Monday, February 8, 2010

The second-mortgage underwriting failure

Original posted on Reuters by Felix Salmon:

In case you missed it on Friday, it’s worth checking out Tracy Alloway’s post about second mortgages in the US. She makes a very good point about how they’re making it a lot more difficult for mortgages to be modified — but we kinda knew that already. What I, at least, didn’t know was this:


All those second-mortgage-backed CDOs which have gone to zero, causing enormous losses? They’re in that tiny little purple wedge at the bottom. The overwhelming majority of second mortgages, it turns out, are held the old-fashioned way, on the books of banks, credit unions, and savings institutions.

Now this goes strongly against the dominant narrative of the subprime crisis, which is that the originate-to-distribute business model was largely responsible for the disastrous collapse in underwriting standards. Here, there was no originate-to-distribute business model, and clearly most of these seconds should never have been written — but they still were, and what’s more they were underwritten disproportionately by the big four commercial banks. (Actually, I’m not clear on if they were underwritten by the big four, of if the big four have just acquired them through the acquisition of companies like Countrywide and Wachovia.)

What explains the commercial-bank loan officers taking toxic second mortgages onto their own books? I think it’s a combination of factors. Firstly, they believed the hype. Secondly, they were reaching for yield in the Great Moderation just like everybody else. And thirdly, the originate-to-distribute model still existed in a smaller form: the banks were acquiring these loans from mortgage brokers who got paid at close, whether or not the loan was a good one.

None of that, of course, is remotely helpful in addressing the problem today, of what on earth to do with $1 trillion in second mortgages. It would be great if all the banks just wrote them down to zero, but you know that’s not going to happen. And first-lien mortgage holders are going to hate to give the second-lien holders anything at all — what Al Yoon calls “a principal reduction plan where losses are shared”. Some of the bondholders might be asking for that, but I’ll bet you they’re mainly the holders of triple-A-rated tranches, who don’t mind if the holders of lower-rated tranches get wiped out through a loss-sharing agreement. If this kind of plan does go through, expect holders of the lower-rated tranches of first-lien mortgage bonds to scream blue murder, and possibly go to the courts. They’re meant to be senior to the second liens, after all, yet they might well get nothing while the second-lien holders get something. What a mess

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