Banking system’s problems at heart of the bear case

(Tony Jackson - Financial Times) Contemplating the year ahead is, when you come to think of it, a slightly pointless exercise. It is not just that forecasts are generally wrong. More seriously, we tend to worry about stuff that never happens, while getting blindsided by events that nobody foresaw.

But financial markets are discounting mechanisms and forecasts are implicit in prices whether we like it or not. So here is my version, starting with a disclaimer.

I am naturally of a bearish disposition. This is not because I have the least aversion to wealth creation. Rather, I put it down to early training as an analyst in Edinburgh. The Scottish approach to investment is traditionally that of the surveyor rather than the estate agent: never mind the sea views, check the dry rot and subsidence.

With that in mind, the big bearish question for next year strikes me as whether the banking system’s problem is one of liquidity or solvency. The central banks can fix the former.

The latter can only be addressed the hard way.

One can lead to the other, as illustrated by the case of Northern Rock. This UK bank was perfectly solvent when first hit by a liquidity crisis and is now on a taxpayer life-support system.

As to whether any big banks will go bust next year, there is as yet no saying. But sticking to the bearish theme, let us tick off some factors which make it more likely.

First, defaults are set to rise. According to Standard and Poor’s, speculative-grade defaults in the US are now at an all-time low, at less than one per cent.

That compares with 10 per cent in 2001 and 12 per cent in 1990 – both recession years. But the proportion of bonds defined as distressed – that is, with spreads of more than 1000 basis points over Treasuries – is rising sharply and now stands at almost 5 per cent compared with 2.1 per cent a year ago.

That is stage one. Stage two – actual defaults – will duly follow.

Hedge fund leverage

At that point, enter one set of actors largely absent from the drama so far – the hedge funds. For years, they have been writing credit protection – in the form of derivatives – as an apparently foolproof way of getting cash flow. But as the Institutional Risk Analyst points out, they are not insurance companies. They do not have permanent capital or reserves. Instead, they have leverage.

So as the defaults come in, the hedge funds eat up their cash pretty quickly. That presents a headache to their counterparties – the investment banks. They will of course require more collateral as the situation worsens – but they cannot call in money which is not there.

On top of that, the investment banks face the continuing problem of structured investment vehicles, or SIVs. Some of those were funded by short-term commercial paper, and have had to dump assets – or get emergency funding from their bank sponsors – as that market dried up.

But according to Dresdner Kleinwort, a further $180bn-worth (£90.3bn) of SIVs are funded by medium-term notes rather than short-term paper. Some $40bn of that will need refinancing by April next year and a further $80bn by September. If the markets are still not open by then, the fire sale resumes.

Private equity bubble

There remains the separate question of loans created in the private equity bubble. Many of those are stuck on the banks’ books and in due course some of them will go bad.

Granted, the pain may in some cases be cushioned by the extraordinarily lax terms on which loans were issued. When you are in default, it helps a lot if you have no covenants to meet.

It also helps if you issued a so-called PIK (payments in kind) loan, whereby you jack up the principal instead of making interest payments. But none of that helps when you are actually bust.

A slightly scary case in point is Chrysler. It insists it is not in any financial trouble after its buy-out by Cerberus.

But according to the Wall Street Journal, its new boss recently told a meeting of workers: “Are we bankrupt? Technically, no. Operationally, yes.

The only thing that keeps us from going into bankruptcy is the $10bn investors entrusted us with.”

This is, as I said, a list of bear points and those of a more bullish temper could no doubt compile offsetting lists of their own. But on the basic question of the banks’ solvency, we are still in the dark, for the simple reason that much of the damage has not yet been inflicted.

Then again, as I also said, the stuff that gets you tends not to be what you worry about, but what sneaks up from behind. For us bears, that is not a particularly soothing thought either.

WSJ on mortgage lender lobbying to limit regulation

(Naked Capital) Since I often take the Wall Street Journal to task on its reporting, I wanted to be sure to point out when they do a good job on topics of interest, per today's page one story, "Lender Lobbying Blitz Abetted Mortgage Mess."

The article describes the lobbying efforts of subprime lender Ameriquest and three industry associations of which it was a member. While it nails details of the efforts at the federal and particularly state level to neuter legislation that would have imposed higher standards on subprime operators, it doesn't give any sense as to how large these contributions were relative to other financial services industry pet causes.

Similarly, the article suggests that these expenditures were effective. Yet the story also mentions,

At that point {October 2002}, opponents of the new {New Jersey} law got some help. Just as it had done in Georgia, Standard & Poor's said it wouldn't rate some securities containing loans from the state. In addition, federal banking regulators issued a series of regulatory orders banning states from applying state consumer-protection rules to federally chartered banks and thrifts, part of a turf battle between federal and state regulators. That put pressure on states to soften predatory-lending rules so federally chartered banks didn't have an advantage over state-chartered ones.

"Put pressure"? It's more accurate to say it made the state rules irrelevant. Federally chartered banks could offer subprime products to mortgage brokers and directly to customers. The fact that some state chartered banks would be constrained would have minimal impact on the availability of the product. And it would therefore be futile to keep the new laws in place, since their effect would simply be to restrict the activities, and likely profits, of state-chartered entities.

From the Wall Street Journal:

During the housing boom, the subprime industry succeeded at more than just writing mortgages. It also shot down efforts by some states to curtail risky lending to borrowers with spotty credit.

Ameriquest Mortgage Co., until recently one of the nation's largest subprime lenders, was at the center of those battles. Working with a husband-and-wife team of Washington lobbyists, it handed out more than $20 million in political donations and played a big role in persuading legislators in New Jersey and Georgia to relax tough new laws. Those victories, in turn, helped blunt efforts by other states to crack down on reckless lending, critics of the industry contend.

Executives at Ameriquest, based in Orange, Calif., acknowledge that the company lobbied heavily against state lending restrictions, but say that other subprime lenders did so as well. In fact, a host of subprime lenders and banking trade groups, including Citigroup Inc., Wells Fargo & Co., Countrywide Financial Corp. and the Mortgage Bankers Association, spent heavily on lobbying and political giving.

Ameriquest, a unit of ACC Capital Holdings, has stopped making new subprime loans, and it has sold some operations and is winding down others. It is now a defendant in hundreds of lawsuits alleging mortgage fraud.

Data from federal and state campaign-finance records, Internal Revenue Service filings, and the National Institute on Money in State Politics show that from 2002 through 2006, Ameriquest, its executives and their spouses and business associates donated at least $20.5 million to state and federal political groups. In comparison, over the same time period, Countrywide Financial, another large subprime lender, gave about $2 million in campaign gifts, and spent an additional $6.7 million lobbying in Washington, records indicate.

Some of the giving by Ameriquest executives and associates was high-profile. President Bush received more than $200,000 for his 2004 re-election campaign, and Ameriquest founder Roland Arnall and his wife, Dawn, contributed more than $5 million to political organizations that backed the president. Last year, President Bush appointed Mr. Arnall ambassador to the Netherlands, and his wife took over as chairman of Ameriquest's parent company. California Gov. Arnold Schwarzenegger's campaigns received at least $1.4 million, along with stacks of tickets to a Rolling Stones concert that were used to lure big donors. A spokesman for Gov. Schwarzenegger said his decisions are not influenced by campaign contributions. Mr. Arnall declined to comment. The White House said Mr. Arnall was nominated because of his qualifications.

Much of Ameriquest's efforts took place below the national radar, at the state level. State legislatures wanted to crack down on so-called predatory lending, which refers to the use of deceptive or unfair practices in the sale of high-interest loans, often to low-income borrowers who can't afford them. In New Jersey, for example, lawmakers passed a strong predatory-lending law in 2003 that made it difficult for Ameriquest to continue doing business there.

Washington lobbyist Wright Andrews and his wife, Lisa, coordinated much of the industry's lobbying. Mr. Andrews's firm, Butera & Andrews, collected at least $4 million in fees from the subprime industry from 2002 through 2006, congressional lobbying reports indicate. Mr. Andrews didn't represent Ameriquest directly. He ran three different subprime-industry trade groups: the National Home Equity Mortgage Association, of which Ameriquest was a member; the Coalition for Fair and Affordable Lending, which spent $6.3 million lobbying against state laws before it dissolved earlier this year, according to federal filings; and the Responsible Mortgage Lending Coalition.

In 2003, Lisa Andrews was appointed senior vice president for government affairs at Ameriquest. Her public-relations firm, Washington Communications Group Inc., claims credit on its Web site for coordinating the industry's victory in New Jersey, as well as its overall strategy at the state level. Ms. Andrews left Ameriquest in 2005 and returned to her firm..

Ameriquest was founded by Mr. Arnall in 1979 as Long Beach Savings & Loan. He later shed all of the thrift's operations except its retail-mortgage unit, which he renamed Ameriquest. During the refinancing boom of the 1990s, Ameriquest became a player in the business of lending to low-income homeowners. The company persuaded many homeowners to take cash out of their houses by refinancing them for larger amounts than their existing mortgages. Many of the new loans carried relatively high interest rates.

Settling Claims

Last year, ACC Capital, its parent company, agreed to pay $325 million to settle regulators' claims that it charged excessively high mortgage rates and didn't adequately disclose loan risks. Some of the state attorneys general who signed the settlement, including Greg Abbott of Texas, received campaign donations from the firm. Utah's attorney general, Mark Shurtleff, received a $1,000 contribution and Rolling Stones tickets. A spokesman for Mr. Shurtleff says the attorney general was not directly involved in negotiating the settlement. A spokesman for Mr. Abbott notes that the settlement was also negotiated and approved by 48 other state attorneys general.

Ameriquest also handed out Rolling Stones tickets to state legislators in Georgia, Maryland, Nevada, Oregon, Utah, Washington and California, according to ethics records and local news accounts.

Federal lawmakers didn't pose much of a threat to the subprime industry in recent years. Members of Congress received at least $645,000 in donations from Ameriquest and large sums from other big subprime lenders, Federal Election Commission records indicate. They debated new oversight of the industry, but took no action.

The states were a different matter. "What seemed to be developing in the states was that there was going to be a wave of legislation," Mr. Andrews, the lobbyist, said in an interview.

In 2001, Georgia passed the Fair Lending Act. Among other things, it required lenders to be able to prove that a refinancing of any home loan less than five years old would provide a "tangible net benefit" to the borrower. Ameriquest began lobbying the state legislature to remove that provision, arguing the standard was too vague. Other lenders also complained about the law, as did Fannie Mae, the giant buyer of mortgages.

"Ameriquest was very, very engaged," recalls Georgia state Sen. Vincent Fort, who authored the law. Mr. Fort says that Adam Bass, a lawyer for Ameriquest, lobbied him directly. The state senator says he accused Mr. Bass of victimizing poor minorities, which angered Mr. Bass. A spokesman for Ameriquest, speaking on Mr. Bass's behalf, says the meeting "was a very candid conversation about complex policy issues."

Mr. Andrews, the industry lobbyist, had roots in Georgia. He had attended college and law school there, and in the 1970s, had worked for Sam Nunn, then a U.S. senator from Georgia. Mr. Andrews got involved directly on the subprime matter, lobbying in his capacity as executive director of the Responsible Mortgage Lending Coalition, one of the subprime-mortgage trade groups he ran out of his Washington office. "I wouldn't say it was a huge effort," he says. "We were just part of the overall picture."

Ameriquest began contributing to Georgia politicians. In December 2001, it donated $2,500 to Lt. Gov. Mark Taylor after he emerged as an influential figure in the debate, according to Georgia State Ethics Commission records. It followed up with another $2,500 in September 2002. Mr. Taylor says he remembers Ameriquest as one of the subprime companies that was lobbying, but doesn't recall meeting anyone from the company or getting the contributions.

In October 2002, Ameriquest announced it would stop doing business in the state until the law changed. Shortly thereafter, Standard & Poor's Corp. announced it would no longer assign credit ratings to many mortgage securities containing subprime loans from Georgia. The ratings agency said that under the new law, such loans, if found to be in violation of the law, might carry legal risk, potentially tainting the securities. Without credit ratings, such securities are virtually unmarketable. The change raised the possibility that subprime lenders would simply stop making loans in Georgia.

The subprime industry mounted a campaign against the Fair Lending Act. Within months, the Georgia Senate voted 29-26 in favor of a new law that eliminated for nearly all loans the tangible-net-benefit requirement opposed by the industry. The state House passed the law, 148-25.

Problems were also developing for the industry in New Jersey. The state Assembly there passed a similar law against predatory lending, the Home Ownership Security Act. It too contained a tangible-net-benefit rule, but it didn't provide much guidance on how the standard would be applied. "The New Jersey law makes it impossible for anyone to be in compliance," Mr. Bass, the Ameriquest lawyer, complained at an industry conference.

In October 2002, Ameriquest and Mr. Andrews's lobbying firm contributed $4,500 to five New Jersey state senators, state campaign reports indicate. The American Financial Services Association, a subprime industry group that included Ameriquest, predicted the law would cause lenders to abandon the state. Nevertheless, in the spring of 2003, the bill passed the state Senate and was signed into law.

At that point, opponents of the new law got some help. Just as it had done in Georgia, Standard & Poor's said it wouldn't rate some securities containing loans from the state. In addition, federal banking regulators issued a series of regulatory orders banning states from applying state consumer-protection rules to federally chartered banks and thrifts, part of a turf battle between federal and state regulators. That put pressure on states to soften predatory-lending rules so federally chartered banks didn't have an advantage over state-chartered ones.

The subprime industry set to work trying to roll back the New Jersey law. The National Home Equity Mortgage Association, one of the subprime groups run by Mr. Andrews, released a survey predicting that the law would reduce mortgages in New Jersey by $4 billion.

Ameriquest and Mr. Andrews's lobbying firm began handing out campaign contributions. Among the recipients were John Adler and Gerald Cardinale, two state senators who had voted for the new law. In October 2003, Mr. Cardinale, a Republican, received a $2,200 donation from Ameriquest, according to state election records. In November 2003, Mr. Adler, a Democrat, received $1,200 from the lobbying firm, the records indicate. In early December, the two senators introduced a bill to make changes sought by the industry.

'Remove Barriers'

"I don't remember ever being lobbied by Ameriquest," says Mr. Cardinale. "I do recall that we were trying to make it easier for folks to be able to access funds. And, in general, I feel it is a good thing for us to remove barriers to people being able to buy homes." He says he doesn't remember receiving any contributions from Ameriquest. "You guys think we know all of our contributors, but that's usually on a staff level. I don't frankly know who Ameriquest is."

Mr. Adler says he doesn't recall meeting anyone from Mr. Andrews's lobbying firm.

That December, Neil Cohen, a state assemblyman who had voted for the new law, received a $500 donation from the lobbying firm, state records show. The Assembly's Financial Institutions Committee, which was headed by Mr. Cohen, offered its own legislation to soften the lending law. Mr. Cohen couldn't be reached for comment.

In 2004, as debate over the predatory-lending law dragged on, Ameriquest and Mr. Andrews's lobbying firm together donated an additional $3,200 to Mr. Cohen, $1,100 to Mr. Cardinale and $1,300 to Mr. Adler, according to state records. Ameriquest gave $10,000 to the Democratic Party in the Assembly, $10,000 to Democrats in the Senate, and $7,000 to Senate Republicans, the records indicate.

Mr. Andrews's wife, Lisa, then head of government affairs at Ameriquest, was also focused on New Jersey. On the Web site of her Washington public-relations firm, she says that she "built a coalition of mortgage brokers, mortgage bankers, appraisers, title companies, and others involved in home mortgage lending to create a grass-roots lobbying campaign that produced 7,000 emails and faxes to state policymakers in a six-week time frame."

Rolling Back

In June 2004, New Jersey's Assembly and Senate unanimously passed bills that rolled back parts of the earlier law, including the tangible-net-benefit rule. Mr. Bass, the Ameriquest lawyer, announced that the company would "be offering a full range of loans in New Jersey." Thousands of New Jersey homeowners subsequently refinanced existing mortgages or took out new loans with Ameriquest before the subprime market tanked. Many of those loans are now in foreclosure.

After the victories in New Jersey and Georgia, the subprime industry and its lobbyists used similar tactics to fend off unfavorable laws in other states. Texas, for example, was debating new restrictions on home appraisers, whose overly generous valuations contributed to subprime-lending problems. ACC Capital, Ameriquest's parent company, and its executives gave more than $350,000 to Texas politicians in 2006, including $100,000 to Gov. Rick Perry, according to state records. No new appraisal restrictions were instituted. A spokesman for Gov. Perry says ACC did not ask for the governor to take any action on behalf of the industry.

In the wake of the collapse of the subprime market, Mr. Andrews's subprime lobbying business has withered. The three trade groups he ran are gone, and most of his subprime clients have stopped lobbying.

"I certainly was not aware of the degree to which many in the industry clearly failed to follow proper underwriting standards -- the standards which they represented they were following to those of us who were lobbying," Mr. Andrews says.

But he also faults the Federal Reserve for letting the industry get out of control.

"Personally, I think and have long felt the Fed should have done more early on," he says. "But I don't think anybody realized the level of problems that were going to come out in the last year or two. If you had said to me the industry was going to melt down, I would have said you were absolutely insane."

The "nobody saw it coming defense"

(Housing Wire) Let’s start out with a basic fact: a whole bunch of people saw the mortgage meltdown coming. Many of these people, in fact, actually worked in the mortgage banking industry, and many were talking about it as far back as three years ago in earnest.

I’m not referring to every free-wheeling mortgage broker that every now and then had a fleeting thought that said it can’t be this easy or you mean I can qualify borrowers like this? I’m referring to the people that worked in default servicing, code named “special servicing” — a side of the mortgage banking industry that up until this year was a mere afterthought for almost anyone running a mortgage operation.

Having worked in that side of the business for years, and having interviewed people in loss mitigation all the way through to REO disposition, I can tell you that nearly every one of them knew this would end badly. And nearly every one of them has told me so.

It’s just that nobody really cared to listen to what the guys in foreclosure or REO thought about origination practices. And this morning’s Wall Street Journal sheds some light more than 20 million reasons why:

During the housing boom, the subprime industry succeeded at more than just writing mortgages. It also shot down efforts by some states to curtail risky lending to borrowers with spotty credit.

Ameriquest Mortgage Co., until recently one of the nation’s largest subprime lenders, was at the center of those battles. Working with a husband-and-wife team of Washington lobbyists, it handed out more than $20 million in political donations and played a big role in persuading legislators in New Jersey and Georgia to relax tough new laws. Those victories, in turn, helped blunt efforts by other states to crack down on reckless lending, critics of the industry contend.

I recall the Georgia mess well from back in 2001 and 2002, when there was actual talk that not just subprime lending — but all lending — might actually come to a halt in the state thanks to so-called “net tangible benefit” provisions in a Fair Lending Act. The WSJ tries to paint a sinister lobbying connection here, but I seem to recall the more public debate was about Federal versus state-led industry oversight. Lenders have long argued that negotiating a patchwork set of varying state laws isn’t good chi for a national mortgage lending operation, something that I’m sure had as much to do with persuading legislators as did any Rolling Stones tickets.

Speaking of Rolling Stones tickets, the story centers on the lobbying efforts of one Wright Andrews, who has seen his business collapse along with the major subprime lenders he once represented:

“I certainly was not aware of the degree to which many in the industry clearly failed to follow proper underwriting standards — the standards which they represented they were following to those of us who were lobbying,” Mr. Andrews says.

But he also faults the Federal Reserve for letting the industry get out of control.

“Personally, I think and have long felt the Fed should have done more early on,” he says. “But I don’t think anybody realized the level of problems that were going to come out in the last year or two. If you had said to me the industry was going to melt down, I would have said you were absolutely insane.”

I’m starting to see alot of “who knew?” responses from various industry participants in the press as of late, and I suppose that’s at least tangentally part of our nation’s 5th amendment rights. After all, I wouldn’t expect Mr. Andrews to admit to the WSJ that he knew it would end badly, but that there were bills to be paid in the meantime.

Nonetheless, it’s got to be a never-ending source of amusement for those industry insiders that did, in fact, know this was coming — because there are plenty of them out there, and most are now knee-deep in trying to manage the unbelievable mess created by the origination side of this business.

ABX.HE 08-1 Announcement

(December 19 Markit Press Release) Markit, the leading provider of independent data, portfolio valuations and OTC derivatives trade processing and owner of the Markit ABX.HE index, today announced that the roll of the Markit ABX.HE has been postponed for three months. The Markit ABX.HE is a synthetic index of U.S. home equity asset-backed securities.

The new series, the Markit ABX.HE 08-1, was scheduled to launch on 19 January 2008. The decision to postpone its launch was taken following extensive consultation with the dealer community. It follows a lack of RMBS deals issued in the second half of 2007 and eligible for inclusion in the forthcoming Markit ABX.HE roll. The Markit ABX.HE 07-2 remains the on-the-run series until further notice.

Under current index rules, only five deals qualified for inclusion in the Markit ABX.HE 08-1. Markit and the dealer community considered amending the index rules to include deals which failed to qualify initially but decided against this approach at this time.

Markit and the dealer community remain fully committed to the index and will update the market as and when appropriate.

Cheat on the Need to Sleep

(Wired) Quality not quantity. No matter how much your mother tells you that you need eight hours of sleep, if you're not tired and you can't truly relax, your sleep time will be worthless.

CENTER FOR APPLIED COGNITIVE STUDIES (CentACS)

CentACS reports that "studies show that the length of sleep is not what causes us to be refreshed upon waking. The key factor is the number of complete sleep cycles we enjoy. Each sleep cycle contains five distinct phases, which exhibit different brain- wave patterns. For our purposes, it suffices to say that one sleep cycle lasts an average of 90 minutes:

• 65 minutes of normal, or non-REM (rapid eye movement), sleep
• 20 minutes of REM sleep (in which we dream)
• Final 5 minutes of non-REM sleep.

The REM sleep phases are shorter during earlier cycles (less than 20 minutes) and longer during later ones (more than 20 minutes). If we were to sleep completely naturally, with no alarm clocks or other sleep disturbances, we would wake up, on the average, after a multiple of 90 minutes--for example, after 4 1/2 hours, 6 hours, 7 1/2 hours, or 9 hours, but not after 7 or 8 hours, which are not multiples of 90 minutes. In the period between cycles we are not actually sleeping: it is a sort of twilight zone from which, if we are not disturbed (by light, cold, a full bladder, noise), we move into another 90-minute cycle. A person who sleeps only four cycles (6 hours) will feel more rested than someone who has slept for 8 to 10 hours but who has not been allowed to complete any one cycle because of being awakened before it was completed.... "

2006 NATIONAL INSTITUTES OF HEALTH CONSENSUS CONFERENCE

Robin Lloyd of Live Science reports that at the 2006 National Institutes of Health Consensus Conference, experts agreed, according psychiatry professor Daniel Kripke of the University of California, San Diego on the following recommendations for obtaining optimum sleep value:

• Do not take sleeping pills. This includes over-the-counter pills and melatonin.
• Don't go to bed until you're sleepy. If you have trouble sleeping, try going to bed later or getting up earlier.
• Get up at the same time every morning, even after a bad night's sleep. The next night, you'll be sleepy at bedtime.
• If you wake up in the middle of the night and can't fall back to sleep, get out of bed and return only when you are sleepy.
• Avoid worrying, watching TV, reading scary books, and doing other things in bed besides sleeping and sex. If you worry, read thrillers or watch TV, do that in a chair that's not in the bedroom.
• Do not drink or eat anything caffeinated within six hours of bedtime.
• Avoid alcohol. It's relaxing at first but can lead to insomnia when it clears your system.
• Spend time outdoors. People exposed to daylight or bright light therapy sleep better.

A six-year study Kripke headed up of more than a million adults ages 30 to 102 showed that people who get only 6 to 7 hours a night have a lower death rate than those who get 8 hours of sleep. The risk from taking sleeping pills 30 times or more a month was not much less than the risk of smoking a pack of cigarettes a day, he says.

So what happens when you don't have time for even 6 hours of sleep? Surely you can't go without sleep? Without adequate rest, the brain's ability to function quickly deteriorates. The brain works harder to counteract sleep deprivation effects, but operates less effectively: concentration levels drop, and memory becomes impaired.

Similarly, the brain's ability to problem solve is greatly impaired. Decision-making abilities are compromised, and the brain falls into rigid thought patterns that make it difficult to generate new problem-solving ideas. Insufficient rest can also cause people to have hallucinations. Other typical effects of sleep deprivation include:

• depression
• heart disease
• hypertension
• irritability
• slower reaction times
• slurred speech
• tremors

Bеcause the amount and quality of the sleep we get affects our hormone levels, namely our levels of leptin and ghrelin, many physiological processes that depend on these hormone levels to function properly, including appetite, are affected by our sleep.

While leptin is a hormone that affects our feelings of fullness and satisfaction after a meal, ghrelin is the hormone that stimulates our appetites. When you suffer from sleep deprivation, your body’s levels of leptin fall while ghrelin levels increase. This means that you end up feeling hungrier without really feeling satisfied by what you eat, causing you to eat more and, consequently, gain weight.

POLYPHASIC SLEEP

Polyphasic sleep is a term used to describe several alternative sleep patterns intended to reduce sleep time to 2–6 hours daily in order to achieve a better quality of sleep. This is achieved by spreading out sleep into short naps of around 15–30 minutes throughout the day, and in some variants, a core sleep period of a few hours at night.

The term "polyphasic sleep" itself refers only to the practice of sleeping multiple times in a 24-hour period (usually, more than two, in contrast to "biphasic sleep") and does not imply any particular schedule.

Uberman's Sleep

In application, Uberman's sleep schedule is likely to be the most widely known type of polyphasic sleep, and also the most strict. It consists of six naps of 20–25 minutes each, occurring four hours apart throughout the day. This is also the closest schedule to the type that has been studied by Claudio Stampi in connection with long-distance solo boat races. Claudio Stampi advocates polyphasic sleep as a means of ensuring optimal performance in situations where extreme sleep deprivation is inevitable (e.g. to improve performance in solo sailboat racers), but Stampi does not advocate the polyphasic sleep as a lifestyle.

Core Sleep

"Core sleep" is a variant of Uberman that adds a block of sleep, usually several hours, to the Uberman schedule, replacing one or two naps. (This term is also sometimes used to describe accidental oversleep by someone following Uberman, though one will more likely see the term "crash", and occasionally "reboot".) Another variant is called Everyman sleep schedule.

Buckminster Fuller advocated Dymaxion Sleep, a regimen consisting of 30 minute naps every six hours. A short article was published about this schedule in the October 11, 1943 issue of Time Magazine. According to this article, he followed this schedule for two years, but after that had to quit because "his schedule conflicted with that of his business associates, who insisted on sleeping like other men."

Scientists say that a successful midday nap depends on two things: timing and (no kidding) caffeine consumption. Experiments performed at Loughborough University in the UK showed that the sleep-deprived need only a cup of coffee and 15 minutes of shut-eye to feel amazingly refreshed.

1. Right before you crash, down a cup of java. The caffeine has to travel through your gastro-intestinal tract, giving you time to nap before it kicks in.

2. Close your eyes and relax. Even if you only doze, you’ll get what’s known as effective microsleep, or momentary lapses of wakefulness.

3. Limit your nap to 15 minutes. A half hour can lead to sleep inertia, or the spinning down of the brain’s prefrontal cortex, which handles functions like judgment. This gray matter can take 30 minutes to reboot.

On Option ARMS

(Calculated Risk) This is a bonus post for those of you who use Excel (or some other software with which you can read and play with .xls files). I'm afraid that those of you who do not possess such software will have to use your imagination here. It's not especially practical to post images of big spreadsheets on the blog, so if you want to see the numbers, you'll need to download the spreadsheets.

These links will download the spreadsheets:

LIBOR-Indexed OA Projection

MTA-Indexed OA Projection

I made two of them for you to play with. Both show a to-date balance history, plus a future balance projection, for a hypothetical Option ARM with payments beginning in 2002, 2003, 2004, 2005, 2006, or 2007. The loan terms are identical for each spreadsheet with the exception of the index chosen: one uses MTA, the other 1-Month LIBOR. The terms of these scenarios are in fact derived from real loan products out there, but of course there are other ways of structuring OAs. I am not making a claim about what product structure was most common (or most likely still to be on the books), as I don't have that kind of data.

What I had in mind for this exercise is to help people see, clearly, how these things work (some folks are still, Lord love you, a bit confused about OA mechanics. That undoubtedly includes some of you who have one. Remember that if you do, your loan might not work like this because the note you signed might have different terms regarding adjustment frequency, balance cap, margin, etc.) Besides that, I wanted to make a fairly simple point about the issue of resets, payment shock, and timing on these things.

That's why the spreadsheets show multiple vintages with identical loan terms: you can see that the actual speed of negative amortization and the forecast date of recast on these loans varies quite dramatically for the vintages, because of the huge impact of the very low 2002-2003 rate cycle. Each of these scenarios assumes that the borrower always makes the minimum payment from inception of the loan, and each assumes that future index values are identical to the most recent available index value (December 2007). Yet even in those circumstances, the earlier loans (2002 and 2003, especially) negatively amortize much more slowly than the later vintages.

My gifted co-blogger has actually created some lovely charts to help make that clear:

Click on graph for larger image.

If you've downloaded the spreadsheets, you can play around with them a little in terms of the future interest rates on these loans, and you can see how the recast date (the date the balance hits the balance cap and the loan payment must be recast to fully amortize over the remaining term) moves forward or back depending on what you do with the rates. This is one reason why modeling actual portfolios of OAs is such a challenge: you have to make assumptions about what will happen with the underlying index.

Of course, in actual portfolio modeling, you would also not assume that every borrower will always make the minimum payment. You would have to look at actual borrower performance to date, and calculate some "average" behavior or project each borrower's past behavior patterns into the future. I am not making the claim that all borrowers always make the minimum payment from inception; I'm trying to show what would happen, in some examples, if a borrower did that. I have heard estimates from different OA portfolios of anywhere from one-third to ninety percent of borrowers who have, historically, done that.

One other thing I wanted to make clear by providing these examples is the mechanics of payment increases for a very common OA type. The product shown in these spreadsheets allows for annual payment increases, but monthly rate increases. (That is how the potential for negative amortization gets created: the payment does not automatically adjust to match the new interest rate each month.) The eventual recast hits at the sooner of the loan reaching 115% of its original balance or 120 months. We know that a recast is nearly always a huge shock, given a low enough introductory rate. But this loan does involve payment increases of up to 7.5% each year (i.e., the next year's payment can be as much as 107.5% of the prior year's payment).

With the later vintage loans, especially, I for one have no confidence that the borrower was qualified at realistic enough original DTIs to withstand several years of payment increases, even before that nasty shock of the recast.

You may if you like change that introductory rate on these loans--I used 1.00%. You will see that increasing that introductory rate actually slows down the negative amortization in most scenarios. (That is because it creates a higher initial first year payment, which thus creates less of a shortfall between interest accrued and payment made.) I suspect that this fact about OA is surprising to some people, who think that folks who got a 1.00% "teaser" on these things got some real deal. In reality, a borrower who was given an introductory rate several points higher than that is probably doing much better, balance-wise.

My scenarios involve the assumption that the initial payment is fixed for only one year. There are OAs out there where the first payment change is two or even up to five years from the first payment date. (They will generally involve a higher introductory rate and margin.) You can change these spreadsheets to extend the original payment out for longer than a year, if you like, and you'll see just how much faster that balance cap hits when you extend the fixed payment period. Ouch.

Finally, while I chose the repayment periods I did quite arbitrarily, you will notice that for both the MTA and LIBOR scenarios, the most recent index value (December 2007) is substantially lower than it had been for quite some time. This means that my balance forecast here just happens to have picked up a relatively low last known index to project out into the future. Had we done this exercise several months ago, the projected future index value would have been higher, and hence the future negative amortization would have been faster. It's an issue to keep in mind as we look at portfolio and security projections regarding OA recasts; those will have to be updated from time to time as rate history unfolds.

And yes, there's a pig, if that makes you want to bother downloading the spreadsheets.

Let the short sale scams begin

(Calculated Risk) Thanks to reader Brad, who sent me the link to this Broker Outpost thread. I suggest reading the replies, too.

I got an agreement of sale today from a realtor looking for a prequal on a shortsale , the buyer lives next door , he has a current mortgage for $800,000 on a home he purchase in 2005 with no money down , the home he has under contact is right across the street from his present home , the offer is for $500,000 and it looks like the bank will accept it

The borrower plans to buy it as a primary , once he moves in , they will stop making payments on the $800,000 loan that they have with CW
He qualifies full doc and has a 770 FICO , he figues letting his credit tank is not a big deal when he is lowering his mortgage debt by $300,000 .

I told him the new bank may deny the deal based on occupancy , tried to convince him to go NOO but he does not want the higher rate .

What do you think ? anyone had this scenario yet , I sure it will be happening more and more especially in CA and FL

ABCP back-up plan takes pressure off banks

(Globe & Mail) JPMorgan's agreement to guarantee shortfall financing means Canadian institutions may 'feel less urgency to sign up'

The committee in charge of fixing the frozen market for troubled commercial paper has hurt its chances of quickly securing financial support from the Canadian banks by announcing a backup plan, sources say.

The fact that the funding is guaranteed regardless of whether the Canadian banks step up takes pressure off them, said Daryl Ching, a former sales and marketing employee of Coventree Inc. - the biggest creator of this type of paper - who is now consulting in the market.

Canadian banks may now "feel less urgency to sign up," acknowledged one person close to the restructuring.

The committee, chaired by Toronto lawyer Purdy Crawford, announced earlier this week that it had put together a rescue package for the $33-billion market, despite an outstanding request to the Canadian banks for roughly $2-billion in financial support.

Having missed a self-imposed deadline to find a solution earlier in December, the committee officially gave itself until Jan. 31, but it was aiming to make an announcement by Christmas. Companies that had invested in the paper, and have been stuck holding it, wanted to know that a deal had been reached in time for their year-end book-keeping. And, after months of work, with the holidays quickly approaching, the committee had finally nailed down every detail of the plan except this relatively small part of its $14-billion margin financing, sources close to it said.

As a result, the committee's financial adviser, JPMorgan Chase & Co., promised that if the Canadian banks didn't come through, it would canvass the market for the financing, and, as a last resort, step in itself. That enabled the committee to announce its restructuring plan.

"JPMorgan will be going to market to find funding for any shortfall, but we don't believe there will be any," said Mark Boutet, a spokesman for the committee, which remains adamant the Canadian banks will step up to the plate.

If there is a shortfall, there will be a competitive process that solicits bids from financial institutions around the world, he said.

Mr. Crawford has said that all of the big Canadian banks except for Toronto-Dominion Bank - which was not a player in the market - have indicated an interest in participating in the margin facility.

National Bank has already said it will contribute $500-million to the facility, and it's understood a number of other Canadian banks were supportive of contributing to some extent.

While the committee said it had a fallback plan for the funding it was seeking from Canadian banks, it did not name the provider other than to say it was a foreign institution. The name was revealed in the Financial Times, sparking a new round of criticism toward the committee.

"JPMorgan can't set the benchmark for the spreads and then come in and fund," said Ross Hendrin, a public relations professional who previously did marketing for Coventree. "If there are banks willing to fund, why are we holding guns to the Canadian banks' heads?" he asked.

Mr. Boutet said it's normal for a financial adviser to arrange for funding, and JPMorgan will not receive extra fees for soliciting bids. It provided this guarantee to assure the committee that this was a viable restructuring proposal, with or without the Canadian banks.

Housing Wire Weekly Mortgage News Roundup

(Housing Wire) I tend to appreciate what I read over at Bloomberg, but commentary from John Berry earlier this week reinforced why I run this blog. Let’s start with his foolhardy premise, which is that market participants are blowing losses out of proportion:

… most subprime borrowers aren’t going to default. Suppose even one in four does and lenders recover somewhat more than half the mortgage amount. A fourth of $1.3 trillion in subprime mortgages is $325 billion, and a 55 percent recovery would mean a loss of about $145 billion.

Here’s hoping he doesn’t ever manage a hedge fund. Or run a mortgage banking operation.

Two words matter here: leverage and derivatives. One dollar paid in by a mortgage borrower has been stretched out over so many different securities that Berry’s scenario ends up being naively Pollyanna-ish. Think CDOs-squared here; think credit default swaps, too. Just as each dollar in a mortgage payment pumped up balance sheets for holders of various derivatives, the disappearance of that same mortgage dollar — even at the one in four level cited by Berry — drives losses that go well beyond any basic sort of dollar-to-dollar math, and certainly well beyond whatever a lender might recover in foreclosure.

Further, the current mortgage mess isn’t just about subprime, and hasn’t been for some time — it’s about the losses coming from HEL/HELOCs, the losses coming from Alt-A, the losses starting to be seen in Option ARMs. Writing about subprime mortgages as if they exist in a vacuum, separate from the rest of the housing market and distinct from other mortgage classes, is at best described as absurd.

Where’s the deficiency?: Berry’s commentary on industry losses has led to some huffing and puffing in the blogos about the importance of estimating the number of recourse versus non-recourse loans.

Those who know anything about the foreclosure industry, however, likely already know the entire discussion is academic at best.

In states where non-judicial foreclosure is an option, a foreclosing party will rarely will pursue a deficiency judgment via judicial foreclosure, simply because of the cost involved in so doing. Add in the fact that many borrowers would be unable to pay even if a deficiency was awarded, not to mention significantly greater exposure to legal risk, and it shouldn’t be a surprise that most lenders choose to avoid judicial foreclosures at almost all costs in states that permit foreclosure by other means.

The bottom line is this: processing a foreclosure is about minimizing legal risk and keeping costs low, in an effort to keep losses to a minimum. Exploding legal risk and blowing up the cost structure just to get a judgment that might impact loss severity is the very opposite of that.

California pain: Christopher Thornberg, who I’ve had the good fortune of interviewing numerous times in the past when he was with UCLA’s Anderson Forecast, put the state of California’s housing market into blunt terms:

The cold, hard truth is that foreclosures are serving only to hasten the painful process of shifting housing prices back to a level the market can sustain. Prices must and will fall. Everywhere. Probably 25% to 30% from their peak.

Scary number for the day: HW readers know I’ve been pointing to option ARMs for some time. The OC Register’s Mathew Padilla did some digging around a recent Standard & Poor’s report and found the following:

One key fact in the S&P report: More than 75% of folks with an option ARM loan have been making the minimum payment, which is subject to negative amortization. It’s not clear from the report if that figure is for all option ARM loans or just those made in 2006.

I’m guessing, although I haven’t seen the study yet, that we’re talking 2006 vintage here.

You might want to read that again: 75 percent of option ARMs originated in 2006 are seeing negative amortization — and that’s on top of likely price declines, given that most of these loans were originated in California. Something tells me we won’t be waiting until 2009 to see problems in the option ARM sector.

Economics of non-judicial foreclosures

(Felix Salmon) Have I mentioned of late how much I love my commenters? Many thanks to James Moore, who adds a very interesting twist to my obsession over the proportion of mortgages which are non-recourse.

Moore gets straight to the heart of the matter: the key question isn't how many mortgages are non-recourse, but rather how many mortgage lenders would go after their borrowers for unpaid mortgage debts even after the property in question is sold at foreclosure. Moore's insight is that just because a lender can pursue a borrower, doesn't mean it will. And the key distinction to be made here is between judicial and non-judicial foreclosure.

I'll let Tanta explain the difference:

Foreclosures can be “judicial” or “non-judicial.” Some states require judicial foreclosure; most states allow one or the other at the lender’s election or in certain other circumstances. A judicial foreclosure requires the lender to sue the borrower in court for satisfaction of the debt. A non-judicial foreclosure allows the lender to use the “power of sale clause” in the mortgage document to force sale of the property without a court order.
Because the non-judicial foreclosure uses powers granted to the lender in the mortgage document, which is executed by the borrower at the time the loan is made, the property sale is, in essence, already “authorized” by the borrower. When you sign a mortgage document, you are agreeing in advance to sell your property at public auction if you do not pay the debt as agreed in the note.
Non-judicial foreclosure is almost always faster and cheaper for the lender than a judicial foreclosure. Most of the time, when there is a choice, the lender chooses the non-judicial option for that reason. The big benefit to the lender of a judicial foreclosure is that the lender can ask the court, when appropriate, to enter a “deficiency judgment” against the borrower; this makes the borrower liable for any difference between the proceeds of the sale and the debt owed when the borrower is upside-down. Practically speaking, a lender who chooses non-judicial foreclosure generally waives its right to seek a deficiency judgment. The lender’s calculation, obviously, comes down to weighing the benefit of quick sale and reduced expenses against the cost of (potentially) writing off part of the debt.

If a mortgage lender wants to sue a borrower for repayment over and above the sale proceeds from the property, then, it basically needs to go to court and get a deficiency judgment. If you're going to go to court anyway, you might as well get a judicial foreclosure: if you opt for a non-judicial foreclosure, then the chances of your going back to court for a deficiency judgment are essentially nil.

Now Moore says that in California, at least (all this is complicated greatly by the fact that foreclosure law is made by the states, not the federal government), "you just don't see judicial foreclosures" – they're simply too expensive for the lenders, and the extra money the lender might be able to squeeze out of the borrower simply can't compensate for the cost of getting that deficiency judgment in the first place.

This surprises me, I must say. After all, California was ground zero when it came to mortgage innovations like 125% LTV mortgages, where the bank lent the borrower more money than the property was worth. Clearly, no one is going to do that unless you have a reasonable expectation that you can go after the borrower individually for any monies not received in foreclosure. The credit markets might have gone a bit crazy over the past few years, but they didn't go that crazy. (Please tell me they didn't go that crazy.)

But it's also obvious that in these stressed times when lenders can't even service their loans properly because they're overwhelmed by the volume of defaults, they're going to be extremely hesitant to go through the hassle of a judicial foreclosure, if they have a much easier alternative in non-judicial foreclosure.

So maybe even recourse borrowers might be able to walk away from their homes without declaring bankruptcy – "jingle mail", it's called – with the reasonable expectation that their bank won't pursue them for any extra money. If that's the case, it adds a whole new and rather unpleasant twist to the dynamics of the property market. Suddenly, it becomes economically idiotic for many prime borrowers to continue to make their mortgage payments, even if they can quite comfortably afford them. And the implications of that for properety prices are nasty indeed.

Comment:

In 20 years as a creditor's rights attorney in California I have never seen a judicial foreclosure on a single family home.

First, purchase money debt is non-recourse. Moreover, the argument that the debt becomes recourse if you refinance is one that I have heard articulated, but I have never seen any cases to that effect.

Second, in California even where a deficiency judgment is available, the judicial foreclosure process results in the borrower/judgment debtor having a one year right to redeem the property at the sale price (i.e., buy it back), which would effectively make it unmarketable by the lender for a year after the judgment was obtained.

Third, under California law a lender cannot foreclose non-judicially and then go to court to seek a judgment against the borrorwer (this rule applies even to commercial real estate foreclosures). So the scenario of a non-judicial foreclosure then a lawsuit for the deficiency is legally impossible in California.

Finally, an issue that will definitely be on the table soon is whether the junior lien is recourse in the so-called "80/20" loan situation (a first mortgage for 80%, and a second "line of credit" used to pay the other 20% of the purchase). Although documented as some sort of "home equity" product, the second lien is, to the thinking of most California lawyers I know, just as much a purchase-money loan as the senior loan, and thus not recourse as well.

What I find fascinating is that the general public is just now getting around to thinking about these kinds of issues. Obviously the lenders aren't exactly advertisng the fact that most mortgage debt (at least in California) is non-recourse. What is odd to me is that so much of the population signs up for the biggest financial obligation of their life without even knowing the basic terms of the transaction (i.e. recourse/non-recourse, etc.).

JPMorgan May Fund Any Shortfall in CP Market Restructuring

(Bloomberg) -- JPMorgan Chase & Co. will cover any shortfall if banks fail to contribute to a $14 billion plan for restructuring C$33 billion ($33.7 billion) of Canadian asset- backed commercial paper, a group representing investors said.

JPMorgan would find lenders or finance any shortage in collateral backing margin calls on new trusts that replace asset-backed commercial paper, Mark Boutet, a spokesman for the committee overseeing the restructuring, said today.

Banks, lenders and funds agreed to convert the short-term debt into longer-term notes with higher interest rates after Canada's market for asset-backed commercial paper sold by non- bank dealers ground to a halt in August. Coventree Inc. and other trusts failed to renew maturing debt then because investors were concerned over ties to U.S. subprime mortgages.

``JPMorgan will find lenders that will sign on the margin facility in the event of a margin shortfall,'' Boutet said. ``The idea is to make sure that we have alternative plans to ensure we have the margin facility required to effect a restructuring.''

It's unlikely that JPMorgan will have to cover any shortfall, Boutet said.

Five of the six biggest Canadian banks have ``indicated interest'' in providing funding, Purdy Crawford, a Toronto lawyer representing investors, said earlier this week.

A spokeswoman for JPMorgan, Tasha Pelio, declined to comment.

Subprime Loan Ties

While only 9 percent of the short-term debt was linked to subprime loans, banks refused to provide backup financing in August, freezing the market and putting the funds at risk of collapsing.

A group of foreign banks, Canadian lenders and pension funds led by Caisse de Depot et Placement du Quebec negotiated the so-called Montreal Proposal standstill on Aug. 16 and agreed to convert the securities into longer-term notes.

The group reached an agreement, which covers 20 of the 22 non-bank trusts, on Dec. 23 after twice missing deadlines to restructure the debt.

Most holders of the commercial paper will get all their money back eventually, Crawford said. The investors' group expects the restructuring to be completed by March.

The C$80 billion market for commercial paper sold by lenders such as Royal Bank of Canada hasn't been interrupted by the freeze in non-bank paper.

$1 Trillion in Mortgage Losses?

(Calculated Risk) Several recent articles have referenced my post on the possibility of a change in attitude towards foreclosure. I wrote:

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

Although the purpose of the post was to discuss changing social norms, the primary reason the post was mentioned was because of some pretty big numbers, like the possibility of $1 trillion in mortgage losses based on a few rough assumptions. A couple of quotes:

Australia theage.com: Americans 'walk' from loans

Late last week ... Calculated Risk figured that housing losses might reach $US1 trillion and even $US2 trillion.

WSJ: How High Will Subprime Losses Go?

Back in the U.S., the Calculated Risk blog sidestepped the colorful language and went straight for the big number: “The losses for the lenders and investors might well be over $1 trillion.”

The $1 trillion number is a simple calculation: If prices fall 30%, then approximately 20 million U.S. homeowners will be upside down on their mortgages. If half of these homeowners walk away from their homes, with an average 50% loss to lenders and investors, that is $1 trillion in losses (the average mortgage is just over $200K).

This wasn't a forecast, just a simple exercise to show why changing social norms is very scary for the lenders.

And this isn't just a subprime problem, and these aren't just potential "subprime losses". In the original post I referred to the potential of foreclosures becoming "socially acceptable" for the middle class.

But even though the problems have spread far beyond suprime, some reporters are stuck on the subprime meme. As an example, Bloomberg columnist John M. Berry wrote: Subprime Losses Are Big, Exaggerated by Some

As the U.S. savings and loan crisis worsened in the 1980s, analysts tried to top each other's estimates of the debacle's cost to the federal government.

Much the same thing is happening now with losses linked to subprime mortgages, with figures of $300 billion to $400 billion being bandied about.

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy.

A loss of $150 billion would be less than 12 percent of the approximately $1.3 trillion in subprime mortgages outstanding. About $800 billion of those are adjustable-rate mortgages, the remainder fixed rate.

This is subprime reporting. It's absurd to think that mortgage losses will only come from subprime loans; in fact most of the upside down homeowners will be Alt-A and prime borrowers. By focusing solely on subprime, Berry misses the larger mortgage problem.

And the credit problems extend well beyond mortgages. As an example, from Bloomberg this morning: Citigroup, Goldman Cut LBO Backlog With 10% Discounts

Citigroup Inc., Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co. are offering discounts of as much as 10 cents on the dollar to clear a $231 billion backlog of high-yield bonds and loans.

We don't know the exact haircut on each LBO deal, but an average 5% haircut would be over $10 billion in losses. And there are losses coming from corporate debt, CRE loans, and other consumer debt too. As Floyd Norris asked at the NY Times this morning: Credit Crisis? Just Wait for a Replay

"... just how different was subprime lending from other lending in the days of easy money that prevailed until this summer?"

Short answer: not very.

Back to mortgage losses, both Felix Salmon: Are Subprime Losses Being Exaggerated? and Paul Krugman, Jingle mail, jingle mail, jingle mail — eek! bring up a key issue: recourse vs. non-recourse loans. Felix writes:

... no one is going to have a real handle on mortgage losses unless and until someone manages to get a handle on the percentage of mortgage loans which are non-recourse. If your house falls in value and you have a non-recourse mortgage, then it makes perfect economic sense for someone in a negative-equity situation to simply walk away – something known as "jingle mail". But given the amount of refinancing going on during the last few years of the mortgage boom, I suspect that the vast majority of mortgages are not non-recourse. (Refis are never non-recourse.)

This is an important issue. In California, purchase money is non-recourse. If the borrower walks away and mails in the keys (Fleckenstein's "jingle mail"), the lender is stuck with the collateral. However, if the California borrower refinanced, then the lender has recourse, and can pursue a judicial foreclosure (as opposed to a trustee's sale), and seek a deficiency judgment.

The lender can enforce that deficiency judgment by attaching other assets, or by garnishing the borrower's wages. Historically lenders rarely pursued (or enforced) deficiency judgments, but that could change if many middle class borrowers, with solid jobs and assets, resort to jingle mail.

For purchase money, state law determines the recourse vs. non-recourse issue. As Felix noted, refis are always recourse, and there was significant refi activity in recent years.

But before we think most loans are recourse, we have to remember that about 22.3 million homes were purchased during the last 3 years (2005 through 2007), and in a period of rising rates, many of these homeowners probably did not refi. It's difficult to estimate the exact losses - since we don't know the percent of recourse loans, we don't know how far prices will fall, and we don't know how homeowners will react to being upside down - but we know the losses will be significant.

Note: I'm trying to find a state by state list of recourse vs. non-recourse for purchase money.

On recourse loans, Tanta adds (via email):

I suspect that you will have some very aggressive lenders and some not very aggressive lenders in that respect.

Which will tell you who thinks it doesn't have a fraud problem and who does.

Back in my day working for a servicer, we never went after a borrower unless we thought the borrower defrauded us, willfully junked the property, or something like that. If it was just a nasty RE downturn, it rarely even made economic sense to do judicial FCs just to get a judgment the borrower was unlikely to able to pay. You could save so much time and money doing a non-judicial FC (if the state allowed it) that it was worth skipping the deficiency. Plus we had a soft spot, I guess.

At any rate, the absolute all time last possible thing you could get me to do is send an attorney barging into court demanding a deficiency judgment if I had any reason whatsoever to fear that my own effing loan officer was implicated in fraud on the original loan application. Any borrower with half a brain will raise that as a defense, and any judge even slightly awake will not only deny the deficiency but probably make the lender pay all costs, or worse. And I'd call that justice.

This goes double if the loan was made as a "stated asset" deal. I can just hear a judge asking me why I deserve to get other assets now when I never bothered to make sure the borrower had any in the beginning.

So yes, some people will get hit with a deficiency. But I'm not sure it will be as many as you might think.

Option ARM Ttightening

(Calculated Risk) A quite decent piece on Option ARMs in the LA Times. I liked this part:

Despite such risks, the initial low payments on option ARMs have kept a lid on serious delinquencies -- 3.7% of all option ARMs, Standard & Poor's analysts said in a report last week. That's higher than before, but still low compared with the 6.3% delinquency rate on loans to good-credit borrowers with so-called hybrid ARMs, which have a low fixed rate for two to 10 years before becoming adjustable-rate loans.

At Calabasas-based Countrywide Financial Corp., which S&P said made about a quarter of all option ARMs last year, 3% of such loans held by the lender as investments were delinquent at least 90 days, up tenfold from 0.3% a year earlier. Delinquency rates were even higher on option ARMs from other lenders, including Pasadena-based IndyMac Bancorp and Seattle's Washington Mutual Inc., S&P said.

Countrywide and other lenders tightened their lending standards last summer to ensure borrowers could afford loans after the interest rates adjusted upward.

Had those guidelines been in effect previously, Countrywide recently said, it would have rejected 89% of the option ARM loans it made in 2006, amounting to $64 billion, and $74 billion, or 83%, of those it made in 2005.

I made an argument a while ago that focussing regulator attention exclusively on disclosure documents can be just a touch beside the point if lenders are no longer offering the product in question. You have to wonder, if we just cut off 80-90% of the OA borrower pool, whether the remaining 10% really need those new and improved disclosures, or can muddle along with the ones already in use. If you take the OA out of the mass market and put it back into the high-net worth, high-income crowd it was originally designed for, you might find that your borrowers are already selected to be people who either read and understand disclosures, or who hire an attorney or financial planner to read them. I can certainly think of better uses for regulators' time and energy than fooling around with disclosure documents that would be clear to borrowers who are now in a rather different kind of trouble than not understanding the teaser rate on their OA.

The other thing to notice is that the obligatory example borrower supplied in the article is having trouble with her first payment increase (the typical 7.5% annual increase in the minimum payment), which is still not enough to cover all the interest due. As that sort of situation increases (as more and more 2005-2006 vintage OAs get to their second or third payment increase), we'll start seeing defaults long before the recast date.

Speaking of which, when I am not making cartoon pigs I have been creating some spreadsheets to show examples of how to project the recast date on Option ARMs. That's total and compleat Nerd territory, but if anyone is interested I'll post them (as spreadsheets or as images thereof). You tell me whether that's more detail than you can stand or not.

Warren Buffett, Bond Insurer

(Felix Salmon) I'm fascinated by the news that Warren Buffett is starting up a new bond insurer. On the one hand, it makes perfect sense: he's an expert in insurance, he already has a triple-A credit rating, and his competitors in the market are all struggling.

But on the other hand, this is a declining market. This time last week I posted a blog entry headlined "Munis Back Away From Ratings-Agency Domination," which celebrated the fact that city and state issuers were increasingly wondering whether bond insurance was worth their while.

After all, in an efficient market, bond insurance shouldn't really exist as a standalone product. That's because it already exists, in the form of tradeable credit risk. Someone buying an uninsured municipal bond is essentially taking exactly the same default risk as a bond insurer who insures that bond. And in a market with thousands of bond investors, it's pretty ridiculous to assume that one specific bond insurer will always have a greater appetite for that default risk than the marginal bond investor would.

Now historically, there's been another reason why bond insurance exists, and that's credit ratings. There are some investors who will invest only in AAA-rated securities, and who will pay through the nose for the privilege of being able to do so. They don't want to take default risk, and they're happy to pay bond insurers to take that default risk for them.

Well, two things have changed of late. The first is that investors don't care as much as they used to about AAA ratings, ever since a bunch of AAA-rated securities started defaulting not long after they were issued. If the ratings agencies can't be trusted to be right on the subject of how rock-solid a triple-A rating really is, then there's much less justification for paying a premium for AAA-rated paper.

The second development is the explosion of the credit default swap (CDS) market. There's now a very liquid market in default risk, which means that again investors don't need to rely on bond insurers to take their default risk from them. Of course, they still need to worry about counterparty risk, but let's say that they restrict their CDS counterparties to the known bond insurers. In that case, their counterparty risk is no greater than if they'd bought a wrapped bond. As ACA has proven, counterparty risk is hardly unknown in the bond-insurance market.

What's more, Buffett seems to be saying that he's going to charge more for bond insurance not only than the CDS market, but even than his competitors in the bond-insurance industry.

Mr. Buffett said his company will charge more than his competitors because of what he calls the "moral hazard" inherent in bond insurance. That is, governments that have insurance could take advantage of it by borrowing and spending far beyond their means to repay the debt, and simply default, leaving the insurer on the hook.

I think this is a polite way of saying that he will charge more than his competitors because his AAA is real, while their AAAs are looking increasingly fictional. Moral hazard in the muni bond-insurance market is a bit of a non-issue: if a democratically-elected municipality slides into default, it's not going to be because its bonds are insured.

So I'll be surprised, then, if Berkshire Hathaway Assurance Corp becomes a major business. To be sure, it might become a bigger business than Dairy Queen, and Buffett seems to be very happy owning Dairy Queen. But I do have a feeling that the basic bond-insurance business model is probably doomed, even if (or, rather, because) it will continue to be very profitable until its demise.

Squeeze shines a light on bank treasurers

(Gillian Tett - Financial Times) Treasurers used to be thought of as faceless individuals who hid away in the back office of the banking system and did little more than rubber-stamp lending decisions. But these herbivores of the financial savannah now find themselves at the centre of the credit crunch.

Having previously taken easy funding for granted, treasurers are now facing up to the task of rationing scarce cash resources.

In the five years that preceded this summer’s credit squeeze, treasurers rarely had to consider liquidity – the availability of cash – when approving lending requests. Their concerns were whether their institution had sufficient capital to back a particular opportunity and whether the piece of business would generate a suitable return.

But the crisis of confidence in the banking system has changed all that.

Banks’ traditional sources of funding have dried up and cash is now in short supply. This has left treasurers scrambling to develop a system for rationing liquidity as well as capital. It is a steep learning curve for some.

“On a day-to-day basis people are coming to me and saying that they want to do this or that. Before, we might have just said ‘yes’. We did not really worry, money was very cheap and capital was available. But in the new environment we have introduced new rules. For us it is still a learning experience, and that is true of all banks,” says the treasurer of one large European bank.

“In the past there was a lot of focus on how banks managed their capital but not how they managed liquidity. It was possible to add to your balance sheet things that were capital neutral,” he adds.

With no established rubric for adjudicating between competing demands on liquidity, treasurers have found it easier to say ‘no’.

Meanwhile, the risk that banks may have to take on assets from their structured investment vehicles (SIVs) is also prompting treasurers to play the miser. Indeed, the treasurer’s traditional conservatism is being institutionally reinforced.

“In this climate, you lose your job for messing up. It is the ultra-cautious who do well. So we get rewarded for being extremely conservative,” says a treasurer at another European lender.

Treasurers say the reason they have become less willing to lend to rival banks in the so-called interbank market is not fears about each other’s solvency, but the need to conserve cash to lend to corporate clients.

That is due to a shortage of funding from the money market funds on which banks have come to rely in recent years, although the foreign exchange accounts of Asian central banks have been more reliable suppliers of funding.

Money-market fund managers agree.

“There is a sense of paralysis. Funds are scared of withdrawals by their investors so they are being as risk averse as possible and don’t want to touch banks,” says one.

Another says: “Our fund has about 30 per cent of its money in cash now. That is pretty typical of the industry. That means that when confidence returns, there could be an amazing change in mood – all that liquidity could come in. But right now, that is not happening at all.”

Some market participants are confident the tide could turn in the New Year, now that the European Central Bank has made cheap funding available over the Christmas period.

One treasurer says January could even see “euphoric” conditions.

If so, he would seek to raise more cash by issuing cheap senior debt in the expectation that any such window of opportunity would open only briefly.

More money funds are bailed out

(Financial Times) More than 10 North American banks and fund managers have collectively injected $3bn into their money market and cash funds since October to stem losses.

Janus, the fund manager, this week became the latest to bail out its money market funds. It put in $109m to buy troubled asset-backed securities from its funds. Half a dozen firms have made similar moves.

The bail-outs, in the form of guarantees, credit lines and the buying out of troubled securities, are intended to stop funds falling below the $1 a share promised to investors. They show how seriously the parent companies take the reputational risk of “breaking the buck”.

Not all bail-outs have been made public but more are believed to be being drawn up. The extent of losses is not yet known.

BlackRock – which has been hired to manage Florida’s troubled cash investment fund – faced further pressure this week over one of its funds. Moody’s downgraded its credit rating on BlackRock’s institutional cash strategies fund to junk status after redemptions in the fund were suspended a few weeks ago.

Two other fund managers have suspended redemptions at money market funds.

Only one money market fund in the US has broken the buck – in 1994 – but, in effect, many funds have recently. Observers question how the funds can be properly valued, given that many of the asset-backed securities they hold are not trading.

Even conservative managers have been caught by the credit crisis. It takes only a tiny loss to push a fund’s value below 99.5 cents in the dollar, the point at which boards must take action.

James McDonald, a portfolio manager for T Rowe Price, said some of his firm’s funds had invested in the short-term paper of four structured investment vehicles – instruments that sell cheap, short-term debt to invest in longer-term assets with higher yields. But Mr McDonald thought the exposure amounted to less than 1 per cent in each fund.

“We have moved those securities to our ‘illiquid’ bucket in the fund until they start trading again,” he said.

T Rowe Price, known as one of the most conservative managers, values its securities daily rather than weekly. The firm would act if the fund’s value fell three-tenths of a cent below the $1 par value, Mr McDonald said.

Goldman says...

(Housing Wire) Goldman Sach analysts said Thursday that Citigroup Inc. may cut its dividend by up to 40 percent as the financial giant faces mortgage-related writeoffs that could total $18.7 billion in the fourth quarter.

According to Reuters, who obtained a copy of an investor newsletter penned by Goldman analysts William F. Tanona, Betsy Miller and Neil C. Sanyal, Citigroup will announce write-downs as much as 70 percent greater than the $8 to $11 billion forecast in early November.

“Although we have seen many firms take the appropriate actions in recent weeks as they relate to write-downs and capital raises, we still believe it will be a couple of quarters before the current credit crisis is fully digested by the markets,” the analysts are quoted as saying.

Goldman also said it expects to see increased writeoffs at Merrill Lynch as well as the investment bank reels from historic upheaval in the secondary market. Reuters reported that Goldman’s analysts expect an additional $11.5 billion write-off from Merrill Lynch & Co. in the fourth quarter.

The news of increased losses comes as a news brief at National Mortgage News Online on Wednesday alleged that Merrill’s subprime lending arm First Franklin Mortgage had seen 60 percent (400 positions) of account executives eliminated at the firm since late August.

Shares of both Merrill Lynch and Citi were off prior day’s market close in pre-market trading, as of when this post was published.

Out of foreclosure in reverse

(Calculated Risk) The WSJ (sub only, I'm afraid) had a piece yesterday on a process it never actually names--the "short refi" (related to the "short sale"). What makes these short refis--refinance transactions where the new loan is less than the balance due on the old loan, with the old lender agreeing to call the loan paid in full and write off the difference--so unusual is that the old loans are nasty high-rate subprime loans to old people, and the new loans are reverse mortgages.

The strategy worked recently for Gloria Forts, a 62-year-old retired federal worker in Forest Park, Ga., a suburb of Atlanta. After refinancing her home in August 2006 with a $106,500 mortgage from Fremont Investment & Loan in Brea, Calif., Ms. Forts was facing monthly payments of $950.41. That consumed 70% of her monthly income from Social Security and a pension. Intending to start a new job, she found herself kept at home by diabetes complications and back surgery. In June, she sought help from the Atlanta Legal Aid Society.

There, she found William J. Brennan Jr., a veteran housing attorney who, over the past 18 months, has developed a sophisticated model for settling subprime debts with reverse mortgages. After Ms. Forts received a foreclosure warning in October, Mr. Brennan connected her with Genie McGee, a reverse-mortgage specialist with Financial Freedom Senior Funding Corp., an Irvine, Calif., unit of IndyMac Bancorp Inc. She determined that Ms. Forts would qualify for a reverse mortgage of about $61,000.

Mr. Brennan sent Fremont's loss-mitigation department a letter proposing that the company agree to take that sum and cancel its plans to foreclose on the house. On Dec. 3, the day before the foreclosure sale was supposed to take place, Fremont agreed to the deal and stopped the foreclosure.

Using a reverse mortgage as a foreclosure workout is certainly unusual. I've written about reverse mortgages here if you're not familiar with the beast. They were designed for older borrowers (the minimum age is 62 for all products I know about) who are house-rich but cash-poor. Using them for borrowers who are house-poor, to prevent foreclosure, isn't exactly what they were intended for. And using them to "create" an equity cushion that they can then absorb in deferred interest is quite the innovation. (Of course the "equity" here isn't being "created"; it's being "donated" by the old lender.)

Then again, it isn't every historical moment in which lenders are willing to accept 57 cents on the dollar on a short refi, either. The key to the reverse mortgage is that the maximum loan amounts are much lower, on the whole, than they are for forward mortgages. (Because the amount that can be borrowed is a function of both the value of the home and the age--the likely remaining lifespan--of the borrower, only the very very old can borrow as much with a reverse mortgage as with a forward mortgage.) The WSJ doesn't give the current appraised value of Ms. Forts' property, but I'd guess that the original LTV of the new $61,000 reverse mortgage is not much more than 50% (suggesting that the old $106,500 mortgage, which apparently carried an interest rate of 10% or so, was around 90% of current value). It says a lot about Fremont's estimate of loss severity that they took the money and ran.

Is this a good deal for Ms. Forts? Well, she gets to stay in her house. (She might describe this as getting to "keep" her house, but the way a maximum-balance reverse mortgage to a 62-year-old borrower is likely to work, statistically, what she just did, in effect, was give the deed to IndyMac while reserving a life estate.) She is highly unlikely ever to be able to withdraw cash again from it; at her age and that loan balance, my guess is that compounding interest on the original balance will far outstrip any possible positive appreciation on that property in Ms. Forts' lifetime, and her heirs will simply hand over the deed to the bank.

What I find mildly amusing is that the WSJ reporter almost, but not quite, gets the issue here:

With a reverse mortgage, the bank makes payments to the homeowner instead of the homeowner making payments to a bank. The loan is repaid, with interest, when the borrower sells the house, moves out permanently or dies. The products are complex and have high fees -- typically about 7% of the home's value -- and they make it difficult for homeowners to leave the property to their heirs. But they may be the best option for people who have built up equity in their home and would otherwise lose it.

Actually, a reverse mortgage doesn't make probate any harder than a forward mortgage does. It's not that it's "difficult" to leave the property to the heirs; it's that the loan amount is likely to be equal to or more than the property's value at that point. Notice the odd phrasing of that last sentence: grammatically, "it" probably refers to "equity," but that of course is going to be lost in all cases (except for borrowers unfortunate enough to die prematurely; one hopes that doesn't make the heirs happy). The only thing a reverse mortgage borrower "keeps," in practical terms, is occupancy.

This is also curious:

The transaction illustrates one of the biggest challenges in getting lenders to accept payouts from reverse mortgages: taking less money than the house may be worth.

My sense is that the WSJ reporter just can't really wrap her mind around the reality of the mortgage and housing markets today. This business of "taking less money than the house may be worth" (as opposed to "taking less than the loan amount") may just be sloppy phraseology, but I think it's kind of sypmtomatic of how hard it really is for some folks to shed the assumptions of the Boom. Short refis are going on all around us, not just with reverse mortgages: a lot of the loans going into FHASecure, for instance, are short (by the amount of some or all of a second lien, often, but in some cases even the first lien payoff is short). I'm surprised that you still have to say this out loud to people, but what "the house is worth" is no longer a particularly relevant concern for a lot of people. The issue is what you owe, and as long as there are places in the world where expected loss severity to lenders can be in the neighborhood of 47% of the loan amount, you probably owe too much.