staff of 4,600 at the end of 2007, has brought back about 80 people — largely retirees — and may well recruit dozens and even hundreds more people.

The extra people will help the agency, whose day-to-day activities are providing insurance for depositors, collecting premiums and regulating the nation’s financial institutions, work out the loans at failing banks.

The advantages to retirees are several. Not only do they work for a specified length of time, but they also have something that the younger people lack: experience overseeing failed institutions.

Commuting to faraway cities may prove tiresome, but the workers do not have the responsibilities of younger people with growing families either. Getting home is a hassle, Mr. Holloway concedes. The F.D.I.C. staff members on bank workouts are sent home every two weeks, but flying and making connections mean frequent delays.

The F.D.I.C. hopes the retirees will share their knowledge with the less experienced. “We are trying to cross-train them to existing staff to work on bank failures, so we don’t need a huge staff waiting around for the next bank failure,” an F.D.I.C. spokesman, David Barr, said.

Even if the agency’s work force continues to swell, the figure will probably be dwarfed by the nearly 23,000 — many of them part time — who were working at the F.D.I.C. at the height of the savings and loan crisis.

Few expect the scale of the current crisis to approach that of the 1980s debacle, in which 2,000 banks and savings and loans were eventually closed. Since the mortgage crisis began a year or so ago, the F.D.I.C. has seized 11 banks, the largest being IndyMac, a mortgage lender in Pasadena, Calif., last month. (The peak year during the savings and loan crisis was 1989, with 534 closings.)

“In the 1980s one-third of the S.& .Ls were insolvent,” Mr. Barr said. “Even if you listen to the extreme reports today, it does not sound as if it will be anything like that.”

For Mr. Holloway, the return to work was quick. Within six weeks of the agency’s call, Mr. Holloway and three other returning retirees were working in Dallas on a strategic plan for the troubled ANB Financial, a bank in Bentonville, Ark., with $2.1 billion in assets that had moved fatefully into construction lending.

“I came in about three weeks before the bank was closed,” Mr. Holloway recalled. Though he was briefly in Dallas, his real office “is on the road,” he said.

The F.D.I.C. seized ANB on Friday, May 9, so that it could use the weekend to regroup and open for normal business on Monday. A total of 100 people moved into the bank’s nine Arkansas branches and three offices in the West, with the mandate to separate the assets and deposits that would be transferred to the Pulaski Bank and Trust Company.

The acquisition, by a rival bank in Little Rock, was arranged by another part of the F.D.I.C. The team was careful to camouflage their identity in the days leading up to the seizure.

Mr. Holloway and his colleagues used personal credit cards, rather than cards provided by the F.D.I.C., to avoid detection. “If anybody asked why they were in town, they were told to say that they were with the Toy Shop on business,” he said.

“It is kind of cloak and dagger,” Mr. Holloway said. “You don’t want to start a run on the bank.”

From the seizure on Friday until ANB Bank reopened all its branches on Monday for customers under the Pulaski name, it was continuous work.

Mr. Holloway and five colleagues huddled in the bank’s loan office in St. George, Utah. Two-thirds of ANB’s loans had been made in Utah.

“I was the asset manager, and the biggest assets were in Utah,” he said. “They also had offices in Jackson Hole, Wyo., and Idaho Falls, Idaho. So we consolidated them.”

ANB, like other smaller banks, had been eager to grow and had determined that its local northern Arkansas housing market, heavily laced with retirees looking for new leisure homes, was saturated. It moved further west and into construction loans. Those can be among the most treacherous because it takes years to determine if the development is successful, if people will buy the properties and if the bank will be repaid.

“Between Friday night and Sunday morning, we separated the bad loans that would ultimately be sold off from the assets and deposits that would go to Pulaski Bank and Trust Company,” Mr. Holloway said. In their first week of bank control, members of his team worked 60 to 70 hours.

They were making the sorts of decisions that would determine the fate of many projects under construction.

In one case, Mr. Holloway and his team decided to advance more money to a golf resort project that was nearly 90 percent complete. While he says the resort’s units may not bring as much as two years ago, he is convinced they will sell.

On the other hand, “we are contemplating turning one project down where the borrowers need another $7 million to $8 million,” he said. “We are about halfway through, but the builders’ net worth is not as strong as we would like.”

What the F.D.I.C. decides to sell is posted on its Web site. About $145 million in nonperforming loans of various types are listed for sale from ANB, along with a few properties from Arkansas to Utah.

For all the pressure and long hours, Mr. Holloway said he was invigorated by his new temp job. During the two years out of circulation, he spent more time at his lakefront home with his wife, Carla, wakeboarding and enjoying their leisure time. Partly for pay and partly to keep busy, Mr. Holloway worked one week a month — largely from home — reviewing small banks’ loans for the Small Business Administration.

He finds bailing out troubled banks more exciting and fulfilling. After all, the agency is assuring people that most accounts are guaranteed up to $100,000 even in a failure, and in larger amounts in certain circumstances. About $40 million of $1.8 billion in deposits at ANB was not covered by government insurance. That meant most depositors were protected by the F.D.I.C.

“I get gratification at a job well done and knowing that people did not lose their money,” Mr. Holloway said.

Then there is that bonus that all retirees can appreciate at a time when living costs have been rising and investment returns paltry He is now making as much as he did before he left the F.D.I.C., and he is collecting his pension.

Saturday, August 16, 2008

Winners and Losers As Loan Fees Change

(WP) The two biggest sources of mortgages for American home buyers plan to raise their base fees to counter what they call continuing "adverse conditions" in the real estate market.

At the same time, Fannie Mae and Freddie Mac, which fund more than three-quarters of all new home loans, also plan to selectively reduce fees for certain applicants whose likelihood of default and foreclosure appear to be lower than the companies' previous estimates.

The changes are being driven by what's known as risk-based pricing. Factors such as credit scores, the size of the down payment and the type of loan can push expenses on a new mortgage up or down significantly -- costing or saving a borrower tens of thousands of dollars over the term of the loan.

Here's what's happening: As of Nov. 1 for new mortgages delivered to Fannie Mae, and Nov. 7 for those delivered to Freddie Mac, baseline "adverse market" fees will be doubled, to 0.5 percent -- from $250 per $100,000 borrowed to $500 per $100,000 borrowed. That applies to all home purchasers and refinancers, irrespective of their individual risk characteristics. The higher fees either will be paid up front by borrowers or will be folded into the interest rate on the notes, adding about an eighth of a point.

Although the formal start dates for the higher fees are not until fall, major lenders already are incorporating them into their quotes and rate sheets. Neither company announced the jump in fees to the public but instead sent e-mail bulletins to their lender partners.

On the flip side of the higher baseline costs is a series of risk-based pricing changes keyed to borrowers' scores and down payments. Both companies plan to reduce fees for borrowers with high FICO credit scores -- 720 and up -- who make down payments of less than 15 percent. These borrowers will be quoted credits of one-quarter of a percentage point, amounting to cuts in their fees, at the application stage.

At the same time, borrowers with FICO scores below 720 and down payments of less than 15 percent will be charged quarter-point higher fees upfront. Why? Credit scores never have been more powerful in determining the rates and fees borrowers pay. Even more important, credit-score standards are being ratcheted up dramatically.

During the housing boom years, the dividing line between subprime applicants and borrowers deserving better rate quotes was a 620 FICO. A 700 score was a virtual guarantee of the best quotes available. Fair Isaac Corp.'s FICO scores range from about 300 -- the highest risk -- to 850, the lowest risk. Now, even FICO scores in the upper 600s or above 700 are subject to higher fees in some cases.

For example, if you are applying for a loan destined to be funded by Fannie Mae and you have a 739 FICO score and a down payment of 20 percent to 25 percent, you're likely to be hit with a quarter-point fee increase that you wouldn't have been charged as recently as last month.

You might protest. Since when is a FICO of nearly 740 not deserving of the lowest fees? Fannie's implicit answer through its revised risk-based pricing system: Sorry, but a 739 FICO no longer makes the highest grade when the applicant can't make a 30 percent or 40 percent down payment.

Worse yet, if you've got a FICO score below 720 and don't have at least a 30 percent down payment, you're going to get hit with a half-percentage-point delivery fee upfront.

So why are Fannie Mae and Freddie Mac actually decreasing fess to borrowers with high credit scores who make down payments of less than 15 percent? Isn't that counterintuitive, because default risks rise when down payments are smaller?

Yes, but in Fannie Mae and Freddie Mac's world, all loans with 20 percent or smaller down payments require private mortgage insurance to protect the companies from the deepest losses associated with foreclosures. Now both companies have decided that they can charge a little less on such loans because the insurance lowers their risk of serious loss. That's good news for moderate-income first-time buyers with sterling credit who don't have a lot of cash.

Not coincidentally, both companies are required by Congress to serve such creditworthy buyers, many of whom have lately been turning to the Federal Housing Administration for lower-cost, low-down-payment mortgage deals.

Friday, August 15, 2008

Home Equity Frenzy Was a Bank Ad Come True

(NY Times) "Live Richly” That catchy slogan, dreamed up by the Fallon Worldwide advertising agency, was pitched in 1999 to executives at Citicorp who were looking for a way to lure Americans to financial products like home equity loans. But some in the room did not like it. They worried the phrase would encourage people to live exorbitantly, says Stephen A. Cone, a top Citi marketer at the time.

Still, “Live Richly” won out. The advertising campaign, which cost some $1 billion from 2001 to 2006, urged people to lighten up about money and helped persuade hundreds of thousands of Citi customers to take out home equity loans — that is, to borrow against their homes. As one of the ads proclaimed: “There’s got to be at least $25,000 hidden in your house. We can help you find it.”

Not long ago, such loans, which used to be known as second mortgages, were considered the borrowing of last resort, to be avoided by all but people in dire financial straits. Today, these loans have become universally accepted, their image transformed by ubiquitous ad campaigns from banks.

Since the early 1980s, the value of home equity loans outstanding has ballooned to more than $1 trillion from $1 billion, and nearly a quarter of Americans with first mortgages have them. That explosive growth has been a boon for banks. Banks’ returns on fixed-rate home equity loans and lines of credit, which are the most popular, are 25 percent to 50 percent higher than returns on consumer loans over all, with much of that premium coming from relatively high fees.

However, what has been a highly lucrative business for banks has become a disaster for many borrowers, who are falling behind on their payments at near record levels and could lose their homes.

The portion of people who have home equity lines more than 30 days past due stands 55 percent above its average since the American Bankers Association began tracking it around 1990; delinquencies on home equity loans are 45 percent higher. Hundreds of thousands are delinquent, owing banks more than $10 billion on these loans, often on top of their first mortgages.

None of this would have been possible without a conscious effort by lenders, who have spent billions of dollars in advertising to change the language of home loans and with it Americans’ attitudes toward debt.

“Calling it a ‘second mortgage,’ that’s like hocking your house,” said Pei-Yuan Chia, a former vice chairman at Citicorp who oversaw the bank’s consumer business in the 1980s and 1990s. “But call it ‘equity access,’ and it sounds more innocent.”

Changing the Language

Many experts say the ads encouraged Americans to go deeper into debt.

“It’s very difficult for one advertiser to come to you and change your perspective,” said Sendhil Mullainathan, an economist at Harvard who has studied persuasion in financial advertising. “But as it becomes socially acceptable for everyone to accumulate debt, everyone does.” A spokesman for Citigroup said that the bank no longer runs the “Live Richly” campaign and that it no longer works with the advertising agency that created it.

Citi was far from alone with its simple but enticing ad slogans. Ads for banks and their home equity loans often portrayed borrowing against the roof over your head as an act of empowerment and entitlement. An ad in 2002 from Fleet, now a part of Bank of America, asked, “Is your mortgage squeezing your wallet? Squeeze back.” Another Fleet ad said: “The smartest place to borrow? Your place.”

One in 2006 from PNC Bank pictured a wheelbarrow and the line, the “easiest way to haul money out of your house.”

In 2003, one from Citigroup said a home could be “the ticket” to whatever “your heart desires.” It continued: “You’ve put a lot of work into your home. Isn’t it time for your home to return the favor?”

In 2004, Banco Popular said in its “Make Dreams Happen” ads: “Need Cash? Use Your Home.”

“Seize your someday,” a Wells Fargo ad advised in 2007.

It might seem hard to believe, but not long ago people borrowed money to buy a home with the expectation that they would eventually pay off the debt. A mortgage had a finish line. You mailed your check to the bank every month for 20 or 30 years, paying interest and principal, and bit by bit, at the end you owned your home free and clear.

The newly mortgage-free even used to throw mortgage-burning parties to celebrate their financial freedom. In 1975, Edith and Archie Bunker torched their mortgage on “All in the Family.” Two years later, the Walton family burned theirs on “The Waltons.”

Now the idea of paying off the mortgage and owning a home outright is disappearing. One reason is that many people make smaller down payments on homes than they once did, so it takes longer to pay off their debt.

But another reason is that banks now enable homeowners to keep borrowing. In fact, they encourage it. Little by little, millions of Americans surrendered equity in their homes in recent years as home prices seemed to rise inexorably from one peak to the next.

As a result, the United States has become a nation of half-home owners. For the first time since World War II, the portion of home value that Americans own has fallen to less than 50 percent. In the 1980s, that figure was 70 percent.

Bankers defend home equity loans by saying they merely give customers what they want: Easy credit to buy things that they otherwise might not be able to afford. Advertising executives say society’s attitudes about debt shaped the ads, not the other way around.

The phrase home equity loan has been around since at least the Depression, when it appeared in classified ads. But the transformation of the second mortgage into the home equity loan began in earnest in the 1970s and early 1980s.

That was when federal laws allowed mainstream banks to offer second mortgages as well as loans with interest-only, adjustable rates and so-called piggyback features combining first and second mortgages. Until then, such products were primarily marketed to lower-income customers by savings and loans and financing companies, like Beneficial and Household Finance.

Marketing executives knew that “second mortgage” had an unappealing ring. So they seized the idea of “home equity,” with its connotations of ownership and fairness. The phrase was also used for lines of credit, which are sometimes taken out by people who have already paid off their first mortgage.

But in the early 1980s, Americans were not very familiar with the concept of dipping into home equity. Charles Humm, the senior vice president for marketing and sales at Merrill Lynch Credit Corporation, had to go on a road show explaining the idea to potential customers.

He had to change the notion that only people in financial trouble took out a second mortgage, he recalls. Merrill wanted to sell second mortgages to consumers who did not need to borrow money urgently.

“The second mortgage category, then as probably now, suffered from a pretty bad reputation,” he said. “It generally tended to be a credit facility of last resort, and it was done by people in dire straits. That was not the audience we were after.”

The campaign worked. The amount of home equity loans outstanding grew from $1 billion in 1982 to $100 billion in 1988 — in part because a portion of the loans were tax deductible, as the ads often pointed out.

A Bank of New York ad in 1986, for instance, told homeowners who exploited those tax advantages they were “absolutely brilliant.”

An ad from CIT Financial, now struggling, said, “You don’t have to sell your home to get $10,000, $30,000 or even more in cash. You don’t even have to walk out the door.”

Citibank’s home equity ads portrayed housing as a revolving account similar to the plastic card in your wallet. One in the mid-’80s, for example, bragged: “Now, when the value of your home goes up, you can take credit for it.” Citigroup also used equity in its product name, calling the line an “Equity Source Account.”

A Different Approach

Advertising historians look back at the ’80s as the time when bank marketing came into its own. Citigroup led the way by hiring away advertising staff from packaged goods companies like General Mills and General Foods, where catchy ads were more common.

“Banking started using consumer advertising techniques more like a department store than like a bank,” said Barbara Lippert, an advertising critic for the magazine Adweek. “It was a real change in direction.”

Banks thought they were in safe territory. A Merrill Lynch executive, Thomas E. Capasse, told The New York Times in 1988 that home equity loans were safe because bankers believed that consumers would spend the money on wise investments and not “pledge the house to buy a blouse.”

Mr. Capasse worked in the bank’s division that was repackaging mortgage loans into bundles of loans to resell to investors, a practice that enabled lenders to make even more loans.

But other executives at Merrill were worried about the explosion of home equity lending. Mr. Humm, the marketing executive in Merrill’s credit division, said he was concerned about ads from other banks that suggested using home equity loans for family vacations, new pools and shopping jaunts.

“We thought it was an inappropriate use,” Mr. Humm said. “We thought it would bring to the equity access category the same kind of reputation over time that had come to the second mortgage category.”

Marketing executives who pushed the easy money slogans of the 1980s and 1990s now say their good intentions went awry.

Mauro Appezzato used to run marketing at The Money Store, now defunct, the lender whose longtime television spokesman was Phil Rizzuto, the former Yankees shortstop and announcer. In 1993, Mr. Appezzato helped come up with the pitch line “less than perfect credit,” a phrase he said was meant to refer to people whose credit was only slightly problematic.

But by the late 1990s, the phrase was co-opted by subprime lenders like Countrywide Financial, Washington Mutual, New Century and Ameriquest.

Ameriquest ran an ad in 2004 during the Super Bowl, one of the biggest advertising events of the year, that has come to symbolize the excesses of subprime lending. The ad showed a woman on an airplane climbing over the man sitting next to her to reach the aisle. The plane’s lights go off during turbulence and the woman slips, landing on the man’s lap. Other passengers gasp because it looks as if they were in a sexual embrace.

“Don’t Judge Too Quickly,” the ad said. “We Won’t.” Two and a half years later, Ameriquest went bankrupt.

Bank executives say that their customers wanted to borrow more money, and that desire is what drove changes in the marketplace. Consumers gave a resounding yes to offers of new credit, said Richard Kovacevich, the chairman of Wells Fargo, recalling questions he raised back in the 1980s when he oversaw retail banking at Citigroup.

“When you went to market research and asked people questions: would you like to have 24 by 7 access to your money? Would you like to have access to home mortgages and credit cards? Even if the product didn’t exist as such, would you like a line of credit where you can just write a check anytime?” Mr. Kovacevich said. “There’s no question, then, that that caused credit to enlarge.”

Still, Elizabeth Warren, a professor at Harvard Law School who has studied consumer debt and bankruptcy, said that financial companies used advertising to foster the idea that it is good, even smart, to borrow money.

“That ‘unused home equity in your house? Put it to work for you.’ ” Professor Warren said, mimicking the ads. “Doesn’t that sound financially sophisticated?” Not to Professor Warren. “Put it to work,” she said, is just a euphemism for borrowing.

Thursday, August 14, 2008

Jumbo Rates May Fall as Larger Mortgages Enter Market

(Bloomberg) -- Jumbo mortgage borrowers may pay lower interest rates after a trade group loosened restrictions on a market for Fannie Mae and Freddie Mac mortgage bonds to combat the housing slump.

The Securities Industry and Financial Markets Association will permit the larger loans that Fannie and Freddie will be financing to be accepted into the main market for mortgage bonds in limited amounts. That may boost rates on loans of less than $417,000 and cut the costs of some larger, or ``jumbo,'' loans.

Revised guidelines for the so-called To Be Announced market will permit securities composed of as much as 10 percent of the bigger loans, New York-based Sifma said in a statement today. Lawmakers, seeking to boost the housing market, last month expanded the ability of government-chartered Fannie and Freddie to guarantee certain jumbo loans.

``We expect higher balance borrowers to receive both rate relief and increased liquidity as was desired in the legislation,'' Sean Davy, a managing director at Sifma, said in the statement today.

Sifma, the largest Wall Street lobbying group and a successor to the Bond Market Association, sets the rules for the TBA market, where offers to buy or sell securities may be filled with debt with a range of characteristics.

Fannie Mae rose 46 cents, or 6 percent, to $8.10 in composite trading on the New York Stock exchange as of 1:42 p.m. Freddie Mac rose 40 cents, or 7.2 percent, to $5.95.

Yield Spread
The difference between yields on 10-year U.S. Treasuries and Fannie's current-coupon, 30-year mortgage securities was little changed after the announcement, at 2.15 percentage points, according to data compiled by Bloomberg. Similar rules will be adopted for Ginnie Mae securities, Sifma said.

The 10 percent limit ``preserves the overall homogeneity of the market while at the same time minimizing the risk of a negative impact on mortgage rates for lower balance loan borrowers, or, potentially, all borrowers,'' Davy said.

Rates on typical 30-year fixed-rate mortgages yesterday averaged 6.43 percent, while the cost of jumbo loans larger than Fannie and Freddie can finance was 7.5 percent, according to data. The companies earlier this year offered to purchase jumbo loans that they can finance under the February law at the same prices as smaller loans, after U.S. Representative Barney Frank complained lawmakers hadn't gotten enough ``bang for the buck.''

Sifma Options
Sifma considered accepting larger loans without limits for individual pools as well as excluding the loans, according to UBS AG analysts. The first option may have increased the sensitivity to interest-rate changes of TBA bonds and hence reduced prices, further boosting smaller-loan rates. Excluding the loans, which was Sifma's ruling when the standards for Fannie and Freddie were first relaxed by Congress in February, hindered the benefits to jumbo borrowers, Fannie and Freddie executives have said.

The National Association of Realtors had lobbied Sifma to allow the inclusion of larger loans in an Aug. 9 letter, saying the ``very favorable pricing'' the liquidity of the TBA market produces was needed to bring down large-loan rates. The group said it would accept some limits on their inclusion.

Washington-based Fannie and Freddie of McLean, Virginia, were temporarily allowed to buy or guarantee loans as large as $729,750 in high-cost areas under an stimulus bill passed in February. Under the new law, Fannie and Freddie won a permanent right to finance loans of as much as $625,500 in more expensive areas, starting next year.

Larger Loans
Sifma had said one reason it didn't allow larger loans into the TBA market after February law was because the previous legislation covered only mortgages from mid-2007 to yearend.

The rule change won't permit banks to package older mortgages into TBA-eligible securities, according to a separate e-mail from Sifma to members.

Limits for Federal Housing Administration loans, the main Ginnie collateral, also rose permanently, to the lesser of 115 percent of an area's median home price and 150 percent of the current base limit of $417,000.

TBA mortgage bonds will be worth about 5 cents to 9 cents less per $100 of principal as a result of the change ``depending on coupon and program,'' Citigroup Inc. analyst Brett Rose wrote in a note to clients today.