The financial and real estate markets are fighting on the playground. Obama tries to enforce playground etiquette but with only small successes. A stream of new government incentives and "fixes" flood the news with Obama's efforts to stem the foreclosure tide and rescue distressed borrowers.
The refinancing of distressed loans held by Fannie Mae and Freddie Mac under the Making Homes Affordable program is an excellent move in as far as it goes. It is particularly excellent on an individual basis. But while the market continues to decline, those underwater borrowers will continue to sink, eventually many arriving back at the day of reckoning.
Some say the government programs just haven’t had enough time to make a difference. Try as they may, the government's foreclosure avoidance efforts will be negligible, but it won't be for lack of effort. We have not yet hit a bottom in foreclosures and the Making Home Affordable program, gallant as the premise is, will not make an appreciable difference in a housing market recovery. In fairness to Obama, et al., they have stated their purpose is to keep people in their houses. They haven't oversold the mission, just overstated the numbers.
Obama is begging banks to do short sales ahead of foreclosures. Or to take a deed-in-lieu-of foreclosure, which makes little sense to lenders in most cases. The numbers will prove so negligible as to have no recognizable impact on the housing market. Short sales would prove less costly to the bank than moving through the foreclosure process, but the time involved as well as the degree of difficulty make it only marginally successful. Loan modifications requiring more than minimal principal reductions is like Sisyphus rolling the bolder uphill for eternity.
Short sales and deed-in-lieu-of-foreclosure are both messy and can leave problems embedded in the property. On the other hand a foreclosure wipes the slate clean with no overhanging hidden liabilities. And foreclosures are generally better deals for the buyer drawing attention away from the short sale process.
The complicated nature of securitization not only makes short sales maddening and time consuming it also makes negotiating a real estate sale that results in a loss nearly impossible.Everyone involved in the credit houses are stressed beyond measure making even easy tasks difficult. The financial system simply can't handle a collapse of the magnitude of what they have been hit with. Based on current foreclosure rates, the U.S. could see foreclosures top 3 million units for 2009.
The problem with wholesale loan modifications, short sales or buying up toxic assets, continues to land at the feet of a less than sinister financial tool - securitization. But what Wall Street did with securitization is sinister and scary and the complexities of the web they weaved, virtually impossible to unravel. Like any good mystery, the story starts out simply on a sunny day. But the tension quickly builds as the plot is driven towards its cliff-hanging climax.
Until relatively recently, mortgage originations and the issuance of mortgage-backed securities was dominated by loans to prime borrowers underwritten by the old conforming standards set by the GSEs, Fannie Mae and Freddie Mac. This was that sunny day when the story begins with good solid investments.
Then a savvy group of financial “Masters of the Universe” strolled across Wall Street with a whole new securitization plan that promised to rock the world with profits beyond the imagination. And rock it did – the world that is.
First a very elemental discussion on securitization ... Mortgage-backed securities (MBS) are a group of loans lumped together as one instrument, or bond, and sold to investors. The initial sale of the MBS is put together either by a GSE, Fannie Mae, Freddie Mac or Ginny Mae (for FHA and VA loans), or by private financial institutions such as Countrywide, Lehman Brothers, or Wells Fargo (all among the top six private issuers in 2006). They allow lenders to sell the mortgages they make, thus replenishing their coffers and allowing them to lend again. For their part, buyers of mortgage-backed securities take comfort in the knowledge that the value of the MBS package doesn't just rest on the creditworthiness of one borrower, but on the collective creditworthiness of a group of borrowers.
This chart offers a visual explanation. We’ll get to CDOs in a minute.
The increasingly lucrative MBS market drove a larger share of home mortgages to be securitized. In 2006 private firms made up 56% of securitized investors. The basic pass-through nature of most MBSs is the same: the borrower pays his mortgage payment to the servicer which is then paid to the investor. Payments are made on the underlying mortgages as you would expect. The profit is the spread on interest.
A typical issue of MBSs however, is much more complicated, in part because of the intricate allocations of the risks of the underlying mortgages to investors. There are three major risks to MBS investors: interest rate, prepayment and default, each representing breach or change in the income stream and negatively affecting the return for the investors.
The chart below represents a sample structure for a MBS. A MBS can include multiple classes of bonds that differ in the order in which they are repaid (these classes are typically referred to as “tranches”). For example, all principal payments could be allocated to the A bonds until those are completely repaid. Then, principal payments would start being allocated to the B bonds.
Pools of MBSs are sometimes collected and securitized. Bonds that are backed by pools of MBSs set up on the principal of the tranch are referred to as collateralized debt obligations (CDO). Each tranch has a different maturity and risk associated with it. The higher the risk, the more the CDO pays. CDOs can also include various types of assets. The issuers of CDOs were the major buyers of the low-rated classes of subprime MBSs in 2006.
When Paulson came up with his scheme last fall to resolve the credit crisis by buying toxic assets with TARP funds, it seemed like a brilliant plan. But Paulson’s plan was stopped dead in its tracks by the same insurmountable obstacle that is stymieing the foreclosure prevention programs and short sales – securitization.
The following video will further explain the world of CDOs and offer the key to the untenable Paulson plan to buy toxic assets and why Geithner's Public-Private partnership to do the same never gained much anticipatory steam - interest anticipated just never materialized. But Geithner will be ready within six weeks with his final plan. We'll see what interest he can garner.
The next layer that makes the securitization process even more complicated are credit default swaps (CDS). CDSs are insurance contracts that Wall Street created in the early 1990s. They allow holders of CDOs to protect themselves against losses if a debt issuer defaults. The credit-default swaps were wildly profitable until defaults started rising. Many argue that the credit markets are dysfunctional today because of credit-default swaps.
I have two more very worthwhile videos that explain credit default swaps perfectly. It will take a few minutes but is well worth the time investment to watch both. On the other side you will understand the difficulty of modifying mortgage principal and completing short sales. But most important you will understand the rudiments of the house of cards that collapsed last fall. And you will have the ability to impress friends with your knowledge at your next dinner party. It’s really fascinating stuff.
From my friends at KhanAcademy.org:
Credit Default Swaps I - The $30 trillion elephant in the room.
Credit Default Swaps II
Congress has had as much success untangling this mess as real estate agents.From a recent Huffington Post article:
"We've been trying to figure out probably for close to two years now why so few mortgages are being modified when it seems to make absolute business sense for the person holding the mortgage to modify rather than foreclose or to take a smaller loss selling it rather than a bigger loss foreclosing on it," said Rep. Brad Miller (D-N.C.).Now you start to see the complicated path of a single mortgage securitized in this fashion. By no means are all mortgages securitized in this way but the prevalence of the practice almost brought a world economy down. The bonds were sold all over the world to hedge funds and entities as weird as the Abu Dhabi Camel Drivers' Pension Fund.
Miller points his finger at securitization. Once the mortgages are bundled and sliced up into different pieces, known as tranches, the owners of the pieces get paid back according to a certain pecking order. Senior investors get paid back first and if there's a loss, the most junior investors won't get anything. It's those investors who are blocking short sales.
"The people with the least senior tranches have no reason to agree to the modification because they take a complete loss and the people in the most senior tranches don't lose anything. So they've managed to structure their mortgages in a way that makes it almost impossible to modify or sell short," said Miller.
“What people do not understand is that the lender has "insurance" on most of these loans, the credit-default swaps that you hear about but do not understand, or other types of insurance that pay them in the event of default. However, to file an insurance claim, the lender MUST foreclose and take back the home.” explained Patrick Pulatie, forensic loan auditor and consumer advocate working in California.
How do you extract one particular loan from this complicated morass of debt and get permission from an uncooperative investor who has little to gain from a release and reduction of principal? Huffington Post reported that according to research firm Campbell Communications, only 23 percent of short sale transactions are actually completed.
Obama’s urgings to short circuit the foreclosure process will fall on deaf investor ears.The lack of responsibility for the originator of the toxic mortgages encourages the seller of the loan to be indifferent to the qualifications of the borrower to repay the loan. As many of the loans were sold, the emphasis in creating a loan was only on the profitability of selling the securities created from the loan. But now the backlash of the irresponsibility in lending has caused the secondary mortgage markets to go up in smoke, freezing the credit markets. With little appetite for these mortgages, the system isn't working properly and money isn't flowing in its usual channels.
With credit worthy borrowers and a steady market, there are few problems. But by 2006 non-conforming loans of $1.480 trillion was more than 45% larger than conforming (agency) originations. The issuance of non-agency MBSs and then CDOs grew to staggering proportions. "It's going to blow!" And it did.
Last Thursday, Treasury Secretary Timothy Geithner and Housing and Urban Development Secretary Shaun Donovan announced new steps to encourage short sales or voluntary transfer of property (deed-in-lieu-of-foreclosure) when a loan modification is not possible. The much-to-do-about-nothing plan is offering incentive payments of up to $1,000 to banks for allowing a short sale if a loan modification is not possible. Big deal! Not worth the time and trouble say the banks.
“The Obama plans may have some impact on the margin but the ultimate solution to this problem is going to be the same as the solution to any other asset bubble. Prices are going to have to reach a clearing level and the excess inventory absorbed over time. The world will begin to properly spin on its axis again but it won’t be due to the intervention of the government,” wrote Tom Lindmark for Seeking Alpha. I regretfully agree.
But Obama can't just sit by and do nothing. That would be political suicide, and he is, if anything, a talented politician.I leave you with a few words on the bust of AIG and an example of the effects of the unraveling of these financial instruments. From Barry Ritholz, The Big Picture:
Of all the corporate bailouts that have taken place over the past year, none has proved more costly or contentious than the rescue of American International Group (AIG). Its reckless bets on subprime mortgages threatened to bring down Wall Street and the world economy last fall until the U.S Treasury and the Federal Reserve stepped in to save it.For the future, the point is to prevent the AIG problem where a big company has sold so many derivatives, with no reserves, to so many financial institutions around the world, that if it collapses the whole global economy might collapse. Regulation is on the table, but I often think had they exercised any degree of responsibility my 3,000 shares of AIG might at least be worth a cup of java.
So far, the huge insurance and financial services conglomerate has been given or promised $180 billion in loans, investments, financial injections and guarantees - a sum greater than the annual cost of the wars in Iraq and Afghanistan.
A last word from Patrick Pulatie describing what loan work-outs are like for the borrower: "The loan modification process is one of the most convoluted processes imaginable. Each lender has its own standards and procedures, ones that change on a daily basis, and from person to person. To make matters worse, you will hang on the phone for hours, never speaking to the same person twice, and when you do talk to a live person, you will have to retell your story again and again. What is never mentioned is that each negotiator for the lender has from 500-700 files that they are working on at the same time. Most of these people NEVER get help, and many end up losing their homes. Of those people who attempt to do it for themselves, perhaps 20% actually succeed."
Securities and Exhange Commission
Wall Street Journal
The Big Picture
Loan Fraud Detective, Patrick Pulatie
New York Times