Friday, May 29, 2009

Possible S&P CMBS Downgrades

Posted on Calculated Risk:

On Tuesday, S&P issued a request for comments on proposed changes to their CMBS rating methodology. This was the key sentence:

Our preliminary findings indicate that approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages, respectively, may be downgraded.
After some negative analyst reactions, S&P extended the comment period (ht Jason):
Standard & Poor's Ratings Services today extended the comment period for its proposed changes to its methodology for rating U.S. CMBS conduit/fusion pools to June 9, 2009. The longer consultation period, which many market participants have requested, will allow time to provide further constructive feedback.downgraded.
Citi held a conference call this morning to discuss the proposed S&P changes. One of the key points was that Citi considered the S&P rent assumptions draconian. Basically S&P was going to start with the lower of current or market rents, and then decrease rents a further 6 to 30% depending upon property type.

Actually this seems reasonable - rents are falling for all property types. Of course existing tenants will keep paying their current rent - or will they? From Bloomberg: Starbucks Pushing Landlords for 25% Cut in Cafe Rents
Starbucks Corp., the world’s largest coffee-shop operator, is pushing some U.S. landlords for as much as a 25 percent reduction in lease rates, taking advantage of a declining real estate market to save on rent.
This seems like deja vu with analysts arguing against subprime rating cuts - the duper AAA are bulletproof - only to find the rating agencies were actually behind the curve.

Thursday, May 28, 2009

Potential Consequences of 5.5% Mortgage Rates

Posted by Mark Hanson on the Field Check Group website:

With respect to yesterday’s in the mortgage market — yes, it is as bad as you can imagine. No call can be made on the near-term, however, until we see where this settles out over the next week of so. If rates do stay in the mid 5%’s, the mortgage and housing market will encounter a sizable stumble. The following is not speculation. This is what happens when rates surge up in a short period of time - I lived this nightmare many times.

Yesterday, the mortgage market was so volatile that banks and mortgage bankers across the nation issued multiple midday price changes for the worse, leading many to ultimately shut down the ability to lock loans around 1pm PST. This is not uncommon over the past five months, but not that common either. Lenders that maintained the ability to lock loans had rates UP as much as 75bps in a single day. Jumbo GSE money — $417k - $729,750 — has been blown out completely with some lender’s at 8%. I have seen it all in the mortgage world — well, I thought I had.

A good friend in the center of all of the mortgage capital markets turmoil said to me yesterday “feels like they [the Fed] have lost the battle…pretty obvious from the start but kind of scary to live through it … today felt like LTCM with respect to liquidity.”

The consequences of 5.5% rates are enormous. Because of capacity issues and the long time line to actually fund a loan in this market, very few borrowers ever got the 4.25% to 4.75% perceived to be the prevailing rate range for everyone.

A significant percentage of loan applications (refis particularly) in the pipeline are submitted to the lenders without a rate lock. This is because consumers are incented by much better pricing to lock for a short period of time…12-30 day rate locks carry the best rates by a long shot. But to get this short-term rate lock, the loan has to be complete enough to draw loan documents, which has been taking 45-75 days over the past several months depending upon the lender’s time line. Therefore, millions of refi applications presently in the pipeline, on which lenders already spent a considerably amount of time and money processing, will never fund.

Furthermore, many of these ‘applicants’ with loans in process were awaiting the magical 4.5% rate before they lock — a large percentage of these suddenly died yesterday. From the lows of a month ago to today, rates are up 20%. To make matters worse, after 90-days much of the paperwork (much taken at the date of application) within the file becomes stale-dated and has to be re-done with new dates — if rates don’t come down quickly many will have to be canceled out of the lender’s system.

To add insult to near-mortal injury, unless this spike in rates corrects quickly, a large percentage of unlocked purchases and refis will have to be denied because at the higher interest rate level, borrowers do not qualify any longer. For the final groin kicker, a 5.5% rate just does not benefit nearly as many people as a 4.5%-5% rate does. Millions already have 5.25% to 5.75% fixed rates left over from 2002-2006.

This is a perfect example of why the weekly Mortgage Applications Index is an unreliable indicator of future loan fundings and has been for a year and a half with the market so volatile. As a matter of fact you will see this index crumble over the next few weeks at the same disproportional rate as it increased over the past several months if rates don’t settle lower quickly.

With respect to banks, mortgage banks, servicers etc, under-hedging a potential sell-off with the Fed supposedly having everybody’s back was a common theme. Banks could lose their entire Q2 mortgage banking earnings and middle market mortgage banker may never recover or immediately have to close shop.

Lastly, consider sentiment — this is a real killer. This massive rate spike may have invalidated hundreds of billions spent to control the mortgage market literally overnight. This leaves the mortgage and housing market very vulnerable.

Mortgage loan officers around the country are having a very very bad day today explaining to their clients why their rate was not locked and how rates are going to come right back down. They are also taking calls from borrowers with locked loans to confirm that the loan is indeed locked, inquiring as to when it will be approved or fund, and to rush the process in order to fund the loan by end of the lock-in term. This creates a customer service log-jam that chews through lender capacity quickly making the loan process even longer. Loans with second mortgages that need to be subordinated, are in a world of their own. Essentially, everything becomes a rush. Subsequently, loan officers will not feel like getting too aggressive taking new loan applications at least for the next month unless this corrects quickly.

Press surrounding this event will be the talk of Main Street immediately and cast a serious doubt over the housing recovery story that has been the common theme for months. An overnight housing market sentiment killer wildcard is something that nobody was factoring in.

We have to see where all this settles over the next few days before making a near to mid-term call on the outright damage because at this point, Fed or Treasury shock and awe is almost certain — another common theme has been ‘if it doesn’t work throw much more money at it’.

Obviously they have been following this closely for the past few weeks, as conditions began to deteriorate, and have likely been waiting to see where the upper range was before shocking in order to get maximum benefit…that would be a humongous short squeeze in Bonds driving rates lower. The problem is…if they do shock her and it is sold into with the same fury that we have been seeing, there may not be an act two.

The bond and mortgage market got complacent with the ultimate in moral hazard’s — the Fed’s got my back. Complacency is a killer. Where we stand in two weeks in unknowable.

Re-leveraging Through Exotic Interest Only Financing

Those that must close a loan, who were not locked and who need a rate in the 4%’s will be forced into an Agency 3/1 or 5/1 fully amortized or interest only. Obviously, interest only affords the most leverage but is in part what got us here in the first place. Maybe that is the plan behind all of this — today’s rates for good borrowers are still in the high 4%’s.

Your Field Guide To The Mortgage Collapse

Posted on the Business Insider by Henry Blodget:

The housing market is crashing, and it's taking us, our banks, our economy, and our government down with it. Why? Because of the debt! The value of our houses is plummeting, but the value of our debt is staying just the same.

mortgage meltdown, chart 5-9

You knew that already. What you didn't maybe know, or at least fully appreciate, is exactly what's happening in the mortgage market that's causing all this hideousness.

Well, thankfully, Whitney Tilson has laid it all out for us. START THE TOUR >

Whitney's the managing partner at T2 Partners, a hedge fund and mutual-fund company. He's also just published a book called More Mortgage Meltdown: 6 Ways To Profit In These Bad Times.

In the book, Whitney lays out the whole mortgage disaster in pictorial form, and he has been kind enough to allow us to reprint some of his charts here. If you'd like to see updated, interactive versions, please visit Or just head over to Amazon and buy the book.

Saturday, May 23, 2009

An Easier Short-Sale Process

Posted in the Washington Post by Benny L. Kass:

If you owe more on your home than it's worth, you may be hearing a lot about short sales.

That's when you sell your property for the current market value, even though that's less than your mortgage. Your lender agrees to take the proceeds, and you walk away from the house.

Since the foreclosure frenzy began last year, many consumers who have embarked on short sales have found the process complex and time consuming. Lenders can delay decisions for months on whether to accept the process. In many cases, potential buyers have walked away from the deal because they wanted to buy a house quickly and not lose a favorable mortgage.

In an effort to smooth out the process, the Obama administration on May 14 unveiled new incentives and uniform standards and procedures for parties involved in short sales.

The changes, announced by Housing and Urban Development Secretary Shaun Donovan, are structured as an extension to the government's main foreclosure prevention program, called Making Home Affordable. They offer cash incentives to lenders and borrowers to encourage them to participate.

Donovan said the program should reduce "the damage that foreclosures impose on borrowers, financial institutions and communities."

The plan -- to go into effect when the government issues standardized documents -- does not cover everyone. To be eligible, the home must either be owner-occupied or a one-to-four unit property. Condominiums, cooperatives and mobile homes are eligible.

First trust loans must have an unpaid principal balance of $729,750 or less, before including arrearages. (Amounts are higher for multi-unit buildings.)

Here are some highlights:

-- There will be a standard "Short Sale Agreement" and an "Offer-Acceptance Letter." The lender must independently evaluate and establish the market value and determine the minimum acceptable price that it will accept.

-- The borrower must list the property with a licensed real estate agent who has experience in the area where the house is located. Lenders must allow at least 90 days for the property to be marketed and sold, although more time can be allowed depending on local market conditions.

-- The short-sale process can proceed even if the lender has started the foreclosure process, but the foreclosure sale cannot take place until the short-sale timelines have been exceeded.

-- The real estate agent is entitled to receive the usual commission, which can be deducted from the selling price. This is a significant change from the way short sales have been conducted. Until now, real estate agents often had to significantly reduce their commission to obtain lender approval. Under the new guidelines, the lender must agree not to negotiate a lower sales commission after an offer to purchase has been received.

-- The government will provide financial incentives for lenders and homeowners to participate. Lenders may receive up to $1,000 for completing a successful short sale. Homeowners may receive up to $1,500 to assist with moving expenses.

One of the most significant barriers to a short sale comes when there is a second mortgage on the property. The first lender may be willing to engage in the short sale because it is less expensive than a foreclosure. More important, many times, no one buys at the foreclosure auction, and the lender ends up stuck with the house -- and the associated costs of upkeep.

Though the first trust lender is taking a hit, it will get some cash from the sale. The second trust lender, however, will often be completely wiped out. Typically, these second-place lenders object to this.

The new plan attempts -- in a modest way -- to satisfy these concerns. The Treasury Department has agreed to share the cost of paying junior lien holders to release their claims, and will match $1 for every $2 paid by the senior lien holder, up to a total government contribution of $1,000. In effect, the junior lienholder will get a minimum of $3,000.

Clearly, this will not make these lenders happy. But they also face an unpleasant reality: If they block a short sale and the home goes to foreclosure, second trusts are by law eliminated. And although that second lender has the right to sue the borrower, as a practical matter such a lawsuit is meaningless against an insolvent debtor.

Although borrowers cannot be charged a fee for engaging in a short sale under the government plan, the plan unfortunately is silent on whether the lender can require the homeowner to come up with additional money to cover the lender's shortfall.

HUD must address this important issue when drafting the implementation documents. In my experience, some lenders will waive such payments, while others will demand that a large percentage of the shortfall be paid by the borrower.

This new program also addresses deeds in lieu of foreclosure. This is a procedure where the homeowner says in effect: "Lender, take my house and release me from my loan." If the lender agrees, it saves the cost of foreclosure, including legal fees, advertising costs and auctioneer charges.

This program will run until Dec. 31, 2012. Homeowners should consider it only as a last resort because your credit rating is hurt if you choose a short sale or a deed in lieu of foreclosure instead of going all the way to foreclosure. You should first consider refinancing, if possible, or seek a loan modification from your lender.

Renters Get New Protection From Foreclosure Renters just scored a big win against foreclosure.

Posted on the Washington Post's Local Address by Elizabeth Razzi:

You might think renters don't have to worry about losing their homes to the bank. But many have been turned out onto the street--although they were current on their rent--because the landlord wasn't current with his mortgage payments. The National Low Income Housing Coalition estimates that 40 percent of the households that lose their homes to foreclosure are renters evicted after the bank takes the home from their landlord.

Renters now have more protection against losing their homes under the new foreclosure prevention bill President Obama signed into law yesterday.

Starting immediately, the law requires that tenants who pay their rent on time can remain in their home until the end of their lease, unless the bank sells the property to someone who intends to make it his own residence. Even without a lease, renters must be allowed to stay in their home for 90 days after the foreclosure. The provision is scheduled to expire at the end of 2012.

Jurisdictions that already have more stringent renter-protection laws in place won't see the rules loosened by the new federal law. The District, for example, already protects renters from being evicted during the term of their lease unless they fail to pay rent or provide another just cause for eviction. The National Law Center on Homelessness and Poverty has a state-by-state description of eviction and foreclosure laws on its Web site.

Thursday, May 21, 2009

Jumbo Woes

Posted in the American Banker:

The National Association of Realtors is lobbying the federal government to support the jumbo mortgage market.

The trade group says it thinks securities backed by these loans should be eligible for purchase through the Term Asset-Backed Securities Loan Facility or the Public Private Investment Program. The association also says it wants the government to consider temporarily lifting the limit for conforming mortgages and "facilitating" warehouse lending to small and midsize lenders.

The association released a study last week analyzing the impact of the jumbo market on the housing market and broader economy.

As recently as 2007, jumbo mortgages comprised 10% of all mortgages for home purchases and 30% of mortgage originations in dollar volume. The share of home sales above $750,000, however, has now fallen to about 2.3% of home sales overall, as bigger loans have become more expensive and harder to find.

The government has already acted to help homebuyers in high-cost markets by lifting the limit on conforming loans in these areas to $729,750, compared with $417,000 in most parts of the country. But this has not stopped spreads on jumbo loans from rising sharply. In 2005, these loans typically had interest rates 144 basis points above 10-year Treasuries, but this spread had risen to 387 basis points by March 2009. The association said the bigger spread "does not appear warranted by increased risk."

It said that in high-cost areas, such as California, New York and Florida, the lesser availability of jumbo loans appears to work its way through much of the market, further depressing home prices.

One homeowner presumably affected by problems in the jumbo mortgage market is Bank of America Corp.'s chief executive, Ken Lewis, who has reportedly cut the price on his vacation home on Springs Island, S.C.

A story in The Wall Street Journal last week said that Lewis has been unable to find a buyer. He bought it in 2002 for $3 million and is listing it for sale at $3.3 million. The story did not report the previous listing price.

Buyers scramble for bargains

Posted on Cyberhomes by Lauren Baier Kim:

Bidding wars are back. But these competitions aren't like those of the housing boom, where homebuyers bid up already high-priced homes to new highs.

Low end heats up

Instead, these bidding wars are taking place in markets like Florida, Arizona and Florida, where there is a high inventory of foreclosures and other entry-level priced homes. In these states, first-time buyers, anxious to pick up foreclosures and significantly discounted homes before the housing market starts to inch back up, are vying against each other to snap up bargains in the lower tier of the housing market. Some sources even report that there are would-be buyers who are are losing out to higher bids multiple times.

Signs of a bottom

In some cases, the wars are sparked by savvy agents using artificially low prices to attract buyers, say sources like the Burbank Leader, in California. Especially in the lower half of the market (with homes priced to about $500,000), such pricing tactics sometimes reap sellers tens of thousands of dollars above their asking prices, the newspaper says.

Meanwhile, says there are signs of a housing market recovery in Florida and Arizona, with sales in Florida of existing single-family homes for the first quarter of this year up 25 percent, and Phoenix in Arizona seeing more homes sell than at any time since 2006, the website says.

Wednesday, May 20, 2009

Loan reset threat looms till 2012

Posted on the Mortgage Insider by Mathew Padilla:

Homeowners nationwide with good credit but artificially low mortgage payments could be forced to pay more to the bank sometime within the next three years, according to Credit Suisse.

If low interest rates remain, some of these borrowers will be spared payment shock. But those with extremely low payments via deferral of interest/principal owed, will not.

While preparing a story about high-priced foreclosure resales selling slowly in Orange County, I asked Credit Suisse for the latest version of its chart on loan resets nationwide. (The chart has popped up on several Web sites in past months.)

Resets and Recasts. Updated April 2009.To the right is the version updated last month (click on it for larger image). It shows resets increasing from here with peaks in 2010 and 2011/2012 in the range of $30 to $45 billion monthly. The chart also shows subprime resets are still going on, but decreasing in frequency over the rest of 2009. However, prime resets and resets on loans to people with decent credit scores but special circumstances (stated income) are heading straight up through early 2012.

Note that the chart uses both resets, when interest rates change, and recasts, when payments change. Resets and recasts often happen at once, but not always. Credit Suisse, an analyst told me, used resets in the chart for all loans except option adjustable-rate mortgages, when borrowers can choose a minimum payment less than principal and interest owed (option ARMs are in yellow on the chart… see how they are rising!). For option ARMs it used recasts, which can happen either when the loan amount expands to a maximum allowed — often 115% or 125% of original principal — or a set period, such as five years. (Read more on resets/recasts at Calculated Risk.)

February Chart

Now here is a copy of the chart published in a February report. This chart goes back further in time. The older chart shows a big peak in 2010 — about $40 to $45 billion a month in loans around September/October 2010. The newer chart pushes that peak about one year into the future into late 2011/beginning 2012.

Some borrowers will hold on a little longer. Maybe the housing market will recover by 2012 and they can sell to avoid foreclosure.

But if any of these borrowers are deferring principal and interest owed, reaching say a maximum of 125% on a loan amount on 2005 to 2007 prices, then it is much less likely home prices will have rebounded enough to save them by 2011 or 2012.

Friday, May 8, 2009

Mortgage Duration Risk: The Banks Are No Longer the Problem

Posted on the Institutional Risk Analyst:

The bank stress tests conducted by regulators are not so much about capital adequacy through the current economic cycle as identifying enough capital to get the large zombie banks through the end of the year. While Larry Summers and the other economic seers who populate the Obama Administration actually believe that we'll see an economic bounce in Q3 2009 - a key assumption that also underlies the regulators' approach to designing the bank stress tests - we see nothing in the credit channel that suggests improvement in the real economy. Both residential real estate or "RES" and commercial real estate or "CRE" markets in the NY area, for example, are starting to see an acceleration in price declines, this as the swelling population of frustrated sellers is starting to capitulate in the face of few or no buyers.

But the chief reason for this sad tale above is that there is no financing for jumbo loans in the RES market. Indeed, as one of the bankers who participated in the "Market & Liquidity Risk Management for Financial Institutions" conference sponsored by PRMIA at the FDIC University on Monday noted, banks are not originating any RES paper that cannot be sold to Fannie Mae or Freddie Mac, soon to be merged into "Frannie Mae," as we noted earlier.

During a luncheon keynote address at that event, Josh Rosner of Graham Fisher & Co. noted much of the "growth" in non-conforming real estate markets during the final years of the boom was fueled by speculative buying and that the lack of financing in the jumbo, non-conforming RES markets is forcing price compression in markets like the urban RES and CRE markets of NY, CA, MA, etc.

"The lack of attention paid to the creation of industry wide standards and a more solid legal basis for securitzation has only hindered the recovery of a financial intermediation in a market that once funded about 50 percent of all consumer revolving and non-revolving credit," Rosner told The IRA.

While regulators think that stabilizing the banks was the real battle, is it in fact the dysfunction of the non-bank securitization markets and the effect of this dysfunction on valuations in the RES and CRE real estate markets that is now driving the US economic meltdown? While the Fed as a good bit to the toxic securitizations in cold storage on its balance sheet, the central bank's best efforts at adding liquidity facilities cannot replace this multi-trillion dollar market if banks won't originate paper.

If you want to learn more about the problems in the non-bank sector and how products like ARMs are about to push the US economy into a meltdown, take a look at the presentation from the PRMIA event on Monday by Alan Boyce, the former CFC executive and now chief executive officer of Absalon, a joint venture between George Soros and the Danish financial system that is assisting in the organization of a standardized mortgage-backed securities market for Mexico.

Go to the last slide. This is an illustration of the Option Adjusted Duration ("OAD") of the US mortgage markets. Notice that the OAD calculated by Boyce has grown from a low of $23 trillion in Sep 05, which just happens to be the nadir of loan defaults for the US mortgage market, to $45 trillion in Mar 09. The OAD is set to grow significantly as US interest rates rise or as the slope of the interest rate curve steepens.

OAD is essentially a way to measure the economic weight of debt, basically time x money or the price response for a given move in interest rates. Using existing data and some clever suppositions, Boyce constructed an alternate explanation of "the conundrum" of 2003 to 2006. This was driven by the Fed's very predictable interest rate policy, which flattened the interest rate curve and compressed interest rate volatility.

Homeowners were encouraged to refinance into ARMs and there was significant cash out refinancing into premium fixed rate mortgages. Interest rate risk was transferred to US consumers and created a ticking time bomb for US markets in terms of the future duration of the total corpus of outstanding mortgage debt.

During the PRMIA conference, Boyce echoed the view of other participants that the failure to act on securitization ensures further RES and CRE price compression. In a rising rate environment the OAD of this RES exposure in particular will grow exponentially and dwarf the "weight" or OAD of the UST debt issuance. The US homeowner will be trapped in their homes, unable to sell as nominal mortgage debt exceeds house values.

Of note, in the Danish system, rising interest rates do not create negative equity for home owners, performing borrowers may redeem their mortgage by purchasing the associated bond at the prevailing market rate. Credit risk is kept out of the bond market, making the mortgage bonds a pure reflection of the associated interest rate risks. By efficiently splitting credit and interest rate risk, there are no surprises as each risk resides where it is best analyzed and hedged.

Bottom line is that securitization machine operated by Wall Street doubled the outstanding stock of mortgages during the last five years of the boom, but the falling OAD driven by Fed rate policy hid the growth.

Unfortunately, in their wisdom, federal regulators actually encouraged US mortgage originators to use ARMs and other products to push interest rate risk onto the backs of homeowners and bond market investors ill-equipped to understand let along manage such risks. Boyce and many others believe that without a complete refinancing for all performing mortgage borrowers, the US real estate markets - and thus the financial industry - will in trapped in a deflationary environment for years to come.

The only way to fix this mess, Boyce suggested at the conference, is to refinance the entire performing mortgage market into standardized, transparent, callable, fixed rate loans, which allow the homeowner to value his liability at the market price. The interest of the mortgage originator needs to closely aligned to that of the borrower via a minimum 10% first loss risk sharing.

Rosner told The IRA he doubts that America's political and business sectors are ready or willing to embrace the transparency and consumer-friendliness of Denmark's mortgage sector, but the fact that Boyce and George Soros are advancing this example as a solution may be significant - especially as the year-end deadline for resolving the conservatorships of Fannie Mae and Freddie Mac approaches. Rosner and Boyce believe that the restructuring of the housing GSEs presents an opportunity to set a new, consistent standard for securitization in the US.

Wednesday, May 6, 2009

Senate Passes Servicer Safe Harbor

Posted on the Housing Wire by Diane Golobay:

The Senate voted 91-5 in favor of S 896, the Helping Families Save Their Homes Act of 2009, which includes legal protection for servicers that modify residential mortgages. Five Senate Republicans voted against the housing bill.

The safe harbor protects mortgage servicers from lawsuits by investors holding relevant modified mortgage bonds.

The provision is intended to encourage more servicers to modify more mortgages, but critics say it will hurt private investors whose funds help maintain banks’ liquidity and stimulate lending.

Modifications often involve altering original mortgage terms and forbearing a portion of the principal for lump repayment at the end of the loan life. The reduced principal lowers monthly payments, increasing affordability for borrowers and consequentially reducing the monthly return for investors.

If the mortgage is securitized, then the principal payment coupons, or pass-throughs, will also take a hit. For the long investor, change to term is a bad thing and likely to shake-up an already nervous financial market.

However, the aim of the bill essentially provides legal protection for servicers to alter mortgage contracts and, as the argument goes, investor contracts where mortgages have been securitized.

The bill also changes the borrower certifications under Hope for Homeowners, a program that encourages refinancing into Federal Housing Administration-guaranteed mortgages. The bill’s changes mean borrowers going forward must provide proof they didn’t intentionally default on their mortgage in order to qualify.

The bill provides the Federal Deposit Insurance Corp. with increased borrowing authority, extends the time period for restoration of the insurance fund from five to eight years, provides a temporary extension of the FDIC’s $250,000 deposit insurance limit. Supporters of the bill say these changes will bolster confidence in the FDIC and meet banks’ lending needs.

“During this time of economic uncertainty, bankers recognize the importance of maintaining public confidence in the FDIC,” American Banker Association executive director Floyd Stoner. “We also believe that it is important to strike the right balance between maintaining a strong deposit insurance fund without unnecessarily taking money out of the system.

Regulating ABS: cage the sell-side or tie down the buy-side?

Posted in Euroweek:

Politicians and regulators around the world are beginning to set out their visions for how securitisation markets will be regulated in future. International coordination is vital to prevent distortions, but will be hard to achieve given widely varying philosophies.

The European Parliament is on Wednesday set to vote on amendments to the Capital Requirements Directive, which will impose strict requirements on bank buyers and sellers of securitisations. Meanwhile on Tuesday the International Organisation of Securities Commissions (IOSCO) published its interim recommendations on the regulation of securitisation and credit default swaps.

The CRD amendments contain two main elements — the much debated “skin in the game” proposal for originator/sponsor banks to retain 5% of securitised exposures for the life of any deal, and less discussed credit analysis requirements for bank investors. While the former rule has been the subject of the most heated arguments and active lobbying, the latter has the potential to change the marketplace far more dramatically.

After all, European banks tended to retain the first loss of securitisations they issued, although the same did not always apply to non-bank issuers or structured credit. However, the new rule that in future investors will have to prove that they can perform detailed credit analysis — evaluating and monitoring specified information such as delinquencies of 30, 60 and 90 days, loan to value ratios and diversification — makes genuinely new demands on investors. This requirement is balanced by an obligation on originator/sponsor banks to provide sufficient disclosure for the investors to perform this analysis.

IOSCO, by contrast, focuses its recommendations on the sell-side. It too calls for regulators to “consider” requiring retention by originators/sponsors and for disclosure of any due diligence performed, but does not suggest sanctions for firms investing in non-compliant issues.

Similarly, the report accompanying the IOSCO recommendations acknowledges the role played in the crisis by investors over-relying on credit ratings and failing to perform their own analysis, but proposes to solve the problem by improving the definition of a “sophisticated investor” and requiring dealers to “ensure the product being sold is suitable for the financial requirements and risk profile of the investor”.

Thus while there is considerable overlap between the two proposals, there remains a wide gap too. The EU has been far keener — since the crisis, anyway — to strictly regulate the investment process than have other jurisdictions, particularly the US, which prefer to control the sell side. Investors such as pension funds have a powerful voice in US politics and the Treasury needs them on board for programmes such as the Term Asset Backed Lending Facility and Public Private Investment Funds.

The EU’s approach has some strong attractions from a politician’s point of view, given the seemingly intractable problem of entrenched use of credit ratings. But it has high costs as well — smaller banks which are unable or unwilling to bring their internal systems and staffing up to scratch, or to outsource them to a reliable but expensive third party, may well pull out of the ABS market altogether.

With the investor base for securitisation already vastly diminished, the proposals threaten to delay the market’s recovery even longer and reduce Europe’s competitiveness.

As with so many initiatives arising from the ruins of the global financial system, international coordination will go a long way to improving the odds of success and reducing the potential for harm. In this case, however, it seems unlikely.

Homeowners Underwater

Posted on Calculated Risk:

There is substantial disagreement on the number of homeowners underwater (they owe more than their homes are worth). At the end of 2008, American CoreLogic estimated there were 8.2 million homeowners underwater. is now estimating 26.9 million homeowners with negative equity.

From the WSJ: House-Price Drops Leave More Underwater

Real-estate Web site said that overall, the number of borrowers who are underwater climbed to 26.9 million at the end of the first quarter from 16.3 million at the end of the fourth quarter.
Moody's estimates that of 78.2 million owner-occupied single-family homes, 14.8 million borrowers, or 19%, owed more than their homes were worth at the end of the first quarter, up from 13.6 million at the end of last year.
This is a substantial difference. Apparently Zillow assumes that borrowers with HELOCs have drawn down the maximum amount, and I suppose they use their house price software. My guess is's estimate is closer.

Monday, May 4, 2009

U.S. Government Foreclosure Mitigation Policies: Too Little, Too Late? (Part 2)

Posted on the Shadow Bankers by John Kiff:

In the first post in this series, I gave a very broad brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. In this post, I’m going to dive a bit deeper into the details of the Home Affordable Modification Program (HMP), the more recent of the government’s two active foreclosure mitigation plans. I’ll get into the Hope for Homeowners (H4H) program in the next post.

The point of both programs is to get the borrower’s payment-to-income (PTI) ratio down to 31 percent. The PTI is calculated by dividing all mortgage-related payments (including insurance and property taxes, but excluding mortgage insurance premia) by the homeowner’s gross income. HMP does it by offering to subsidize the cost to the lenders of temporarily reducing monthly payments to the 31 percent PTI ratio.

HMP gives lenders a subsidy of up to one-half the difference between the monthly payments at the 31 percent PTI ratio, and what the payment would have been at a 38 percent ratio, for up to five years. In addition, they get $1,500 for every current loan modified to encourage the offering of early intervention (rather than waiting until the borrower is seriously delinquent). Studies have shown that early intervention results in lower redefault rates (see “loan modifications and redefault risk”).

Servicers also get $1,000 for each modification, plus another $500 if the borrower was still current and $1,000 each year (for up to three years) that the borrower stays current (“pay for success”). One of the reasons cited for the H4H’s poor results has been that servicers are unincentivized and under resourced.

HMP also subsidizes lender costs of extinguishing junior liens (up to 12 percent of the unpaid balance), or subsidize junior lien holder costs of temporarily reducing interest rates to as low as one percent. Junior lien servicers who opt to reduce the interest rate will receive $500 upfront and $250 per year for up to five years. For more information see the April 28 update.

In order to make this all more concrete, I’m going to run some numbers on a hypothetical seriously delinquent $200,000 10 percent 30-year mortgage on a property that was worth $250,000 at origination (an 80 percent LTV). The monthly payment is $2,380, including $625 of insurance and property taxes. The borrower’s gross annual income is assumed to be $57,120, to imply a current PTI of 50 percent.

In order to get the PTI down to 31 percent the interest rate must be reduced from 10 to 3.125 percent (see table). Lender subsidies will amount to $326 every month that the modified loan stays current (half the difference between payments at the 38 and 31 percent DTI levels) for up to five years. Since the rate is below the current Freddie Mac Weekly Primary Mortgage Market Survey (PMMS) rate, after five years, the rate increases by one percent every year until it reaches the PMMS rate. I assume that the PMMS Rate is five percent.


The result of all of this, in net present value (NPV) terms using a 7.50 percent discount rate, is an effective write down from $200,000 to $122,530 plus $8,143 if the modified loan stays current for five years. However, before racing ahead into this modification, the servicer will compare this potential $130,673 NPV to the liquidation value in foreclosure.

The table below estimates these liquidation values in three home price depreciation (HPD) scenarios. For example, at zero, the lender will net about $148,750, making foreclosure a better alternative to an HMP modification. At 25 percent the net is $106,563, making it a close call between modification and foreclosure. At 50 percent HPD the $64,375 recovery value makes modification a possibly better choice.


The table below shows the outcomes for the HMP modifications under the three HPD scenarios, compared to the outcomes if the servicer just rides out the loans (“status quo”). The dollar numbers are the NPVs, and the assumed probabilities are in the parentheses (more about those later). It suggests that HMP modifications aren’t likely work out so well in the zero and 25 percent HPD scenarios for this particular example, because their expected NPVs are less than those in the status quo scenarios (see below for more detail). However, in the deep depreciation scenario (HPD = 50 percent), the HMP modifications have a have higher expected NPVs.


In general, the ultimate success of the HMD modifications will depend on whether the modified loan stays current (“cures”) or redefaults. The decision as to whether to modify will also depend on the likelihood of the unmodified loan becoming or staying current. The Treasury is making available to servicers an NPV calculator which embeds their suggested assumptions for the two key default probabilities, and large servicers (with books exceeding $40 billion) “may” use their own. I’m not a servicer, so for now, all I have to go on are the HMP NPV guidelines which remain vague on many key details and parameters.

In the above table I assume that the default probability on the unmodified seriously delinquent loan is 85 percent and 30 percent if it is modified. The expected NPV on the modified loan is $147,493 or less (depending on the amount of post-modification HPD), and $164,090 on the unmodified loan. In all but the 50 percent HPD scenario, for this specific example, it looks like it would be better not to modify.

Of course, as we discussed in the last post, default rates on modified loans are likely to vary according to the type of modification and the degree to which the loan balance exceeds the value of the underlying property (“negative equity”). Hence, a more sophisticated analysis would vary the probabilities according to the negative equity, which might even swing the evaluation towards the status quo in the 50 percent HPD scenario.

However, we’re not quite done yet! The hypothetical loan we just worked over was seriously delinquent. What about current borrowers? Recall that HMP is going to pay lenders $1,000 and servicers $500 for every current loan that they modify under HMP. However, although proactive modifications can be a good thing, they can backfire if borrowers who would have otherwise stayed current come forward for modifications. HMP controls this “moral hazard” risk by requiring that the borrower give proof of a significant change in income or expenses, to the point that the current mortgage payment is no longer affordable. However, keep in mind that, despite all the nasty headlines, there are still lots of nonprime loans that are not delinquent, so this risk could be significant.

Anyways, one of the key take aways from this post should be that loan modification analysis has a lot of moving parts, many of which I’m leaving out of this example (e.g., delinquency and prepayment timing, the evaluation horizon, and discount rate). Also, there are numerous other combinations and permutations of DTIs, LTVs and HPDs. In the next post in this series, I’ll go through a similar analysis of the H4H program, and show how it fits with the HMP under different DTI/LTV/HPD scenarios.