Tuesday, March 31, 2009

The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices

This [BIS working] paper [by Ingo Fender and Martin Scheicher] investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite.

The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment.

This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure.

In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks' balance sheets - such as the US Troubled Asset Relief Program (TARP).

Case-Shiller indices show continued falls in US house prices

House prices in 20 US cities fell 19 per cent in January compared with the same period a year ago, according to the S&P/Case-Shiller home price indices released on Tuesday. This is the fastest decline since record keeping for year-over-year declines began in 2001.

Consensus expectations of economists polled by Bloomberg had been for decline 18.6 percent from a year earlier.

The sharpest year on year declines were seen in Phoenix, where prices fell 35 per cent, and Las Vegas, which registered a 32.5 per cent fall. All 20 of the cities covered in the report posted both year on year and month on month declines.

S&P/Case-Shiller chart depicting annual returns of 10-City and 20-City home price indices

“There are very few bright spots that one can see in the data,” David Blitzer, chairman of the index committee at S&P, said in a statement. “Most of the nation appears to remain on a downward path.”

In a separate report, the Mortgage Bankers Association said its analysis showed a further decline in home loan origination volume in the fourth quarter of 2008. Commercial and multifamily mortgage debt outstanding remained relatively stable, the MBA said, noting:
Though economic pressures such as job losses and the decline in retail spending will continue to curtail originations and to raise the pressure on outstanding mortgages, expectations for the commercial mortgage market have been set so low that it may be hard to underperform them.

Tuesday, March 24, 2009

The Next Mortgage Mess: Loan Servicing?

On Forbes.com by Maurna Desmond:

When billionaire investor Wilbur Ross sued a Connecticut hedge fund Thursday, he shined a light into one of the murkier regions of the subprime mortgage morass: loan servicing.

Ross' American Home Mortgage Servicing claims Carrington Capital asked it to block the sale of homes to siphon money away from other investors and enrich itself. Irving, Texas-based American Home services some of the loans related to mortgage-backed securities where Carrington is the junior investor. "Carrington resorted to fraud when the subprime market deteriorated," says Brian Otero, a lawyer at Hunton & Williams representing American Home. Carrington declined to comment.

The suit, first reported on Housingwire.com, underscores the complicated relationship that exists between servicers and mortgage investors, especially when the one collecting payments also has skin in the game. (See "Tranche Warfare.")

Loan servicers act as middlemen between the borrowers paying the loan and investors who own the mortgages. They are responsible for monitoring delinquencies and managing billions in monthly payments. Though they play a growing--and crucial--role in unwinding the subprime mortgage mess, they have virtually no oversight. American Home Mortgage is the largest servicer of subprime and so-called "Alt-A" mortgages. Some of the biggest banks on Wall Street dominate the business. Citigroup, Wells Fargo, JP Morgan Chase and Bank of America service 55% of outstanding mortgage debt.

The four loan pools identified in the lawsuit were created from the remains of subprime lender New Century, which Carrington bought in 2007. American Home alleges the hedge fund tried to keep getting paid interest on the mortgages it held by insisting the homes be sold at above-market values, stalling the sales. At sale, the proceeds would have gone to investors senior to Carrington. American Home says the hedge fund has also been pulling more loans into its own servicing shop, called Carrington Mortgage, in order to keep its activities under wraps.

It's a twist on what critics complain is a major problem in the industry: Servicers are often investors on the mortgages they manage. "When someone is servicer and junior investor, they have a serious conflict of interest," says Jeff Gundlach chief investment officer of TCW, an L.A.-based money manager. "Their interest is supposed to be to that of the investor, but it can't be."

Delaying foreclosure or masking rising defaults can keep the money flowing to the junior investors. This hurts senior investors, often pension funds and life insurance companies, who paid a premium to buy up "Triple A" bonds which were supposed to be as safe as Treasuries.

Says Joseph Mason, a professor of finance at Louisiana State University and fellow at Wharton Business School: "Investors are right to be skeptical of the servicing industry's capacity to walk the tightrope of modifying loans in both investors' and borrowers' joint interests."

Concern about servicer integrity is heightened by the key role that the Obama administration is hoping they'll play in the costly unwind of the subprime mortgage mess. The plan is for servicers to modify delinquent loans to more affordable levels, incentivized by taxpayer funds. (See "Loan Modification Plan Gets Sweeter.") Despite that fact that the servicers collect payments, monitor delinquencies and manage billions in cash flow, they have virtually no regulatory oversight. They only report as much detail as they choose to. Industry groups such as the American Securitization Forum have repeatedly called for increased transparency and regulation.

American Home isn't the only one crying manipulation. Carrington filed its own complaint in February against a loan servicer alleging it was selling properties at "fire sale" prices because it was short on cash. The defendant: American Home.

SEC’s Probe into Subprime Mortgages Continues

Posted on the Housing Wire by Paul Jackson:

The mortgage industry remains squarely in the sights of a series of investigations by the Securities and Exchange Commission, an SEC commissioner said in Congressional testimony last Friday. The regulator continues to investigate lenders, key issuers of subprime MBS, and credit rating agencies for evidence of illegal activity, SEC commissioner Elisse Walter told members of the House Financial Services Committee.

“The SEC is investigating, among other things, improper accounting, disclosure issues, and insider trading,” she told committee members. In particular SEC officials are looking into how lenders accounted for loan loss reserves, as well as assessing whether lenders have been or continue to book foreclosed property at inflated values.

The SEC’s investigation into all things subprime has been ongoing since march 2007, but Walter’s remarks shed new light on directions the regulator is pursuing in its efforts to leave no stone unturned. Among them: an inquiry into possible understatement of mortgage delinquency and default rates.

That angle of investigation stands out, in particular, because there has long been plenty of ‘grey area’ in terms of how a lender categorizes and reports properties on its books, sources have suggested to HousingWire.

In terms of investment banks, Walter said investigations have centered on material misrepresentation of risk and expsoure, as well as the “possible intentional mispricing of securities and the knowing underwriting of securities based on collateral likely to default.” That last part should give industry participants some reason to pause — after all, numerous state attorneys general have gone after large lenders for so-called ‘predatory lending’ practices over a similar claim.

The SEC has taken nine subprime-related enforcement actions since its investigation into the area began two years ago — hardly a heavy caseload. Walter suggested the SEC needed to beef up its staffing and resources to the House committee.

“The SEC’s examination and enforcement resources are inadequate to keep pace with the growth and innovation in our securities markets,” she said.

Read her complete testimony.

Monday, March 23, 2009

Buying REOs to Rent

Posted on Calculated Risk:

The evidence suggests there has been a surge in rental units in the U.S. - far exceeding the number of new rental units being built (see: The Residential Rental Market Update). I've argued that the key factors in this surge in supply are "REO sales to cash flow investors, and frustrated sellers putting their homes up for lease".

Here is some evidence of investors buying REOs to rent.

From Jim Wasserman at the Sacramento Bee: Novice investors turn repos into rentals

... Preliminary estimates from researcher MDA DataQuick indicate that 28.4 percent of February buyers in Sacramento County were investors aiming to buy, repair and rent out their new acquisitions.

The numbers confirm a huge shift in the Sacramento housing market in recent months, one that has consumed thousands of foreclosure properties and helped prevent a once-feared pileup of for-sale signs.

Alongside an army of first-time buyers, these investors – many doing cash deals with banks – have fueled growth in home sales for nearly a year. ...

Investor market share in Sacramento County last hit 25 percent in mid-2004, the most frenzied sales year of the region's housing boom. Then it declined by half as the housing market cooled in 2006 and 2007, according to DataQuick.
Sacramento County couple Oscar Vargas and Gladys Flores ... bought five houses last year priced between $50,000 and $100,000.

"We buy the repos, and the prices are about what it was 15 years ago," Flores said. "We fix what's wrong with them. We spend a little money and put in new carpets and remodel. We do it ourselves and rent them."

The plan is to hold them for several years to see gains, she said. Flores said it's the same drill as the 1990s downturn. Then, the pair bought houses low and sold them high during the boom that followed. They now own and manage 15 rental homes, she said.
In 2004 the "investors" (really speculators) were betting on appreciation. The current breed of investor is buying for cash flow.

Saturday, March 21, 2009

How far will mortgage rates fall?

Posted on Calculated Risk:

With the Fed buying longer term Treasury securities, how far will 30 year mortgage rates fall?

On CNBC yesterday, PIMCO's Bill Gross suggested mortgage rates might fall to 4%. I think this is unlikely.

30 Year Mortgage Rates vs. Ten Year Treasury Yield Click on graph for larger image in new window.

This graph shows the relationship between the Ten Year yield (x-axis) and the 30 year mortgage rate (y-axis, monthly from Freddie Mac) since 1971. The relationship isn't perfect, but the correlation is very high.

Based on this historical data, the Fed would have to push the Ten Year yield down to around 2.3% for the 30 year conforming mortgage rate to fall to 4.5%.

Currently the Ten Year yield is 2.58% (typo corrected) suggesting a 30 year mortgage rate around 4.7%.

If the Fed buys Ten Year treasuries with the goal of 4.0% mortgage rates, they might have to push Ten Year yields down under 2.0%, maybe close to 1.5%.

Impact of Foreclosure Sales on Home Prices

Posted on the Housing Wire by Kelly Curran:

The gap between REO sales prices and the rest of the market is growing at an accelerating pace, according to a recent study by Lender Processing Services, Inc., released Thursday. In general, markets that experienced sharp drops in home prices in 2008 also saw deeper REO discounts, revealing the impact of foreclosure sales on home prices, the study said.

The home price index by LPS provides a mechanism to “separate the general trend in home prices from the trends in foreclosure and REO sales,” said Nima Nattagh, senior vice president, LPS Applied Analytics. “The ability to differentiate between the general trend in home prices and REO sales is important and allows REO asset managers to make more informed decisions about asset disposition strategies.”

The largest drop in prices of REO sales were observed in Riverside County, California, where home prices fell 28 percent between 2007 and 2008; however, including REO sales, prices in Riverside County plunged a significantly higher 34 percent from 2007 to 2008.

The study also found that, including REO sales, home prices declined by 29 percent during 2008 in the Phoenix market, where analysts cite considerable overbuilding. When REO sales were excluded from the analysis, though, the price decline was much less severe at 19 percent year-over-year.

The gap between home prices with and without REO sales was smallest in Seattle, New York and Cambridge, Massachusetts, offering further evidence that the current downturn in the housing market is regional.

While the Western states and Michigan and Florida saw double-digit declines in home prices, other regions have fared much better. But based on study results, further deterioration in the housing market will most likely deepen the REO discount levels in these markets, the study’s report concluded.

Friday, March 20, 2009

FTC to Draft New Curbs on Mortgage-Lending Abuse, Chairman Says

Posted on Bloomberg by James Rowley:

The U.S. Federal Trade Commission will use new authority to bar lending practices by mortgage brokers who have deceived and bilked borrowers, the agency’s chairman said.

A $410 billion spending package passed by Congress this month authorizes the FTC to ban abusive practices such as deceptive advertising and servicing procedures, Chairman Jon Leibowitz said yesterday in his first interview since becoming the new head of the agency.

With the U.S. economy in deep recession, “we have to step up our vigilance on predatory practices in the financial services area” because “there are a lot of American consumers that are hurting,” he said.

Leibowitz, 50, also vowed more aggressive enforcement of antitrust laws to challenge business practices by companies that harm competition.

Saying that antitrust enforcement “has been circumscribed” by court decisions over the last three decades, “it could be time for the pendulum to swing back” to allow tougher enforcement, he said.

The FTC has suffered a series of antitrust defeats in the last eight years. Last month, the Supreme Court rejected the commission’s effort to impose antitrust penalties on memory-chip technology company Rambus Inc.

The FTC had accused Rambus of scheming to get secretly patented technology included in industry-wide standards so it could exact royalties. Leibowitz said the Supreme Court’s action won’t deter the FTC from trying to stop companies from using standard-setting organizations to hurt competitors.

‘A Good Case’

“We just need to find a good case,” he said.

In cases where it’s difficult to prove a violation of antitrust laws, the FTC will bring complaints under the Federal Trade Commission Act that empowers the agency to force companies to cease particular practices, he said.

The FTC will also make greater use of its authority to force companies to return ill-gotten gains to consumers, he said. “If you are taking money away illegally from consumers you ought to give it back.”

The new authority to ban specific practices was added to the spending bill by West Virginia Senator Jay Rockefeller, a Democrat who is chairman of the Senate Commerce Committee, and North Dakota Democrat Byron Dorgan, a member of the panel. The FTC’s regulatory power over mortgage lending extends only to finance companies not owned by banks.

The provision frees the agency, in the area of mortgage lending, from following “medieval” procedures that could delay issuance of new regulations for six to eight years, Leibowitz said.

‘Bottom Fell Out’

Before the ‘bottom fell out” of the housing market, the FTC had already assigned more staff lawyers to investigate complaints of predatory lending, he said.

“The one thing we couldn’t do” was “set rules about what’s permissible and what isn’t,” Leibowitz said. The FTC had to act by bringing a consumer-protection case against a particular practice.

The new authority “will be very, very helpful to us,” said Leibowitz, who said he hoped the agency would issue new mortgage lending regulations by year’s end.

In September, the FTC obtained a $28 million settlement from Bear Stearns Cos. and its mortgage servicing unit. The company, which was acquired by JPMorgan Chase & Co. last May after its collapse, was accused of imposing unauthorized fees for late payments, inspections and loan modifications. “We are sending redress checks to 86,000 consumers,” he said.

More Cases

More cases will be announced soon, he said.

Rules for mortgage brokers are needed because “a lot of the advertising is clearly, facially deceptive” and “a lot of mortgage holders have been deceived” about what they must pay, he said. Such practices are not limited to subprime lending by mortgage brokers, he said.

Abusive and deceptive lending is “not the only reason for this problem” of foreclosures “but it is one of the reasons we are in this mess,” said Leibowitz, an FTC commissioner since 2004 who was appointed the agency’s chairman last month by President Barack Obama.

The FTC will work with Congress to expand its staff to meet the larger enforcement agenda, he said. The agency’s staff has shrunk from 1,800 in 1980 to about 1,100 today. “The quality of our work is being strained by the quantity of demands placed on us,” he said.

Lawmakers who oversee appropriations for the agency have voiced an interest in providing more staff, said Leibowitz, a former Senate aide and lobbyist for the Motion Picture Association of America.

A Democrat, Leibowitz replaced Commissioner William Kovacic, a Republican, as the agency’s chairman. Kovacic remains on the commission along with Pamela Jones Harbour, an independent and J. Thomas Rosch, a Republican. Obama has not yet nominated another Democrat to fill a vacant seat on the five- member commission.

Warning: Credit Card Practices Can Be Detrimental to Your (and Their) Health

Posted on Credit Slips by Christian E. Weller:

Here is another example from the list of “things that we saw coming, but nobody cared.” Credit card companies are suffering from record default rates. In the fourth quarter of 2008, credit card companies charged off – declared as uncollectible – a whopping 6.3 percent of their debt. Aside from a fluke spike in the data in the first quarter of 2002, this was the largest charge-off rate since the Federal Reserve began collecting these data in 1980.

Interestingly, these record setting losses for credit card lenders come after the punitive changes to the bankruptcy code were supposed to weed out the “deadbeat” borrowers and lead to lower default rates. Apparently, things did not work out as planned.

The credit card quality continued to deteriorate for a number of reasons. First, credit card lenders happily filled the void left by less access to mortgages starting in early 2006, as my colleague Tim Westrich and I documented in a report for the Center for American Progress last year. Credit card lenders expanded their business when everybody who had paid any attention knew that the overall credit quality was already deteriorating.

Second, people borrowed money because they had to. The argument that all forms of household debt, including credit cards, were caused by irresponsible borrowers has never jibed with the data. For instance, data from the Federal Reserve’s Survey of Consumer Finances show that families became less accepting of debt for conspicuous consumption over time. Also, irresponsibility cannot explain why the growth rate in debt abruptly changed after 2001. Interest rates after all fell much more slowly in the 2000s than in the 1990s. And finally, people would have to plaster the walls of their homes with plasma screen TVs, have a different iPod for every day of the year, and rent out storage units for all of their new designer wardrobes to explain the enormous additional debt that families have taken on.

Third, credit card companies milked every last dollar out of their preferred customers, the so-called “revolvers” – people who carry a balance and make some payments. Higher interest rates, increased fees, and fewer perks were typically in store for these card holders when defaults surged. The only problem with this strategy is that it will lead to an acceleration of credit card default, especially in a recession. Still, a number of credit card companies are raising their fees, cutting back on perks associated with their cards, and raising interest rates right now, even though consulting firms already estimate that the average chare off rate could go as high as 8 percent to 9 percent this year. Apparently, bilking the customer in the current quarter beats making sure that the customer can still pay the bills next quarter.

Some lenders, though, are trying to clean their balance sheet by getting rid of a selection of risky borrowers, such as American Express with its announcement to pay certain borrowers $300 if they pay off their balance and close their accounts before a specific date. They are probably not doing this out of the goodness of their hearts. Rather, having a lot of bad debt out there could cost them a hefty chunk of change. American Express already disclosed a net charge off rate of 8.7 percent in February 2009. A substantial amount of credit card debt, though, is securitized. When the excess returns on the securitized funds – earnings for investors – shrink far enough because of a rise in defaults, the investors can ask for more cash from the credit card lender or, in extreme cases, demand their money back. The term liquidity crunch probably does not aptly describe what this would mean for credit card companies.

The worst part of this crisis is that it was foreseeable. For decades, credit card companies have layered fees and excessive interest rates on their borrowers. Instead of addressing the consequences of high, complex, poorly understood credit card costs, though, the high default rates were simply explained away by declaring defaulting borrowers as deadbeats. Now that there won’t be another round of bankruptcy reform that could be sold as salvation, credit card lenders will have to come to terms with the fact that their practices were actually detrimental to their own financial health.

Wednesday, March 11, 2009

Great New Reading on Mortgage Modification

On Credit Slips by Jason Kilborn:

It's not all just fun and games with old credit cards at Katie Porter's house! She and a couple of co-authors have a great new paper on SSRN describing the history of the anti-modification provision for principal residence mortgages, an empirical study of home mortgage burdens in Chapter 13 plans, and some comments on how reasonable forced modifications of those burdens could save not only these folks' homes, but Chapter 13 in general. This had not occurred to me (I admit), but the 66% failure rate for Chapter 13 plans must be in large part explained by the burden of bloated mortgage obligations. Katie's paper more or less confirms this suspicion empirically. Reducing that burden to a reasonable level would therefore not only help people to stay in their homes, but it could result in a much higher plan-completion rate in Chapter 13 generally. This would be a great double-whammy. The paper deserves a close look by anyone interested in this hot topic.

In other related news, another CreditSlips blogger has released a particularly high-profile paper on the subject of addressing mortgage foreclosure woes. Elizabeth Warren heads the Congressional Oversight Panel looking into foreclosure mitigation practices, and the panel released its report last Friday. I can only assume the report was authored in large part by Elizabeth--it has the tell-tale signs of her incredibly lucid and incisive writing style, backed up by a wealth of empirical knowledge about how struggling with mortgages and other debts really looks in practice. Check it out!

Monday, March 9, 2009

Watchdog Critiques Obama’s Mortgage Plan

From the Housing Wire by Kelly Curran:

The Obama administration’s housing rescue plan is a step in the right direction, but the plan certainly isn’t without its downfalls, said a congressional oversight panel in a report released Friday.

The $275 billion plan, announced on February 18, aims to prevent unnecessary foreclosures through obtaining affordable payments for struggling homeowners. It’s a plan that the administration estimates could help between four and five million homeowners who would otherwise find themselves in foreclosure. While these projections are encouraging, there are “additional areas of concern that are not addressed in the original announcement of the plan,” wrote the oversight panel in its report.

“In particular, the Plan does not include a safe harbor for servicers operating under pooling and servicing agreements to address the potential litigation risk that may be an impediment to voluntary modifications,” the report said.

However, the U.S. House of Representatives approved Thursday a bill that contains a provision that would legally give mortgage service firms “safe harbor” if they try to revise distressed loans. The Senate is expected to consider its own version of the bill soon, but the chance of passage is uncertain, according to a Reuters report.

The plan also falls short in fully addressing the contributory role of second mortgages in the foreclosure process — both as it affects affordability and as it increases the amount of negative equity, the report said. And while the modification aspects of the Plan will be mandatory for banks receiving TARP funds going forward, the panel is concerned with how federal regulators will enforce these new standards industry-wide in order to reach the needed level of participation.

The Plan also supports permitting bankruptcy judges to rework underwater mortgages in certain situations. “Such statutory changes would expand the impact of the Plan,” said the report. “Without the bankruptcy piece, however, the Plan does not deal with mortgages that substantially exceed the value of the home,” which the panel warns could limit the relief it provides in parts of the country that have experienced the greatest price declines.

“The foreclosure crisis has reached critical proportions,” the oversight panel said. But it hopes by identifying the current impediments to sensible modifications that the nation can move toward “effective mechanisms to halt wealth-destroying foreclosures and put the American family — and the American economy — back on a sound footing.”

Sunday, March 8, 2009

More FHA-Backed Mortgages Go Bad Without a Single Payment

By Dina ElBoghdady and Dan Keating (Washington Post):

The last time the housing market was this bad, Congress set up the Federal Housing Administration to insure Depression-era mortgages that lenders wouldn't otherwise make.

This decade's housing boom rendered the agency irrelevant. Americans raced to aggressive lenders, seduced by easy credit and loans with no upfront costs. But the subprime mortgage market has crashed and borrowers are flocking back to the FHA, which has become the only option for those who lack hefty down payments or stellar credit. The agency's historic role in backing mortgages is more crucial now than at any time since its founding.

With the surge in new loans, however, comes a new threat. Many borrowers are defaulting as quickly as they take out the loans. In the past year alone, the number of borrowers who failed to make more than a single payment before defaulting on FHA-backed mortgages has nearly tripled, far outpacing the agency's overall growth in new loans, according to a Washington Post analysis of federal data.

Many industry experts attribute the jump in these instant defaults to factors that include the weak economy, lax scrutiny of prospective borrowers and most notably, foul play among unscrupulous lenders looking to make a quick buck.

If a loan "is going into default immediately, it clearly suggests impropriety and fraudulent activity," said Kenneth Donohue, the inspector general of the Department of Housing and Urban Development, which includes the FHA.

The spike in quick defaults follows the pattern that preceded the collapse of the subprime market as some of the same flawed lending practices that contributed to the mortgage crisis are now eroding one of the main federal agencies charged with addressing it. During the subprime lending boom, many mortgage brokers and small lenders milked the market for commissions and fees by making as many loans as possible with little regard for whether they could be repaid.

Once again, thousands of borrowers are getting loans they do not stand a chance of repaying. Only now, unlike in the subprime meltdown, Congress would have to bail out the lenders if the FHA cannot make good on guarantees from its existing reserves. And those once-robust reserves are showing signs of stress, raising the possibility that taxpayers may have to pick up the tab for the first time since the agency was established in 1934.

More than 9,200 of the loans insured by the FHA in the past two years have gone into default after no or only one payment, according to the Post analysis. The pace of these instant defaults has tripled in one year. By last fall, more than two dozen FHA home loans on average were defaulting this way every day, seven days a week.

The overall default rate on FHA loans is accelerating rapidly as well but not as dramatically as that of instant defaults.

The agency's share of the mortgage market is up from 2 percent three years ago to nearly a third of the mortgages now made, its highest level in at least two decades, according to Inside Mortgage Finance, an industry trade publication. The FHA does not lend money directly. It provides mortgage insurance for borrowers working with FHA-approved lenders and uses the premiums to cover its losses. If the premiums are not enough, taxpayers could be on the hook.

At the same time, Congress has substantially increased the amount a homeowner can borrow on an FHA loan in pricey areas, thrusting the agency into markets it was previously shut out of, such as California, where plunging home prices have made people more vulnerable to foreclosure. Moreover, lawmakers last year put the FHA in charge of a program created to address the roots of the financial crisis by helping delinquent borrowers refinance into new mortgages.

On top of all these strains, the agency now faces this swell of loans that default almost immediately.

Under the FHA's own rules, there's a presumption of fraud or material misrepresentation if loans default after borrowers make no more than one payment. In those cases, the lenders are required by the FHA to investigate what went awry and notify the agency of any suspected fraud. But the agency's efforts at pursuing abusive lenders have been hamstrung. Once, about 130 HUD investigators teamed with FBI agents in an FHA fraud unit, but this office was dismantled in 2003 after the FHA's business dwindled in the housing boom.

At the same time, the FHA office responsible for approving and policing new lenders has not expanded even as the number of active lenders doing business with the FHA more than doubled to 2,300 in the past two years.

Although the FHA insures mortgages issued by lenders, it leaves these companies to conduct their own business. If a lender writes a lot of bad loans, that's when the agency can eject it from the program. Experts in housing finance warn, however, that the FHA has inadequate staffing and technology to keep up.

William Apgar, senior adviser to new HUD Secretary Shaun Donovan, agreed that early defaults are a worrisome sign that a lender is abusing FHA-backed loans.

Malfeasance is of such concern to the Obama administration, he said, that Donovan's first meetings at HUD were about ramping up measures to combat fraud.

"We have to make sure people don't scam the system and when they do, they are held accountable," Apgar said.

Pressure to 'Get These Loans Done'

For those still looking to write loans in volume, the only game in town is government-backed mortgages, mostly those guaranteed by the FHA. But unlike with subprime business, lenders in the FHA program are asked to follow agency rules requiring borrowers to document their income, put up a modest down payment and commit to live in the homes.

"With the onslaught of FHA lending that's going on right now, they're bringing in lenders who are not familiar with FHA guidelines," said David Hail, a vice president of Allied Home Mortgage of Houston, one of the nation's largest FHA partners. He said the lenders are "under pressure from their builders or buyers to get these loans done. They're approving loans that they should not be."

The Palm Hill Condominiums project near West Palm Beach, Fla., exemplifies the problem. The two-story stucco apartments built 28 years ago on former Everglades swampland were converted to condominiums three years ago. The complex had the same owner as an FHA-approved mortgage company Great Country Mortgage of Coral Gables, whose brokers pushed no-money-down, no-closing-cost loans to prospective buyers of the condos, according to Michael Tanner, who is identified on a company Web site as a senior loan officer.

Many of the borrowers were first-time home buyers and were unable to keep up their payments. Tanner said he complained to his company that extending loans without any money down lured borrowers who either didn't understand or take seriously the payments they'd have to make. Great Country's owner, Hector Hernandez Jr., could not be reached for comment.

Eighty percent of the Great Country loans at the project have defaulted, a dozen after no payment or one. With 64 percent of all its loans gone bad, Great Country has the highest default rate of any FHA lender, according to the agency's database. It also has the highest instant default rate.

In Reston, Access National Mortgage has watched its default rate climb in three years to 6 percent from 4 percent, and the firm has had more than three dozen FHA loans go into instant default, according to federal data.

The lender is among a growing number that market FHA mortgages to borrowers through direct mail, telemarketing and the Internet, practices approved by the agency in 2005 as it tried to compete with the thriving subprime market. By the end of 2008, more than 5,200 of the agency's defaults were on loans promoted with these techniques, a sevenfold increase in one year, accord to the review of federal data. This includes, in particular, a small but rapidly growing percentage of loans that instantly defaulted.

Dean Hackemer, president of Access National Mortgage, defended direct marketing, saying it increases competition among lenders and thus forces down interest rates for borrowers. He blamed his firm's rising defaults on a bleak economy that has cost some borrowers their jobs. But he added that many of the lenders now running into trouble with FHA loans were previously selling subprime loans and related Alt-A mortgages, which required no documentation.

Refinanced Back Into Trouble

Among FHA loans with instant defaults, the upward trend is especially pronounced in refinanced deals. The number of refinancings that defaulted after zero payments or one have more than quadrupled since then end of 2007 and now represent two-fifths of all instant defaults.

The FHA is attractive to borrowers looking to refinance, in part because the agency allows for cash-out refinances, a practice Apgar called "particularly problematic." It has become rare among conventional lenders, who fear that borrowers will take the cash and walk away from the loan.

The FHA also permits "streamlined" refinancing, in which established FHA borrowers get lower rates without verifying their income. The thinking is that borrowers who are on time should stay that way if their rate drops.

Karmen Carr, a housing finance consultant for the FHA, said some mortgage brokers have been known to game the system. They coax homeowners to refinance repeatedly even though it's a costly process for the borrower, she said.

"The broker makes money on every transaction," said Carr, a former executive at mortgage financier Freddie Mac. "They're not going to turn away an application if they can get it through. There have been situations where people refinance and refinance to avoid making payments and the broker just keeps getting the fees. What do they care?"

For one homeowner in Spotsylvania, Va., it took only a month to fall behind on a new FHA-backed mortgage after she took it out in November 2007. The homeowner, a retired federal worker who asked not to be named because she's embarrassed, said she soon refinanced into another FHA loan as a way of slightly delaying a subsequent payment. Then, she refinanced again. Now, she's in default on that third loan, which she said requires two-thirds of her monthly income. Still, the mortgage pitches keep coming.

"The mortgage broker just called me again to say rates have fallen, do I want to refinance?" she said in an interview last month.

Some of the country's largest and most established lenders are so concerned about this new threat to the credit market that they are not waiting for the FHA to tighten its requirements. Instead, they are imposing new rules on the brokers they work with. Wells Fargo and Bank of America, for instance, now require higher credit scores on certain FHA loan transactions and better on-time payment history.

"We have some self-preservation methods," said Joe Rogers, executive vice president at Wells Fargo.

These large lenders often buy home loans from smaller mortgage originators and in turn bundle them as securities, which they sell to investors. The lenders typically take a fee for servicing the loans, collecting monthly payments from borrowers. If too many loans default, the lender can suffer a loss because it must keep paying the investors until the loans go into foreclosure and the FHA pays the lender for the bad loan. That can take more than a year in some states and may not fully compensate the lender.

Some experts who track FHA lending say the agency should not wait for lenders to take the lead on toughening the rules, especially given the mortgage industry's poor track record for policing subprime and other risky home loans.

"Even if the market eventually gets these guys, they shouldn't have to wait for the market to do it," said Brian Chappelle, a former FHA official who is now a banking industry consultant. "The most frequent question I get asked by the groups I talk to is: 'Is FHA going to implode?' . . . They haven't seen HUD do anything significant in the past two years to tighten up its lending."

Saturday, March 7, 2009

Housing Market’s Upside: Affordability

By Floyd Norris (NY Times):

HOUSES in the United States are now more affordable than at any time in the last 40 years, when compared with personal income.

Only a couple of years ago, home prices rose to clearly unsustainable multiples of income, and the abrupt change could hold out hope for a revival of the housing market.

In the summer of 2005, when funny-money mortgages were readily available and helping to drive up home prices, the national median sales price of a home was almost eight times as much as the average per capita after-tax income of Americans.

But by this January, with incomes up and home prices down sharply, that multiple had fallen to less than five.

That may be little comfort for many homeowners who owe more than their homes are now worth, but it does indicate that home prices have fallen far enough, at least in many areas, to make them affordable.“You have a big debt overhang problem, but you don’t have a house price problem anymore,” said Robert J. Barbera, the chief economist of ITG, an advisory firm.

Home prices vary widely from region to region, and people in areas like New York or Los Angeles can only dream of finding an acceptable home for $169,900, which the National Association of Realtors says was the median sales price of previously owned homes sold in January. That figure was down from a peak of $230,900 in July 2006. It is not clear that prices have declined enough to make houses broadly affordable in some regions.

National median prices can be misleading, particularly because more or fewer sales may be coming from high-cost or low-cost areas. Moreover, the volume of home sales has plunged. Many recent sales involved homes that were in or close to foreclosure, and may have been conducted at prices lower than the asking price for other homes in the area.

But it is also possible that the decline in the median price may understate the devastation that has befallen the housing market in some areas. In December, the latest figure available, the S.& P./Case-Shiller composite home price index for the 20 regions was off 27 percent from July 2006.

The personal income figures may also be high, since they are affected by government transfer payments and include significant increases in Medicaid and unemployment insurance payments. But the trend is the same even with transfer payments eliminated from the calculation.

Pressures are still forcing home prices down, including the difficulty of obtaining mortgages for prospective buyers who cannot meet the standards set by Fannie Mae and Freddie Mac, the government-controlled agencies that finance the bulk of new home loans now.

In addition, there was a lot of overbuilding in many areas, and even though construction has plunged, the inventory of unsold homes has stayed stubbornly high. Rising unemployment levels may discourage some who could buy from doing so.

But at least by one measure, home prices no longer appear to be high by historic standards. That fact could help to stimulate demand, if not immediately, then at least when the economy appears to stabilize.

Obama's Budget Seeks to Shrink Tax Benefits of Owning

By Kenneth R. Harney (Washington Post):

The cluster of special federal tax benefits and subsidies for homeowners has long seemed politically untouchable. Those include deductions for mortgage interest, local property taxes and capital gains exclusions on up to $500,000 in sale profits.

Is the Obama administration serious about beginning to limit at least some of these subsidies? The administration isn't commenting on anything beyond what was proposed in its first budget, submitted last week, but housing and banking trade groups are worried that the proposal to cut back on the ability of upper-income families to write off mortgage interest and other expenses is just the opening move in a longer-range effort to reform the federal tax code.

They also argue that because tax subsidies are now embedded in home prices in most segments of the market -- not just the upper end -- removing them even partially would cause housing values to drop across the spectrum.

What should homeowners make of all this? Is there a real possibility that Congress will take away tax breaks that millions of people have come to consider an essential part of the home-buying equation? Here's a quick overview of the issue:

-- What did the Obama budget propose specifically on mortgage interest and property tax deductions? Starting in 2011, homeowning households with adjusted gross incomes of $250,000 and above could take write-offs only at a 28 percent marginal tax bracket rate. To illustrate, say you're in the 35 percent bracket and have $20,000 of mortgage interest, property tax and charitable deductions, all of which are targeted in the Obama proposal. This year you would be able to write off 35 percent of the $20,000 -- $7,000. If you were capped at a 28 percent rate, you could write off only $5,600. Your tax bill would go up by $1,400.

-- Why cut these deductions? Very simply, to raise tax revenue so the government can spend the money elsewhere, such as for health care. Mortgage interest and property tax write-offs cost the Treasury massive amounts annually. In a report in October, the bipartisan congressional Joint Committee on Taxation estimated that in 2009, the mortgage interest deduction alone would cost the government $89.4 billion in forgone taxes. From 2008 to 2012, according to the committee, the interest write-off in its current form will cost the Treasury $443.6 billion. Property tax deductions will cost an additional $112 billion over the same period.

-- What impact might these -- and possibly further-reaching future changes -- have on the housing market? Home building, real estate brokerage and banking industry leaders passionately oppose the deduction cutbacks because, they say, they could lower property values and are ill-timed in terms of the vulnerable state of the market.

John Courson, president of the Mortgage Bankers Association, said that even two years in advance of the actual starting date of the Obama plan, buyers will start "pricing in" the lower tax benefits -- discounting what they are willing to pay for a house given lower future deductions.

Lawrence Yun, chief economist for the National Association of Realtors, said the devaluation ripple effect would extend to the lower- and middle-income segments.

Joe Robson, chairman of the National Association of Home Builders, said, "Financing health-care reforms by chipping away at the mortgage interest and real estate tax deductions . . . will only hurt the ailing housing market and U.S. economy." No trade group has offered specific projections of price or sales reductions attributable to the cutbacks, however.

-- Is there a longer-range plan here? Obama has not referred to a broader agenda, but some of his top economic advisers have advocated major reforms of the federal tax system. For example, his budget director, Peter R. Orszag, is on record favoring scrapping current tax deduction incentives and replacing them with a system of "refundable tax credits." The credits would provide the identical dollar amounts to homeowners at all income and price brackets. The advantage of a uniform tax-credit approach, Orszag argued in a 2006 paper for the Brookings Institution, is that it is usable by lower-income and higher-income taxpayers alike, whether they itemize or not. The credits would be "refundable" in that households who pay little or no income taxes could receive them as income supplements.

-- Could Congress agree with this year's budget proposals on tax write-offs? Given how deeply rooted the breaks are in politics and the economy -- plus the fragile state of housing -- the odds would appear to be against it. But Obama is at the height of his game, and he needs to come up with revenue to pay for health-care reform from somewhere. So don't count him out.

A Mortgage Muddle for Homeowners With Lots of Equity but Little Income

By Jack Guttentag (Washington Post):

A common problem among older homeowners is that they no longer have the income to service their mortgage and don't have a good way to convert the substantial equity in their house into cash flow. The case below is typical.

Q: I am a 67-year-old widow with a mortgage of $414,000 on a house valued at $1.25 million. I can no longer afford the mortgage payment and property taxes, but the lender will not discuss modifying my loan contract until I am behind by three payments. I don't want to destroy my credit, so I have been borrowing from family to stay current. Is there anything else I can do?

A: Assuming that you want to remain in the house, a reverse mortgage is the best solution. It would allow you to convert the existing mortgage with its accompanying payment obligation into a loan back to a bank, in which you receive the money.

Unfortunately, the loan limit on the Federal Housing Administration's Home Equity Conversion Mortgage is not high enough to help you, and the private programs with higher loan limits have essentially shut down because of the financial crisis.

In a similar case some years ago, I recommended that the borrower do a cash-out refinance, invest the cash in a mutual fund and draw cash out monthly to make the mortgage payment. That would work in this case, too.

For example, if you borrowed $800,000, the cash of $386,000 would cover the payment for at least seven years.

The trouble is that this loan would not meet current underwriting rules because the payment is too high relative to the your income -- it is not "affordable." Because of the abuses committed during the housing bubble, when many houses were sold to people who couldn't afford them, underwriting affordability rules have become extremely rigid.

No allowance is made for a situation in which the borrower is already in the house and can't afford the payment, and the purpose of the refinance is to allow her to remain in the house for years longer. Applying an affordability rule in this situation is ridiculous.

Still another possible solution is for the lender to simply drop the payment to a level that is affordable, adding the unpaid interest to the balance, for a specified number of years. Because you have so much equity, the risk of loss to the lender is negligible.

The trouble with this is that it constitutes a modification of the loan contract, and in all probability it will not be considered until the borrower is in default.

In sum, the elderly borrower with little income but a lot of equity is poorly served by our housing finance system.
Take a Chance With a Credit Line?

Among those who have benefited unexpectedly from the financial crisis are those with home equity lines of credit. Credit line rates are based on the prime rate, plus or minus a margin. The prime rate is currently 3.25 percent, the lowest it has been since 1955.

A reader with a line of credit who wrote me recently had a margin of minus 0.75 percent, which made her rate 2.5 percent. Her first mortgage had a rate of 6.5 percent, and her credit-line lender offered to increase her line by enough to pay off the first mortgage. The prospect of converting a 6.5 percent loan into a 2.5 percent loan was indeed enticing.

Nonetheless, I advised against it. That's because she did not expect to pay off the loan for 15 years, and over that long a time, the risk is too high.

The prime rate is extremely volatile. In 1980, it jumped from 13.5 percent to 21.5 percent in two months. This was an unusual episode, but unusual episodes are becoming common these days.

Furthermore, home equity credit lines offer borrowers no protections against rising market rates. On conventional adjustable-rate mortgages, the rate does not change until a specified rate adjustment date, and it is subject to a rate adjustment cap and to a maximum increase over the initial rate. On a credit line, in contrast, the rate changes whenever the prime rate changes, there are no adjustment caps, and the only maximum rates are those set by the states, and they are very high.

I did some simulations using one of the calculators on my Web site to see how long it would take a borrower who refinanced from a 6.5 percent fixed-rate mortgage to a 2.5 percent credit line to lose all the benefit of the refinance from a rising prime rate. Assuming the prime rate rose by 1 percentage point a year starting in six months, break-even occurs in about 7.5 years. The borrower who stays longer than that is a loser. If the prime rate rises by two percentage points a year, which is still quite modest, break-even becomes 3.5 years.

If the spread between the first mortgage rate and the credit line rate is four percentage points, and the borrower expects to be out within five years, I think a refinance into the home equity credit line is a good gamble.

If the rate spread is only two percentage points, I would not do it unless I planned to be out within three years.

Friday, March 6, 2009

Role of Subprime in Housing Boom Exaggerated: St. Louis Fed

By Kelly Curran (Housing Wire):

The role subprime lending played in the creation of the nation’s housing boom has most likely been overstated, according to a recent analysis released this week from the Federal Reserve Bank of St. Louis.

In fact, between 2001 and 2006, the number of terminated subprime purchase-money loans — those used to purchase rather than refinance a house – outweighed the estimated number of first-time-homebuyers with subprime mortgages. According to the analysis, many subprime borrowers may have intended to make a quick exit from subprime loans — using the loans as “bridge financing” to speculate on house prices and then sell for a profit after values increased.

Loans originated between 2001 and 2006 generally lasted less than three years, according to the report. About half the loans exited the market through pre-payment or default within the first two years of origination and nearly 80 percent did so within three years of origination. For loans originated when house prices appreciated the most, terminations were dominated by prepayments. When the housing market slowed, terminations were mostly in the form of defaults.

Yuliya Demyanyk, a senior research economist with the Federal Reserve Bank of Cleveland and author of the subprime report, said her findings are in line with an earlier study that found the housing crisis — the unusually high default rates among 2006 and 2007 — did not occur because more recent loans were in some respects much worse than all loans that originated earlier. Demyanyk said the quality of loans was declining for at least six consecutive years before the housing market crashed.

“Subprime mortgages were very risky all along,” she said. “The extent of their risk, however, was hidden by the rapid appreciation in house prices, allowing terimination of the mortgage by refinancing or pre-payment. When pre-payment became to costly — with zero or negative equity in the house increasing the closing costs of refinancings — defaults took their place.”

The study also found that subprime lending did not increase homeownership, as subprime activists believed it could. The number of defaults in a sample of subprime purchase-money mortgages within two years of origination is almost equal to the estimated number of first-time homebuyers who held subprime mortgages, the analysis found. And if the data for the rest of the market were available, Demyanyk said “the number of defaults would no doubt be even greater.”

Tranche Warfare: MBS Investor Sues American Home Over REO Sales

By Teri Buhl (Housing Wire):

A Greenwich-based hedge fund manager is in a desperate fight to keep his subprime MBS investment strategy alive. HousingWire peeled back the layers to uncover what’s really going on behind the scenes in what has become a vicious battle between the hedge fund and legendary investor Wilbur Ross’ mortgage servicing company, Irving, Tex.-based American Home Mortgage Servicing, Inc.

The lawsuit underscores just how complicated servicing non-agency securitized loans can really be, amid a push by legislators and regulators to put a common set of standards into place to help manage a housing crisis that as of yet shows little signs of slowing down.

Bruce Rose, who runs hedge fund Carrington Investment Partners LP – and who purchased a mortgage servicing platform of his own last year when former subprime high-flier New Century Mortgage went bankrupt – filed a lawsuit last month claiming that American Home Mortgage Servicing, the nation’s largest independent mortgage servicer, had been selling the REO homes it manages at ‘fire sale prices,’ because it needed cash to pay off its warehouse credit facility.

The REO sales push was hurting Rose’s hedge fund, because the loans on the homes are tied to mortgage-backed securities Rose had invested in. According to Carrington investors and sources familiar with Rose’s investment strategy, the hedge fund owns the junior tranches of the deals in question.

Carrington, which leaked a copy of the lawsuit to the Wall Street Journal before the suit had been served to American Home Mortgage and filed in court, alleges in its complaint that AHMSI saw its core credit facilities shrunk, forcing the REO sales. But sources familiar with Irving-based servicer say they’ve never worried about being able to tap the credit market – and say that selling the REOs had nothing to do with paying down an existing credit facility.

Instead, AHMSI’s decision to sell the homes was driven out of a desire to serve the best interests of the trust that represents all investors, sources say – to get the most money they could for the trust, because holding on to properties while home prices remain in a negative freefall costs most bondholders more money than simply getting the properties off the books. Most servicers have a fiduciary duty to a trust to maximize net present value of cash flows to investors, per most traditional pooling and servicing agreements that bind servicer’s activities.

David Friedman, CEO of American Home Mortgage, told HousingWire today, “The financial health of our company is strong. We paid off the original credit facility and replaced it with an AAA-rated facility. In fact, if needed, we can expand our credit limit and others can now invest in our high quality debt.”

So-called ‘tranche warfare’ is something that most investors and servicers have become accustomed to, but the Carrington/AMHSI dispute is unique because of the structure of the specific deals Carrington invested in. According to the complaint, Carrington acquired a 100 percent interest in a unique class of subordinate certificates in various MBS deals during 2005 and 2006, totaling $128.1 million in principal amount.

These subordinate certificates allegedly give Carrington the right to direct the servicer over the management and sale of all REO properties tied to the trust, a right that Carrington asserts in the pleading it had bargained specifically for in structuring the deals – three of the four MBS deals in question were issued directly by Carrington. All four deals were serviced by Option One Mortgage Company until Ross’ AHMSI unit acquired the Option One platform last year from tax giant H&R Block (HRB: 18.68 +7.85%).

Carrington argues in the complaint that its interests as a junior bondholder are in line with those of the senior bondholders, as well as trustees including Deutsche Bank (DB: 23.36 -0.13%) and Wells Fargo & Co. (WFC: 8.61 +6.03%) – allegations that are being hotly contested by sources that spoke with HousingWire.

Holding REO hostage?

Rose is currently battling an investor-led lawsuit, filed early last year, for alleged securities fraud and breach of his duties as the manager of the hedge fund; his fund booked a negative 9.75 percent return for 2008, according to an investor letter reviewed by HousingWire. That return is actually amazingly good given the upheaval among most funds investing in private-party MBS – but according to the investors in the lawsuit, Rose is improperly marking the assets in the fund to his own model.

Carrington was also one of the first hedge funds to get investors to vote on an amendment halting redemptions in late 2007; according to the securities lawsuit against the fund, Rose said if he had to sell the subprime-backed mortgage securities he would only get 10 cents on the dollar and would have to shut down the fund. The attorney representing Carrington investors told HousingWire that they anticipate moving for summary judgment shortly after Rose finally answers the original complaint, which is due later this month; such a judgment could invalidate the redemption amendment, and leave Carrington’s fund open to significant redemptions.

Sean O’Shea, an attorney representing Carrington, said that Rose was acting to protect investors by preventing redemptions. “By putting up the gate, Rose acted in the interest of all his investors and upheld his duty to all,” he told HousingWire. O’Shea also stressed that the investors’ claims are baseless. Nonetheless, a Connecticut federal judge ruled last month that the Carrington investors’ complaint had strong enough evidence to move forward with the securities fraud claim.

Rose allegedly told a fellow top hedge fund manager in 2007 that his strategy was to “isolate and hold the credit risk on subprime deals,” a strategy borne out by the unique class of securities Carrington now holds on the AMHSI-serviced loans. A hedge fund manager who knows Rose and spoke on the condition of anonymity told HousingWire, “I’d be amazed if there was actually any money left in the fund.”

How much money is left remains to be seen; but the special rights allegedly given to Carrington as a junior bondholder in the disputed loans have apparently led to some strange behavior, including allegedly attempting to direct AHMSI not to sell its REO properties, or to list them above market value to ensure they do not sell. When a loan in the pool does default, as long as the servicer still holds on to the property as a bank owned asset and marks it at the level of the original loan investment, the junior bond continues to pay out, sources told HousingWire.

In contrast, if the REO property is sold and actual market prices are recognized, the junior tranche would effectively be wiped out while the senior tranches divide up the recovered principal. So by dictating how a servicer can manage the loan, Carrington could control the value of its investment while setting up senior bondholders for a fall they may or may not have expected. Sources familiar with the situation told HousingWire that Rose has been asking AHMSI to book the REO in its deals at a mark-to-model method he prefers, rather than using independent appraisals or other common methods of property valuation.

Sources familiar with the situation also suggested that Rose originally attempted to get the trustees on the deals – Deutsche and Wells Fargo – to fire AHMSI as servicer of record, a move that led the trustees to suggest they poll all other investor classes first. When it became clear that other investors were unwilling to support the move, Rose attempted to purchase the relevant servicing rights himself to have the servicing moved over to his own shop; allegedly, Rose could not secure enough financing to manage such a purchase, and filed suit shortly thereafter.

O’Shea, Carrington’s attorney, says financing wasn’t the issue, and contends that AHMSI didn’t offer terms that were acceptable to Carrington to purchase the servicing. He also says that the hedge fund has ample room in its own credit facility to buy the servicing rights, if it wanted to.

Carrington’s complaint did not peg an alleged monetary damage suffered by the hedge fund, nor did the fund attempt to file an injunction to stop AHMSI from selling further REO properties tied to the contested securities. O’Shea told HousingWire his client has lost $128 million thus far on forced REO sales – all of the original principal amount invested. Of course, whether Carrington would have such broad rights as a junior bondholder to direct both the pricing and disposition methods of REO properties is a matter yet to be sorted out by the courts.

Both sides say they expect a long fight.

O’Shea told HousingWire that he believes according to the pooling and servicing agreement, AHMSI was required to uphold Carrington’s ‘special rights,’ as a responsibility to all investors. “They did it for the first few months, why aren’t they doing it now?” he said.

AHMSI’s Friedman told HousingWire that the servicer plans a fight of its own. “We plan to vigorously defend Carrington’s baseless claims in a court of law,” he said. “The servicer stands by the fact their real responsibility is to not violate its contractual obligations of the trust, and do right by all investors, not just the ones conveniently holding the ‘special rights.’”

Thursday, March 5, 2009

Matters of Principal

TO stanch the hemorrhage of foreclosures, we don’t need another bailout. What we need is a fix — and the wisdom to see what is in our own self-interest.

An avalanche of foreclosures is coming — as many as eight million in the next several years. The plan announced by the White House will not stop foreclosures because it concentrates on reducing interest payments, not reducing principal for those who owe more than their homes are worth. The plan wastes taxpayer money and won’t fix the problem.

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line. This is also best for taxpayers, who now effectively guarantee the securities linked to these mortgages because of the various deals we’ve made to support the banks.

For these non-prime mortgages, there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

The taxpayers need not and should not be responsible for making up the difference between the payments due bondholders before a loan is modified, and those due after modification. Why? Because the bondholders and the banks, the ultimate beneficiaries of homeowner payments, will be better off if mortgages are modified correctly and foreclosures stopped. The government “owes” them nothing more than that.

Why is writing down principal, which the Obama plan rejects, so critical to stopping foreclosures? The accompanying chart, courtesy of Ellington Management, an investment firm in Old Greenwich, Conn., tells the story.

It shows that monthly default rates for subprime mortgages and other non-prime mortgages are stunningly sensitive to whether a homeowner has an ownership stake in his home. Every month, another 8 percent of the subprime homeowners whose mortgages (first plus any others) are 160 percent of the estimated value of their houses become seriously delinquent. On the other hand, subprime homeowners whose loans are worth 60 percent of the current value of their house become delinquent at a rate of only 1 percent per month.

Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those “underwater” on their mortgages — with homes worth less than their loans — who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because — for anyone with an already compromised credit rating — it is the economically prudent thing to do.

Think of a couple with a combined income of $75,000. They took out a subprime mortgage for $280,000, but their house has depreciated to a value today of $200,000. They’ve been paying their mortgage each month, about $25,000 a year at a 9 percent rate including principal and interest. But the interest rate is not the problem. The real problem is that the couple no longer “own” this house in any meaningful sense of the word.

Selling it isn’t an option; that would just leave them $80,000 in the hole. After taxes, $80,000 is one and a half years of this couple’s income. And if they sacrifice one-and-a-half years of their working lives, they will still not get a penny when they sell their home.

This couple could rent a comparable home for $10,000 a year, less than half of their current mortgage payments — a sensible cushion to seek in these hard times. Yes, walking away from their home will further weaken their credit rating and disrupt their lives, but pouring good money after bad on a home they do not really own is costlier still.

President Obama’s plan does nothing to change the basic economic calculation this hard-pressed family and millions of others like it must make. The Obama strategy — which involves reducing their interest rate for five years and giving them, at most, $5,000 for principal reduction over five years — will still leave them paying much more than the $10,000 it would cost to rent.

And five years later, after the Obama plan has run its course, this couple will still not “own” this house. Those who accept an interest modification under that plan are likely to realize at some point that they are essentially “renting” a home and paying more than any renter would. Many of those families will re-default, and see their homes foreclosed.

Bondholders today anticipate making as little as $70,000 on a foreclosed home like that in our example. But consider how much might change simply by writing down the principal from $280,000 to $160,000, 20 percent below the current appraised value of the house. The homeowner might become eligible to refinance the $160,000 loan into a government loan at 5 percent, which would be impossible on the $280,000 mortgage.

Even if the couple couldn’t refinance and still had to pay the original rate of 9 percent, the payments would be reduced to $14,400 a year, considerably less than the $25,000 now owed, and no longer wildly more than renting would cost. And the couple would have $40,000 of equity in the house: a reason to continue to pay, or to spruce up the house and find a buyer. Either way, the original bondholders would have a very good chance of making $160,000, instead of the $70,000 expected now. Everybody wins.

If writing down principal is such a good idea, why aren’t banks and servicers (the companies that manage the pools of mortgages that have been turned into investment vehicles) doing it now? Many banks are not marking their mortgages down to the foreclosure values the market foresees, hoping instead that we taxpayers will buy out mortgages at near their original inflated value —another government bailout. Reducing principal would force them to take an immediate markdown, but a smaller one. The servicers, meanwhile, are afraid that bondholders, their clients, will sue them if they write down principal — a real prospect because the contracts that allow servicers to modify securitized mortgages put restrictions on the kinds and number of modifications they may make. Moreover, making sound modification decisions is costly; servicers don’t want to spend the money and lack the personnel to do the job.

Beyond all that, the servicers have a conflict that all but guarantees they will not modify loans to maximize bondholder value. Once a homeowner is in default, the servicer must advance that homeowner’s monthly payments to the bondholders, getting repaid itself only when the house is sold or the loan is modified. So cash-strapped servicers want to foreclose prematurely or do a quick-and-dirty modification (without due diligence and thus without considering principal reduction) to get their money back fast.

Paying servicers, these conflicted agents, $1,000 per mortgage to reduce interest payments, as the Obama plan provides, is a bad use of scarce federal dollars. Last October, on this page, we proposed that Washington pass legislation that would remove the right to modify loans or decide on foreclosure from the servicers and give it to community banks hired by the government. These community organizations would have the power to modify mortgages (including reducing principal) when doing so would bring in more money than foreclosure — particularly loans that are now current but are in danger of delinquency. Those now current would be presumed ineligible if they default before the trustees arrive to modify. Our plan is simple and would require little government spending, somewhere from $3 billion to $5 billion over three years, as opposed to the $75 billion or higher price tag for the Obama plan.

We know there are some who will be outraged at the idea that their neighbors might get a break, while they — so much more responsible — get nothing. To these outraged folks we say, you would benefit too. It is not just your home values and your neighborhoods that will deteriorate if you insist that your underwater neighbors not get relief; it is your tax dollars and that of your children that will be needed to make up for the plummeting value of those toxic assets held by banks, which we taxpayers now guarantee and may soon own outright. It is your job that will be at stake when your neighbors can no longer afford to buy goods and services, causing more companies to cut jobs. So you need to act responsibly again, for your own sake and for the welfare and future prosperity of the entire nation.

Pushback from John Carney (Clusterstock):

Obama’s mortgage plan is taking a lot of flak from people who are upset that it rejects forcing banks to write down principal on underwater mortgages. In today’s New York Times, two people who are much smarter than us bring out the big guns and fancy charts to show that writing down principal is critical to stopping foreclosures.

We wish they were right. It would be great if we could keep people in their homes and reduce the losses from foreclosure by making some minor adjustments to principal. They even expect more money would ultimately be made if banks took write downs on principal now rather than hope for either rising home prices or another bailout to save them.

Unfortunately, the smart folks--John D. Geanakoplos, a professor of economics at Yale and a partner in a hedge fund that trades in mortgage securities, and Susan P. Koniak, a law professor at Boston University—are only half right. Obama’s plan probably won’t do much. But neither will principal cram downs.

The charts of the smarts show them that default rates for mortgages are super sensitive to whether a homeowner has an ownership stake in his home. The more equity you have in your house, the more likely you are to keep paying your mortgage. That’s very true.

But this doesn’t mean that having the government cram down principal on mortgages will slow down the defaults very much. The error in the analysis is that the smarts are assuming that people with magical government-created equity will behave just like people who have equity in their homes that they earned through sweat and toil.

People who are just granted equity will behave very differently since they will essentially be playing with found money. The studies of how people treat found money are pretty decisive. They don't regard it as really their own and don't act to protect it. Found equity in homes will have the same result.

Let’s put this in language the smarts understand: they assume a homogeneity among home owners when our recent experience points to heterogeneity. In fact, the smarts are making the same error that people made when they assumed expanding home ownership would have all sorts of positive externalities and that new homeowners who bought homes during the boom would pay their mortgages just like people had for forty years.

That’s a dangerous assumption that we simply cannot afford to make again. Back to the drawing board!

House Passes Cramdown Legislation

By Paul Jackson (Housing Wire):

The House approved a hotly-contested measure that would grant bankruptcy judges the authority to alter mortgage terms to help homeowners skirt foreclosure, 234- 191, in a late Thursday vote.

Bankruptcy courts are currently barred from rewriting the loan terms on a primary residence, but under the proposed legislation, judges could reduce the interest rate, reduce the principal or extend the life of an existing loan — but only for loans underwritten prior to the enactment of the bill, at least for now.

The bill, called the Helping Families Save Their Homes Act of 2009, has been painted by key Democratic lawmakers as essential in easing the housing crisis, and was central to President Obama’s election platform; nonetheless, the original version hit a snag last week when some Democrats, who likely heard complaints from the lending community and even the general public, voiced their concerns that homeowners might abuse bankruptcy to obtain reductions in mortgages they can actually still afford.

“Our intention was to make sure this was available, but as a last resort,” said Ellen Tauscher (D-CA), a leader in the quest for provisions.

Tauscher, joined by colleagues Zoe Lofgren (D-CA) and Dennis Cardoza (D-CA), helped to hammer out a compromise to the housing bill. The compromise requires bankruptcy judges to consider whether banks offered homeowners a “qualified” loan modification –- defined as one that set monthly payments equal to approximately one-third of a borrower’s income — before opting to grant judicial aid.

“The concern is that we want to ensure that those people who get relief have tried other avenues,” House majority leader Steny Hoyer, (D-MA), said Tuesday, according to Yahoo! News. In other words, borrowers must prove they’ve thoroughly attempted to help themselves, although critics suggest such hurdles are more a decoration than any real impetus to preventing the abuse of the bankruptcy system.

The revised bill would require homeowners facing foreclosure to seek a loan modification 30 days prior to pursuing one in court, and provide their lender with the necessary personal financial information — “not just [make] a phone call to an answering machine,” said Lofgren.

Judges would also have to use federally approved appraisal guidelines in determining a home’s value and weigh a borrower’s income against their current payments before deciding whether an interest rate or principal reduction was essential.

“Some may think the changes made to the bill go too far, while others will contend that they do not go far enough,” wrote Tauscher, Lofgren and Cardoza to their colleagues. “Given the ever deepening housing crisis, however, we ask you to place such differences aside — as we have done — and support this effort.” Democrats say the legislation could cut foreclosures 20 percent.

The mortgage industry still argues that such loose access to bankruptcy court mortgage modifications could impose significant costs on its companies, which would eventually be handed off to borrowers in the form of higher fees and rates — although, the revised bill may seem somewhat more appealing to the mortgage industry.

Efforts to pass cramdown legislation has faced tough opposition in the Senate, too, at least previously, which could consider its own version of the bill later this month according to sources.

PennyMac, Mortgage-Servicing Hero

By Felix Salmon (Portfolio.com):

I'm heartened by the content of Eric Lipton's NYT story on PennyMac, even as I'm disappointed in its tone. PennyMac is a company set up by former Countrywide executives -- people who understand the mortgages which are souring around the nation. It is dedicated to buying up and servicing those mortgages in the most effective manner: reducing interest rates, working with borrowers, and not foreclosing.

One of the biggest problems in the mortgage industry right now is the lack of intelligent servicers: far too many of them are overworked and underqualified, and careen towards foreclosure even when it benefits no one. PennyMac is clearly not one of those servicers: it makes its money from homeowners' renegotiated mortgage payments, not from distressed foreclosure sales. It's exactly the kind of company this country needs more of right now.

So why has the NYT decided to run the story under the headline "Ex-Leaders of Countrywide Profit From Bad Loans"? Why does it quote one person comparing them to an arsonist (albeit a very curious type of arsonist who "buys up charred remains") and another saying that what PennyMac is doing is "tragic"?

The answer is that one of the downsides to being a distressed-debt investor is that you will always get vilified. (See vulture funds, passim.) It's very unfortunate, because these investors are a necessary part of any resolution to the current mortgage mess. We need private money to come in, provide a bid for distressed assets, and work intelligently to put homeowners on a sustainable footing. It's the kind of thing which is far more useful than filing lawsuits against lenders, as PennyMac's critics are wont to do. And yet the consumer advocates have no interest in dirtying their hands in such matters, and seem to be very happy sniping from the sidelines when someone like PennyMac starts doing something useful on a for-profit basis.

And the NYT only serves to confuse matters with reporting like this:

Its biggest deal has been with the Federal Deposit Insurance Corporation, which it paid $43.2 million for $560 million worth of mostly delinquent residential loans left over after the failure last year of the First National Bank of Nevada. Many of these loans resemble the kind that Countrywide once offered, with interest rates that can suddenly balloon. PennyMac's payment was the equivalent of 38 cents on the dollar, according to the full terms of the agreement.
Under the initial terms of the F.D.I.C. deal, PennyMac is entitled to keep 20 cents on every dollar it can collect, with the government receiving the rest. Eventually that will rise to 40 cents.

None of this is easy to understand. For one thing, PennyMac didn't pay $43.2 million for the loans -- if it had done, then it would have been paying less than 8 cents on the dollar, not 38 cents. Instead, PennyMac paid $43 million for the right to receive 20% of the income from the loans, rising to 40% when the income passes a certain level. If you use that datapoint to mark the loan portfolio to market, perhaps the value of the loans can be pegged at 38 cents on the dollar. But the point is that PennyMac is no passive bond-market investor: instead it's investing a lot of its own time and effort in this mortgage portfolio, with its phone banks working 15 hours a day to try to come to an agreement with individual homeowners.

In an ideal world, the homeowners in question would be reaching out to their servicers, asking for a renegotiation of their loans. In practice, however, people who are behind on their mortgage tend to be scared and suspicious of anybody from the mortgage company: they often avoid phone calls, and adopt an adversarial stance. Working constructively with these people is not always easy. I'm happy that PennyMac is putting real resources into doing just that.