Friday, February 29, 2008

Homebuyers and Sellers Blacklisted By Lenders

(eFinance) As home prices fall across the nation, lenders are becoming more unwilling to write loans for home purchases in some geographical regions. The result is that financing is almost unattainable in certain areas.

Some of the nation's largest lenders have found an old, but useful way to protect their capital-impaired behinds: blacklists.

BankUnited, Wachovia and Washington Mutual are among the lenders who are shying away from writing loans in areas with declining home values. And they're considering more than just location. Some housing types or projects are also being put on the no-no list--namely condominiums.

The lists aren't widely circulated and usually go under another name. 'We don't call it blacklisting,' a banking official told CNN Money. 'We just don't write the loan.'

Although some banks don't call it blacklisting, there are actual blacklists that contain non-permissible housing projects and geographical areas. To see an example, check out the BankUnited list of non-permissible condominium projects in Miami and Las Vegas.

The practice isn't abnormal, particularly in a housing downturn. The lenders who aren't blacklisting entire areas have pulled back on the amount of money they are willing to loan. For example, CitiMortgage and JPMorgan Chase both reduce the maximum amount they will loan in counties and states that are known to have declining home values. Reductions are usually between five and ten percent.

The Effect of Blacklisting

While it's good that the banks are doing what they can to protect themselves now, they are most certainly putting some people in a precarious position in the process. Anybody who owns a home--and especially a condo--will find it more difficult to sell in areas where credit has dried up.

The end result will be falling home prices. This is not necessarily a bad thing for regions with inflated home values. Prices are bound to decline anyway. The faster they fall, the faster things can get back to normal.

However, it will be interesting to see what kind of domino effect this might create. The banks that financed the now-sweating condo developers and current condo owners in Florida, Vegas and other shaky areas may end up eating the money loaned before the blacklisting began.

Borrowers Abandon Mortgages as Prices Drop

(WSJ) As home prices plummet, growing numbers of borrowers are winding up owing more on their homes than the homes are worth, raising concerns that a new group of homeowners -- those who can afford to pay their mortgages but have decided not to -- are starting to walk away from their homes. [Chart]

Typically borrowers who turn in their keys are those who have run into financial trouble or need to relocate but can't sell their homes. But mortgage-industry executives and consumer counselors say they are starting to see people who aren't in dire financial straits defaulting on their mortgages because they don't want to pay for properties that have negative equity.

Many are speculators who had planned to quickly flip the home, but others appear to be homeowners who had second thoughts about their purchase.

"It may not be a big thing yet, and hopefully it won't be," says David Berson, chief economist for mortgage insurer PMI Mortgage Group Inc., of Walnut Creek, Calif. But if it turns out to be a significant trend, he says, it means that "delinquencies and defaults could be higher than the industry is estimating."

Some borrowers feel they have no good alternative. A tight credit market has made it tough for would-be sellers to find buyers or for borrowers looking to lower their mortgage costs to refinance.

Other borrowers are walking away in frustration because they can't arrange a workout with their lenders, says D.J. Enga, director of outreach services for Auriton Solutions, which counsels homeowners nationwide. Mr. Enga expects that 10% to 15% of the roughly 4,000 callers counseled this month by Auriton, of St. Paul, Minn., will walk away from their mortgages.

Sgt. First Class Nicklaus Skaggs is among those looking to walk way. Mr. Skaggs bought his home in April 2005 shortly after returning to California from a one-year tour of duty in Baghdad.

The $455,000 three-bedroom home he and his wife purchased in Vacaville, about one hour northeast of San Francisco, is worth an estimated $285,000 today, well below the $453,000 he owes on his mortgage. The monthly mortgage payment, which jumped after its interest rate increased, is now $4,000, up from $2,980 when he bought the house.

Mr. Skaggs expects to be redeployed to Iraq again later this year. But he can't sell his home, since there are few buyers, and he can't refinance because lenders require a large down payment he doesn't have. Now, the 18-year Army veteran has decided to walk away from his mortgage. He hopes in a few years lenders see his decision as a unique situation created by the housing meltdown. "I don't think that house is going to recover in value any time soon," said the 40-year-old. "I'd just be throwing the money away."

A rise in the number of people choosing to default on their mortgages would represent a significant departure from past behavior of American homeowners, who during past housing downturns tended to walk away only as a last resort, often because they couldn't afford to pay because of unemployment, illness, divorce or other life-altering changes that reduce income. And even then, the number of people who walked away was relatively small. During the oil bust in the Houston area during the 1980s and in California during the early 1990s, for instance, there was a brief spate of people sending in their keys to their lenders.

What's different now, analysts and economists say, is that home prices have fallen so far so quickly that some homeowners in weak markets are concluding that house prices won't recover anytime soon, and therefore they are throwing good money after bad. Also, many borrowers who bought in recent years have put down little if any equity. "If they haven't lived in [the home] very long and haven't put any cash in it, it's a lot easier to walk away," says Chris Mayer, director of the Milstein Center for Real Estate at Columbia Business School. He also notes that new homeowners may not have strong ties to the community.

Some borrowers, says Mary Kelsch, senior director at Fitch Inc., are less willing to make the sacrifices needed to stay in their homes, given the current environment. "It's a change of mind-set" she says. They are "looking more at their home as an investment that has lost its appreciation potential and don't really want to continue to pay."

Some in the industry want to toughen the consequences for borrowers who walk away. Executives at Fannie Mae say they are working to create harsher penalties for people who walk away from mortgages, and they plan to pursue some borrowers in court. They also want to extend the amount of time between when borrowers default and when they become eligible again for a Fannie Mae-backed loan.

"Of course, we will make exceptions for extenuating circumstances, like divorce or death," says Mike Quinn, a Fannie Mae executive. "But who we are trying to get are the people who can afford to make payments but have decided not to."

Goldman Sachs economists estimate that as much as $3 trillion in mortgages could be underwater by the end of the year, leaving 30% of the country's outstanding mortgages in negative equity. Since there is roughly $1 trillion in subprime mortgages outstanding, that means a large amount of better-quality mortgages, such as prime and Alt-A -- a category between prime and subprime -- will be attached to negative equity.

"The focus has been on the [interest rate] resets," said Goldman Sachs economist Andrew Tilton. "But if you're in a deep enough negative-equity position, defaulting has its own kind of logic."

In the Phoenix area, where home prices were off 15% in the fourth-quarter when compared with a year ago, accountant Steven Ulrich says several of his clients have recently said they plan to walk away. One client's home is now worth $100,000 less than the mortgage and the other is $60,000 underwater.

"It surprised me," said Mr. Ulrich, who works at The Focus Group in Scottsdale. "I'd never had people doing that before, if they had to it was something they were forced into. But these people are choosing it as a strategy, and I think it's going to be happening a lot more."

Some financial advisers are even encouraging homeowners who are upside down to consider foreclosure, which they see as a purely financial decision with limited negative consequences., a Web site started in January that offers foreclosure counseling to homeowners, advises that borrowers who default on one mortgage can typically get another mortgage between two and four years after a foreclosure. Then, "before you know it, you will have this behind you and a fresh start!" the site says.

A foreclosure will stay as a "strong negative" on your credit report for as long as seven years, though the impact on a borrower's credit score declines over time, says Mike Campbell, chief operating officer of Fair Isaac Corp., maker of the popular FICO credit score.

"Every single person we talk to either owes 100% [of their equity] or is upside down anywhere from $10,000 to $300,000," says John Maddux, co-founder of, which charges borrowers about $1,000 for advice. Mr. Maddux says the site has received more than 190,000 visits and about 20% of their clients are investors.

FASB to Look Into Off-Balance-Sheet Vehicles - WSJ

(Reuters) - The agency that sets accounting standards will look into how U.S. banks treat off-balance-sheet vehicles that contributed to the more than $150 billion in losses that have hit financial institutions, the Wall Street Journal reported on Thursday.

Robert Herz, chairman of the Financial Accounting Standards Board (FASB), told the Journal the agency will look into rules that allow banks to keep assets in special financing vehicles, off the books.

FASB will weigh whether problems stemmed from the accounting rules, disclosure requirements or the way banks complied with existing rules, Herz said in an interview.

The rules were crafted following the collapse of Enron Corp in an effort to limit the use of the sort of off-the-books vehicles that Enron used to hide its true financial state.

But banks found ways around some of the new rules, the report said.

FASB previously did not believe there was a problem with the accounting for these vehicles. The current financial crisis has altered that thinking, the report said.

What isn't clear, Herz told the Journal, is whether to change the rules, increase disclosure or force banks to better comply with existing rules.

"Whenever you have a stress test like this in the market and people are saying there are reporting problems, we need to understand the nature of those problems and to what extent there's something we have to change," Herz said. "But we also don't want to have blanket rules that make everyone consolidate everything."

Insight: True impact of mark-to-market on the credit crisis

(FT) Back in April 1993 the eyes of the world were on the beseiged Balkan town of Srebrenica, which the UN declared a safe haven for Bosnian muslims, and on Northern Ireland, where secret talks between leaders from rival factions kick-started a tentative peace process.

In the same month, a less-noticed development saw US accountancy regulators approve a rule that paved the way for today’s widespread use of mark-to-market accounting standards. This rule, which forced US banks to carry more securities at market value, emerged from the wreckage of the US savings and loan crisis when losses on loans had been hidden by the use of “historic cost” accounting.

Only now, in the middle of a global credit crisis, is the impact of the broad introduction of mark-to-market accounting becoming clear. The critical concerns are around how much these changes helped to inflate the credit bubble and whether they will increase the speed and destructive power of its collapse.

To be fair, the US banks protested at the outset that the move would change their role in the economy. So did the French banking federation before similar changes came to Europe in 2005. It warned that fair-value accounting “could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis”. Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced a string of work about this kind of “pro-cyclicality” in finance and the economy, culminating in a paper last September entitled Liquidity and Leverage.

This paper examines the links between asset prices and the value of banks’ capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance sheets.

The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire – or created “positive feedback loops”.

The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating “negative feedback loops” with a destructive impact on all kinds of asset values – from structured finance to house prices and equities.

In a way this is nothing new – the old adage about a banker is that he gives you an umbrella when it is sunny and asks for it back when it starts to rain.

But there are two important differences. First, fair-value accounting will speed up the process. One of Adrian and Hyun’s conclusions is that it was the speed of balance sheet expansion that caused the most blatant excesses of US mortgage lending.

Second – this isn’t mentioned in the paper – there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.

This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.

Banks’ use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.

What we will see over the remainder of this year is an ongoing painful reduction of capital values and leverage levels throughout the economy, centred around banking.

Investors need to believe this re-adjustment has at least stabilised before they will return. Each new wave of price falls in leveraged loan markets or asset-backed securities markets – and each post-earnings restatement of losses from the likes of AIG, Credit Suisse or whoever is next – illustrates that the prognosis is not good either for the financial world or the wider economy.

The lesson for regulators is that the solution to one problem almost always contains the seeds of another.

Peloton Blames Wall Street Lending Crackdown for Fund Collapse

(Bloomberg) -- Peloton Partners LLP, the London- based hedge fund manager being forced to liquidate a $1.8 billion asset-backed fund, said it's a victim of Wall Street's reduced lending.

``Credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls,'' Peloton co-founders Ron Beller and Geoff Grant said in a letter yesterday to clients.

Peloton joins Thornburg Mortgage Inc. and Sailfish Capital Partners LLC on the growing list of funds and companies that have had to sell securities or shut down after banks restricted how much they could borrow, or demanded more collateral as values of securities backed by mortgages slumped. The world's biggest financial institutions are cutting off lines of credit to hedge funds after at least $163 billion of asset writedowns and market losses.

``More hedge funds will blow up this year than ever before,'' said Michael Hennessy, who helps oversee $10 billion of hedge fund investments at Morgan Creek Capital Management in Chapel Hill, North Carolina. ``Financing is much harder to get. The bubble has burst.''

UBS AG, Goldman Sachs Group Inc., Merrill Lynch & Co. and Deutsche Bank AG were among the firms that lent money to Peloton, said people with knowledge of the matter, who declined to be identified. Officials at the banks declined to comment.

Freeze on Redemptions

Peloton said yesterday in a separate letter to investors that it froze customer redemptions from its $1.6 billion Multi- Strategy Fund, which has a ``very large position'' in the ABS fund.

Beller and Grant, who founded their firm in 2005, are seeking buyers for mortgage securities held by the ABS fund. The fund provided clients with an 87 percent return last year after the managers bet on a surge in delinquencies on loans to homeowners in the riskiest subprime category. Beller said in a Jan. 25 telephone interview that the firm bought securities backed by mortgages that are safer than subprime.

The price of top-rated Alt-A securities, which rank above subprime, dropped 10 percent to 15 percent this month, according to Thornburg Mortgage, the Sante Fe, New Mexico-based finance company which yesterday said it may sell securities to meet a margin call.

``Risk managers everywhere are revisiting how collateral is being priced so you're seeing margin calls,'' said Kenneth Hackel, managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut. ``As risk appetites decline, the price of assets that are used as collateral decline.''

Sailfish Fund

Beller, 45, led Goldman's fixed-income currency and commodity sales group in London before leaving in 2001 to reorganize New York City's school system. Grant, 47, was co-head of New York-based Goldman's so-called macro proprietary trading group. Grant, who works in Santa Barbara, California, declined to comment.

Sailfish's Multi-Strat Fixed Income fund, which had $1.9 billion in July, collapsed as credit bets went sour and the Stamford, Connecticut-based firm unwound positions into a declining market.

The average price of an actively traded high-yield, high- risk loan tumbled this month to a record low of 86.28 cents on the dollar from 100 cents last July.

Margin Calls

The extra yield, or spread, investors demand to own high- yield, high-risk, or junk, bonds instead of Treasuries widened to 718 basis points from 592 basis points in December, according to data compiled by Merrill Lynch & Co. in New York. A basis point is 0.01 percentage point. Junk debt is rated below Baa3 by Moody's Investors Service and less than BBB- by Standard & Poor's.

An increase in margin calls may drive prices even lower, RBS's Hackel said.

``I feel like so many shoes have already dropped, the shoe store should be empty by now,'' he said. ``I'd like to think we're pretty close to the end of the game, but I can't say that with any degree of confidence.''

Thursday, February 28, 2008

As America's mortgage mess worsens, radical solutions are gaining appeal

(Economist) With brick-fronted townhouses and old-fashioned street lamps, Faulkner's Landing in Ashburn is one of hundreds of new developments that sprouted across the farmlands of northern Virginia during America's housing boom. Less than three years old, these houses originally sold for around $550,000, but are now worth some 40% less that that. Foreclosures are rising. For owners who put little or no money down, points out Danilo Bogdanovic, a local estate agent, it is often not worth paying a mortgage far greater than the value of the house.

As America's house prices slide, fears are growing that more people will post the keys to their lender and walk away. The practice, already common among speculative buyers, has a nickname, “jingle mail”. For a fee, websites such as, explain what to do. Laws on repossession differ by state. But thanks to high legal costs, mortgage firms have historically not chased borrowers even when the law allows it.

It is easy to paint grim scenarios. Repossessions are soaring, up 90% from a year ago according to RealtyTrac, a seller of foreclosure statistics. According to the S&P Case-Shiller index, average house prices fell by 9% in 2007 (see chart), and the pace of decline is accelerating. Mark Zandi of Moody's reckons that 8.8m mortgage-holders, 17% of the total, have home loans that are greater than the value of the house. If house prices fall by another 10%, as he expects, Mr Zandi expects almost 14m mortgages to be underwater in a year's time.

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Given that the typical mortgage is worth $225,000, over $3 trillion of debt would be affected. Since the costs of foreclosure can eat up 25% or more of the value of a loan, the losses could be enormous if a large fraction of these borrowers walk away. Nouriel Roubini, one of Wall Street's most pessimistic seers, worries that the “forthcoming jingle-mail tsunami” could spawn $1 trillion-2 trillion of financial losses, creating a systemic banking crisis.

Experience from previous regional housing busts suggests most people with negative equity do not simply walk away from their houses. But much about today's situation is unprecedentedparticularly the high initial loan-to-value ratios. On February 27th Fannie Mae, the government-backed mortgage giant, announced an unexpectedly big loss of $3.55 billion for the fourth quarter of 2007 because of increased foreclosures.

Until recently, Washington's main fear was that foreclosures would soar as the low initial interest rates on some 2m adjustable subprime mortgages reset. In December 2007, to great fanfare, the Bush Treasury cajoled the mortgage industry into promising a (voluntary) temporary rate-freeze for certain groups of borrowers. So far, these efforts have yielded little. But thanks to big rate cuts by the Federal Reserve, resets are becoming less of a problem. One analysis suggests that the typical reset now involves a jump in monthly payments of just over 10%, compared with 25-30% six months ago.

But even as resets become less painful, analysts are realising that they are not the main cause of foreclosure. An influential study from the Federal Reserve Bank of Boston points to falling house prices, and the resultant negative equity, as a far bigger trigger. Stemming foreclosures, points out Paul Willen, an author of the study, will depend on reducing the size of mortgages relative to the value of a house.

One approach under consideration in Congress is to adjust America's personal-bankruptcy law so that judges can “cram down” a mortgage to the market value of a house. Under current law, judges cannot reduce the debt on someone's main residence, though they can do so for holiday homes or investment properties. Proponents of the legislation reckon 600,000 people could avoid foreclosure if the rules were changed.

The mortgage industry is vehemently opposed. And many economists worry that allowing cram-downs will worsen the drought of credit in America's mortgage markets. Chris Mayer of Columbia Business School points out that some $750 billion of annual mortgage lending has dried up as the securitisation of subprime and jumbo loans has collapsed. Changing bankruptcy rules, he argues, would make matters worse by raising the cost and reducing the supply of mortgage credit. Several studies have shown that borrower-friendly laws lead to more restricted credit. However, a new paper by Adam Levitin of Georgetown University Law School and Joshua Goodman of Columbia University finds scant difference in interest rates on mortgages that can already be crammed down (such as holiday homes) and those that cannot.

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Unsurprisingly, bankers are lobbying for a different approach, one where the government stems the foreclosure spiral (and limits losses) by buying and refinancing whole swathes of mortgages. One idea, championed by Chris Dodd, the chairman of the Senate Banking Committee, is to recreate a modern version of the Home Owners' Loan Corporation, a Depression-era institution that refinanced mortgages in the mid-1930s when almost half of all home loans were in default. Other proposals have similar aims. A government institution, such as the Federal Housing Administration (FHA), would buy mortgages at a discount and refinance them into new loans with a government guarantee. Credit risk for the refinanced mortgages would shift to Uncle Sam.

How much of a “bail-out” this implies depends on the discount at which the mortgages are bought and on their subsequent performance. Most proposals suggest using the market price; Mr Zandi wants the government to buy mortgages by auction. Some plans are ambitious: Alan Blinder of Princeton University foresees an institution that takes over between 1m and 2m loans, worth $200 billion-$400 billion. Other schemes are narrower. Democratic congressmen talk of an initial capitalisation of around $20 billion.

Another complementary idea, touted by the Office of Thrift Supervision (OTS), is to give mortgage lenders a share of the upside if properties appreciate. Under this scheme, the FHA would insure a new mortgage at a house's current value. The existing lender would get a “negative equity” claim for the difference between that and the original loan, which could be exercised if the house later sold at a higher price. Some proponents of bankruptcy reform want to attach similar provisions to the cram-down. But the details of any “shared appreciation” devices are tricky. If homeowners have little hope of building equity in their house, the incentive to default remains.

All told, all the plans are fraught with problems. Bankruptcy reform will help some of today's borrowers while hurting tomorrow's. Government refinancing potentially puts taxpayers' money at risk. For the moment, the Bush administration opposes both and pins its hopes on voluntary loan modifications. Public opinion is also against any “bail-out”. But the climate in Congress is shifting. As the housing market worsens, bigger government intervention is becoming ever more likely.

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Some insurers reckon they can teach investment bankers a thing or two about handling risk

(Economist) WITH their snappy name and flashy mathematical formulae, “quants” were the stars of the finance show before the credit crisis erupted. Now the complex models of risk that they developed are accused of misleading banks about the safety of subprime-laced securities. Small wonder that investment bankers are working overtime to fix what went wrong.

One source of wisdom they may overlook is the staid world of insurance. After all, what could the green-eyeshade brigade of actuaries possibly teach the wizards of Wall Street? Several important lessons, reckon some insurers, who point out that much of their industry has thus far avoided the worst of the credit crisis.

Although a few firmsincluding Swiss Re, a big reinsurer due to report its 2007 results after The Economist went to pressface billions of dollars of write-downs on ill-judged involvement in America's mortgage crisis, much of the European industry has so far come out relatively unscathed. Announcing a record profit for 2007 on February 25th, Munich Re, another big reinsurer, boasted it had just €340m ($514m) of subprime-related exposure, or less than 0.2% of its investments.

American insurers have a slightly bigger slug of subprime holdings than the Europeans (see chart), but analysts are sanguine. Fitch, a rating agency, notes that America's life-insurance industry could probably weather $7 billion-8 billion of unrealised losses, though damage on such a scale would harm some firms.

This is a very different story from the bursting of the dotcom bubble. Back then, returns on insurers' equity portfolios plunged just as liabilities on everything from life policies with guaranteed pay-outs to directors-and-officers (D&O) insurance soared, almost bringing the industry to its knees. Banks fared far better.

So what can banks learn from the insurers now the boot is on the other foot? Raj Singh, a former investment banker who recently became chief risk officer of Swiss Re, points out that the banks' risk models, which try to put a value on how much they should realistically expect to lose in the 99% of the time that passes for normality, draw on reams of historical data. But this can produce a false sense of security.

Insurers looking at, say, catastrophe risks have relatively few data points and thus tend to have a healthy scepticism of models. They more often brainstorm their own scenarios. “In insurance, we have to think the unthinkable all the time,” says Mr Singh, pointing out that the industry came up with a scenario of a multiple plane crash above a metropolitan area well before the attacks on New York's World Trade Centre in 2001.

Scenario-building usually involves insurers' senior managers, whereas in many banks the “stress testing” of risk models is the preserve of quants. Moreover, in banks different teams often track different risks, masking potentially catastrophic correlations between them. Smart insurers are increasingly aware of the way in which life, property, business interruption and other risks interacta portfolio risk-management approach encouraged by both regulators and investors.

Insurers have a list of other things banks can learn too, including the idea that getting a customer to retain a part of a risk reduces moral hazardsomething investment banks' pass-the-risk-parcel approach to securitisation blithely ignored. Swiss Re's Mr Singh notes that insurers have a respect for risk that is reflected in the status of the chief risk officer, who is treated as an equal partner in senior management. In investment banking, he claims, such people tend to get sidelined when the good times rollthough big investment banks such as Merrill Lynch and Morgan Stanley have belatedly rejigged their risk set-ups.

Pots and kettles
Yet, the insurers should not get carried away. Although many have performed better than the banks, some of them have tripped up nonetheless. Worst-hit are America's bond insurers which, lemming-like, rushed into guaranteeing dodgy asset-backed securities that eventually threatened a further meltdown in credit markets. Such fears were partially assuaged this week when Moody's and Standard & Poor's (S&P), two credit-rating agencies, affirmed the top-notch ratings of MBIA, one of the biggest bond insurers. S&P also affirmed its AAA rating on Ambac, another big insurer that is trying to raise billions of dollars of capital from a group of banks.

Then there are the mortgage insurers, another obscure corner of the industry that is a financial black hole. Big mortgage underwriters such as MGIC and PMI Group may well see their credit ratings cut soon. MGIC recently revealed that it lost almost $1.5 billion in the last quarter of 2007 alone, as mortgage defaults soared.

Such problems will seep into the mainstream industry via reinsurers such as Swiss Re and XL Capital, which underwrote some of the specialists' risks. Red lights are also flashing in the D&O market because of an expected flood of litigation linked to the credit crunch. On February 24th HSH Nordbank, a German lender, sued UBS to recover millions of dollars of losses it incurred on a portfolio of credit derivatives sold to it by the Swiss bank. Bear Stearns reckons liability insurers could lose up to $8 billion-9 billion on claims related to such lawsuits. That is a big numberuntil you compare it with the banks' total subprime write-downs, already well above $100 billion.

But the biggest losers are those who tried hardest to behave like banks and sought to jettison their industry's plodding image. A case in point is American Insurance Group (AIG), the world's largest insurance company, which recently had to write down $4.9 billion of swaps related to collateralised-debt obligations. Swiss Re has already written down $1 billion or so on two related credit-default swaps. Such mishaps suggest insurers, too, need to remember that modelling risks is not necessarily the same thing as managing them.

Reasons to be Sanguine about CDS Counterparty Risk

(Felix Salmon) I spoke today to Nishul Saperia at Markit about credit default swaps, and I'm very glad I did: he's cleared a lot of things up for me, especially on the problem of counterparty risk. Here's one problem, as explained by the NYT's graphics team when they illustrated an article by Gretchen Morgenson:


I asked Nishul about this. If I own a credit default swap (let's say I'm Party B in the graphic above), and I want to get out of my position, am I likely to assign that CDS to someone else, or am I likely instead to simply enter into a new insurance contract which is equal and opposite to the first one?

If you're worried about counterparty risk and the NYT's problem, then there's good news and bad news. The bad news is that I am indeed most likely to assign the contract I've got, rather then piling up a bunch of nominally-offsetting trades. The good news, however, is that hedge funds and other buyers of CDS almost never trade directly with each other. If I assign the contract, I'm going to be assigning it to a dealer.

What this means is that you're very unlikely to get a long chain of assignments as illustrated by the NYT. Normally the chain stops at Party C: the dealer that the original counterparty assigned his contract to. This doesn't increase counterparty risk, it reduces it, since dealers generally don't worry about each others' counterparty risk. It's much more likely a hedge fund will go bust than that a broker-dealer will go bust and be unable to fulfill its commitments, especially since broker-dealer CDS desks generally don't make big directional bets.

But what about those CDS auctions I was so worried about? Surely anybody can wind up buying a contract in one of those? Actually, no. The auctions held by Markit and Creditex are the auctions which happen after an event of default - they're called "credit event auctions" - and they exist to set a cash-settlement price on the value of the CDS. The CDS themselves don't actually change hands.

Obviously, counterparty risk in the CDS market is non-zero. But the fact that you can assigning your CDS to a third party doesn't in practice exacerbate it, and neither does the existence of these auctions.

Surprise!!! You've earned a discharge and a foreclosure

(Credit Slips) Tomorrow, the Senate is expected to vote on the Foreclosure Prevention Act of 2008, Title IV of which would permit bankruptcy courts to modify home mortgages in certain ways if the loan and the debtor met specified criteria. We've described that idea before, but the bill has crucial implications for bankruptcy that are not related to loan modification. Specifically, take a look at section 421, which proposes a solution to a problem with current bankruptcy law. Many Chapter 13 debtors pay for 3 to 5 years on a repayment plan, doing everything the law requires of them, and only a week or two later, face a foreclosure. How does this happen? Because the mortgage servicers frequently assess charges during a bankruptcy case, but fail to disclose these fees. Courts don't approve them; trustees don't adjust the debtor's payments to account for them; and debtors aren't even given notice that these charges are piling up. Instead of emerging from bankruptcy with a fresh start, homeowners find themselves defending a foreclosure or having to immediately pony up hundreds or thousands of dollars. Just last week, Judge Brendan Shannon of the Delaware Bankruptcy Court addressed this issue, challenging lenders to disagree that these undisclosed "surprise" fees don't "frustrate" bankruptcy's home-saving purpose. The Foreclosure Prevention Act of 2008 tackles this problem by requiring mortgage companies to disclose all fees within the earlier of 1 year of assessing the charges or 60 days before the end of the bankruptcy. The law also specifies that a lender may only charge such fees if they are lawful, reasonable, and provided for in the contract. It's sad that this latter requirement is even necessary--it essentially just prohibits mortgage servicers from violating existing law by overcharging consumers, a problem that an increasing body of case law and research suggests occurs with alarming regularity. I see lots of reasons why permitting bankruptcy courts to modify mortgages may be the best comprehensive solution to the foreclosure crisis, but I also hope Congress takes a hard look at the rest of the bill and considers its overall importance. If consumers do their part in bankruptcy and make every payment required by law, the system should honor its promise to give them a financial fresh start.

"Turmoil reveals inadequacy of Basel II"

(Naked Capitalism) This comment in the Financial Times by Harald Benink and George Kaufman, discusses a major shortcoming in Basel II, the new bank capital standards promulgated by the Bank of International Settlements, namely, that banks can use their own risk models to set minimum capital levels. That procedure allows them to tell the regulators how much equity they need to hold, putting the inmates in charge of the asylum.

This practice dates back to the mid 1990s, when derivatives started to become popular. The Fed adopted a "let a thousand flowers bloom" approach, allowing dealers to create and refine their own risk metrics, rather than having the central bank develop an independent understanding of the downside exposure. Admittedly, the Fed has tried to encourage banks to adopt what it considers to be best practices, but since it has little expertise in this area, it is hardly in a position to judge whether more sophisticated approaches are more effective, or merely create an illusion of greater understanding.

From the Financial Times:
Instability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today’s market turmoil, were a flashing yellow light to drive carefully.

Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.

However, recent events challenge the usefulness of important elements in the Basel II accord. The need to recapitalise banks reveals that the internal risk models of many banks performed poorly and greatly under-estimated risk exposure, forcing banks to reassess and reprice credit risk. To some extent, this reflects the difficulties of accounting for low-probability but large events.

A more fundamental problem is that Basel II creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be overoptimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity.

Bank capital-asset ratios are near historically low levels, typically at about 7 per cent of total assets (on a non risk-weighted basis). During the past five years, several so-called “quantitative impact studies” (QISs) have been conducted under the auspices of the Basel Committee on Banking Supervision to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50 per cent for some of the largest banks.

The turmoil on financial markets, which has caused large banks to take substantial losses and search for significant new capital, indicates that Basel II should not be implemented, if at all, without first making a number of important changes. We advocate the following improvements in order to correct some of its deficiencies.

First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.

Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements. Consistent with the FDIC chairman, we believe that it is important to have a minimal capital cushion in the banking system, even when risk-based Basel II capital rules indicate lower risk. Strong capital allows banks to recognise losses and put problems behind them in times like the ones we are now experiencing. And strong capital gives banks the flexibility to serve as shock absorbers to our economy during difficult times.

Third, we recommend that the Basel II approach using banks’ own risk models should be complemented by a credible and effective form of market discipline. While Basel II contains information disclosure requirements, at the same time it fails to create incentives for professional investors to use this information in an optimal way. As long as professional investors holding bank liabilities have the perception that large banks are too big to fail – or that all deposits will be fully protected against loss, as in the Northern Rock case – they will have the idea that their money is not really at stake. This will mitigate their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks’ incentives to reduce capital.

Auction Rate Securities: Manipulated from the get-go

(Naked Capitalism) DealBreaker does some serious reporting today, informing us that some traders have told them that the failed auction rate securities market was always dependent on stabilization by dealers.

For anyone who has worked in the securities industry, the term "stabilization" pregnant with regulatory significance. Stabilization, as defined by the SEC, is
…transactions for the purpose of preventing or retarding a decline in the market price of a security to facilitate an offering....Although stabilization is a price-influencing activity intended to induce others to purchase the offered security, when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers.

So let's be clear about this: stabilization is a form of market manipulation authorized by the SEC. Its main use is in public offerings of stocks. Immediately after the shares are issued, the syndicate manager will intervene in the trading, usually for the first day, to make sure (if possible) that the shares don't fall unduly.

So the question with the ABS market is: did the market manipulation by the dealers fall within SEC guidelines? DealBreaker has doubts:
The immediate cause of the auction failures was the pullback of the banks and brokerages. In mid-February the financial institutions conducting the auctions stopped acting as principals or buyers of excess ARS inventory....

“Wall Street executives have defended their conduct, saying losses on holdings such as mortgage assets have curtailed their ability to use their balance sheets to support faltering markets,” the Wall Street Journal’s Randall Smith and Liz Rappaport report in their article today about a large bond marketer lashing out against Wall Street over the auction failures.

But this raises the question of why the markets were faltering in the first place. In our earlier reporting, we revealed how accounting changes may have set some corporate buyers running for the exits from this market. More recent conversations with a broader array of bond traders and dealers points toward another possiblility—the market never had enough buyer demand to support itself and has been dependent on stabilization from the banks for a very long time.

“The truth is there was no natural auction success rate. But for the banks acting as market makers, these auctions would have failed from the get go,” a bond trader told DealBreaker.

Rather than merely acting as buyers of the last resort, the financial institutions have been consistently called upon to stabilize the ARS market. In many cases, investors were lead to believe the market was much healthier than it has ever been. But with balance sheet capital at a premium due to recent losses, the banks decided that the fees received for structuring the auctions and managing clients money in ARS were did not justify deploying the capital necessary to support the market.

If these bond traders are correct about the way the ARS market operated, Wall Street may soon find itself the subject of yet another round of lawsuits and investigations by authorities.

And indeed, in 2006, the SEC's chief of the Office of Municipal Securities, Martha Mahan Haines made remarks that now seem prescient, particularly where she suggests ABS should be called "BS Securities".

Her discussion refers to a settlement reached with 15 broker dealers regarding alleged manipulation in the ARS market in 2005:
If you read between the lines of the Commission’s recent settlements involving auction rate securities and the “Best Practices” released by TBMA, it appears that the way rates are actually set on auction rate securities often may bear little resemblance to the way the process was described in offering statements...... The market for ARS bears little resemblance to the kind of so-called Dutch auctions known to most investors: those for U.S. Treasury securities.....

As a result, I believe that a few topics about the auction rate market generally avoided before now, should be aired and discussed. First of all, we should acknowledge that, although broker-dealers involved in this market generally claim that their intervention is for the good of the market as a whole, this has not been studied. In fact, the outcome of even a completely independent study would be dependent on one’s view of what is best for the market. It is true that, due in large part to BD intervention, there have been few “failed” auctions, resulting in windfall interest rates for investors until the next auction, or “all hold” auctions, resulting in below market rates briefly benefiting issuers. Broker-dealers also intervened when the rate that would be set was not, in that broker-dealer’s opinion, an appropriate market rate. (But wasn’t a determination of the market rate the very purpose of an auction?) We are told that this is in the best interests of both issuers and investors. But is it? ..... This intervention supported the rapid growth of this market to over $200 billion. Was it in the best interests of issuers and investors to be so heavily dependent on broker-dealer intervention to support the expansion of that market?....

Disclosure should make it clear that broker-dealers commonly intervene in auctions, bid with knowledge of other bids, submit bids after the internal bidding deadline imposed on other investors, and directly or indirectly influence or set the clearing rate with considerable frequency. I am not saying that this is necessarily good or bad, but it should be disclosed in plain language. ......Do not dance around this issue: describe what really happens flat out. If this is the way that investors and issuers prefer for the market to function, so be it. If not, perhaps practices should change to reflect their true preferences?

Secondly, it may not be accurate to call this an auction at all. In a true Dutch auction, no bidder has knowledge of the bids submitted by others. This protects the process from manipulation and ensures that the price set is truly reflective of the market. Perhaps consideration should be given to a different name for this type of security or of the process by which rates are set? “Managed auction process” and “bidding system” have been suggested to me..... I recognize that “BS Securities” is not an appealing acronym and I leave it to those more creative than me to come up with an alternative title....

Lastly, I would like to remind everyone that adherence to industry practices does not give anyone a pass under the securities laws. Although best practices and similar releases by industry organizations may be useful, it is important to keep the overarching requirements of the securities laws and its basic themes of disclosure, fairness and integrity firmly in mind.

The kind of disclosure Haines called for appears to have been neglected. For instance, in the widely reported case of the New Jersey Maher brothers, Lehman was given $600 million to manage and was told to put it temporarily in short-term liquid instruments while the brothers decided on their long-term strategy, $286 million went into auction rate securities and so far, the Mahers have been unable to access their cash. It's a virtual certainty that they were not told how the auction process worked. And if very large customers are ill informed, there is no reason to think the small fry are treated any better.

Paulson says no go on housing bailouts

(Naked Capitalism) Treasury Secretary Hank Paulson has thrown a bucket of cold water on a number of proposals being floated in Washington to rescue troubled borrowers via the explicit use of public funds, such as the idea of reviving the 1933 Home Owner's Loan Corporation to buy underwater mortgages and renegotiate them.

In some respects, Paulson's tough stance is welcome, because many of these proposals would do more for banks and investors than borrowers. Many homeowners, including ones who are capable of servicing their mortages, are walking away because they deem them an unattractive investment. There is now a large class of nominal homeowners who in fact are more akin to renters with a home ownership option that is now deeply out of the money. And they can often rent more cheaply too.

But unfortunately, what is driving Paulson isn't a pragmatic assessment of what measures might be cost effective and not involve undue moral hazard. Instead, he is guided primarily by the ideological imperatives of this Adminsitration, which is to favor so-called private sector solutions. But that construct is dishonest and limiting. For instance, the Journal reports that Paulson maintains that "market-based approach will be enough to keep the situation under control."

If Paulson considers the worst housing market since the Depression to be under control, I shudder to think what an unmanaged situation would look like.

However, a grey area in "private sector solutions" is a willingness to rack up government contingent liabilities. The portfolio ceilings on Fannie Mae and Freddie Mac were lifted Wednesday, and OFHEO's James Lockhart had said earlier this month that the two GSEs could add $100 billion in mortgages in the next six months without running into capital limits. The plan now in place is to keep Fannie and Freddie in remediation mode, setting aside reserves 30% higher than the usual minimum. However, fi the GSEs come under increasing pressure to take on weaker mortgages to salvage the housing market, even those higher reserves may prove insufficient.

Similarly, the Treasury has not nixed some proposals to increase the role of the FHA. The FHA is the historical source of mortgages to middle and lower income borrowers, so an increased role for the FHA could well make sense. But again, it may be subject to pressures to relax its standards and become a warehouse for mortgages on the brink.

The dead body in the room that Pauson has addressed only in part, by his cosmetic Hope Now Alliance plan, is that securitization impedes the traditional practice of having the lender restructure mortgages for those borrowers who can be salvaged. In fairness, due to high loan to value ratios on new mortgages and the heavy use of cash out refinancings and home equity loans, many of the stressed borrowers may in fact not be able to afford even a generous mod. That poses a conundrum: does the collateral damage to communities and lenders warrant rescuing them anyhow? This tradeoff isn't discussed honestly, as it should be; instead all troubled borrowers are wrapped in the mantle of "about to lose their homes."

And the problem with the failure to acknowledge the major impediment, in combination with the Administration's ideological fixation, is that the best available solution is likely to be blocked. The Democrats have proposed changes to bankruptcy laws to give judges more authority to modify mortgages, While this may sound overreaching, in fact this simply puts residential mortgages on the same footing as commercial mortgages and vacation property. In effect, judges will do the mods that the mortgage services are either unwilling or unable to make. But the bill has already been watered down in the House and faces opposition in the Senate.

From the Wall Street Journal:
In an interview yesterday, Treasury Secretary Henry Paulson branded many of the aid proposals circulating in Washington as "bailouts" for reckless lenders, investors and speculators, rather than measures that would provide meaningful relief to deserving, but cash-strapped, mortgage borrowers....

Rep. Barney Frank (D., Mass.), chairman of the House Financial Services Committee and typically an ally of Mr. Paulson's, said that, until now, he had supported the Treasury's steps to address mortgage delinquencies and the credit crunch they have spawned. "But they're not helping enough people," Mr. Frank said yesterday. "We're not going to get out of the crunch until we stop this cascade of foreclosures."

The Fed's Mr. Bernanke appeared to take a slightly more flexible position than Mr. Paulson, telling a congressional committee yesterday that the turmoil in the housing market doesn't yet merit large amounts of public money. "I don't think we're at that point, but I do think it's worthwhile to keep thinking about those issues," Mr. Bernanke said....

Administration officials "have been willing to broker deals, but they haven't been willing to put taxpayer money on the line," said Mark Zandi, chief economist at Moody's, a West Chester, Pa., consulting firm. "I think they're trying to stick to those principles, and now they're running out of ideas that are consistent with those principles."....

"I'm seeing a series of ideas suggested involving major government intervention in the housing market, and these things are usually presented or sold as a way of helping homeowners stay in their homes," Mr. Paulson said. "Then when you look at them more carefully what they really amount to is a bailout for financial institutions or Wall Street."

The secretary added one caveat: "It would be imprudent not to have contingency plans, but we are so far away from seeing something that would have me calling for a bailout that I don't see it."

Mr. Bush is threatening to veto a Senate bill that includes $4 billion to help states and localities redevelop abandoned and foreclosed houses. "I believe the evidence is clear that these [voluntary industry] initiatives alone will not steer enough families away from foreclosure or our country away from further economic weakening," Mr. Reid wrote in a letter to the president yesterday, referring to the main element of the White House-backed industry plan. "In my view, the enormity of the foreclosure crisis requires a much more aggressive response."

The Reid bill also includes a provision -- opposed by many Republicans and the White House -- that would allow bankruptcy judges to alter the terms of mortgages.

Wednesday, February 27, 2008

Today's a big day for BMO and ABCP exposure

(Globe & Mail Streetwise) Today is a big day for Bank of Montreal as it tries to avoid a $495-million writedown on its exposure to ABCP trusts called Apex and Sitka.

Last week, the bank said that it could write off the whole exposure if the restructuring of Apex/Sitka failed. Today is deadline day, because the trusts face a collateral call at close of business today if the bank, which sponsors the trusts, cannot negotiate an agreement with a swap counterparty, according to DBRS.

Without an agreement, BMO would either have to put up the collateral or face a "notice of failure" that could lead to the sale of assets from the trusts after a short grace period (usually three days). That collateral is not worth much in today's markets, with the kinds of structured products that are in the trusts selling at big discounts to face value.

It's a big issue for the overall restructuring process for ABCP, argues RBC Dominion Securities analyst Andre-Philippe Hardy. While he continues to expect a restructuring of the roughly two dozen frozen ABCP trusts that the Crawford Committee is working on, many may face a similar problem because their holdings are structured in the same ways.

If the move down in credit markets has spooked swaps counterparties, that could be the reason the Crawford Committee has gone silent in recent days, even as investors wait for an update on whether a standstill with counterparties that expired on Friday has been extended.

"If the delay is due to swap counterparties becoming less supportive of the restructuring and they ask for margin to be posted, it could derail the restructuring," Mr. Hardy wrote in a note to investors today.

Frank: Bailout-as-you-go

This is what the Financial Times is reporting:

A leading Democratic lawmaker on Tuesday called for $20bn in public funds to be made available to the Federal Housing Administration to purchase and refinance pools of subprime mortgages. . . .

Mr Frank said “we can do it through an existing vehicle rather than a new vehicle”. But the underlying logic of the two proposals is similar.

Mr Frank said that under his plan, the FHA would “buy up packages of mortgages but at a substantial discount”. It would then refinance the loans.

This would require about $20bn up front, but Mr Frank stressed that “the FHA would be repaid” as the loans were refinanced. The ultimate cost of the scheme to US taxpayers, under Congressional scoring practices, would probably be about $3bn to $4bn.

Mr Frank also called for between $5bn and $10bn in loans to the states, which would be used to purchase and refurbish foreclosed homes, and extra funding for counselling services.

Mr Frank said the “lesser efforts” to tackle the mortgage crisis to date “have not been very successful”. The housing crisis was “getting worse not better”.

The externalities involved in foreclosures justified the commitment of public funds. “We are talking about terrible impact on society.”

The main difference between the Frank plan and some of the other proposals circulating is the scale of the intervention envisaged.

Alan Blinder, a professor of economics at Princeton, has called for a new government vehicle modelled on the Home Owners Loan Corporation of the 1930s to borrow between $200bn and $400bn to buy up and restructure distressed loans.

Mark Zandi, chief economist at Moody’s told the House financial services committee that it would take about $250bn in upfront funds to purchase all 2m loans expected to end in foreclosure by the end of this decade.

Mr Frank said “reality constrains” and his plan was limited to $20bn for the FHA because of the budget deficit and the need to meet pay-as-you-go spending rules.
So far this morning, my attempts to find more details on the Frank plan have not succeeded. I did, however, find this recently published statement of priorities for the House Committee on Financial Services, of which Frank is the chair:
The Committee on Financial Services urges the congressional budget resolution to prioritize the following critical issues:

(1) Housing Initiative. Over the last six months, the nation has experienced a significant increase in the number of homeowners facing the risk of foreclosure, with estimates of as many as 2.8 million subprime and “Alt A” borrowers facing loss of their homes over the next five years. We have already experienced declining home prices in many areas of the country, and the physical deterioration of certain communities, as a result of waves of vacant homes that were foreclosed or abandoned.

The Financial Services Committee is developing a number of proposals to address these growing problems. Given the urgency to take action, a significant portion of the cost of such proposals will likely be incurred in the current fiscal year. However, there would be some loan activities, FHA administrative costs, and additional housing counseling funding that would be needed over the period of the Budget Resolution.

First, the Committee is working on a proposal to provide refinancing opportunities to save as many as 1 million distressed homeowners from having their homes go into foreclosure. Such a proposal will likely involve using FHA and may involve the federal government purchasing loans. It would be implemented through separate authorizing legislation. Any proposal will require the existing holder to write down the loan to a level that is consistent with the homeowner’s ability to pay, and would exclude investor-owned and second homes. The estimated credit subsidy cost could be as much as $15 billion over the next five years. The Committee is also exploring options to limit federal government exposure and thus reduce costs. We could, for instance, require a limited soft second mortgage to the government that would enhance recoveries resulting from future property sales.

Second, the Committee is working on a proposal to provide as much as $20 billion in the form of grants, loans, or a combination of the two, for purchase of foreclosed or abandoned homes at or below market value. The purpose would be to help stabilize home prices and to begin to reverse the serious physical deterioration of neighborhoods with high numbers of subprime borrowers, defaults, and foreclosures. The structuring of such an initiative as a loan program would help to minimize the cost of the federal government, through net recoveries from the subsequent sale of properties.

Third, a substantial expansion of FHA to help keep homeowners in their home will require the contracting out by FHA for independent expertise for the development of underwriting criteria for refinanced loans and for quality control of the loans as they are being made, as well as increased FHA personnel costs for such activities as loan processing. This will require additional FHA administrative funding in the Budget Resolution for FY 2009 and possibly in subsequent years, in an estimated range of several hundred million dollars a year.

Finally, it is important for Congress to increase funding over FY 2008 levels by at least an additional $200 million a year for federal housing counseling grants. Such grants would increase capacity, in order to ensure that sufficient numbers of borrowers are assisted in implementing these and other initiatives to keep people in their homes.
I still have no particular idea where the "one million distressed homeowners" figure comes from, but we can, I think, conclude that it would be a total number of all FHA-related initiatives, including FHASecure and other kinds of fairly straightforward refinance programs, not just a program that involves FHA purchasing an existing loan in order to refinance it.

If the FT has the number right, we're looking at $20 billion for loan purchases. It's hard to calculate how many loans that would be without knowing just what kind of a discount is on the table. If you assumed a 10% discount and an average original loan balance of $200,000, you'd get just over 100,000 loans. At a 50% discount you could buy around 200,000 loans. That's a long way from a goal of one million loans, however you slice it.

On the other hand, there's the potential of several hundred million dollars a year on the table for independent experts who want to write FHA's credit guidelines for them. We knew that was coming.

The sanity level of this kind of plan still depends on why it is we want FHA to buy these loans and then refinance them, as opposed to simply refinancing them. The risk in the buyout, of course, is always that FHA pays too much for the loan; if buyer and seller need to do the full loan-level analysis to calculate the amount of the necessary loan balance to write off before establishing a price, then the practical thing to do at that point is simply a refinance, without FHA ever owning the old loan. If the point is that there isn't time or capacity for current loan holders to do that analysis, then the amount of the discounted price FHA would pay is uncertain at best.

I am also still eager to hear how this proposes to work from the perspective, specifically, of buying loans out of REMIC pools--and that is, presumably, where the problem loans in question are likely to be, not in bank whole loan investment portfolios. REMICs just cannot sell loans at less than par under current rules; without a change to those rules, it seems likely to me that in the process of selling defaulted loans to the government at a discount, the sponsors of these securities are committing themselves to bringing the deals onto their balance sheets, and possibly facing taxation of the trust itself (not just the investors receiving pass-through income). This is one of the several important differences between the current situation and the old HOLC situation in the Depression (where loans were being purchased from banks and were not securitized).

At this point I'm tempted to think it's a lot of additional mess for $20 billion. The Securities Lawyer Full Employment Act probably wasn't what anyone had in mind . .

ARS issuers beg SEC for help

(Naked Capitalism) A group of hospitals which has issued auction rate securities and are now choking on the "failed auction" rates have petitioned the SEC to allow them to buy back the debt. The notion is that they'd either hold the debt off the market until conditions normalize, or would retire it completely, replacing it with longer term debt.

The article on this topic in the Wall Street Journal doesn't mention how the hospitals intend to fund these purchases (presumably via bank debt). It does note that some issuers are barred from pursuing this avenue because their indentures prohibit them from making bids for the debt.

So get a load of this:
The SEC is weighing the requests and hasn't come to any decision, according to people familiar with the matter. The agency is evaluating concerns about whether a borrower's participation in setting the clearing bid in an auction for its own debt would be market manipulation. Issuers of debt would have a strong incentive to support the market price to avoid triggering higher interest rates.

The SEC is worried whether this constitutes market manipulation while state and city finances go into crisis? Yes, this is market manipulation, except, guess what, there is no functioning market right now, hence no damage.

Certain types of market manipulation are routinely permitted and exempted, such as stabilizing transactions in a public offering or an underwritten call. And even though there were apparently concerns about manipulation in this market a few years ago; the Journal mentions a settlement reached with 15 brokerage firms that led to the development of best practices. Nevertheless, dealers were permitted to bid at auction without it being deemed manipulation; in fact, it's the absence of deal bids that has elevated this situation to a crisis.

Here we have an SEC that, as Floyd Norris told us yesterday, pushed to weaken Sarbanes Oxley. Note this isn't a trivial issue; the SEC is responsible for administering Sarbox. Even worse it shows no interest in blatant violations like late in the day leaks to the media that seem designed to kill shorts (most recent example: the Ambac "hey maybe we have a rescue" CNBC story that led to a 250 point rally in the Dow and more important, a 30% increase in Ambac's stock price before the session finished).

The required way to handle material announcements during trading hours is to call a halt and make a statement or release the news after trading hours. Technically, this is a violation of the New York Stock Exchange's rule, "Timely Alert Policy," but the NYSE is under the SEC's authority.

So for the SEC to suddenly be concerned about strict application of the rules seems rather out of character. It wouldn't be all that hard to come up with a temporary, narrow, provisional carve-out. But small fry like hospitals clearly don't rank very high in the SEC's list of priorities.

S&P on moolines: "no problem"

(Accrued Interest) S&P and Moody's have now both affirmed MBIA. S&P also more or less said they would affirm Ambac as well if the reported $3 billion capital infusion is completed. MBIA's infamous 14% surplus note is now trading comfortably above par ($101 bid, $104 offer last night). So are we out of the woods with the monolines?

Well let's start by looking at S&P's methodology. In short, S&P will bestow a AAA rating if they believe an insurer can survive their "stressed" scenario. Here are their assumptions for various types of mortgage-related securities.

First, the cumulative losses for various types of loans. Note these are losses, not default rates. If you assume, say 50% recovery on first liens, then the default rates assumed would be roughly double what you see here. For some context, during the 2001 recession subprime default rates got as high as 9%, so clearly these loss rates are a multiple of historic norms, even during a recession.
Table 2 shows S&P's loss assumptions on direct RMBS transactions. That's where the monoline has insured a pool of loans directly, as opposed to a tranche of a RMBS transaction. So here a AAA-rated RMBS tranche means that S&P estimated the whole pool was worth a AAA at the outset.

Table 3 is starting to get to the real problems. What they mean by a "tranched" RMBS is one where there is a subordination credit enhancement. In other words, losses hit the lower-rated tranches first, and higher rated tranches only if the lower-rated pieces are completely wiped out.

You can't get much worse than those 2006-2007 loss levels, even on AA-rated tranches. Note that these loss levels will dictate the loss levels on ABS CDOs, which is table 4.

I noted in a previous post that CDOs was the monolines biggest exposure, so this table is the real kicker. Remember that the monolines basically only insured senior tranches of CDOs, so these loss rates would seem to represent an assumption that all the subordination will turn out to be worthless. When they say "high-grade" CDOs, they mean a CDO made up of ABS paper rated A or better. That does mean that the transaction is more leveraged, i.e., there is less subordination under the AAA-rated tranche. "Mezzanine" CDOs were usuallly made up of paper rated A or BBB. Since a lot of these mezz ABS pieces are turning out to be worthless, its not surprising that the CDOs are going to take huge losses. I'd say the only thing preventing these losses from being 100% is that most CDOs had more than just RMBS in them, and not all that paper will turn out to be worthless.

So all in all, I'd say that's a pretty stressful scenario.

Tuesday, February 26, 2008

Commentary: Not Your Garden Variety Foreclosures

(Housing Wire) RealtyTrac announced today that foreclosures are up markedly. While the number of foreclosure filings, which includes default notices, auction sales notices, and bank repossessions, rose 8% in January compared to the previous month, the new figures represent a 57% increase compared to a year ago.

While the number of subprime mortgages, especially those that were written in 2006 when rational lending guidelines took a hiatus, is a major factor contributing to this increase, another trend that’s emerging is painting a disturbing picture.

A few days ago, Global Economic Analysis (GEA) posted a screen shot from a particular Washington Mutual Alt-A mortgage pool known as WMALT 2007-0C1. The screen breaks down the pool of mortgages into the typical categories, including delinquencies. Here are some of the highlights from the pool:

Weighted Average LTV = 78%
Fico Score = 705
Full Doc Loans = 11%
Geography = 48% California, 15% Florida

The chart breaks down performance by month, starting with July 2007. By most standards, 705 is a respectable credit score, which makes the delinquency numbers all the more surprising. In a period of 7 months, this pool is showing a massive foreclosure rate of 13.17%. Add REOs into the mix and the figure goes to 15%. Even the vintage 2006 subprime pools didn’t default at such a rapid rate.

GEA poses an interesting question as to whether the FICO system has lost its mind or if maybe there’s a larger issue at work. Although it’s hard to imagine borrowers with a 20%+ equity stake (albeit phantom like) and strong credit scores defaulting at a rate that would lead any servicing portfolio manager to jump out of the nearest window, the numbers seem to indicate that borrowers may be walking away when they are 30 or 60 days delinquent, not even waiting for foreclosure. In December 2007, the 90 days delinquent category stood at 3.79%. Even if every one of these delinquencies became a foreclosure, the figure should only double to 7.58% in January. Instead, the foreclosure figure is 13.17%.

A look at the details shows that nearly 93% of the pool was rated AAA yet almost 15% of the entire pool is in foreclosure or REO after 8 months.

What does it all mean? Until recently, I may have been one of the last holdouts on the FICO bandwagon. I’ve seen enough delinquency reports to make me believe in the ability of FICO to accurately predict performance. But something is terribly wrong with this picture. Credit scores north of 700 have not, in my experience, shown such poor performance levels so quickly. While it’s possible that a deterioration in the underwriting guidelines (e.g. reverses after closing) that we saw on the subprime side became part of the fabric in Alt-A lending, it doesn’t explain these numbers, even if most of them were stated income loans. Unless of course, these were mostly No Doc loans, meaning that most of the borrowers didn’t have jobs. It’s hard to imagine just what was going on in the underwriting department.

If there was ever a doubt that the phenomenon recently dubbed as “jingle mail” actually exists, wonder no more. It’s alive and well. Hopefully, it won’t be still be around around come Christmas time. But given the recent trends, that may be wishful thinking.

OFHEO: HPA diverges between purchases and refis

(Housing Wire) U.S. home prices in the conforming mortgage market diverged sharply depending on whether the mortgage was a purchase or refinance transaction, according to data released Tuesday by the Office of Federal Housing Enterprise Oversight.

A price index looking only at conforming purchase transactions — excluding appraisals used for refinancing — found that prices fell dramatically, dropping 1.3 percent between the third and fourth quarters of last year. That’s a sharp decline when compared to the 0.3 decline posted between Q2 and Q3, and it led to a 0.3 percent annual price decline during 2007 for purchase transactions, OFHEO said.

The annual price decline was the first four-quarter decline in the purchase index since the series began in 1991.

Adding in refinancing appraisals, however, erased any evidence of a price decline: home prices actually appeared headed upwards when refinancing activity was included in the fourth quarter index. As a result, OFHEO’s all-transactions housing price index posted a 0.1 gain in the fourth quarter on a quarter-over-quarter basis, and 0.8 percent gain over the past year.

Evidence of inflated appraisals?
OFHEO director James Lockhart only indirectly addressed the divergence in price trends, saying that the results illustrated greater stability in the conforming mortgage market.

“Both OFHEO’s purchase-only index and the all-transactions index show relatively greater house price stability than do other nationwide house price indexes,” he said. “That may reflect, in part, the greater stability in the prime, conforming mortgage market served by the Enterprises than in other segments of the mortgage market,” Lockhart said.

Or it may reflect inflated appraisals, according to sources interviewed by Housing Wire, who said that appraisers face greater pressure to be aggressive on their valuation opinions when the transaction is a refinance.

During the housing boom, that pressure was to hit a target value often so that the borrower could obtain cash-out from the transaction. During the bust, the new pressure appraisers face may be to hit a target value high enough so that the same borrower doesn’t lose their house.

“You’re not looking at the potential loss of a home if an appraisal comes in too low for a purchase transaction,” said one source, who asked not be named in this story. “So the appraisals are sort of more free there to come in where the appraiser really thinks market value is. That’s not always the case if we’re talking about refinancing in this market.”

The mortgage industry has been under intense pressure from the public and from government officials to help millions of borrowers that are faced with the prospect of a mortgage rate reset refinance into a GSE-backed or government-insured fixed-rate loan. But faced with prices that are declining in many neighborhoods, refinancing has become increasingly problematic as highly-leveraged borrowers find themselves owing more on their house than it is currently worth.

It’s pressure that some industry sources think appraisers feel, even if only indirectly.

“Do you think an appraiser wants to be the reason that someone didn’t get refinanced, and as a result lost their house? No way, no how,” said one source that spoke with HW on the condition of anonymity.

Both Fannie Mae and Freddie Mac, who are regulated by OFHEO, were subpoenaed in November of last year by New York Attorney General Andrew Cuomo, who is suing the First American Corp. over the appraisal practices of its subsidiary eAppraiseIT.

The Wall Street Journal reported Tuesday that both GSEs are nearing a deal with Cuomo’s office that would eliminate broker-ordered appraisals completely, potentially in response to claims that appraisals were being inflated as housing prices rose — and, now, that in some cases they’re being inflated as prices drop.

Goldman, Lehman May Not Have Dodged Credit Crisis

(Bloomberg) -- Even Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. may find they haven't dodged the credit crisis.

The new source of potential losses: so-called variable interest entities that allow financial firms to keep assets such as subprime-mortgage securities off their balance sheets. VIEs may contribute to another $88 billion in losses for banks roiled by the collapse of the housing market, according to bond research firm CreditSights Inc. Goldman, which hasn't had any of the industry's $163 billion in writedowns, said last month it may incur as much as $11.1 billion of losses from the instruments.

The potential for a fire-sale of the assets that would bring another round of charges has ``always been our greatest fear,'' said Gregory Peters, head of credit strategy at New York-based Morgan Stanley, the second-biggest securities firm behind Goldman in terms of market value.

VIEs, known as special purpose vehicles before Enron Corp.'s collapse in 2001, finance themselves by selling short- term debt backed by securities, some of which are insured against default.

Now that Ambac Financial Group Inc. and other guarantors have started to lose their AAA financial-strength ratings, Wall Street firms may be forced to return those assets to their books, recording the declining value as losses. MBIA Inc., the biggest insurer, said yesterday it plans to separate its municipal and asset-backed businesses, a move Peters said would likely result in a lower credit rating for the types of assets owned by VIEs.

`Significant Consequences'

Wall Street's writedowns stem from a surge in mortgage delinquencies among homeowners with the riskiest subprime-credit histories. The industry's VIEs, also known as conduits, had $784 billion in commercial paper outstanding as of last week, according to Moody's Investors Service and the Federal Reserve.

``There's a big number at work here and it will have significant consequences,'' said J. Paul Forrester, the Chicago- based head of the CDO practice at law firm Mayer Brown. ``The great fear is that a combination of subprime CDOs, SIVs and conduits result in a flood of assets into an already-stressed market and there's a price collapse.''

CreditSights has one of the highest projections for additional losses. Moody's says the fallout from VIEs, collateralized debt obligations, and other deteriorating assets may run to $30 billion. CDOS are packages of debt sliced into pieces with varying ratings.

`Lightning Rod'

One type of VIE that's already been forced to unwind or seek bank financing is the structured investment vehicle, or SIV. Like SIVs, VIEs often issue commercial paper to finance themselves and may have multiple outside owners that share in the profits and losses. Because banks agree to back VIEs with lines of credit, they have to buy commercial paper or notes when no one else will.

Ambac, the world's second-biggest bond insurer, and two smaller competitors lost a AAA rating from at least one of the three major ratings companies in recent months. Standard & Poor's yesterday affirmed the AAA ranking of MBIA, the largest ``monoline,'' though it said the outlook is ``negative.'' MBIA yesterday eliminated its quarterly dividend and said it won't write new guarantees on asset-backed securities for six months.

The more widespread the downgrades, the more likely the assets in the VIEs will be cut. Some buyers of the debt demand the highest ratings, giving banks a vested interest in helping the insurers salvage their ratings.

Ambac Financing

New York-based Ambac may get $3 billion in new capital with the help of Citigroup Inc. and Dresdner Bank AG as early as this week, the Wall Street Journal reported yesterday. MBIA raised money by selling common shares and warrants to private-equity firm Warburg Pincus LLC and issuing $1 billion of surplus notes.

``The lightning rod of the monoline fix is so important to so many banks,'' said Thomas Priore, chief executive officer of New York-based Institutional Credit Partners LLC, which manages $12 billion in CDOs.

Accounting rules allow financial firms to keep VIEs off their balance sheets as long as they're not the ones that stand to gain or lose the most from the entity's activities. A bank would also have to account for its portion of a VIE if prices for the debt owned by the fund fall too far or if the bank is forced to provide financing.

Goldman, Lehman

Goldman, the most profitable Wall Street firm, and Lehman, the biggest commercial-paper dealer, have avoided much of the pain so far.

Goldman, which earned a record $11.6 billion in the year ended in November 2007, said it avoided writedowns by setting up trades that would profit from a weaker housing market. Now the threat is $18.9 billion of CDOs in VIEs, the firm said in a regulatory filing on Jan. 29. Goldman spokesman Michael DuVally declined to comment.

Merrill Lynch & Co. analyst Guy Moszkowski today cut his estimate for Goldman's first-quarter earnings for the second time this month, citing growing losses from assets outside residential mortgages.

Lehman, which wrote down the net value of subprime securities by $1.5 billion, guaranteed $7.5 billion of VIE assets as of Nov. 30, according to a filing also made on Jan. 29.

``We believe our actual risk to be limited because our obligations are collateralized by the VIE's assets and contain significant constraints,'' Lehman said in the filing. Spokeswoman Kerrie Cohen wouldn't elaborate.

Citigroup Losses

Citigroup, which has incurred $22.1 billion in losses from the subprime crisis, has $320 billion in ``significant unconsolidated VIEs,'' according to a Feb. 22 filing by the New York-based bank. New York-based Merrill Lynch, which recorded $24.5 billion in subprime writedowns, has $22.6 billion in VIEs, according to CreditSights.

Merrill spokeswoman Jessica Oppenheim declined to comment, as did Citigroup's Danielle Romero-Apsilos.

The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets, according to David Hendler, an analyst at New York-based CreditSights. Hendler based his estimate on the recent sale of $800 million of bonds by E*Trade Financial Corp.

Predictions for losses vary widely because banks aren't required to specify the type of assets being held in the VIEs or how much they are worth, said Tanya Azarchs, managing director for financial institutions at S&P.

``The disclosure on VIEs is hopeless,'' Azarchs said. ``You have no idea of the structure or how that structure works. Until you know that you don't know anything. It's like every day you come into the office and another alphabet soup has run off the rails.''

US pension body's shift over equities adds insult to injury

(Zvi Bodie and John Ralfe in the FT) The Pension Benefit Guaranty Corporation, an agency of the US federal government which protects the pensions of 44m Americans in defined benefit pension plans, has just announced a shift in its strategic asset allocation from 15-25 per cent equities to 55 per cent equities (report, February 19). This reverses the policy adopted in 2004, which saw a significant move from equities to duration-matched bonds. Does the move back to equities make sense for the PBGC?

The PBGC already has huge exposure to equities through guaranteeing company pension plans. Poor equity performance, reflecting a weak economy, will increase the number of bust companies passing their pensions to the PBGC. With typical equity weightings in US pension plans, deficits and each PBGC loss will also be bigger.

For the PBGC itself to hold more of its assets in equities adds insult to injury - like a company which insures hurricane damage investing its reserves in beachfront property. Annuities paid by the PBGC can only be matched by holding bonds - holding more equities looks like the PBGC trying to bet its way out of a loss. The UK equivalent of the PBGC, the Pension Protection Fund, has certainly got this simple message and holds only 20 per cent equities, explicitly limiting the equity "double whammy".

The PBGC press release asserts that the new strategy significantly increases the likelihood of full funding within 10 years and that the new policy "is designed to take advantage of a long-term investment horizon". The PBGC clearly believes that equity risk, measured by the volatility of returns, decreases the longer the time horizon.

Volatility analysis as a measure of equity risk ignores the severity of any shortfall. Although the probability that equities will earn less than the risk-free rate decreases with the time horizon, the extent of any possible shortfall increases. Equity risk should be measured as the cost of buying insurance via an equity put option, which increases over time. Adjusted for risk there is no equity "free lunch".

The PBGC guarantee of pensions has institutionalised "moral hazard" in the US since it was set up in 1974. US trustees have little incentive to reduce risk for members by matching assets and liabilities - they know that if the company goes bust, the PBGC will pick up the tab. The UK may be seeing this since the PPF opened.

At September 2007 the PBGC had a $14bn deficit - assets of $68bn and liabilities of $82bn - following several large losses from bankrupt companies, as well as another $66bn of "reasonably possible" exposure for plans sponsored by junk-rated companies.

As the US federal government backs the PBGC its structural deficit will, sooner or later, have to be made good by the government. We could see a re-run of the 1980s US saving and loans debacle.