Friday, July 31, 2009

Mortage servicers’ perverse incentives

Posted on Reuters by Felix Salmon:

Last month, I wondered whether banks’ seeming inability to effectively modify mortgages was a function of “greed on the part of the banks — that while they pay lip service to the idea of modifying mortgages, they actually make more money by being recalcitrant and obstructive and unhelpful.”

It turns out that the answer is yes, it is — and the NYT’s Peter Goodman has chapter and verse:

Many mortgage companies are reluctant to give strapped homeowners a break because the companies collect lucrative fees on delinquent loans.

Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.

In a sidebar, Goodman examines the case of a mortgage servicer, Countrywide, which refused to let Alfred Crawford sell his house for $620,000 in settlement of mortgage debts exceeding $800,000. The latest offer on the house is now just $465,000, and still no short-sale is being allowed.

In the meantime, Countrywide is paying itself lots of fees — fees which will ultimately come out of the pockets of the investors who bought the mortgage-backed bonds which Crawford’s loan was bundled into. The minute that Countrywide allows the house to be sold, that fee income dries up.

Countrywide’s official response is hilarious:

David Sunlin, Bank of America’s senior vice president in foreclosures and real estate management, acknowledged that Mr. Crawford’s applications for short sales had suffered from “a number of communication issues,” but he said that the bank had acted in good faith.

“We have to protect our investors’ interests,” he said. “We have reputational risks involved.”

A bank spokesman, Dan Frahm, said Bank of America owned a second mortgage on the property with a balance of $85,000 and stood to “take the full losses on it,” so it is at risk of loss along with the investors who own the first mortgage.

Countrywide clearly isn’t protecting its investors here: in fact, it’s gouging them for fees. And the second lien is a sideshow: that’s going to zero whether the house sells for $620,000, for $465,000, or for even less.

It’s not going to be easy to solve this problem. And I particularly feel for Mr Crawford, who moved out of his house two years ago, but who, it turns out, could simply have lived there rent-free for the past two years instead, while the process dragged on. Why should the servicers be the only people benefitting from all this inefficiency?

The Financial Innovation That Wasn’t.

Posted on Rortybomb by Mike:

I need to set up the urgency over the past two years to get the mortgage-backed security refinancing question just right. So I’m going to start with two long blockquotes (forgive me) from Lewis Ranieri, who created the mortgage-backed security in the 1980s. In 2004 Newsweek gave him the title of one of the greatest innovators of the past 75 years. (Awards that year for top historical innovators included James Watson, Frank Lloyd Wright, and Jonas Salk. Mortgages bonds right up there with the cure for Polio – bet someone is regretting that call.)

It is April 2007. Everyone is starting to think there’s going to be a problem with subprime loans. The smartest people realize that traditionally mortgages could be written down easily by intermediaries on the ground – someone at your local bank who you could shake hands with – but that the mortgages packed into sieves of bonds held internationally couldn’t easily be modified. Here’s Lewis Ranieri speaking at the Milkin Institute Conference on financial innovation:

the real dilemma for me and I think the real issue . . . will be, we’ve never had to do substantial restructurings in housing in mortgage securities…

One of the accountants – you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can’t do that. If you restructure that many loans, you’re going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you – when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you’ve just tainted 140 and Q election…

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don’t know how long it would take us. I mean, you know you’ve just basically told us we now have a problem that we don’t quite exactly know how we’re going to fix – and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we’ve done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we’re talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we’re talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don’t have that freedom because you’ve got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I’ve been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I’m doing that now, too and we were told, well you’re doing it wrong. You’ve got to send out a 1099.

That’s an incredibly dopey idea. We’re restructuring a loan around a borrower; he can’t afford the loan and now we’re going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

Jump forward 1 year. May 2008. Milkin Institute Conference on financial innovation. Here is Lewis Ranieri with the same worry, however he believes we will be able to “innovate” our way out of it. Video from Mark Thoma’s page, my transcript (”…” indicates skipping on my part):

[24m19s] Narrator: Lou, how do we use financial innovation to go forward?…How bad do you think the markets could become if we get mired in a fear of using financial innovation?

Lewis Ranieri: Mortgages are real estate and all real estate is essentially local. The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” And what we need here is financial innovation in the first instance because you can’t do this loan by loan, you are going to have to scale this up to a bigger level and we are going to … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy

Narrator: How optimistic are you Lou? You used crisis, you used Great Depression a few minutes ago. That’s a little strong…

Lou: It’s not strong. I believe we know what to do because it is not remarkably different than what we’ve done in the past in the context of the housing bubble. if we are allowed to do it. We know how to restructure loans. The process has not changed and technology has made it easier….it will work because of the financial technology and internet technology…I don’t think this is an issue of the government, in fact we’d be better left to do what it is we actually know how to do, we know how to deal with housing crisis…but the difference between a foreclosure and a restructuring is frequently over 30%and because of the feedbackloop that foreclosures create you keep taking a 30% loss on a smaller number. It doesn’t get to be fun. So no this isn’t a government issue, it is something the market needs to do…

And now it is end of July 2009.



Where’s that innovation that will restructure the loans without needing foreclosures? The one thing we needed them to innovate, the one thing!, and they couldn’t pull it off. If it was a sneaky way to get 40-to-1 leverage, sure. Sell retail consumers put options hidden as bonds, all over it. Take care of the one information asymmetry and principle-agent problem in their instrument, nope. Nothing.

Instead we get this:

Many mortgage companies are reluctant to give strapped homeowners a break because the companies collect lucrative fees on delinquent loans.

Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.

Recall Lewis’ one problem for financial innovation to solve a year ago: “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” Now notice that the solution we have in place, this innovation, is completely backwards. Someone is paying a person to not restructure loans. Lewis knew back in 2007 that this cycle would be incredibly destructive, and in 2008 look the world in the eye and said government intervention was not needed since the innovation was on the way.

Not only is it not here as they wanted, the exact opposite of it is here. Instead of incentives that line up with the investors, or even the households, the quants ended up with someone who makes the most money when both parties suffer. I knew a Russian equities finance quantish guy who said they he’d never need to know game theory since he’d never do corporate finance. Too bad those mathematicians didn’t know about the Principle-Agent problem and rent seeking sneaking into his equations; maybe he would have had a head’s up.

The one financial innovation that could have helped, finding a way to mass refinance failing mortgages, the one financial innovation people were calling for 2 years ago, hasn’t arrived, and I’m tired of waiting for a financial Godot. They have failed, the problem is growing, and the government needs to step in. Dean Baker’s Right-To-Rent should be a serious policy consideration, and I will give it coverage next week. I encourage you to do the same.

Thursday, July 30, 2009

Foreclosures Up Again Reports RealtyTrac

RealtyTrac® ( released its Midyear 2009 U.S. Foreclosure Market Report, which shows a total of 1,905,723 foreclosure filings — default notices, auction sale notices and bank repossessions — were reported on 1,528,364 U.S. properties in the first six months of 2009, a 9 percent increase in total properties from the previous six months and a nearly 15 percent increase in total properties from the first six months of 2008. The report also shows that 1.19 percent of all U.S. housing units (one in 84) received at least one foreclosure filing in the first half of the year.

Foreclosure filings were reported on 336,173 U.S. properties in June, the fourth straight monthly total exceeding 300,000 and helping to boost the second quarter total to the highest quarterly total since RealtyTrac began issuing its report in the first quarter of 2005. Foreclosure filings were reported on 889,829 U.S. properties in the second quarter, an increase of nearly 11 percent from the previous quarter and a 20 percent increase from the second quarter of 2008.

“In spite of the industry-wide moratorium earlier this year, along with local, state and national legislative action and increased levels of loan modification activity, foreclosure activity continues to increase to record levels,” noted James J. Saccacio, chief executive officer of RealtyTrac. “Unemployment-related foreclosures account for much of this increased activity, and the high number of borrowers who find themselves owing more on their mortgages than their homes’ are now worth represent a potentially significant future risk. Stemming the tide of foreclosures is a critical component to stabilizing the housing market, so it is imperative that the lending industry and the government work in tandem to find new approaches to address this issue.”

View heat map and share your comments on this report.

Nevada, Arizona, Florida post top state foreclosure rates
More than 6 percent of Nevada housing units (one in 16) received at least one foreclosure filing in the first half of 2009, giving it the nation’s highest foreclosure rate during the six-month period. A total of 68,708 Nevada properties received a foreclosure filing from January to June, an increase of 23 percent from the previous six months and an increase of 61 percent from the first half of 2008.

Arizona registered the nation’s second highest state foreclosure rate in the first half of 2009, with 3.37 percent of its housing units (one in 30) receiving at least one foreclosure filing, and Florida registered the nation’s third highest state foreclosure rate, with 3.08 percent of its housing units (one in 33) receiving at least one foreclosure filing.

Other states with foreclosure rates ranking among the nation’s 10 highest were California (2.94 percent), Utah (1.46 percent), Georgia (1.42 percent), Michigan (1.34 percent), Illinois (1.31 percent), Idaho (1.26 percent) and Colorado (1.25 percent).

California, Florida, Arizona post highest foreclosure totals
A total of 391,611 California properties received a foreclosure filing in the first half of 2009, the nation’s highest total and 2.94 percent of the state’s housing units (one in 34) — the nation’s fourth highest state foreclosure rate. California foreclosure activity in the first half of 2009 increased nearly 14 percent from the previous six months and increased nearly 15 percent from the first half of 2008.

With 268,064 properties receiving a foreclosure filing in the first six months of 2009, Florida documented the second highest state total. Florida foreclosure activity in the first half of 2009 increased 7 percent from the previous six months and was up nearly 42 percent from the first half of 2008.

Arizona’s 89,799 properties receiving a foreclosure filing in the first six months of 2009 was the third highest state total. Arizona foreclosure activity in the first half of 2009 increased 13 percent from the previous six months and was up nearly 55 percent from the first half of 2008.

Other states with totals among the 10 highest in the country were Illinois (68,932), Nevada (68,708), Michigan (60,786), Ohio (58,937), Georgia (56,391), Texas (49,144) and Virginia (28,368).

Report methodology
The RealtyTrac U.S. Foreclosure Market Report provides a count of the total number of properties with at least one foreclosure filing reported during the first half of the year at the state and national level. Data is also available at the individual county level. Data is collected from more than 2,200 counties nationwide, and those counties account for more than 90 percent of the U.S. population. RealtyTrac’s report incorporates documents filed in all three phases of foreclosure: Default — Notice of Default (NOD) and Lis Pendens (LIS); Auction — Notice of Trustee Sale and Notice of Foreclosure Sale (NTS and NFS); and Real Estate Owned, or REO properties (that have been foreclosed on and repurchased by a bank). If more than one foreclosure document is filed against a property during six-month period, only the most recent filing is counted in the report.

Wednesday, July 29, 2009

Those cheery US housing numbers, reconsidered

A debate is brewing between über housing blogger Calculated Risk and the equally anonymous Free exchange blog. The crux of the debate is whether the May numbers for US house prices, as represented by the Case Shiller index, are as bullish a sign as commentators (read: the media) seem to think.

Here, for instance, is how the FT reported the numbers:

US home price rise hints at stability

US house prices showed their first monthly gain in three years in May offering another sign that the stricken residential real estate market is stabilising.

And the WSJ:

Home Prices Rise Across U.S.

Home prices in major U.S. cities registered the first monthly gain in nearly three years, according to a new report that provided fresh evidence that the severe U.S. housing downturn could be easing.

Even David Rosenberg thought he’d spied green shoots. But Calculated Risk was having none of it:

…the Case-Shiller report today really bothered me. To be more accurate, the reporting on the Case-Shiller report bothers me. As I mentioned earlier today, there is a strong seasonal component to house prices, and although the seasonally adjusted Case-Shiller index was down (Case-Shiller was reported as up by the media) - I don’t think the seasonal factor accurately captures the recent swings in the NSA data.

I have no crystal ball - and maybe prices have bottomed - but this potentially means a negative surprise for the market later this year - perhaps when the October or November Case-Shiller data is released (October will be released near the end of December). If exuberance builds about house prices, and the market receives a negative surprise, be careful. Just something to watch later this year (I will post about house prices, but I will not mention the possible impact on the stock market in future posts)

Free exchange was not quite so persuaded, arguing thus:

…the first step in [CR’s argument] is that all of the writers out there trumpeting rising home prices are paying attention to the not seasonally adjusted data. This is true, but not that damning; it’s not as if the seasonally adjusted data show a sharply different picture.


Which then leads Calculated Risk to argue that the seasonal adjustments are insufficient. The evidence? Well, a chart of the NSA and SA data together shows that the SA data series hasn’t been smothing seasonal spikes in the last decade as completely as it did during the 1990s (although the SA series is pretty smooth between 2005 and 2008; it basically points straight down). He therefore concludes that seasonal factors aren’t adequately being taken into account, and that prices will surprise to the downside in the fall.

Free exchange cites to main reasons to doubt CR’s pessimism:

The first is that I don’t understand why the seasonal factors shaping housing prices would have intensified in recent years. If anything, it seems as though the typical seasonal pattern should have weakened, as more market participants bought or sold out of necessity.

And the second point is that I don’t see how you judge the importance of cyclical factors-which are hugely important-relative to normal trends. The recession began in the winter, then leveled off last summer (at which point the economy was actually notching an increase in output), then imploded in the fall and entered free fall this past winter. There’s nothing seasonal about the cycle, that’s just how the timing worked out. But that timing has obviously had a major influence on housing prices.

Conclusion? We’ll see.

In the interim, Rosenberg has backpedalled a bit from his green shoots call, saying in a note on Wednesday:

On a seasonally adjusted basis, and that is really the only way to look at the data sequentially, 8 of the 20 major cities still posted house price declines in May (though the front page of the WSJ chose not to mention that fact — Home Prices Rise Across U.S.— it screams). At issue is whether (i) home prices have indeed stopped falling, (ii) whether this is just noise in what is still a fundamental downtrend, or (iii) there are some methodological problems with the data.

Indeed, Rosenberg contends that the index itself is flawed, because the price data:

are likely not accurately taking into account the mix of actual home sales because it has come to our attention that an increasing number of high-end homes are now entering the foreclosure sales process, which are skewing these price indices higher after a prolonged period when the data were being pulled down by the preponderance of ever-cheaper subprime units hitting the auction market.
The Gluskin Sheff chief economist notes that at the beginning of the year when prices were sliding more than 2 per cent per month,

half the sales were coming from foreclosure auctions and many of these were low-end units; now the foreclosure share is down to 30% and more of these are higher-end homes seeing as prime-based mortgage default rates are now rising faster than subprime.

And, he says:

the banks are sitting on a record number of foreclosed units that have yet to hit the market (don’t forget that the government-imposed moratorium just terminated). And once these homes flood the market, we may well get another big leg down in the price data — the shadow inventory of homes is very troubling and is not counted in the official data from the National Association of Realtors or the Commerce Department. To date, the sales of foreclosed units have been rather limited and we are hearing that there has been bidding wars for the well-priced properties at these auctions — these bidding wars may dry up as more supply comes onto the market, which is the major point.

The downgrade pressure on house prices from fundamental factors like inventory levels is significant, Rosenberg argues - the bottom is a ways off yet.

Related links: A comment on seasonal adjustments - Calculated Risk

Tuesday, July 28, 2009

Study Finds Underwater Borrowers Drowned Themselves with Refinancings

Posted in the Wall Street Journal by Nick Timiraos:

Why are so many homeowners underwater on their mortgages?

In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they’ve lost equity primarily through forces beyond their control.

A new study challenges this premise and finds that excessive borrowing may have played as great a role.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

If other housing markets across the country offer similar findings, then the study argues that current “policies aimed at protecting homeowners from foreclosure are misguided” because lenders, and not borrowers, have born the lion’s share of economic losses.

Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. “Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear,” the authors write.

Foreclosures Are Often In Lenders' Best Interest

More blah blah that ignores the elephant in the corner (negative equity) from the Washington Post:

Government initiatives to stem the country's mounting foreclosures are hampered because banks and other lenders in many cases have more financial incentive to let borrowers lose their homes than to work out settlements, some economists have concluded.

Policymakers often say it's a good deal for lenders to cut borrowers a break on mortgage payments to keep them in their homes. But, according to researchers and industry experts, foreclosing can be more profitable.

The problem is that modifying mortgages is profitable to banks for only one set of distressed borrowers, while lenders are actually dealing with three very different types. Modification makes economic sense for a bank or other lender only if the borrower can't sustain payments without it yet will be able to keep up with new, more modest terms.

A second set are those who are likely to fall behind on their payments again even after receiving a modified loan and are likely to lose their homes one way or another. Lenders don't want to help these borrowers because waiting to foreclose can be costly.

Finally, there are those delinquent borrowers who can somehow, even at great sacrifice, catch up without a modification. Lenders have little financial incentive to help them.

These financial calculations on the part of lenders pose a difficult challenge for President Obama's ambitious efforts to address the mortgage crisis, which remains at the heart of the country's economic troubles and continues to upend millions of lives. Senior officials at the Treasury Department and the Department of Housing and Urban Development have summoned industry executives to a meeting Tuesday to discuss how to step up the pace of loan relief. The administration is seeking to influence lenders' calculus in part by offering them billions of dollars in incentives to modify home loans.

Still, foreclosed homes continue to flood the market, forcing down home prices. That contributed to the unexpectedly large jump in new-home sales in June, reported yesterday by the Commerce Department.

"There has been this policy push to use modifications as the tool of choice," said Michael Fratantoni, vice president of single-family-home research at the Mortgage Bankers Association. But "there is going to be this narrow slice of borrowers for which modifications is the right answer." The size of that slice is tough to discern, he said. "The industry and policymakers have been grappling with that."

The effort to understand the dynamics of the mortgage business comes as the administration is prodding lenders to do more to help borrowers under its Making Home Affordable plan, which gives lenders subsidies to lower the payments for distressed borrowers. About 200,000 homeowners have received modified loans since the program launched in March, while more than 1.5 million borrowers were subject during the first half of the year to some form of foreclosure filings, from default notices to completed foreclosure sales, according to RealtyTrac.

No doubt part of the explanation is that lenders are overwhelmed by the volume of borrowers seeking to modify their mortgages. Rising unemployment and falling home prices have added to the problem.

But a study released last month by the Federal Reserve Bank of Boston was downbeat on the prospects for widespread modifications. The analysis, which looked at the performance of loans in 2007 and 2008, found that lenders lowered the monthly payments of only 3 percent of delinquent borrowers, those who had missed at least two payments. Lenders tried to avoid modifying the loans of borrowers who could "self-cure," or catch up on their payments without help, and those who would fall behind again even after receiving help, the study found.

"If the presence of self-cure risk and redefault risk do make renegotiation less appealing to investors, the number of easily 'preventable' foreclosures may be far smaller than many commentators believe," the report said.

Nearly a third of the borrowers who miss two payments are able to self-cure without help from their lender, according to the Boston Fed study. Separately, Moody's, a research firm, estimated that about a fifth of those who miss three payments will self-cure.

When Adrian Jones fell behind on the mortgage payments for her Dallas home earlier this year, her lender asked her to cut other expenses. Jones said she eliminated movies and coffee breaks. She turned to family members for loans. When that failed to raise enough, she sold her second car.

"It hurt, but it also made sense. The debt was my responsibility," Jones said.

But six months later, after catching up on the mortgage, Jones is again feeling pinched after her hours as an office assistant at an architecture firm were cut. This time, she's not sure she can fix the problem herself.

"I am going to try, obviously," she said. "But it is getting harder and harder."

Like Jones, those who are most determined to meet their obligations are often unlikely candidates for loan modifications.

"These are the people who will get a second job, borrow from their family to keep up," explained Paul S. Willen, a senior economist at the Federal Reserve Bank of Boston and an author of its report. ". . . From a cold-blooded profit-maximizing standpoint, these are the people the banks will help the least."

Lenders also worry that borrowers may re-default even after receiving a loan modification. This only delays foreclosure, which can be costly to the lender because housing prices are falling throughout the country and the home's condition may deteriorate if the owner isn't maintaining it. In some cases, lenders lose twice as much foreclosing on a home as they did two years ago, said Laurie Goodman, senior managing director at Amherst Securities.

American Home Mortgage Services, based in Texas, was willing to modify Edward Partain's mortgage on his Tennessee home last April after business at his beauty salon slowed and a divorce stretched his budget. But after months of negotiating with his lender, Partain said he was surprised to learn that it would only lower his payments by $90 a month, instead of the $250 decrease he expected.

"At $250, I would have had a chance, but after they added in late fees and payments, I couldn't do it," he said.

Partain soon fell behind on his payments again and went back to American Home Mortgage Services seeking a more affordable payment. Partain said he was told that he was ineligible for another modification because it had been less than a year since his last. A foreclosure sale was scheduled for late July.

After American Home Mortgage Services was contacted by The Washington Post about the case, the company said Partain would be considered for the federal foreclosure-prevention program and it delayed the sale by three months. Partain is relieved but anxious about the details.

"You want to wait and see what figures they come up with," he said.

Administration officials have not said publicly how many borrowers they expect to re-default under Obama's program.

But the experience of a separate program run by the Federal Deposit Insurance Corp. could be instructive. After taking over the failed bank IndyMac last year, the FDIC began modifying troubled mortgages held or serviced by the company. Richard Brown, the FDIC's chief economist, said the agency expects up to 40 percent of those borrowers to re-default.

Even at that rate, he said, the modification program is more profitable than doing nothing. "The idea that 30 to 40 percent re-default is a failure to a program is false," Brown said.

The administration has estimated that its foreclosure-prevention program would help 3 million to 4 million borrowers by 2012. But lenders' reluctance could limit the impact to less than half that, said Mark Zandi, chief economist for Moody's Coupled with re-defaults, this would mean that the number of people losing their homes to foreclosure could reach nearly 5 million by 2011, he said.

Mark A. Calabria, director of financial-regulation studies at the Cato Institute, warned that political rhetoric is driving the policy discussion. "What we really need to do is have an honest debate about what are the magnitudes of people we really can help," he said. But administration officials defended their program's progress, reporting that it has surpassed an initial goal of offering 20,000 modifications a week. These officials said they have taken into account the re-default risk and possibility for self-cure in designing the effort.

Michael S. Barr, assistant Treasury secretary for financial institutions, noted that the report by the Boston Fed does not cover the period since the administration launched its initiative. "We will continue to refine the program as new data becomes available," he said. "We are committed to studying the effectiveness and efficiency of the program, and we welcome outside analysis."

Willen, of the Boston Fed, said the government program could boost several-fold the number of seriously delinquent borrowers receiving modifications. But so few people had been getting their loans modified that even a dramatic increase in the percentage would still touch only a small fraction of troubled borrowers, he said.

"We're still not talking about a program that will stop a large number of foreclosures," he said. "We're talking about a program that, at the margins, will assist more people. It is unlikely we will see a sea change."

Monday, July 27, 2009

Did Housing Prices Drive Borrowing and GDP?

Posted in RiskCenter by Walter Kurtz:

An excellent paper recently came out of University of Chicago by Mian and Sufi called House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis.

There has always been a debate on whether housing price increases drove household leverage and spending. Some argue that housing prices and household debt were just correlated, not that one led to the other. People felt good about their future, equities were up, there were more jobs, households borrowed more, and house prices went up driven by optimism (not that house price increase caused more borrowing.)

The way Mian and Sufi got around this is by separating the population into two categories: those who live in areas where housing supply was very limited (inelastic) and areas where new construction could add to the supply (elastic). The inelastic areas saw rapid house price increases that were not related to equity prices, job growth, optimism, etc.

What Mian and Sufi show is that it was the inelastic areas that saw the most borrowing - that is higher house prices were directly responsible for increased borrowing. Furthermore it was the poor credit consumers in inelastic areas who leveraged the most.

First one can see that consumer debt rose much faster than corporate debt,

and consumer leverage far outpaced corporate leverage:

House prices experienced most of the growth in the "inelastic" areas:

Leverage consequently grew most in the inelastic areas as well,

driven mostly by the low credit quality borrower.

Thus the lower credit quality borrower in inelastic areas experienced the high default rates:

Mian and Sufi proceed to show that home equity based borrowing was used mainly for consumption and added 2.3% to GDP every year between 2002 and 2006. This has enormous implications on any recovery from this recession. All other factors aside, over 2% of US GDP has been near permanently taken out, making it highly unlikely that we revert to pre-recession growth levels any time soon.

Friday, July 24, 2009

GAO: Obama housing plan may fall short of goal

GAO's sixth report on the Troubled Asset Relief Program (TARP) focuses on the Department of the Treasury's (Treasury) efforts to establish its Home Affordable Modification Program (HAMP). This 60-day report examines (1) the design of HAMP's program features with respect to maximizing assistance to struggling homeowners, (2) the analytical basis for Treasury's estimate of the number of loans that are likely to be successfully modified using TARP funds under HAMP, and (3) the status of Treasury's efforts to implement operational procedures and internal controls for HAMP. For this work, GAO reviewed documentation from Treasury and its financial agents and met with officials from Treasury, its financial agents, and other organizations.

Thursday, July 23, 2009

The CRE disaster

Posted on Reuters by Rolfe Winkler:

Earlier this week, I was surprised when I read that Moody’s put the decline in commercial real estate at 16% over the last TWO MONTHS. That’s a stunning rate of decline that has very negative consequences for banks who are still carrying commercial whole loans on their balance sheet at close to 100¢ on the dollar.cre-vs-residential-prices

For comparison, consider the chart to the right, which compares the Case-Shiller Composite 20 Index for residential real estate prices with the Moody’s/REAL National All Property CRE Index.*

(Click chart to enlarge in new window)

Peak to trough the declines are similar: Residential is down 33% from its July ‘06 peak while commercial is down 35% from its October ‘07 peak.

But note the stunning rate of decline of late for commercial. 28% since September. Residential is off half as much over that time.

To be sure, comparing these two indices isn’t totally fair. As Dan Alpert of Westwood Capital pointed out to me, there are millions of transactions that go into Robert Shiller’s residential index. It’s very granular. On the CRE side there have been very few actual sales that indicate recent pricing. So you have to read Moody’s/REAL with a grain of salt.

Directionally, however, the index is correct. Commercial is collapsing very quickly, even as residential looks to be forming a bottom.

What are the implications? Consider the $1-$1.5 trillion in commercial mortgages being held as whole loans at commercial and savings banks in the U.S. Because whole loans are typically “held to maturity,” they are carried at full value until the borrower actually defaults. Never mind that the underlying collateral is now worth far less than the mortgage.

But banks aren’t forced to take writedowns until an event of default. To avoid that they can play all sorts of games to make things easier for the borrower. According to Alpert:

Banks and other lenders with loans collateralized by income-producing properties have been offering borrowers nearly any forbearance imaginable: loan extensions, interest rate reductions, delayed principal payments, wavers of covenants and guarantees, and in some instances additonal funding—anything and everything to avoid taking a current loss, as long as there is some cash flow or reserve balance to draw on so as to maintain that the loan is performing against its (often heavily modified) terms.

The bottom line is that banks still have hundreds of billions of losses buried on their balance sheets. Commercial real estate prices aren’t coming back, which means these loans will have to be marked down eventually. The longer banks wait, the more painful the writedowns will be.

Bank shareholders should take note. There are still stupendous losses to come. Will the government agree to absorb all of them? Probably not, which means equity holders will feel the pain.

Are Bankruptcy Mortgage Cramdowns Back?

Posted on Credit Slips by Bob Lawless:

As I write this, the Senate Judiciary Committee's Subcommittee on Administrative Oversight and Courts is holding a hearing entitled, "The Worsening Foreclosure Crisis: Is It Time to Reconsider Bankruptcy Reform." The witnesses include Credit Slips's own Adam Levitin.

After the Senate failed to support changing the Bankruptcy Code to allow judges to do mortgage modifications, it appeared to be a dead issue. The hearing is great news and hopefully an indication there may be some interest in moving the legislation forward. There have been increasing reports (e.g., here) recently that lenders are not doing voluntary mortgage modifications in the numbers that need to happen. Yeah, I know -- who could have possibly foreseen the possibility that a solely voluntary system would not work? There need to be carrots that encourage lenders to do the modifications. The change in the bankruptcy law is the missing piece -- the stick that makes the program work.

Ten Myths about Subprime Mortgages

Posted on the Cleveland FRB website by Yuliya Demyanyk:

On close inspection many of the most popular explanations for the subprime crisis turn out to be myths. Empirical research shows that the causes of the subprime mortgage crisis and its magnitude were more complicated than mortgage interest rate resets, declining underwriting standards, or declining home values. Nor were its causes unlike other crises of the past. The subprime crisis was building for years before showing any signs and was fed by lending, securitization, leveraging, and housing booms.

Subprime mortgages have been getting a lot of attention in the United States since 2000, when the number of subprime loans being originated and refinanced shot up rapidly. The attention intensified in 2007, when defaults on subprime loans began to skyrocket. Researchers, policymakers, and the public have tried to identify the factors that explained these defaults.

Unfortunately, many of the most popular explanations that have emerged for the subprime crisis are, to a large extent, myths. On close inspection, these explanations are not supported by empirical research.

Subprime mortgages went to all kinds of borrowers, not only to those with impaired credit. A loan can be labeled subprime not only because of the characteristics of the borrower it was originated for, but also because of the type of lender that originated it, features of the mortgage product itself, or how it was securitized.

Specifically, if a loan was given to a borrower with a low credit score or a history of delinquency or bankruptcy, lenders would most likely label it subprime. But mortgages could also be labeled subprime if they were originated by a lender specializing in high-cost loans—although not all high-cost loans are subprime. Also, unusual types of mortgages generally not available in the prime market, such as “2/28 hybrids,” which switch to an adjustable interest rate after only two years of a fixed rate, would be labeled subprime even if they were given to borrowers with credit scores that were sufficiently high to qualify for prime mortgage loans.

The process of securitizing a loan could also affect its subprime designation. Many subprime mortgages were securitized and sold on the secondary market. Securitizers rank ordered pools of mortgages from the most to the least risky at the time of securitization, basing the ranking on a combination of several risk factors, such as credit score, loan-to-value and debt-to-income ratios, etc. The most risky pools would become a part of a subprime security. All the loans in that security would be labeled subprime, regardless of the borrowers’ credit scores.

The myth that subprime loans went only to those with bad credit arises from overlooking the complexity of the subprime mortgage market and the fact that subprime mortgages are defined in a number of ways—not just by the credit quality of borrowers. One of the myth’s byproducts is that examples of borrowers with good credit and subprime loans have been seen as evidence of foul play, generating accusations that such borrowers must have been steered unfairly and sometimes fraudulently into the subprime market.

Myth 2: Subprime mortgages promoted homeownership

The availability of subprime mortgages in the United States did not facilitate increased homeownership. Between 2000 and 2006, approximately one million borrowers took subprime mortgages to finance the purchase of their first home. These subprime loans did contribute to an increased level of homeownership in the country—at the time of mortgage origination. Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of origination. The number of such defaults outweighs the number of first-time homebuyers with subprime mortgages.

Given that there were more defaults among all (not just first-time) homebuyers with subprime loans than there were first-time homebuyers with subprime loans, it is impossible to conclude that subprime mortgages promoted homeownership.

Myth 3: Declines in home values caused
the subprime crisis in the United States

Researchers, policymakers, and the general public have noticed that a large number of mortgage defaults and foreclosures followed the decline in house prices. This observation resulted in a general belief that the crisis occurred because of declining home values.

The decline in home values only revealed the problems with subprime mortgages; it did not cause the defaults. Research shows that the quality of newly originated mortgages was worsening every year between 2001 and 2007; the crisis was brewing for many years before house prices even started slowing down. But because the housing boom allowed homeowners to refinance even the worst mortgages, we did not see this negative trend in loan quality for years preceding the crisis.

Myth 4: Declines in mortgage underwriting standards
triggered the subprime crisis

An analysis of subprime mortgages shows that within the first year of origination, approximately 10 percent of the mortgages originated between 2001 and 2005 were delinquent or in default, and approximately 20 percent of the mortgages originated in 2006 and 2007 were delinquent or in default. This rapid jump in default rates was among the first signs of the beginning crisis.

If deteriorating underwriting standards explain this phenomenon, we would be able to observe a substantial loosening of the underwriting criteria between 2001–2005 and 2006–2007, periods between which the default rates doubled. The data, however, show no such change in standards.

Actually, the criteria that are associated with larger default rates, such as debt-to-income or loan-to-value ratios, were, on average, worsening a bit every year from 2001 to 2007, but the changes between the 2001–2005 and 2006–2007 periods were not sufficiently high to explain the near 100 percent increase in default rates for loans originated in these years.

Myth 5: Subprime mortgages failed
because people used homes as ATMs

Rising house prices and falling mortgage interest rates before 2006 gave many homeowners an opportunity to refinance their mortgages and extract cash. The cash extracted from home equity could be spent for home improvements, bill payments, or general goods and services. Among subprime mortgages that were securitized, more than half were originated to refinance existing mortgages into larger ones and to take cash out of home equity.

While this option was popular throughout the subprime years (2001–2007), it was not a primary factor in causing the massive defaults and foreclosures that occurred after both home prices and interest rates reversed their paths. Mortgages that were originated for refinancing actually performed better than mortgages originated solely to buy a home (comparing mortgages of the same age and origination year). The rates of default for cash-out refinance mortgages within one year of origination were 17 percent for mortgages originated in 2006 and 20 percent for those originated in 2007. In contrast, the rates of default within one year of origination for mortgages originated to buy a home were 23 percent and 27 percent for the origination years 2006 and 2007, respectively.

Myth 6: Subprime mortgages failed
because of mortgage rate resets

Among subprime loans, the most popular type of adjustable rate mortgage (ARM) is a hybrid, a loan whose interest rate is reset after an initial two- or three-year period of fixed rates. A fixed-rate mortgage (FRM), on the other hand, never has its rate reset. The belief that rate resets caused many subprime defaults has its origin in the statistical analyses of loan performance that were done on these two types of loans soon after the problems with subprime mortgages were coming to light. Those analyses compared loan performance in a way that was conventional at the time, but which turned out to be inappropriate for these loans.

To ascertain whether ARMs or FRMs were experiencing different levels of default, analysts compared the proportion of outstanding FRMs that were delinquent to the proportion of outstanding ARMs that were delinquent. Based on that comparison, the proportion of delinquent hybrid loans had begun to skyrocket after 2006, while that of fixed-rate loans looked as if it was fairly stable.

The problem with this type of analysis is that it hid problems with FRMs because it considered all outstanding loans; that is, it combined loans that had been originated in different years. Combining old with more recent loans influences the results, first, because older loans tend to perform better. Second, FRM loans were losing their popularity from 2001 to 2007, so fewer loans of this type were being originated every year. When newer loans were defaulting more than the older loans, any newer FRM defaults were hidden inside the large stock of older FRMs. By contrast, the ARM defaults were more visible inside the younger ARM stock.

To illustrate the problem, consider the following example. Suppose there are 1,000 FRMs and 100 ARMs outstanding in the market. In the current year, 100 new FRMs and 100 new ARMs are originated. Suppose the default rate for both types of new loans is 100 percent within a year and that old loans do not default. The observed default rate for FRMs is 100 out of 1,100 outstanding loans (9.1 percent), and the default rate for ARMs is 100 out of 200 outstanding loans (50 percent). Even though the level of default is the same for all new originations, the FRM pool looks much healthier.

If we compare the performance of adjustable- and fixed-rate loans by year of origination (which keeps new and old loans separate), we find that FRMs originated in 2006 and 2007 had 2.6 and 3.5 times more delinquent loans within one year of origination, respectively, than those originated in 2003. Likewise, ARMs originated in 2006 and 2007 had 2.3 times and 2.7 times more delinquent loans one year after origination, respectively, than those originated in 2003. In short, FRMs showed as many signs of distress as did ARMs. These signs for both types of mortgage were there at the same time; it is not correct to conclude that FRMs started facing larger foreclosure rates after the crisis was initiated by the ARMs.

Myth 7: Subprime borrowers with hybrid mortgages
were offered (low) “teaser rates”

By design, a hybrid mortgage contract offers a fixed mortgage rate for a couple of years; after that, the rate is scheduled to reset once or twice a year to the current market rate plus a margin that is prespecified in the contract. A market rate combined with the margin may be lower or higher than the initial fixed mortgage rate, as it largely depends on the market rate that prevails at the reset time.

Hybrid mortgages were available both in prime and subprime mortgage markets, but at significantly different terms. Those in the prime market offered significantly lower introductory fixed rates, known as “teaser rates,” compared to rates following the resets. People assumed that the initial rates for subprime loans were also just as low and they applied the same label to them—“teaser rates.” We need to understand, though, that the initial rates offered to subprime hybrid borrowers may have been lower than they most likely would have been for the same borrowers had they taken a fixed-rate subprime mortgage, but they were definitely not low in absolute terms.

The average subprime hybrid mortgage rates at origination were in the 7.3–9.7 percent range for the years 2001–2007, compared to average prime hybrid mortgage rates at origination of around 2–3 percent. The subprime figures are hardly “teaser rates.”

Myth 8: The subprime mortgage crisis in the United States
was totally unexpected

Observing the extent of the subprime mortgage crisis in the United States and the global financial crisis that followed, it is hard to tell that this turmoil and its magnitude were anticipated by anyone. The data suggest, though, that some market participants were likely aware of an impending market correction.

In a market with rapidly rising prices, mortgage contracts that cannot be sustained can be terminated through prepayment or refinancing. Borrowers can change houses and mortgage contracts easily in a booming environment, and defaults do not occur as frequently as they would without the boom. Because of this ability to dispose of unsustainable mortgages, signs of the crisis brewing between 2001 and 2005 were hidden behind a “mask” of rising house prices. Using a statistical model to control for rising housing prices, Otto Van Hemert and I determined that default rates were increasing every year for six consecutive years before the crisis had shown any signs. This deterioration is observable now, with the help of hindsight and research findings, but it was also known to some extent to those who were securitizing subprime mortgages in those years. Securitizers seemed to have been adjusting mortgage interest rates to reflect this deterioration in loan quality. In short, lenders’ expectations of the increasing risk of massive defaults among subprime borrowers were forming for years before the crisis; most likely, it was not the crisis that was unexpected, it was its timing and magnitude.

Myth 9: The subprime mortgage crisis in the United States
is unique in its origins

The mortgage crisis in the United States is large and devastating, and it has led to global financial turmoil. In this sense, it is certainly unique. However, neither the origin of this crisis or the way it has played out was unique at all. In fact, it seems to have followed the classic lending boom-and-bust scenario that has been observed historically in many countries. In this scenario, a lending boom of a sizable magnitude leads to a lending-market collapse if it is associated with a deterioration in lending standards, an increase in the riskiness of loans, and a decrease in the price markup of said risk. Argentina in 1980, Chile in 1982, Sweden, Norway, and Finland in 1992, Mexico in 1994, and Thailand, Indonesia, and Korea in 1997 all experienced a pattern similar to the U.S. subprime boom-and-bust cycle. The United Stated has had similar episodes, though on a smaller scale, as well: a crisis with farm loans in the 1980s and one with commercial real estate loans in the 1990s.

Myth 10: The subprime mortgage market was
too small to cause big problems

Before the crisis, there was a conventional belief that a market as relatively small as the U.S. subprime mortgage market (about 16 percent of all U.S. mortgage debt in 2008) could not cause significant problems in wider arenas even if it were to crash completely. However, we now see a severe ongoing crisis—a crisis that has affected the real economies of many countries in the world, causing recessions, banking and financial turmoil, and a credit crunch—radiating out from failures in the subprime market. Why is it so?

The answer lies in the complexity of the market for the securities that were derived from subprime mortgages. Not only were the securities traded directly, they were also repackaged to create more complicated financial instruments (derivatives), such as collateralized debt obligations. The derivatives were again split into various tranches, repackaged, re-split and repackaged again many times over. This, most likely, was one of the mechanisms that amplified problems in the subprime securitized market, and the subsequent subprime-related losses. Each stage of the securitization process increased the leverage financial institutions were taking on (as they were purchasing the securities and derivatives with borrowed money) and made it more difficult to value their holdings of those financial instruments. With the growing leverage and inability to value the securities, uncertainty about the solvency of a number of large financial firms grew.


Many of the myths presented here single out some characteristic of subprime loans, subprime borrowers, or the economic circumstances in which those loans were made as the cause of the crisis. All these factors are certainly important for borrowers with subprime mortgages in terms of their ability to keep their homes and make regular mortgage payments. A borrower with better credit characteristics, a steady job, a loan with a low interest rate, and a home whose value keeps increasing is much less likely to default on a mortgage than a borrower with everything in reverse.

But the causes of the subprime mortgage crisis and its magnitude were more complicated than mortgage interest rate resets, declining underwriting standards, or declining home values. The crisis had been building for years before showing any signs. It was feeding off the lending, securitization, leveraging, and housing booms.

Recommended Reading

“Understanding the Subprime Mortgage Crisis,” by Yuliya Demyanyk and Otto Van Hemert. 2008. Forthcoming in the Review of Financial Studies. Working paper available at

“Quick Exits of Subprime Mortgages,” by Yuliya Demyanyk. 2009. St. Louis Review 91:2 (March/April), pp. 79–93.

Wednesday, July 22, 2009

Does Securitization Affect Loan Modifications?

Posted on Credit Slips by Adam Levitin:

A few days ago I wrote a long and detailed critique of a Boston Federal Reserve staff study that argued, among other things, that securitization was not a factor in the paucity of loan modifications. The study reached this conclusion based largely on the similar rate of modifications for portfolio and securitized loans. Although the study controls for the effect of the modification in terms of monthly payment, it otherwise assumes all modifications are created equal. But clearly they are not. There is a significant difference in redefault rates for securitized and portfolio loans, and the securitized loan mods perform much worse. This is something the Boston Fed's study cannot explain other than if there is (1) unobserved heterogeneity in the loans or (2) differences in the loan mods.

The nature of unobserved heterogeneity in data is that it can't be observed, so all that can be said of (1) is that it is a possibility. But assuming that there isn't a heterogeneity problem about the unmodified loans, what about the mods? Is there heterogeneity problem in mods that makes comparisons of mod rates a poor measure for evaluating the impact of securitization. It appears that there is.

The Boston Fed study did not control for the effect of the loan modification on the homeowner's equity. It does have controls for LTV and negative equity, but those don't seem to have been applied to the serviced/portfolio distinction, at least in the paper. I'm not sure whether there is sufficient data to do this, but what the study could have controlled for, but did not, was whether the modification involved a reduction in the unpaid principal balance. In this aspect, there is a significant difference between portfolio and securitized loans.

OCC/OTS Mortgage Metrics Data for the first quarter of 2009 indicates that very few loan modifications have involved principal balance reductions. In fact out of 185,186 loan modifications in Q1 2009, only 3,398 (1.8%) involved principal balance reductions. All but 4 of those 3,398 principal balance reductions were on loans held in portfolio. The other 4 are quite likely data recording errors. This means that there is heterogeneity in loan mods between securitized and portfolio loans.

The difficulty in doing principal reduction mods for securitized loans is quite important because to the extent that negative equity is driving foreclosures (and there is significant evidence that it is), principal reduction modifications are the tool for eliminating negative equity (with an shared appreciation clawback or not). The quality of loan modifications matters, and securitization affect the quality.

There is also a major difference in the ability of portfolio lenders and Fannie/Freddie/Ginnie servicers to extend the term of a mortgage that private-label servicers don't have. Not all securitization is the same. Private label servicers can usually stretch out the term of a loan by no more than a year or so because the servicing contracts prohibit the extension of the term beyond the last maturity date of any loan in the pool, and pools are usually of similar vintage and duration loans. Fannie/Freddie/Ginnie loans can be bought out of a pool and modified, making them more like portfolio in this regard. Thus 49.2% of portfolio loan mods, 50.8% of Fannie, 61.2% of Freddie, and 17.2% of Ginnie mods involved term extensions, but only 3.9% of private-label securitization mods.

Quite likely there is other heterogeneity that cannot be as easily discerned. This makes sense--portfolio lenders are much less constrained in modifications than securitization servicers. Attempts to quantify servicers' constraints by looking at contract language are inherently limited, as there are structural and functional constraints that are not apparent from an examination of the face of the servicing agreements. Moreover, securitization servicers are adverse to principal write-downs because that affects their compensation far more than an interest rate reduction. The agency problem just doesn't exist for portfolio loans.

Finally, the study has a very strange observation that there is a moral hazard problem in principal balance reductions, but apparently not for interest rate reductions: "Balance reductions are appealing to both borrowers in danger of default and those who are not." Therefore, borrowers might default to get principal reductions. Sure, that's right, but everyone would also like a lower interest rate too. I don't see why a principal reduction presents a different level of moral hazard from an interest rate reduction. In terms of net present value, principal and interest rate are interchangeable (yes, there's an interest deduction, and a principal reduction changes the ability to refinance, but that's not the distinction at issue). The bigger factor pushing against principal reductions (other than servicer compensation) is an accounting issue. A principal reduction shows up on the balance sheet immediately. A reduction of interest just reduces future income.

The take-away here is that even if the Boston Fed staff is right that securitization doesn't affect the prevalence of loan modifications, it clearly affects the quality of those modifications, and that is every bit as important, not least because the performance of past modifications is the basis for servicers' calculation of the redefault risk that the Boston Fed staff emphasizes as constraining modifications. If servicers do bad mods and have high redefaults, that will make them more adverse to doing mods in the future because they will think that the mods don't work.

Bienvenido multi-cedula

Posted on the Financial Times Alphaville by Tracy Alloway:

Spain’s multi-cedulas are back — even as their problems may only just be beginning. From The Cover:

A new Eur1.45bn five year issue for AyT Cedulas Cajas is expected to be priced at 160p over mid-swaps this (Tuesday) afternoon, at the tight end of guidance, but towards the wider end of the levels at which the issuer is believed to have been sounded.
The AyT Cedulas Cajas issue, arranged by Ahorro Corporacion Financiera, is the first multi-cedulas benchmark since November 2007.

AyT is the biggest player in the Spanish multi-cedula market, apparently having established the general model for the covered bonds. The multi-cedula basically involves repacking smaller sized cedulas issues (mortgage securities) into one big package, providing regional savings banks (cajas) with cheaper funding. Think CDOs, but with the liability staying on the balance sheet of the participating banks.

A big criticism of the structure has been that because the cajas’ combined mortgage books comprise the underlying cover pools, the bonds are rather exposed to the problems of a single institution. For instance, Moody’s placed a series of multi-celudas issued by Caja Castilla-La Mancha and a number of other institutions on review for a downgrade back in January, because of perceived financial difficulty only at Caja Castilla-La Mancha.

Here’s Covered Bond Investor on the subject:

On the other hand, the Moody’s rating action in Spain illustrates the maxim that a chain is no stronger than its weakest link. This is not a fatal flaw in the potentially useful joint issuance structure, but it underscores the need for a participating institution to be very choosy about who its “partners” are.

The partners in that AyT issue, in case you’re wondering, are Caja Espana, Caixa Penedes, Caja Cantabria, Caja Insular de Canarias, Bancaja, Caja de Ahorros del Mediterraneo, Sanostra, Caja Granada and Caja Burgos.

Let’s hope the chain holds.

The Role of the Securitization Process in the Expansion of Subprime Credit

Abstract of paper written by the FRB's Taylor D. Nadauld and Shane M. Sherlund:

We analyze the structure and attributes of subprime mortgage-backed securitization deals originated between 1997 and 2007. Our data set allows us to link loan-level data for over 6.7 million subprime loans to the securitization deals into which the loans were sold.

We show that the securitization process, including the assignment of credit ratings, provided incentives for securitizing banks to purchase loans of poor credit quality in areas with high rates of house price appreciation. Increased demand from the secondary mortgage market for these types of loans appears to have facilitated easier credit in the primary mortgage market. To test this hypothesis, we identify an event which represents an external shock to the relative demand for subprime mortgages in the secondary market.

We show that following the SEC’s adoption of rules reducing capital requirements on certain broker dealers in 2004, five large deal underwriters disproportionately increased their purchasing activity relative to competing underwriters in ZIP codes with the highest realized rates of house price appreciation but lower average credit quality.

We show that these loans subsequently defaulted at marginally higher rates. Finally, using the event as an instrument, we demonstrate a causal link between the demand for mortgages in the secondary mortgage market and the supply of subprime credit in the primary mortgage market.

Monday, July 20, 2009

Right-to-rent gets more traction

Posted on Reuters by Felix Salmon:

Obama administration officials are now going on the record when it comes to what I’ve been calling the Baker-Samwick proposal but which Dean Baker has now much more pithily rechristened the right-to-rent plan:

A top Treasury Department official told a Senate panel yesterday that the government is considering a proposal to allow homeowners to stay in their home as renters after a foreclosure…

“It’s certainly an idea we’re thinking about,” Herbert M. Allison, assistant secretary for financial stability, told the Senate Banking Committee.

The idea was first floated by Dean Baker in August 2007; Andrew Samwick signed on, from the other end of the political spectrum, almost immediately. (Contra Joe Nocera, this idea was not “first broached” by Dan Alpert in October 2008; the Alpert plan is needlessly complicated, and involves giving away to homeowners a valuable option to repurchase their homes which is neither necessary nor desirable.)

It’s worth noting that the right-to-rent plan is very different from the existing Fannie Mae plan which allows homeowners to rent their homes on a month-to-month basis, if they give up their cash-for-keys option whereby they get paid for moving out. Renting month-to-month is not a happy state of affairs: your landlord can kick you out of your home at any time. It’s easy to see why most homeowners would prefer cash up front for moving now. Under right-to-rent, by contrast, the homeowner can stay in the home for at least five years, if not ten.

In an ideal world, banks which foreclosed on homeowners would then sell those homes to professional landlords, who would rent the houses out in perpetuity, either to the former homeowner or to renters who moved in after the homeowners moved out. That would raise the amount of rented housing in the US, and decrease the homeownership rate — and lower homeownership means lower unemployment. This plan isn’t just good for soon-to-be-foreclosed-upon homeowners, it’s good for employment, too!

Thursday, July 16, 2009

Is Redefault Risk Preventing Mortgage Loan Mods?

Posted on Credit Slips by Adam Levitin:

There's a very interesting new study on mortgage loan modifications out from the Boston Federal Reserve staff. This sort of study is long-overdue and from an academic standpoint, there's a lot I really like about this study. But the study is going to get a lot of policy attention, and I think it's important to point out some of the problems with the study that limit its ability to serve as a policy guide.

The study has two big claims. First is that the reason we aren't seeing many mods is because of high redefault and self-cure rates for borrowers in general, basically type I and type II errors respectively. If a mortgagee modifies a loan and it redefaults in a declining real estate market, the mortgagee's recovery from the foreclosure or REO sale will be diminished. Thus, there is a danger of modification actually reducing value for mortgagees. Conversely, some the defaults on some loans that are modified would have been cured without modification. The modification is thus a give-away from the mortgagee's perspective. Mortgagees are scared of both of these possibilities (or maybe rationally recognize that they are quite likely) and therefore aren't doing mods.

The other claim, based on an empirical analysis of a sample from the LoanPerformance database, is that there is no statistically significant difference in the percentage of portfolio and securitized loans being modified. From this the study concludes that securitization is not an important factor in the paucity of loan modifications. Instead, the authors' identify the common factors of redefault and self-cure as limiting mods.

From this, the study reaches two conclusions. First, that there are far fewer preventable foreclosures than assumed. Second, that servicer safe-harbor provisions to allow servicers to modify loans without fear of litigation are unimportant.

So what's wrong with this picture? Regarding the claim that redefault risk and self-cure risk are limiting loan mods, I think that as a pure matter of theory, it makes a lot of sense. But when the claim is tested against the actual numbers produced in the study, it doesn't hold up--there's still plenty of room to do value-maximizing modifications.

One of the very strange things about this study is that it has some empirical data and a model, but it never puts the two together. Instead, the study assumes that the empirical data and the model support the interpretation advanced simply because the model indicates that high levels of redefaults and self-cures would make modifications no longer worthwhile, and the numbers of redefaults and self-cures look really large. But just because a number looks large doesn't mean that it necessarily shifts the modification calculus. I've tried putting the numbers together with a model. Bear with me on the math--it's entirely possible that I've overlooked something in my calculations, and if I have please comment to let me know--but if my math is right, then redefault/self-cure risk just isn't what's limiting mods.

The question a rational mortgagee with no outside interests should ask when faced witha defaulted loan is whether the net present value (NPV) of a modified loan is greater than the NPV of a unmodified loan. If so, a modification would be value maximizing for the mortgagee. My NPV modeling is somewhat crude, not least because it tries to avoid discount rate and refinancing horizon issues by treating UPB and NPV as equivalent, which they are not, but I think it captures the essential point.

Let's use some very conservative assumptions--that there will be high redefault and self-cure rates, and that foreclosure losses will be high, and much higher for redefaults. For a modified loan, lets assume a 30% chance of self-cure (from the study), a 40% chance of redefault (conservative from the study), resulting in a 75% loss severity (quite conservative), and a 35% chance the modified loan will perform as modified. For an unmodified loan, there is a 30% chance of self-cure and a 70% chance of foreclosure, with a 55% loss severity (conservative--it's more like 60% now). Let's assume a mortgage with a $200,000 NPV if it performs unmodified, and that M is the maximum NPV of a modified loan such that it will be greater than the NPV of the loan unmodified. Thus:

[Value if modified, but would have self-cured] + [value if performs as modified] + [foreclosure value if redefault]≥ [value if self-cured without mod] + [value if foreclosed without mod]

To put the numbers on it:

.3M + .3M + .4*.25*$200,000 ≥ .3*$200,000 + .7 * .45 * $200,000

.6M + $20000 ≥ $123,000

.6M ≥ $103,000

M≥ $171,666.67

This means that even using the Boston Fed's most conservative assumptions, the principal and/or interest could be written down such that the NPV of the loan would go to $171,666.67 and the modification would still maximize net present value for the mortgagee. To put this in slightly different terms, a modification would still be value maximizing, even with a 15% write-down in NPV. And that's with some very conservative assumptions. Loosen these assumptions (e.g., FDIC's 15% mod-in-the-box self-cure rate or a 30% redefault rate), and there are even more generous modifications possible.

There's also another way to test the explanatory power of redefault and self-cure risk. Presumably redefault risk and cure rates also vary with other mortgage characteristics. For example, it stands to reason that an underwater investor property mortgage is less likely to be cured than an above-water owner-occupied one. The question, then is whether modification rates track the variations in redefault and cure rates by mortgage characteristic. If they do, then the study's conclusion would be much stronger; if they don't then either these factors don't matter or mortgagees only care about them in the very rough aggregate (which seems both unlikely and unfortunate). Hopefully this is something the authors will investigate in later versions of their study.

Regarding the second claim, that securitization doesn't matter in terms of mods, there's first a data question and then, regardless of how that is answered, a factual and a logical problem. I don't know the LoanPerformance data set in great detail. You can see some of its characteristics listed here. I don't know if LP includes data on loans held in portfolio by credit unions and community banks. If it doesn't, that might be distorting the results as the portfolio loans for large banks might well be serviced by the same servicers as securitized loans. If so, the study wouldn't be comparing securitized vs. portfolio, as much as self-serviced vs. serviced-by-others.

Irrespective, there is a major factual issue overlooked by the study: there is a difference in how a securitization servicer and a portfolio lender view redefaults and self-cures. A portfolio lender is fully sensitive to both; a servicer, in contrast, does not care what the property brings in at a foreclosure or REO sale because the servicer is paid off the top. As long as there is just some land value left, the servicer will get paid. The servicer might have to make additional months of servicing advances on a redefault, but those are reimburseable too, off the top. The only cost to a servicer from redefault is some time value. That means servicers are less sensitive to redefault than portfolio lenders. Self-cure is also less of an issue for servicers because most of their mods involve interest rate reductions, and rate reductions have only a small affect on servicer compensation, unlike a principal reduction. In short, redefault and self-cure risk is not an equally applicable factor, so it cannot alone explain the similar rate of mods for securitized and portfolio loans.

So what is the explanation? There are two possibilities. First is that it is simply coincidence. The paper recognizes this as a possibility, although it quickly dismisses this. The second, possibility is that there is another common factor (or factors). I think servicer capacity is a major concern that applies across the board. To start with the bulk of servicer personnel at most companies aren't even in the US; they've been outsourced. Doing a mod is like underwriting a new loan in a distressed situation. That's a skill, and I don't think it's what servicers were looking for over the past decade when they moved operations to India. Instead, they were looking for low-cost labor for their routine ministerial tasks, and it will take a long time for the industry to acquire the workout talent it needs.

In any case, even if there is a common factor, that hardly means securitization doesn't create serious concerns. Even if issues like capacity can be addressed, there are layers of problems preventing modifications, all of which must be addressed, but the study dismisses this possibility a little too quickly, and based on a questionable analysis of the other literature on securitization. For example, the study claims based on a single empirical study of PSA provisions (which has its own limitations), that "suggests a small role for contract frictions in the context of renegotiation." This is a very strange statement, as it assumes that contract frictions are just a matter of formal contract provisions. My article with Anna Gelpern shows that in PSAs there are a variety of frictions to renegotiation, some formal, some functional, and some structural. Our article is cited elsewhere in the study, but doesn't seem to have informed the Boston Fed staff's study on this point. The study also claims that the Congressional Oversight Panel's foreclosure report states that "none of the [contractual] restrictions [on loan modification in PSAs] were binding." The Oversight Panel said no such thing. The Panel merely observed that in some pools where there was a 5% cap on the number of loans that could be modified, that that cap was not yet limiting modifications.

In short, there is no reason to assume that contractual frictions don't matter. That said, I agree with the study's claim that servicer safeharbors are unlikely to do much good, but that is because there are contractual frictions that safeharbors don't address as well agency problems.

Explaining the failure of modification efforts will be an unresolved question for some time, but at this point I think it's really just academic to try and pinpoint why the mods aren't being done. Instead, we have to look for a method that we know will produce loan modifications. I hate to sound like a broken record, but there's a solution that cuts to the chase--bankruptcy modification cuts through all of the mess. And when even a conservative scholar like Stan Leibowitz can write a piece in the WSJ arguing that negative equity is the driving problem, it's time to take another look at cramdown.

Finally, I wonder whether the goal of maximizing NPV for investors is the right metric. A foreclosure might maximize value for investors, but be socially detrimental. If the policy goal is improving social welfare, then we might want to discourage foreclosures that by themselves might be economical.