Wednesday, April 30, 2008

FDIC's Home Ownership Preservation Loan Proposal

(From the horse's mouth...) The FDIC is proposing that Congress authorize the Treasury Department to make loans to borrowers with unaffordable mortgages to pay down up to 20 percent of their principal. The repayment and financing costs for these Home Ownership Preservation (HOP) loans would be borne by mortgage investors and borrowers. This approach is scaleable, administratively simple, and will avoid unnecessary foreclosures to help stabilize mortgage and housing prices.

This proposal is designed to result in no cost to the government:

  • Borrowers must repay their restructured mortgage and the HOP loan.
  • To enter the program, mortgage investors pay Treasury's financing costs and agree to concessions on the underlying mortgage to achieve an affordable payment.
  • Treasury would have a super-priority interest -- superior to mortgage investors' interest -- to guarantee repayment. If the borrower defaulted, refinanced or sold the property, Treasury would have a priority recovery for the amount of its loan from any proceeds.
  • The government has no continued obligation and the loans are repaid in full.

Mortgage Restructuring:

  • Eligible, unaffordable mortgages would be paid down by up to 20 percent and restructured into fully-amortized, fixed rate loans for the balance of the original loan term at the lower balance. New interest rate capped at Freddie Mac 30-year fixed rate.
  • Restructured mortgages cannot exceed a debt-to-income ratio for all housing-related expenses greater than 35 percent of the borrower's verified current gross income ('front-end DTI'). Prepayment penalties, deferred interest, or negative amortization are barred.
  • Mortgage investors would pay the first five years of interest due to Treasury on the HOP loans when they enter the program. After 5 years, borrowers would begin repaying the HOP loan at fixed Treasury rates.
  • Servicers would agree to periodic special audits by a federal banking agency.


  • Mortgage investors would apply to Treasury for funds and would be responsible for complying with the terms for the HOP loans, restructuring mortgages, and subordinating their interest to Treasury.
  • Administratively simple. Eligibility is determined by origination documentation and restructuring is based on verified current income and restructured mortgage payments.


  • A Treasury public debt offering of $50 billion would be sufficient to fund modifications of approximately 1 million loans that were "unsustainable at origination." Principal and interest costs are fully repaid.

Eligible Mortgages:

Applies only to mortgages for owner-occupied residences that are:

  1. Unaffordable – defined by front-end DTIs exceeding 40 percent at origination.
  2. Below the FHA conforming loan limit.
  3. Originated between January 1, 2003 and June 30, 2007.

Home Ownership Preservation Loans: Questions and Answers

Home Ownership Preservation Loans: Examples

Related Link: Financial Times, April 29, 2008 – Op Ed: How the State can Stabilise Housing Market

The State of Catastrophe Bonds

(Felix Salmon) The panel on catastrophe bonds coincided with the release of a Milken Institute report on the topic.

Catastrophe bonds make a huge amount of sense, in theory. The cost of Hurricane Katrina was over $65 billion in insured losses alone. And that's a fraction of potential damages: coastal property in Florida is worth $1.9 trillion, compared to just $66 billion in Louisiana and Mississippi, where Katrina hit. Values in earthquake-prone California are, if anything, even higher. What's more, uninsured losses, especially in areas of the world which have recently been hit by hurricanes and the 2004 tsunami, are higher still: globally about 25% of catastrophe risks are insured, and in the emerging markets it's 7%.

The problem is that the risk of bearing the costs of catastrophes tends to be borne either by private reinsurers, whose capacity tends to top out at about $150 billion, or else, ultimately, by national governments, many of whom in places like Honduras or Sri Lanka simply don't have the fiscal capacity to recover from a major disaster.

Where to turn? Capital markets: they should have much more ability to provide extremely large amounts of money than do reinsurers and other traditional risk takers. But although the issuance of catastrophe bonds has been growing, it's still tiny:


In 2007, which was a record year for cat bond issuance, the total fell just shy of $7 billion. Dan Ozizmir of Swiss Re talked about these numbers growing exponentially in the future, especially if catastrophe bonds expand to include not only earthquakes and hurricanes but also catastrophic mortality risk. Life insurers often have $1 trillion of face value in written life insurance policies, and a major wipeout of human life, like a big terrorist attack or a bird flue pandemic, could destroy the life-insurance industry.

Even bigger sums could be in play with drought insurance - something which Swiss Re has already started offering to Jeff Sachs in conjunction with his Millennium Villages project. There, satellite imagery is used to measure total vegetation, which is an excellent proxy for crop yields. So far, this kind of risk hasn't been securitized, but there's no reason in theory why it shouldn't be.

All of these trillions of dollars in potential catastrophe bonds, then, not to mention associated derivatives, which could be even bigger, have yet to appear. Some of the obstacles to growth in this market are slowly falling away: one, for instance, is the fact that most of these bonds are written and structured by reinsurance companies, and investors are worried about adverse selection: the risk that reinsurers are selling off their worst risk. Slowly independent catastrophe risk rating agencies are appearing, which should help assuage such concerns, although clearly quantifying the risk of future catastrophes is very difficult indeed.

But more profoundly, the market in these bonds at the moment is dominated by hedge funds, who generally require much higher returns than do reinsurance companies. It shouldn't be that way: Pimco's John Brynjolfsson pointed out that total catastrophe exposure globally of about $4 trillion pales in comparison to the $100 trillion in global debt and equity markets. According to his study, on average global markets are a bit higher after a natural disaster than they were before the disaster, which means that catastrophe bonds really are completely uncorrelated to global markets - something very valuable to any institutional investor.

On the other hand, there are some spillovers between capital markets and catastrophe bonds. Catastrophe bonds need to put their principal into collateral, for instance, which needs to be liquidated in the event of a catastrophe, and during a credit crisis there can be concerns over the quality of that collateral.

That said, there does seem to be more demand for catastrophe bonds than there is supply. Right now, the market isn't clearing very well, partly because the transaction fees on these bonds can be very high. I've been hearing a lot of hopeful projections of how fast the catastrophe bond market is going to grow for many years now, and so far it hasn't really happened. This issue was addressed by Jose Siberon of Merrill Lynch, who called for government to help: the state of Florida, he said, should lead the way by insisting on using capital-market structures to help insure its hurricane risk.

One big issue seems to be endemic, however, and that's the difference between parametric risk and indemnity risk. Bond investors want to pay out based on science: earthquakes as measured by the Richter scale or amount that the ground moved; hurricanes as measured by wind speed and the like. Insurers and insured, by contrast, want their payouts based on losses. The basis risk between the two is large: everybody can think of large losses from relatively small events, or small losses from relatively large events. And it's not easy how that basis risk can be reduced.

FDIC Proposes $50 Billion Mortgage Pay Down Program; Questions Abound

(Housing Wire) The Federal Deposit Insurance Corp. on Wednesday proposed the latest in a string of recent attempts by lawmakers and policyheads to stem growing mortgage losses, suggesting that the Treasury fund $50 billion to help borrowers pay down a portion of principal on outstanding mortgages deemed “unaffordable” by the government.

“Government efforts should focus on helping the market reach equilibrium without overshooting,” wrote Sheila Bair in an op-ed published Wedensday in the Financial Times. “This can be done only through widespread restructuring of unaffordable mortgages into affordable ones.”

The program would see certain borrowers’ mortgages restructured by paying down up to 20 percent of principal via a so-called “Home Ownership Preservation loan” backed by the Treasury; borrowers would then refinance into a fixed-rate traditional mortgage, and pay only on that 80 percent of modified principal for the first five years after restructuring.

Investors, in turn, would agree to take a 20 percent haircut on their existing position — sort of. Under the FDIC proposal, investors would receive funds from the Treasury’s HOP loan and agree to pay interest at the Treasury’s rate for the first five years of the loan (making the loan free to consumers). After five years, borrower would then pay on the full 100 percent owed, with the 20 percent HOP loan amortized at below-market, Treasury-specific rates.

If the borrower defaults, sells or refinances, the HOP debt is in the super-senior position, putting the Treasury in the pole position for any recovery.

“The housing crisis is a national problem,” Bair said. “Painful as it is, we must be prepared to apply government efforts now.”

The program would only be available to borrowers whose loans are defined as “unaffordable” — that is, borrowers whose debt-to-income was above 40 percent at the fully-indexed rate when the loan was originated, borrowers whose mortgage fits within current FHA lending limits, and who took out their loan between 2003 and mid-2007.

The FDIC said in press materials that it expects that one million borrowers would qualify for the program.

Industry response tepid
There appear to be a number of concerns about the FDIC’s proposal, according to senior executives that spoke with HW on strict condition of anonymity — not to mention some apparent confusion as to implementation and contingencies.

“We’re talking about underwater borrowers, which means most of these people either have a second lien or they’ve got MI [mortgage insurance],” said one source, an exec at a large servicing operation. “Why would a second lien holder voluntarily agree to be completely and immediately wiped out in a transaction, when they could get more by collecting even one more payment from a borrower that will ultimately default?”

“And what does this mean for a mortgage insurer? That the Federal government is taking up their loss position?”

A review of the proposal materials provided by the FDIC did not answer that question directly, saying only that under the proposal, “the underlying loan is modified within the mortgage pool and does not worsen the position of subordinate lien holders.” Which, we suppose, is another way of saying that you can’t do worse than zero. As our sources have suggested, however, it’s when you reach zero that matters, too.

An attorney that spoke with HW raised different concerns, suggesting that the program could expose the Federal government to various levies and fees that various local municipalities are now charging lien-holders on mortgages.

Most sources had a tough time believing that the program would be costless to the government, a stance the FDIC reiterated numerous times in materials detailing the HOP plan.

“What happens if an investor goes belly up in year two of five? What happens if payments are missapplied?” another source said. “Is the Treasury going to repossess its secured interest because whomever refinanced the loan went out of business or filed bankruptcy? Or are they going to eat the losses? Or are they going to recap that lost interest onto what the borrower owes?”

It’s certainly not out the realm to consider such scenarios, given the number of lenders/noteholders/investors that have run aground in the past 12 months alone.

An ABS analyst that spoke with HW focused on the distribution of proceeds from the HOP loan, saying that it’s unclear which investors would support such a deal and which would not — support would likely depend on the relative status of a given transaction, we were told, and where current and expected losses stacked up against structural keys, like overcollateralization triggers.

“All investors and all deals are not created equal,” said the analyst.

A week in the life of mortgage "reform"

Here's a mortgage crisis chronology for this week, as reported by the New York Times and Washington Post. Can you guess what these articles have in common?

On Sunday, Michelle Singletary's The Color of Money column discussed Treasury Secretary's Henry Paulson's recommendation to create a Mortgage Origination Commission that would promulgate standards for mortgage loan officers and would rate and report state efforts to license and regulate mortgage brokers. In her view, a new Commission isn't needed. Instead, she argues that what we need to do is send some of these people to jail. Rather than have a commission talk about their fraudulent acts, she suggests that we need to criminally prosecute loan officers who have engaged in fraudulent lending activities.

On Monday, the New York Times reported that the mortgage industry has stepped up its attack on proposed Federal Reserve regulations that are designed to regulate certain mortgage lending practices. These regulations would require lenders to disclose all fees (including broker's yield spread premiums), would require lenders to show that customers can actually afford the mortgage, would ban certain types of advertising, and would regulate other practices viewed as abusive. The mortgage community argues (of course) that tighter regulations will increase the cost of credit and ultimately will harm creditworthy borrowers. The Times reports that the industry's aggressive attack on the regulations and their flood of comments have been successful in convincing the Fed to narrow the proposed regulations.

Yesterday (Tuesday). An editorial in the Times criticized the government for waiting too long to respond to the foreclosure crisis and sharply criticizes the pro-mortgage industry aspects of the bill the House recently passed. It specifically notes that the bill relies too heavily on the voluntary participation of lenders, and stresses that lenders can choose whether to reduce the mortgage loan balances or whether to continue with a pending foreclosure. The editorial urges Congress, especially the Democratic leadership, to push forward with legislation that would let borrowers modify their mortgages in bankruptcy.

Today. An article in the Times reports that fewer than 1,800 homeowners have been helped by the Federal Housing Administration program that was designed to provide relief to homeowners who have fallen behind on their mortgage payments. Though FHA officials contend that more than 150,000 people have benefited from the program, the program has largely helped homeowners who are current on their mortgage payments (and who anticipated that they might have problems in the future), not the folks who were in default and at risk of losing their homes in foreclosure. Surprisingly, housing officials seemed surprised by the number of homeowners who sought to benefit from the program. It's surprising that they were surprised by the homeowner interest in the program, since over a million people have fallen behind on their mortgage payments.

Why so few homeowners are benefiting from the FHA program is anyone's guess. Perhaps it's the design of the program, which provides relief only to borrowers who have made 10 timely payments in the 12 months before they went into default. Maybe it's because the program hasn't been well publicized. Or, perhaps officials at the Department of Housing and Urban Development, which oversees the FHA, have been a tad distracted of late by the scandals involving the former-HUD chief (who resigned recently but is still being investigated for questionable business practices). One thing we don't have to guess is that this program is going to do little to help most struggling homeowners this year, unless the program is radically revamped.

So what do these news reports have in common? First, the mortgage industry seems unwilling to voluntarily reform itself. Second, any attempt to regulate the industry will be met with the claim that doing so will do no good and will only exacerbate the credit crisis. Third, no one in the government seems to want to take truly bold steps to do anything meaningful anytime soon, and everyone seems happy to engage in long discussions (in committees or on commissions) about the housing crisis. Fourth, the Fed and members of Congress appear unwilling to alienate the powerful financial services industry.

Of course, the week's not over yet. Things can only go up.

Predatory borrowing, and recidivism

(Housing Wire) We’re probably not going to make a lot of friends on the consumer side with this, but more than a few analysts have asked us here at HW when we’re going to take up the issue of “predatory borrowing,” since the cards have pretty much been dealt on predatory servicing and predatory lending.

How about now?

An earlier story Tuesday on HW covered an upcoming Senate Judiciary subcommittee hearing on foreclosures and bankruptcy, and cited a story in the New York Times. It was penned by Gretchen Morgenson, and we chose to ignore the more — ahem, how shall we put it — misguided portions of her story. We wanted to focus on the news itself.

But those misguided portions that we ignored? They drove Calculated Risk’s Tanta off of a ledge, in a way that only Gretchen seems to have a way of doing as of late. The result is well worth anyone’s time to read, especially if you are in the camp that says all servicers are out to screw borrowers utterly and completely — what you learn just might conflict with your world view.

Tanta went ahead and researched the entire Atchley case history, or at least as much of it was publicly available — the case is the center of the U.S. Trustee’s case against Countrywide — and what she finds is another case of a classic borrower filing bankruptcy to stave off foreclosure and then struggling to make a mortgage payments post-petition, not to mention a lender who managed to screw up on filing Proofs of Claim with the court.

Not exactly the sordid tale of Countrywide and its attorneys quashing a blameless borrower, is it?

Yet somehow, we have a feeling that on May 6, Robin Atchley will be there in front of a nodding Senator from New York named Chuck Schumer — and, oh, did we mention that Diane Feinstein is on the Judiciary subcommittee too? — telling the whole world how wronged she was by that evil, bad and uncaring lender named Countrywide and their nefarious lawyering types.

Tuesday, April 29, 2008

More Subprime, Alt-A Mortgages May Head `Underwater'

(Bloomberg) -- About half of recent subprime and Alt-A borrowers may soon owe more on their mortgages than their houses are worth or hold minimal equity, putting $800 billion of debt at greater risk of default, according to Barclays Capital.

Subprime loans from 2006 and 2007 that exceed the value of the homes jumped 5 percentage points to 19.8 percent in the fourth quarter, and may reach 26 percent by midyear if prices drop at the same pace, Barclays analysts wrote in a report yesterday. Alt-A loans, a grade better than subprime, would grow to 23 percent from 16.3 percent.

Many of the loans are in areas where prices are falling faster than the U.S. average, so the size of the shift is underappreciated, New York-based analysts Ajay Rajadhyaksha and Derek Chen wrote. The odds that a borrower will default, saddling lenders and bond investors with losses, rises when a homeowner owes more on a property than it can sell for, they wrote.

``Mortgage loans are moving underwater at a very sharp pace, far more than suggested by aggregate home price data,'' they wrote. Home mortgages held by households totaled $10.5 trillion on Dec. 31, according to Federal Reserve data.

The analysts used quarterly home-price data from the Office of Federal Housing Enterprise Oversight, which showed a 0.3 percent dip in prices nationwide in the fourth quarter from a year earlier, and tumbles of more than 14 percent in Modesto, California, and Port St. Lucie, Florida. S&P/Case-Shiller indexes tracking areas around 20 cities have shown more severe declines, including a 9 percent nationwide drop in the same period.

`Better to Sell'

Borrowers on about 26 percent of subprime loans from 2006 and 2007 will have equity of less than 10 percent by midyear, down from 29.4 percent at yearend, according to Barclays, as more borrowers slip underwater. The percentage on Alt-A mortgages should hold steady at about 23.5 percent. The report said 10.8 percent of Alt-A loans were underwater on Sept. 30.

``If they have home equity left, borrowers are hesitant to default, even if in trouble,'' the analysts wrote. ``If the house is worth more than the loan, why default and leave money for the bank? Better to sell the house instead.''

Borrowers with poor or limited credit records or high debt used subprime mortgages to buy properties or tap home equity by refinancing. Lenders made Alt-A home loans to borrowers who want atypical terms such as proof-of-income waivers, delayed principal repayment or investment-property collateral, without having to offer sufficient compensating attributes.

Walking Away

Among two-year-old Alt-A mortgages that are underwater, 33 percent are at least 60 days late, the analysts wrote. That compares with 7 percent delinquency on similar loans in which homeowners have equity of at least 20 percent. For corresponding subprime loans, the delinquency rate is 58 percent for underwater debt and 29 percent where equity exceeds 20 percent.

Borrowers who have never been delinquent on a subprime mortgage are three times more likely to miss a payment if they have less than 20 percent equity in their homes, when compared with similar borrowers with more equity, according to a report last week from Credit Suisse Group. These homeowners then catch up only half as often as their counterparts, the report said.

Home prices in 20 U.S. metropolitan areas fell in February by the most on record, according to a report released today. The S&P/Case-Shiller home-price index dropped 12.7 percent from a year earlier, more than forecast and the most since the figures were first published in 2001. The gauge has fallen every month since January 2007.

Senate Panel to Look at Foreclosure Management Practices

(Housing Wire) If anyone needed proof that default servicing is now headed towards the spotlight, look no further than yesterday’s announcement by the Senate Judiciary Committee that it will hold a session focusing on recent high-profile bankruptcy management missteps. The Judiciary Committee’s Subcommitree on Administrative Oversight and the Courts will hold a hearing titled “Policing Lenders and Protecting Homeowners: Is Misconduct in Bankruptcy Fueling the Foreclosure Crisis?”

The hearing, scheduled for May 6, was called by chairman Charles Schumer (D-NY) — who has said that he wants legislation enacted to protect borrowers from servicer missteps in and after bankrupcty proceedings.

Schumer has invited Countrywide Financial Corp. (CFC: 5.85, +0.34%) Angelo Mozilo to testify, the New York Times reported Tuesday. Also invited were representatives from McCalla, Raymer, Padrick, Cobb, Nichols & Clark in Atlanta, a creditor’s rights law firm and one of the largest such firms in the default servicing industry. Both the law firm and Countrywide have been at the center of a highly-publicized series of case involving the United States Trustee, in which the Trustee has alleged “abuses of the bankruptcy process” by Countrywide and its associated counsel in Georgia, Florida and Ohio.

A similar case, a putative class action suit filed in February by a group of borrowers in Texas, was thrown out by a judge in a federal bankruptcy court in Houston this past March.

While it’s unknown whether Mozilo or McCalla Raymer will be attending the hearing, the New York Times reported that three others will be testifying: Robin Atchley, the borrower at the center of the Countrywide bankruptcy brouhaha in Atlanta, as well as Clifford J. White III, director of the executive office for the United States Trustee, and Katherine M. Porter, an associate professor of law at Iowa University. Porter published a study in 2006 that found half of foreclosures contained “questionable fees.”

The New York Times covers more details:

What the hearing is going to show is what an ongoing, awful enterprise some of these companies ran, not just taking advantage of the terms of the mortgage, but when they control the mortgage how they continue to squeeze and squeeze and squeeze,” Mr. Schumer, Democrat of New York, said.

Milken Conference Update: Real Estate Panel

(Felix Salmon) As a general rule, if you get the opportunity to hear Sam Zell speak, you should take it. He was on the real estate panel today, and he didn't disappoint.

The moderator was Lew Feldman, a real-estate lawyer, who started by talking about the "debt and equity markets" in real estate capital, except his accent managed to make it sound like "dead-end equity markets". Thus was the tone set.

Zell started off by blaming the government, at least in part, for the current housing crunch. Every time over the past 40 years that the government decided that they wanted to increase homeownership over 62%, he said, there's been a disaster. This time round seems to be no exception: homeownership went from 62% to 69%, and those new home buyers turned out to be much less creditworthy than most, and also turned out to be the suckers who bought at the top.

Even so, said Zell,

I think it's all overstated. I'd buy all the subprime debt I could find at 40 cents on the dollar, in terms of recovery, and there are subprime CDOs out there which are trading for a nickel.

Zell also pointed out that if a bank tells an underwater borrower to sell his house, the borrower has no incentive to show or sell that house. But when the bank forecloses, it has every incentive to sell. So as foreclosures rise, we might well see even more of an increase in home sales. But that would not necessarily be good news.

Zell then got into an intersting conversation with Bobby Turner, of Canyon Capital Advisors, about demographics and urbanization. Turner, channeling the likes of Ryan Avent and Richard Florida, said that consumer prefences are going to move away from the suburban lifestyle as transportation costs soar.

Zell agreed, pointing to enormous growth of housing in what he called "24/7 cities", putting a lot of that growth down to the societal deferral of marriage.

But as cities become ever more expensive and the suburbs become ever cheaper, he was asked, won't corporations move out to the suburbs? No. Motorola rented 200,000 square feet of office space in downtown Chicago last year, he said, even as they have over half a million vacant square feet not far away in McHenry county. If the employees are moving to the cities, then the companies are going to have to follow suit.

Generally, the panelists were downbeat on all US assets, with Zell reserving most of his zeal for Brazil. But if there is a growth market in the US, it's the big gateway cities: both hotels, which can benefit enormously from the weak dollar, and lower-end rental properties, which will benefit over the long term from immigration and population growth.

Milken Conference Update: The State of Credit

(Felix Salmon) The Milken Global Conference kicked off this morning with a panel moderated by Mike Milken on the only possible subject: credit. It was a high-level panel, with some high-level discourse: one of the most sophisticated conversations I've ever tried to follow at 8 o'clock in the morning.

Wes Edens, the CEO of Fortress Investment Group, kicked things off by pointing out how much worse this credit cycle is than were previous downturns in 1998 or the beginning of 2002: rather than widening out to 70bp or 80bp over Treasuries, investment-grade bonds are now trading at 1200bp over. And a lot of that, he said, isn't necessarily credit risk: "the bulk of it has been due to a tremendous liquidity crisis". Think for instance of the effect of SIVs unwinding: that's $300 billion or more being sold into a market with precious few buyers, with the obvious effect on prices. "It's what happens when the buyers of the assets all become sellers of the assets," said Edens.

Rajeev Misra, head of credit trading at Deutsche Bank, agreed, and said that the reason emerging market debt has been the best performer of late is simply because of the lack of leverage in the asset class. He's also convinced that there's an enormous cash/CDS arbitrage in the investment-grade space, where cash bonds yield 70-80bp more than the yield on the CDS. There's no default or credit risk in this trade, he says, and those bonds are going to mature in 5 years: the spread is a pure liquidity premium. When massive spreads like that don't get arbitraged away almost immediately, you know that financial markets are going through unusual times.

Misra also pointed out an enormous asymmetry in the world of subprime credit default swaps. Hundreds of billions of dollars of BBB-rated subprime CDS were bundled into synthetic CDOs, he said, despite the fact that the BBB slice of a subprime RMBS is only about 2% of the total. If total subprime bond issuance was $700 billion, then all of those credit default swaps - which were then structured into hundreds of billions of dollars of AAA paper - were based on maybe $15 billion of actual bonds. And that's how a tiny number of very risky bonds can, through the magic of structured finance, underpin huge quantities of nominally risk-free debt.

Noel Kirnon, of Moody's structured finance group, seemed a little more slippery. He said that historically structured finance ratings have been more stable than corporate ratings, and that even today structured finance in 2007 has been much less volatile than corporate debt was in 1986 - a period of time I'm sure that Milken remembers very well indeed, and never thought he'd end up reliving.

I suspect, however, that the lack of ratings volatility that Kirnon referenced is a product of the fact that corporates have to be continually re-rated because they are continually issuing. Structured products, by contrast, generally get rated only once, and it takes a lot for a ratings agency to re-rate them without any new issuance from that specific entity.

Steven Tananbaum, the CEO GoldenTree Asset Management, was reasonably constructive. One thing he pointed out is that there's no difference between mean and median bank-loan prices, in stark contrast to the last credit downturn. Back then, most credits performed, while a few plunged in price. Today, there's no differentiation between credits - probably because so far default rates have remained extremely low. Inevitably a large number of credits are not going to default: if you think you know which they are, there are some very attractive yields out there right now.

That said, however, spreads are still narrower than they normally are when default rates pick up, which means we're still early in the credit cycle and spreads are going to widen further when companies start to default. When the default rate does rise, there might well be further spread widening, even on the good credits which ultimately will continue to perform.

One interesting datapoint Tananbaum did come up with was that implied default rates on double-A loans are actually higher than implied default rates on single-A loans. That, he said, is a result of the deleveraging going on: the purchasers of AA tranches were all levered 10x, and are now being forced to unwind. On the other hand, you can only calculate implied default rates by assuming recovery values, and Tananbaum assumed higher recoveries on AA than on A loans. That might well not be the case, this time around.

The binge culture of banking

(Abigail Hofman in the FT) A friend, who is a teacher, lamented to me recently: “For years we have been told that bankers were paid so much because you were cleverer than the rest of us. Now it turns out you were not clever at all and we are all suffering for your stupidity.”

In the past two weeks, big financial institutions in Europe and America have announced losses and savage job cuts caused by new writedowns for US subprime mortgages. So far, we have seen more than $250bn (€160bn, £126bn) of writedowns related to the debt bubble of the past few years. I am reminded of the remark attributed to Everett Dirksen, a former US senator: “A billion here, a billion there and pretty soon you’re talking real money.”

We have become blasé about large banking losses and no one weeps when overpaid bankers lose their jobs. However, we must remember the true victims of this crisis: the underprivileged Americans encouraged by the unscrupulous to take out mortgages they could not afford. “Home ownership is better”, was the siren call. Those who were seduced are now sitting amidst the rubble of their dreams. As global banks, faced with depleted balance sheets, move to hoard cash, ordinary people are finding the well of liquidity has run dry. It is increasingly difficult to borrow money, even for those with pristine credit histories.

Some blame the politicians (not enough regulation), others the central bank officials (for creating asset bubbles). However, I blame the corrosive culture of investment banking.

I worked for 18 years in investment banking and several aspects of the culture unnerved me. Investment banks are all about making money. At the extreme, this means making money for employees not shareholders. The big revenue producers are revered. It is not considered prudent to upset them by asking too many questions. The subprime meltdown is a perfect example of the “emperor has no clothes” phenomenon. These were complex products, yet obfuscation was considered acceptable. Bank chief executives should have asked more questions. I suspect they saw the juicy profits and hoped underlings understood the risks.

Moreover, investment banking culture has a cult aspect to it. If you work on Wall Street or in the City, you toe the party line. Despite lip-service to “diversity”, diversity of thinking is not encouraged. This atmosphere of craven conformity breeds at first complacency and then mistakes.

The past is littered with the fallout of banking binges. Think about the dotcom fiasco of the late 1990s or the leveraged buyout mania of the late 1980s. The sad truth is that the culture is one of lemming-like imitation. There is too much looking over the shoulder at rivals and not enough scrutiny of internal decisions. “It is not how we do,” a senior US banker told me last summer, “it is how we do relative to our peers.” This attitude caused the problem in the first place. If X bank is making millions on an innovative product, Y bank feels pressure to do the same. There is a terror of stepping off the escalator even as it approaches the edge of the cliff.

A recent report from Morgan Stanley and Oliver Wyman claims this is the worst investment banking crisis in 30 years and that it could last for 10 quarters. But it also noted that investment banks bounce back quickly, typically taking less than two years for industry earnings to match previous levels.

So where do we go from here? Some argue that investment banking needs to reinvent itself by developing new revenue sources. That may be true but it will not be easy or rapid, especially in an era of tighter regulation, lower leverage and doubts about the last wave of innovation.

Yet what is most needed is more fundamental changes. Costs must be cut. The compensation model must be modified with bonuses for top performers being risk-adjusted to take account of future business developments. The composition of bank boards has to change. Very few bank non-executive directors have a financial background, raising doubts about whether they are competent to challenge executives on either the general direction or the subtler nuances of the business. The most important thing to change is investment banking culture. Dissonance should be viewed not as disobedience but as necessary debate.

Finally, I would appreciate some sensitivity from financiers who still have jobs: lose the Learjets and limousines and ride the Tube with the rest of us.

The writer is a former investment banker. She is now a commentator on the financial industry and a columnist for Euromoney

Some further thoughts on the Bank of England’s Special Liquidity Scheme

(Willem Buiter at the FT) Tim Young makes three interesting comments on my blog on the Bank of England’s Special Liquidity Scheme:

(1) The Treasury bills involved are of nine months original maturity, not one year.

(2) In the event that the borrower defaults, the public sector gets stuck with a loss if the value of the collateral is less than the value of the t-bill loan, even if the issuer of the securities posted as collateral does not default. Presumably this is much more probable than a simultaneous default, especially if the borrower is widely known to be a holder of such securities.

(3) US mortgages are not in general non-recourse.

As regards Tim’s first point, the Bank of England Information sheet states: To provide banks with the certainty about liquidity that is needed to boost confidence, assets will, unless they mature within one year, be swapped for one year and banks will have the opportunity, at the discretion of the Bank of England, to renew these transactions for a total of up to three years.” In the Market notice for the SLS, it says that “The Bills lent under the Scheme will be for an original maturity of nine months and will have been created within the month preceding the drawdown. Bills must be delivered back to the Bank 10 days prior to their maturity and will be exchanged for a further 9-month Bill.” So Tim is correct. Although the banks will be provided with liquidity through Tbills for a year, the Tbills that are issued as part of the initial swap of Tbils for MBS will have an orginal maturity of nine months. These Tbills will be swapped 10 days before maturity for further 9-month bills, which will be held by the banks for no more than 4 months before the MBS swap reverses (unless the scheme is extended, as is likely).

As regards your second point, the Bank of England Information sheet states, in a section headed (ii) Credit risk stays with the banks: “….the Scheme is indemnified by the Treasury but is designed to avoid the public sector taking on the risk of potential losses. That risk will remain with the banks and their shareholders. The assets are pledged by banks as security against which they will borrow the Treasury bills. When a swap transaction expires, the assets are returned to the banks in exchange for return of the Treasury Bills.”

I interpreted the statement that “The assets are pledged by banks as security against which they will borrow the Treasury bills”, as meaning that the transaction was a collateralised loan of Treasury bills, where the lender of the Treasury bills (the Bank of England) has recourse to the borrower (the bank) and to the collateral. In that case the risk to the Bank of England would indeed be the risk of the joint default of the borrowing bank and of the issuer of the collateral offered by the bank. This interpretation was supported by the Bank of England’s News Release on the Special Liquidity Scheme . The News Release and the Information sheet also makes the separate point that “If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury Bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets.”

However, some recent discussions with Helen Parry of have convinced me that Tim may well be right, and that the so-called swap does in fact shift the default risk on the illiquid bank assets to the Bank of England, without recourse to the borrowing bank. The swap is technically/legally a customised stock lending agreement. In a note on the issue, Helen writes: “Officials at the Bank of England have confirmed that this is the case. Furthermore, while officials at the International Stock Lending Association have indicated that the contractual terms differ in some respects from the standard terms to be found in the ISLA Global Master Securities Lending Agreement, the agreement does provide for the fact that title to the borrowed securities passes to the borrower. This is the normal provision in a stock lending agreement. This means that the title to the illiquid securities will pass to the Bank of England.”

If Tim’s and Helen’s interpretations are correct, the language used by the Bank (and also by the Treasury, as is evident from the Chancellor’s statement to the House of Commons on 21 April 2008) are misleading, to say the least. The assertion by the Chancellor that This means that the banks will continue to hold the risk on the securities they provide, so it is them rather than the Bank of England that will be exposed to any fall in value.would be the exact opposite of the truth.

I look forward to further enlightenment on the issue.

As regards the third point, Tim is right again. While most first mortgages in the USA are non-recourse, this is not true for all states, and it is also generally not true for second mortgages.[1]

[1] From Wikipedia, “nonrecourse debt or non-recourse debt or nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender’s recovery is limited to the collateral”.

(Comment from David Rule, ISLA) I do not know the terms of the legal agreement that the Bank of England is using. But the interpretation of a standard securities lending transaction (eg under the Global Master Securities Lending Agreement) above is incorrect. In such a transaction, legal title over the mortgage-backed securities (the Collateral) would indeed pass to the lender (in this case the Bank). But the lender has a contractual claim on the borrower (in this case the commercial bank) to deliver Equivalent Collateral if the value of the Collateral falls below that of the Loaned Securities (ie it does have recourse to the Borrower). If the Borrower defaults, obligations are accelerated and the current market value of the Collateral is set off against the current market value of the Loaned Securities so that one party has a net claim on the other. In this way the lender will only lose money if the borrower defaults and the value of the Collateral falls below that of the Loaned Securities.

Monday, April 28, 2008

Bank of America Unveils Mortgage Aid Plan

(Housing Wire) Continuing efforts to fast-track its acquisition of Calabasas, Calif.-based Countrywide Financial Corp. (CFC: 5.83, -0.17%), executives at Bank of America Corp. (BAC: 38.18, -0.31%) unveiled an aggressive mortgage aid plan Monday morning, ahead of scheduled testimony at the Federal Reserve in Los Angeles. The bank also confirmed its plans to mothball the Countrywide brand upon completion of the merger, and said that it will centralize its mortgage operations in Countrywide’s Calabasas-based headquarters.

The plan includes a commitment to workout $40 billion in troubled mortgage loans over the next two years, keeping at least 265,000 borrowers out of foreclosure, as well as a doubling of the bank’s commitment to community development lending, according to a press statement released Monday morning. Monday’s announcement comes on the heels of last week’s announcement that the bank would be pulling back on key lending programs once the merger is complete, in an effort to focus on high-quality mortgage originations.

“We believe the financial strength, security and stability of the combined company will allow us to enable people to buy homes and stay in homes, and to assist many of those affected by the current mortgage troubles,” said the bank’s top global consumer and small business banking exec Liam McGee during testimony.

Monday’s testimony also featured remarks from Rep. Maxine Waters (D-CA), as well as representatives from prominent community groups and public offices, including the office of the California Attorney General. The California Reinvestment Coalition sponsored testimony from witnesses with troubled mortgages who have said that the Calabasas-based lender hasn’t done enough to help them, and scheduled a demonstration outside of the Los Angeles Fed branch for after the hearing as well.

Critics have said that BofA needs to make a strong commitment to working with troubled borrowers and minority communities in the wake of the proposed acquisition, which would ostensibly create the nation’s largest mortgage banking operation.

“We will continue to work with distressed borrowers to match the customer’s repayment ability with the appropriate loss mitigation option, including loan modifications, forbearances, repayment plans, lower rates and principal reductions,” McGee said. “We will not assess new late charges for customers in foreclosure and we will waive certain other associated fees, when permitted.”

McGee said that Bank of America would invest $1.5 trillion in community reinvestment funds over the next ten years, an amount equal to double BofA’s previous community development goal. The bank also said it will invest an additional $2 billion over 10 years in housing-related philanthropy.

“This new goal raises the bar and is certain to enhance quality of life for millions of Americans in need,” McGee said.

Interestingly, Bank of America also touted a commitment to tenants of former owners in a foreclosure — saying that it had instituted a national policy of allowing tenants to remain in a subject property for up to 60 days after the completion of a foreclosure sale. BofA also runs an aggressive cash-for-keys program in which tenants vacating within 30 days post-foreclosure will receive $2,000 to help defray the cost of relocation.

Legal sources told HW that the plan was relatively aggressive, and a good response to increasing policital pressure tied to lease holders caught in a foreclosure.

For more information, visit

Servicers Increase Focus on Modifications; Foreclosures Jump 35 Percent in First Quarter

(Housing Wire) Almost 503,000 prime and subprime homeowners were able to stay in their homes during the first quarter of 2008 because of loan workouts provided by mortgage servicers, according to a report released Monday morning by the HOPE NOW coalition.

Of 502,500 total loan workouts booked in the first quarter of 2008, the group said that approximately 323,000 were repayment plans and 179,500 were loan modifications; loan modifications represented roughly 44 percent of all subprime workouts, double the rate recorded in 2007, but were just 23 percent of prime workouts.

“I guess it’s almost better to be a troubled subprime borrower these days,” said one source, who suggested that political pressure to help subprime borrowers has not extended to prime borrowers. “There’s an easy reference point for someone categorized as subprime, whether right or wrong, which means that more effort and focus has gone into programs to help this group of borrowers,” she said.

The difference in workouts offered to prime and subprime borrowers is likely not due to a plan announced in December by the American Securitization Forum that would fast-track solutions for subprime ARM borrowers who could afford their starter rate, but could not afford the reset rate — resets have since become a minimal problem for borrowers, as rates have dipped significantly, essentially eliminating payment shock as a key problem for every class of borrower.

That sentiment is borne out in the data, as well. There were 431,171 subprime 2/28 and 3/27 loans scheduled to reset during the first quarter of 2008, according to HOPE NOW’s data; 14,418 were modified, while 203,000 of these loans — that’s 47 percent of scheduled resets — were paid in full via refinancing or a sale. Many of those prepayments might have been defaults in a different rate environment, industry experts that spoke with HW suggested.

A self-inflicted foreclosure surge?
While total workouts increased roughly 6 percent quarter over quarter — and servicers clearly have focused on more permanent loan modification activity — the increase was not nearly enough to keep pace with a 35 percent quarterly jump in foreclosure activity. The industry recorded a ratio of 2.4 workouts per foreclosure during the first quarter, below the 3.1:1 ratio recorded in Q4 and the 2.9:1 ratio recorded in Q3.

Some sources have suggested that an over-reliance on repayment plans earlier in the current cycle is now coming back to bite servicers and, potentially, investors. Borrowers that might have defaulted in Q3 or Q4 are finally seeing what was essentially an inevitable foreclosure take place in early 2008 instead.

“The pressure on many servicers is just enormous,” said one source, an MBS analyst who asked not to be named. “I’m sure the consumer side will latch onto these numbers as proof that servicers aren’t doing enough, when the real question ought to be: what percentage of these foreclosures were actually preventable, and were they prevented?”

“Mortgage servicers continue to focus on doing everything possible to help troubled homeowners avoid foreclosure,” said Faith Schwartz, executive director of HOPE NOW. “While there is still more work to be done, concrete progress is being made, and HOPE NOW members will continue their efforts and work to help as many borrowers as possible.”

For more information, visit

While You Weren’t Looking: FHA-Insured Jumbos on the Move

(Housing Wire) While the financial press — including HW — and others in the industry have been focused on the new market for so-called conforming jumbos at Fannie Mae and Freddie Mac, none other than Ginnie Mae went ahead and published their first “FHA jumbo” pools on April 15. Industry insiders say that the FHA loans have been moving, while activity on higher-limit jumbos at either GSE has yet to register on anyone’s radar screen.

Under the Economic Stimulus Act of 2008, The Federal Housing Administration received a huge shot in the arm when it saw its lending limits boosted, along with those of Fannie Mae and Freddie Mac. All three are temporarily authorized to purchase mortgages up to $729,500 in certain high cost areas — and while activity thus far has been slow, FHA jumbos have clearly been the first to market as borrowers have flocked to the revitalized government-sponsored lending program.

Ginnie published its guidelines and multi-issuer pool types for the higher balance loans on March 6. The first pools under the new lending limits included three jumbo conforming 30-year fixed rate pools with an issue date of April 1 (pool prefix is JM, for jumbo), led by a $10.9 million issue offering a 5.5 percent coupon; according to eMBS, a provider of mortgage data and analytics, the pool’s collateral is 43 percent in California with average original loan (AOL) amount of $436,907.

Other pools include $3.4 million of a 6 percent coupon, 45 percent in New Jersey; and $2.8 million of a 6.5 percent coupon, 30 percent in Washington, DC.

Small activity compared to the dollar volume other issues, to be sure, but also proof that the market for jumbo conforming loans is beginning to finally move forward.

The FHA was — prior to the emergence of private-party subprime — the traditional vehicle for subprime lending and first-time homebuyers, established during the Depression era to help stabilize a faltering housing market. As the current housing crisis has rolled on, Bush administration officials and Congressional leaders alike have looked to revitalize the program.

That revitalization effort has paid dividends, and quickly. Ginnie Mae said last week that MBS issuance increased to nearly $15 billion during March — it’s highest issuance rate since November of 2003. For the first quarter, issuance totaled $39.1 billion, more than doubling year-ago volume.

“Ginnie Mae has seen a steady increase in our issuance since October of last year,” said Theodore B. Foster, senior vice president for MBS at Ginnie Mae. “As the mortgage credit market tightened, and the subprime mortgage market and the private label MBS market collapsed, investors began moving toward the safety and stability of Ginnie Mae MBS, just as borrowers began moving back to the security of government loans — particularly Federal Housing Administration loans.”

Ginnie Mae also securitizes loans from the Veteran’s Administration — one government program that, oddly enough, was left out of the Economic Stimulus bill. Congressional legislators have proposed an amendment that would see VA lending limits raised to match those of Fannie, Freddie and Ginnie.

Real estate lenders fight tough rules

(Naked Capitalism) The New York Times, in "Loan Industry Fighting Rules on Mortgages," tells us that the real estate creditors are fighting tooth and nail to gut new rules that the Fed intends to impose.

The Times, apparently reflecting the sentiment of sources in the Fed, Capitol Hill, and consumer advocates, seems surprised at the vehemence of the effort.

What did they expect?

This is an industry that has been minimally regulated for at least the last dozen years, which given high turnover in many banks, is almost a lifetime. Anyone who remembers life in the bad old days is by definition a dinosaur.

But what amazes me is not the reaction of the industry, which was predictable, or the litany of arguments against new rules. Some of my favorites:
“We have heard from commenters who have expressed concern that in the current market environment, the proposed trigger could cover the market too broadly, and we will carefully consider the issues they raise and other possible approaches to achieve our objective,” Mr. Kroszner said last month at a conference of the National Association of Hispanic Real Estate Professionals.

Please. By definition, there is never a good time to implement new rules, at least according to those who will have to live with them. Either the industry is suffering, so it's not the time to inflict more pain, or it's doing well, and therefore the rules are obviously misguided and unnecessary. The intent IS to cover the market broadly; anything else leaves the barn gate open for the horse to leave again.
The new rules would apply extra protection to any mortgage with an interest rate three percentage points above Treasury rates. Officials said that they would cover all subprime loans, which accounted for about a quarter of all mortgages last year as well as many exotic mortgages known in the industry as “Alt-A” loans.

These loans are made to people with relatively good credit scores but who might provide little documentation of their income or assets, or who make smaller than usual down payments or purchase loans that have unusual terms, like interest-only payments for an initial period.

Many mortgage brokers and bankers complain that the lower threshold would unnecessarily include many borrowers who are not at risk from abusive practices.

Oh, no, those borrowers are merely at risk of becoming deadbeats, which means society as a whole has to eat the risk due to costly rescue operations that involve hidden or explicit taxpayer subsidies. Alt-As are showing high default rates; to maintain that no docs are a good practice that should continue boggles the mind.
One common industry criticism is that at a time of tight credit, tighter rules could make many mortgages more expensive by creating more paperwork and potentially exposing lenders to more lawsuits.

Um, expensive new paperwork? Much of this is a requirement to do the sort of documentation and analysis banks did once upon a time, when it was understood that lending was a risky business. And the protests confirm that the industry want the right to make risky loans (note the lawsuits point is valid, and by design: Sheila Bair believes the current standards are skewed too far in favor of lenders. So greater risk of being sued is a feature, not a bug.

But what is most surprising about the piece is the spin the Times puts on it, It voices surprise at the vehemence of the response (the only thing that is surprising is how shameless and self-serving it is), when what is really stunning is how fast the powers that be are making concessions. Is this a symptom of how we really do have the best government money can buy, or of how deeply anti-regulatory sentiment has been internalized?

From the New York Times:
The mortgage industry, facing the prospect of tougher regulations for its central role in the housing crisis, has begun an intensive campaign to fight back.

As the Federal Reserve completes work on rules to root out abuses by lenders, its plan has run into a buzz saw of criticism from bankers, mortgage brokers and other parts of the housing industry. One common industry criticism is that at a time of tight credit, tighter rules could make many mortgages more expensive by creating more paperwork and potentially exposing lenders to more lawsuits.

To the chagrin of consumer groups that have complained that the proposed rules are not strong enough, the industry’s criticism has already prompted the Fed to consider narrowing the scope of the plan so it applies to fewer loans.

The debate over new mortgage standards comes in response to a severe crisis in the housing and financial markets that many economists trace back to overly loose credit and abusive loans. Those practices, combined with low interest rates, led to inflated market values that have declined rapidly in recent months as investors have begun to lose confidence in the financial instruments tied to those loans.

Four months ago, the Fed proposed the new standards on exotic mortgages and high-cost loans for people with weak credit. The Fed’s proposals came after it was criticized sharply as a captive of the mortgage lending industry that had failed over many years to supervise it adequately.

Proposals are pending in Congress on mortgage standards, but it is not clear whether they will be adopted this year. The Fed has its own authority under housing and lending laws to adopt mortgage standards.

The plan presented by the Fed was proposed by its chairman, Ben S. Bernanke, and Randall S. Kroszner, a former White House economist in the Bush administration who is now a Fed governor and leads the Fed’s consumer and community affairs committee.

The plan would not cover existing mortgages but would apply only to new ones. It would force mortgage companies to show that customers can realistically afford their mortgages. It would require lenders to disclose the hidden fees often rolled into interest payments. And it would prohibit certain types of advertising considered misleading.

The Fed is expected to issue final rules this summer.

Earlier this month, as the comment period was about to close, the Fed was deluged with more than 5,000 comments, mostly from lenders who said the proposals could affect loans that have not presented problems. Some bankers and brokers also said the rules would discourage them from lending to some creditworthy borrowers.

The plan was criticized in separate filings by three of the industry’s most influential trade groups — the American Bankers Association, the Mortgage Bankers Association and the Independent Community Bankers of America. More modest concerns about some of the provisions were also raised by the National Association of Home Builders and the National Association of Realtors.

Regulators have been meeting about the proposals with bankers, brokers and consumer groups in recent weeks and are continuing to do so.

Some of the groups seeking changes maintain that the proposals threaten to make borrowing for a home far more expensive and would unfairly deny mortgage brokers the right to earn certain fees.

Small community banks, which have played no significant role in the housing crisis, have urged the Fed to limit the scope of the proposed rules so that they do not discourage them from issuing loans. Lending groups have also raised concern that they would lead to frivolous and expensive litigation.

“We support many of the provisions in the proposed rule, but we do have concerns about the increased regulatory burden, liability and reputational risks that lenders might face,” said Kieran P. Quinn, chairman of Column Financial, Credit Suisse’s mortgage lending subsidiary in Atlanta, and the chairman of the Mortgage Bankers Association.

On at least one major aspect of the proposed restrictions — how broadly they should apply — the industry appears to be making headway. In a recent speech, Mr. Kroszner suggested that in response to criticism that the plan was including too many kinds of loans the Fed was considering whether to narrow the plan.

“We have heard from commenters who have expressed concern that in the current market environment, the proposed trigger could cover the market too broadly, and we will carefully consider the issues they raise and other possible approaches to achieve our objective,” Mr. Kroszner said last month at a conference of the National Association of Hispanic Real Estate Professionals.

Before this year, the Fed had applied an extra set of protection from abusive lending practices to a subset of subprime borrowers under the Home Ownership Equity Protection Act of 1994. The Fed has applied the law to fewer than 1 percent of all mortgages — those with interest rates at least eight percentage points above prevailing rates on Treasury securities.

Some economists and housing experts say the Fed’s lax oversight helped enable lending companies to reap enormous profits by providing millions of unsuitable and abusive loans to homeowners who often did not fully understand the terms or appreciate their risk.

As of January, the most recent month of available data, about a quarter of all subprime adjustable mortgages were delinquent, twice the level of the same period last year. Lenders began foreclosure proceedings on about 190,000 of these mortgages in the last three months of 2007.

The new rules would apply extra protection to any mortgage with an interest rate three percentage points above Treasury rates. Officials said that they would cover all subprime loans, which accounted for about a quarter of all mortgages last year as well as many exotic mortgages known in the industry as “Alt-A” loans.

These loans are made to people with relatively good credit scores but who might provide little documentation of their income or assets, or who make smaller than usual down payments or purchase loans that have unusual terms, like interest-only payments for an initial period.

Many mortgage brokers and bankers complain that the lower threshold would unnecessarily include many borrowers who are not at risk from abusive practices.

“There are a lot of community banks that have shied away from these loans because nobody wants to be a higher-priced lender,” said Karen Thomas, a lobbyist for the Independent Community Bankers. “With the trigger being set so low, it is encroaching on traditional, common sense mortgages. Our fear is it will result in less credit availability, which is not what we need in an already tight credit market.”

But consumer groups say that the proposed rules are already weak and that efforts to further weaken them would render them all but useless.

“The Fed has accurately diagnosed that this is a brain tumor and responded by prescribing an aspirin,” said Kathleen E. Keest, a former state regulator who is now a senior policy counsel at the Center for Responsible Lending, a group supporting home ownership. “In the industry, there is a fair amount of denial. They just don’t get it. There is a calamity within the industry, and they don’t have a new script yet, so they rely on the old script, which is that regulation will raise costs.”

But, she went on, “What we now see is that the unintended consequences of deregulation are worse. Their line is that regulation will cut back access to credit. That’s been their line ever since the small loan laws were adopted in the early 1900s.”

At the same time, letters urging the Fed to further tighten the rules were sent by Sheila C. Bair, the Republican head of the Federal Deposit Insurance Corporation, as well as senior members of the House Financial Services Committee.

In her letter, Ms. Bair, whose agency regulates many banks, urged the Fed to apply the proposed restrictions to loans that are three percentage points or higher than equivalent Treasuries. To prevent lenders from evading the limit by creatively structuring the loan and fees, she also suggested that the Fed impose the tighter restrictions if the loan fees exceeded a dollar amount.

While the Fed plan would require disclosures that could make it harder for lenders to include hidden sales fees that are usually paid to the mortgage broker, Ms. Bair suggested that the plan go further and ban some practices.

The plan, for instance, would require subprime lenders to explicitly describe fees that are now hidden. But Ms. Bair has proposed the elimination of such fees, saying such a ban would “eliminate compensation based on increasing the cost of credit and make the amount of the compensation more transparent to consumers.”

Ms. Bair also proposed making it easier for borrowers to sue lenders without having to show that they were engaged in a pattern of abusive practices, which is a requirement under the proposed Fed rules. She said that forcing borrowers to show a pattern of abuse “clearly favors lenders by limiting the number of individual consumer lawsuits and the ability of regulators to pursue individual violations.”

Ms. Bair also recommended that the Fed eliminate a so-called safe harbor provision in the proposal that protects lenders who fail to verify the income or assets of a borrower in some circumstances.

Did Hedge Funds Help Stabilize the Mortgage Market?

(Felix Salmon) Brad DeLong approvingly quotes a correspondent:

The fact that there was an ABX index and thus an easy way for people to bet that the mortage-backed securities market would crash probably cut short the bubble--the true hedge funds were stabilizing speculators; the destabilizing speculators were (i) the funds that were long CDOs and (ii) the banks and other issuers who retained the CDOs because their portfolio managers believed their marketeers. A world without derivatives but with mortgage-backed securities would probably be a world in which we have a bigger problem than we have now.

I've heard this argument made before, by Sebastian Mallaby; I didn't buy it then, and I don't buy it now.

It's easy to be awed by the sums of money made by John Paulson and the Goldman Sachs mortgage desk. But compared to the amount of money tied up in RMBS, the profits made by shorting mortgage-backed securities have been tiny. For Paulson to have played a significant role in stopping the mortgage-backed credit bubble from continuing to exapand, he would have had to have been orders of magnitude larger than he was.

But more to the point, the ABX index is an index of CDS spreads referencing subprime RMBS. The chain of arbitrage which would lead from shorting the ABX to RMBS prices falling is long and convoluted: first any drop in the ABX would have to be arbitraged by buying the ABX whilst selling buying protection on the underlying CDS contracts. Then any widening in those underlying CDS contracts would have to be arbitraged by selling protection on the RMBS while at the same time shorting the underlying bonds. (Good luck trying to do that. And of course this isn't a risk-free arbitrage, since CDS and bonds have been behaving in idiosyncratic and dissimilar manners of late.) Then any drop in the price of the specific RMBS which underlie the CDS which underlie the ABX would have to be arbitraged by buying up those bonds while selling the broad mass of other RMBS, creating generalized downward pressure on the secondary-market prices of subprime RMBS. Then a drop in secondary-market RMBS prices would have to be arbitraged by investors buying up secondary-market securities rather than the primary-market securities being offered to them by the investment banks structuring the RMBS deals, and this would have to be a common enough occurrence that the yields on primary-market RMBS deals would rise as a consequence. Finally - as if all that wasn't improbable enough - the higher yields on these RMBS deals would have to somehow feed through into fewer of those deals being done, and less demand from investment banks for securitizable mortgages.

I'm quite sure that's not what happened in reality. Yes, the people who shorted the ABX made a lot of money, but they made money because the RMBS market imploded for reasons utterly unrelated to - and not even precipitated by - the fact that a few hedge funds and prop desks were shorting the ABX. In other words, a world without derivatives but with mortgage-backed securities would probably be a world in which the RMBS market would still lie in tatters, and the only real difference is that John Paulson would be a great deal less wealthy than he is now.

Sunday, April 27, 2008

A Novel Methodology for Credit Portfolio Analysis: Numerical approximation approach

by Yasushi Takano and Jiro Hashiba of Mizuho-DL Financial Technology

Abstract: This paper proposes a novel numerical methodology for quantifying credit portfolio risk, based on the multi-factor Merton model. This methodology consists of two steps. The first step is a numerical algorithm for computing moment generating function very quickly. The second one is a fast Laplace inversion algorithm first introduced by de Hoog et al. The moment generating function computed in the first step is transformed into a loss distribution function through the second step. It is demonstrated that the risk measures such as VaR and CVaR obtained by this methodology are sufficiently accurate, for a wide range of portfolios. Furthermore, computation time depends on portfolio size quite moderately in this methodology. In fact, by using an ordinary personal computer, we can compute the credit risk of a portfolio with 1 million obligors only in a few minutes. We also present a fast algorithm for computing the risk contributions of obligors to VaR and CVaR.

Download paper (3,043K PDF) 60 pages

Saturday, April 26, 2008

Barriers to Reducing Needless Foreclosures

(Jack Guttentag in the Washington Post) Needless foreclosures are happening all around us.

Note that I am using a coldblooded business definition of "needless foreclosure," not a bleeding-heart one. Under my definition, if it costs the holder of the loan more to foreclose on a mortgage than to make it viable, it is a needless foreclosure. I am not counting the human toll exacted by foreclosures, which can be very high.

For example, it can cost the investor who held the mortgage about $40,000 to foreclose on a home. It might have cost only $25,000 to make the mortgage affordable to the borrower through a reduction in the interest rate. Modifying the loan contract in this way would have kept the person in his home and saved the investor money.

Mortgage contracts are modified, at some cost to the investor, to prevent the larger cost of a foreclosure. Loan modifications include adding the unpaid interest to the loan balance, called "interest capitalization," and calculating a new payment. To make the payment more affordable, the term may be lengthened or the interest rate reduced. In cases where the property is worth less than the loan balance, the balance may be reduced.

The problem is that there are major impediments to loan modifications, including:

· Borrower denial. Developing a new loan contract that a distressed borrower can live with requires the full participation of the borrower. But many borrowers in trouble don't contact their servicers and may not respond when contacted.

· Moral hazard. Investors are concerned that if modifications are offered too easily or too early, some borrowers will pretend to need one even though they really don't. This is a major reason investors restrict the discretion of servicers to modify contracts.

· Restrictions on servicers. Third-party servicing in which the firm servicing the loan does not own it is more often the rule than the exception. In the case of loans that have been packaged and sold to investors, it is always the case.

Investors restrict the discretion of servicers to modify loan contracts because their interests are different. Investors want modification only if the alternative is a more costly liquidation or foreclosure. They want to avoid early modifications that would prove unnecessary, and they want to avoid encouraging borrowers to default who might not otherwise. Servicers, in contrast, want to protect their servicing fees, which they receive only from loans in good standing. Their general preference, therefore, is for early intervention.

A common contractual restriction on servicers is that modifications are permitted only for loans in default or for which default is imminent or reasonably foreseeable. Another is that any modification must be in the best interest of the investor. These create potential legal liability for the servicer. To be safe, some servicers limit modifications to loans already in default, which means 90 days delinquent or more.

· Scarcity of staff. Most interactions between mortgage borrowers and servicers are handled by computers and relatively unskilled employees. Borrowers in serious trouble are referred to a smaller number of more skilled and specialized employees. With the onset of the mortgage crisis, servicers were caught short of this critical but costly resource. While they now claim to have expanded their staffs to handle the workflow, a financial disincentive to staff adequately remains.

· Mortgage insurance. On mortgages carrying mortgage insurance that go to foreclosure, investors are protected up to the maximum coverage of the policy, which is usually enough to cover all or most of the loss. This discourages modifications. Why do a modification for $15,000 if the $40,000 cost to foreclose is going to be paid by the mortgage insurer? Even if the insurance coverage falls short of the foreclosure cost, the shortfall has to exceed the modification cost before modification becomes more attractive financially.

· Second mortgages. Many of the borrowers in trouble have two mortgages with different lenders, which complicates matters. The servicer looking to modify the first mortgage must make sure that the borrower can afford both mortgages and that the second mortgage lender does not upset the apple cart by foreclosing. My mail from borrowers in trouble suggests that some servicers are prepared to work with second-mortgage lenders, and some are not.

· Lack of public disclosure. Nothing in connection with modifications is publicly disclosed except what servicers wish to disclose, which invariably is whatever presents them in a favorable light. There is no way for the public to know who is doing a good job and who isn't.

Because of these impediments, modifications are making only a modest dent in the foreclosure problem. Other remedies will be discussed in a future article.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Friday, April 25, 2008

CDO Loss Term-structure Expansions in a Fatal-Shock Framework

by Laurent Veilex of Credit-Suisse

Abstract: We present a numerical expansion of the forward loss of CDO tranches in the case of fatal-Shock models (also called Marshall- Olkin). The method is very fast and can be compared with Saddle point and Recursion methods for factor copulas. The benefit of the framework is to allow a term structure of spreads and correlation with a natural understanding of the correlation structure.

Download paper (1,067K PDF) 28 pages

Banking reform must begin in boardroom

Paul Myners in the FT) Citigroup made an astonishing announcement this month: it wanted to hire directors who actually knew something about banking. “Citi seeks finance-savvy directors,” ran the headline in one business newspaper. It went on to detail how the institution, having written down more than $20bn (£10bn) since last summer, was after board members with “a particular emphasis on expertise in finance and investments”.

So it took the departure of its chief executive, a historic crisis and massive losses to impress upon the world’s biggest bank that its board could do with a touch more financial knowhow. It would certainly make a change: Citi’s top crust is more likely to come from industry than from Wall Street and only two of the outside directors have any background in financial services.

One of the credit crunch’s recurrent motifs is that of bank directors who lack the expertise or rigour to govern their banks. This week, the chairman of the Royal Bank of Scotland felt obliged to reject suggestions that his non-executive directors were “patsies”, while a UBS report into its own subprime losses suggested the boardroom was largely in the dark about the huge risks being run by staff. Britain’s biggest credit-crunch casualty, Northern Rock, had as its chairman an author of popular science books.

Proposals to overhaul the banking system have largely ignored the governance of our banks. But if other reforms are to have any traction, it is essential to shake up the boardrooms that oversee the rest of the operation.

First, board members should never forget that the most vital part of their job is to challenge executives. My rule of thumb is swiped from Voltaire: judge a person by his or her questions. Are board members asking the right questions and with enough persistence? Simple in theory, but not easy to do in environments where anything more than the occasional mundane query is regarded as bad form. I have had meetings in the boardrooms of nearly all our big banks. Some are stuffy and some are modern, but none of them feels like a room made for serious discussion, decision-making or curiosity about the source of profits and profitability or the location and scale of risk.

The typical bank board resembles a retirement home for the great and the good: there are retired titans of industry, ousted politicians and the occasional member of the voluntary sector. If such a selection – more likely to be found in Debrett’s Peerage than the City pages – was ever good enough, it is not now. The business of banking is exponentially more complicated than a generation ago, and the panel guiding it must be able to follow its dealings. At the very least the chairman and senior independent director or chairman of the risk committee should have recent and relevant banking experience. Most do not. Few non-executives have the skill or appetite to challenge the thinking behind risk budgeting; to identify weaknesses in risk measurement techniques or the spurious accuracy implied; to reach their own view on asset and liability valuations or reach a view on capitalisation independent from the minimum levels required by regulators and suppliers of credit.

Bankers’ pay is an area where independent directors on remuneration committees can have a big influence. It is their job to ensure that compensation aligns with the interests of shareholders. Yet given the explosion in financiers’ bonuses it is doubtful whether banks’ independent directors were sufficiently challenging about incentive effects or sensitive to the culture they were promoting. Since excessive pay often drives goofy corporate strategy, and vice versa, such a relaxed attitude has been doubly harmful.

Finally, all the talk about increased powers for regulators should take into account who those officials deal with. Regulators will typically bring concerns about risk to executives. It would be far more effective if they were also to engage with outside directors. The warnings about underpriced and undermeasured risk, particularly from the Bank of England, did not get through to the non-executive directors who had the obligation and power to challenge reckless pro-cyclical policies.

Unless there is a change in the way banks are governed, the excesses that led to the credit crunch stand to be repeated. It is not surprising that the Bank’s governor said this week’s bail-out was “not to protect the banks but to protect the public from banks”. Bank boards and their non-executives in particular, who played the main role in allowing this crisis to happen, are going to have to raise their game.

Thursday, April 24, 2008

House Panel Approves Two Housing Bills; FHA Reform on the Floor

(Housing Wire) A House panel Wednesday approved two foreclosure-specific housing proposals, including one that would see $15 billion in federally-funded loans and grants given to local governments to purchase and rehab foreclosed properties, as part of a broader package of housing reform measures being pushed by House Democrats.

The House Financial Services Committee voted 38-26 in favor of H.R. 5818, the Neighborhood Stabilization Act of 2008, which would established a loan and grant program administered by the Department of Housing and Urban Development that would fund the purchase of foreclosed properties by local governments.

Funds would be distributed to areas with the highest foreclosure levels, and would be used to turn foreclosed properties into housing for low-income families.

The bill does not have the strong support of House Republicans, including Rep. Spencer Bachus (R-AL), who has said he thinks the bill incentives foreclosures and rewards lenders, investors and speculators in possession of the vacant and foreclosed property. Committee Chairman Barney Frank (D-MA), who strongly pushed for the bill’s passage, has said that he believes the bill contains protections that will prevent its abuse.

Earlier Wednesday, the House panel also passed H.R. 5579, the Emergency Loan Modification Act, without a vote. The proposed bill would seek to shield mortgage servicers from legal liability arising out of bulk loan modifications that may violate existing Pooling and Servicing Agreements, and is strongly opposed by many industry groups.

Congressmen Michael N. Castle (R-DE) and Paul E. Kanjorski (D-PA) originally introduced the bill in mid-March.

“I think it’s in the best interests of at-risk homeowners and investors to work out payment terms that give a homeowner financial stability and the investor some return for their investment,” said Castle. “Without this legislation, I am concerned that lawsuits could bring modifications to a halt.”

FHA reform work begins
The House Financial Services Committee begins work today on FHA reform via the H.R. 5830, FHA Housing Stabilization and Homeowner Retention Act. The bill would allow the Federal Housing Administration to back as much as $300 billion in refinanced loans for homeowners who are facing foreclosure, a move that its supporters say would help troubled borrowers stave off foreclosure.

Early debate from House panel members on Thursday morning focused on counseling requirements, with local lawmakers suggesting that more Federal funds would need to be appropriated for troubled borrower counseling — some House representatives even argued that new Federal funds were needed to fund consumer attorneys who would defend homeowners against foreclosure and eviction actions.

“These people are at the mercy of the lender and servicers in this case,” said Rep. Melvin Watt (D-NC). “They don’t have the legal background that the lenders have needed to defend themselves.”

Watt said consumer counseling doesn’t help borrowers completely, and that he wanted funds appropriated from the Neighborhood Reinvestment Corp. to fund the defense of foreclosure and eviction actions.

Frank voiced supported the proposed amendment as well, in a heated exchange between Housing Republicans and Democrats that set off what is expected to be over a weeks’ worth of discussions covering FHA reform.

“Some legal work is necessary,” Frank said. “The emphasis here is on legal work, not advocacy work.”