The Economy

Rate Watch #610 I'll See you $30 Billion and Raise You $200 Billion

March 21, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

IV) Analysis

The Treasury market is volatile which 1) makes forecasting difficult and 2) creates opportunities. I do believe that this is not going to be a case of constantly declining rates but one of a relatively brief window of opportunity. I say this because we are coming to the end of the secular bull market (long-term trend to lower yields) but the facts are that this is an extremely confusing time and there is a disconnect between Treasuries and mortgage rates. Mortgage rates could start getting lower even if Treasury yields rise.

There is still lack of clarity about the pricing and terms of the new jumbo-conforming loans. The biggest news this week was that FHLMC will do cash-out on these (whereas FNMA will not). Preliminary indication from FHLMC is that the requirement on cash-out jumbo-conforming are: LTV <= 75% and middle credit score >= 720. This is available for primary residence SFR & condo. No multifamily.

You can find the new conforming limit for your county here. That page says "FHA" but those amounts also pertain to FNMA & FHLMC.

If you have a loan which is now conforming as long as it is not a cash out or as long as it meets the FHLMC standards above and are interested please e-mail me or fill out a refi form on my web site. Once I get that I will contact you, discuss what you need and in less than 10 minutes I can take your loan application over the phone. What do I need? The most common things which people do not have at hand is their spouse's social security number and their gross monthly income,

The complete application is accessed from the top right nav bar at www.loanmine.com.

V) Things Are Happening

A lot has happened in the past few weeks regarding which I would like to comment.

1) The Bear Stearns thing. This is most interesting. It represents a daring move by the Fed to accomplish its main purpose which is economic stabilization. Bear was deeply into subprime and clearly had assets which were worth a lot less than folks though. The Fed brought in potential buyers and faced with the necessity of opening its books up it is clear that Bear was exposed a lot more than it had implied. One can figure this out from the fact that JP Morgan's offer was 7% of what the Bear stock closed at on Friday March 14.

In a bigger sense what this is about is the fact that Wall Street firms (primary dealers) act like banks in the sense that folks keep a lot of their liquid assets (which used to be in banks and S&Ls) in accounts with security firms. The Fed's guaranteeing the debt of a non-bank entity really recognizes that for decades it has been the case that the concept of banking was no longer the same. The collapse of one of these firms or even the suggested collapse and the run on its assets was not different in kind and in effect from a bank run.

The important point is that while I often talk about the goals of the Fed (low interest rates, increasing GDP, strong dollar etc.) those goals are less important that the Fed's main task which is stability of the banking system. It is only at time such as the present that this is a goal not to be taken for granted.

Comments that the Fed was somehow "bailing out the rich" while not paying attention to the little guy are inane. The stockholders of Bear were screwed. The people who were bailed out were 1) anyone with a Bear Sterns account and 2) anyone with deposits in any similar Wall Street firm and, to some extent, anyone with deposits in any bank. It is conceivable albeit unlikely that a run on Wall Street firms could set off runs on counterparty banks and then set off runs on those banks.

The point is that if folks decide on a massive scale to take their money out of wherever it is - be in a Wall Street firm, a commercial bank or an S&L the economy will grind to a halt.

The perceived safety of having ones assets in one of these place is the primordial purpose of the Fed.

It has also been suggested that actions such as this or the LTCM bailout in 1998 encourage dangerous practices. Maybe they do but similar logic would indicate that fire departments and insurance companies serve to encourage people to be less careful that their houses do not catch fire. The Fed is like the fire department. They show up in a big way when things go wrong but acting to abate disaster does not per se encourage dangerous practices. The stockholders, employees and executives of Bear Stearns took a beating and the Fed's actions will in no way encourage similar behavior in the future.

It is my belief that once "the dust settles" folks will recognize that having an independent Federal Reserve to adeptly handle the monetary part of federal policy works quite well. Political processes (the fiscal side) take too long to deal with fires. The Federal Reserve is not merely about one guy or even the Governors it is a large collection of economists with a great deal of experience and no political agenda.

As for Bear Sterns the story is truly amazing. Here was one of the firms as the center of the subprime mess and they clearly massively underestimated the risks of the subprime loans they were pushing. There is indeed a sense of justice operating here.

2) the liquidity thing. The Fed offered to provide $200 billion in liquidity by exchanging its Treasuries for MBS of primary dealers. This creates liquidity because those MBS are, at present, illiquid and the Treasuries are liquid. The Fed is to some extent sticking its neck out here by tying up a larger percentage of the Treasuries which it owns but it is doing this for a good reason. This is not mere talk. On Wednesday alone the Fed provided $28.8 billion in lending to primary dealers through this channel.

3) the bigger picture. I suppose that the big picture is reestablishing belief in mortgage backed securities. To some extent the fact that FHLMC & FNMA doing jumbo-conforming this is obviated but banks will eventual want to get back into the mortgage business.

Getting refinancing in place to lower the payments of folks who have ARMs will help to stimulate the economy and getting mortgage rates lower will help to stabilize home values. I still believe that home values will trend downwards for at least another year but the mechanisms for stabilizing the entities that will make those loans have been recast. Housing prices ran up because of unhealthy speculation combined with idiotic lending. The idiotic lending has stopped but it will take time for the demand to catch up with the supply. No act of Congress or Fed intervention will change that.

If you are interested please e-mail me or fill out a loan application or refi form on my web site. The complete application is accessed from the top right nav bar at www.loanmine.com.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

Presidents and the Economy

I need a break from writing about the mortgage mess so...

With this being an election year I have tried to not discuss politics at all but I would like to discuss the economy and suggest that political rhetoric serves little purpose regarding the economy.

Politicians find out what concerns folks and then suggest that they have solutions regarding those concerns. One thing folks are concerned about is the economy so it is natural that Presidential candidates address that issue.

The problem is that the President of the United States has virtually no significant effect on the economy. The only person who is part of the Federal apparatus who can significantly affect the economy is the Chairman of the Federal Reserve. The fact is that the President is affected by the economy to a vastly greater extent that the economy is affected by him.

Presidents do not create significant numbers of jobs. Jobs are created by a coming together of businesses, labor and capital. We have a gigantic system in place which does this. Folks see opportunities for profit and create and expand businesses and create jobs in the process. This also has the annoying effect of creating business cycles which go with those opportunities. It works like this: opportunity knocks, people see a situation where a product or service can be provided at a profit, business expands, jobs are created, at some point supply exceeds demand and a downturn occurs. This is what happened in the dot-com thing and this is what is happening in the present housing cycle.

To be fair there are marginal cases when political intervention does effect the economy. Tax cuts spur short-term economic growth. The recent stimulus package will provide some economic growth. But these are aberrations not the normative methods for job creation.

In short, when any of the Presidential candidates describe how they will create jobs pay no attention to them. They cannot create jobs and their ability to help business and workers create jobs is rather limited.

All that said, this has to be one of the strangest Presidential elections I have witnessed. There are three people still contending and they are all fairly liberal so the conservative agenda is not exactly having a good year. At present this is all about Obama. It is amazing that someone with so little political experience can be doing so well. It is not merely about Obama-mania or his being a sort of cult hero. The stark political fact is that he has made all the right moves while the experienced Clinton machine has made all the wrong moves.

He certainly has engaged the youth of American and that is a good thing. Getting young people involved in politics and interested in finding out what the government does is good. It is too easy to dismiss young folks saying that they are so inexperienced that it is easy for them to be swayed by someone such as Obama merely because of his speaking ability and his appeal to the liberal notions common to youth. There is more here than that. This guy really has engaged people. Folks feel a lot closer to him than they do the other candidates and certainly closer than they do to anyone who has been President in a long time. That by no means certifies that he will be nominated or elected but this is one darn interesting election.

In my view one effect of the potential nomination or election of Obama would be the perception that foreigners would have of what the U.S. is and what opportunities exist here. This is a guy with one black parent, one white parent and a Muslim name. Foreigners will conclude 1) that this is really a land of opportunity where a guy with mixed race and a Muslim name can get elected 2) we are totally insane and this is just a sort of extension of American Idol or 3) both 1) and 2) are true.

In no way do I suggest that we tailor our vote to what pleases foreigners. That makes little sense.

No matter what - whoever is elected will have little effect on the economy.

About Those Mortgage Losses

The announcement of sizable write-offs in the value of mortgage portfolios by large players: Citigroup and Merrill for starters is a very significant and positive step in getting the mortgage machine functioning again. While the losses are not good they did occur and what is necessary is that participants in the markets feel that they have an accurate assessment of the size of the losses and assurance that the parties that took these losses are adequately capitalized.

While the capital to take the losses has been there for the big players the problem with being a financial institution is that one's asset base is capped by one's net worth. Consequently taking an $18 billion loss means that if you want to maintain the same asset base you need to infuse capital. This has been done by going to large players in the middle East and getting capital infusions.

I think that by mid-February there will be a consensus among market participant that while all mortgage related losses have not been taken most will have been and at least the size of the problem will be known with, say, 90% certainty.

Two things will have to then happen: 1) lending standards need to be made sane (I have written about this many times). In general that means full doc for B-paper and Alt-A and higher adds for stated A-paper. It also means stricter LTV guidelines because values are shrinking 2) the existing participants in the business of providing credit default insurance for pools of Jumbo mortgage need to be recapitalized or replaced.

What must be done is this: liquidity must return to the Jumbo A-paper market. At present it is lack of availability of credit default insurance for Mortgage Backed Securities which is preventing this.

Politics & the Economy

Anyone who has been reading these newsletters for any length of time knows that I am not a big fan of politicians. With this being a Presidential election year we will be subjected to an enormous number of inane statement and suggestions from politicians.

The most important single point I have to make is that politicians have little effect on the economy. Politicians do not create jobs. Jobs are created by a coming together of capital and labor.

I believe that is was important than Bernanke addressed the economy this week with fiscal suggestions. In essence he took the initiative telling politicians what he thought needed to be done to prevent recession.

Bush pitched an economic stimulus package today. My notion on these stimulus packages is that they are always far short of ideal but almost always better than nothing.

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Dick Lepre
RPM - SF

Data vs. Opinions

aThe news of the day is BofA's acquisition of Countrywide (CWF). This is an interesting story. It could be a 1) good money after bad story 2) a bargain because BofA has an incredible ability to offer retail banking products (credit cards) to all those CWF customers 3) a really, really bad disaster if the costs of the litigation losses from the lending practices of CWF prove gigantic rather that large.

This is my perspective: BofA is deadly serious about increasing its retail mortgage profile. One of the core beliefs of BofA's present management is that mortgage loan customers can be cross-sold other banking products such as credit cards and can, consequently, become profit centers.

So what BofA is getting is CWF's servicing portfolio and the database of clients and what they are risking is the potential of some gigantic losses associated with the litigation which will result from potential class action lawsuits regarding CWF's lending practices.

The losers are the folks who created CWF and worked to make it the great company which it was. They made the one mistake of getting heavily into subprime because it was short-term profitable. In a sense the story of CWF is a capsule of the mortgage disaster. The winners are litigation attorneys. Litigation law firms now have BofA to pay the cost of potential litigation rather than suing a bankrupt CWF and counterparties.

The mortgage business is still in a state of chaos. The most important thing is getting credit insurance for Jumbos. It does not appear to me as is anyone is really addressing this issue but rather papering it over.

Let's go bank and examine what insurance is. Insurance is the exchange of a relatively small loss (the principle payment) in place of the possibility of a potential large loss. Looked at over time one can personalize this by regarding it as a payment plan for disasters. In essence whet we get out is equal to what we put in, It's just that we put it in in small amounts and take it out in large amounts.

In short there is no mystery. Credit default insurance must be built into the cost of the loan - either up front or in the cash stream or both. In the subprime disaster the money to cover the credit insurance is not there because the risk was, as Mr. Bush would say, misunderestimated.

The present credit insurers are - how to put this? - uhh, bleeped. The alternatives are 1) have the lenders pump more money into them so that the insurance can be paid 2) have the debt issuers take the loss because the insurers fold 3) let 2 happen and create new credit insurers.

V) Data and Analysis

Last December I was at a meeting with a bioscientist (this is something which I will write about in a future newsletter). One topic we were discussing was how a scientist deals with the large amount of research published in his field. He picked up a journal which had been sitting on his desk and made an insightful comment. He said, essentially, "The thing to do is read these articles and just look at the data and pay no attention to the conclusions drawn by the researchers."

His notion was that anyone reading any such publication was just as capable of drawing his own conclusions from the data than the authors were.

Of course with science there may be cases where profound conclusions are drawn but they are, in fact, rare.

We live in a media-rich era. Economic data is treated like yesterday's sports scores - not really important. The savants and the people who play fantasy baseball want to guess what is going to happen tomorrow or, at bare minimum, draw conclusions from yesterday's data.

A few weeks ago I commented that I found it strange that the NYT defined Christmas Retail Sales gains of +3.6% as "weak." To me, a gain of +3.6% in face of the mortgage crisis was indicative of strength. The NYT points out that sales grew 6.6 percent in 2006 and 8.7 percent in 2005 so, yes, the rate of growth was smaller in 2007 than in the pervious two year but the 3.6% growth in 2007 was compounded on the growth of the previous two years. In short, Retail Christmas Sales are 120.04% of what they were three years ago.

The point here is that the data is the data and while the New York Times and Dick Lepre may have varying opinions about what the data implies you should look at the data and draw your own conclusions. What I mean is that markets may work best if individuals look at the data, draw their own conclusions and make market decisions accordingly.

At the opposite end of the spectrum one has things such as the CIA. These are folks who amass large amounts of data, draw conclusions, and then only share the conclusions with the public not the data. Perhaps it is more accurate to say that they only share that part of the data which supports the conclusions.

I am in no way suggesting that the CIA should share everything of even anything. I am simply stating that the process of presenting the conclusions without presenting data may well be flawed simply because the data is much more important than the conclusions.

My belief here is in keeping with the fact that I value the technical interest rate forecasts. The technicals do not really draw any conclusions except for the thesis that it is that data that drives the data. The stochastic seeks no rationalization of what happened or what is going to happen. It is a notion that markets have cycles and it seeks to quantify those cycles. It does not forecast economic fundamentals.

Markets

Another issue is that markets tend to trade based not on data but on guesses about data. The typical scenario is that a company announces its quarterly and the earnings and sales are great and the stock gets hammered because the data was presumed.

So we have an unfortunate paradox. It is the data that is important to the economy but it is the opinions about what the data will be and the difference between the forecast and the actual data that moves markets.

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Dick Lepre

Mortgages, Risks, Solutions

1) There is still a liquidity problem in the Jumbo and subprime mortgage markets.

2) this problem came to the surface subsequent to recognition of substantial losses in subprime. These losses had been inevitable. It was only when they actually started appearing on balance sheets and in quarterly reports that folks paid heed.

3) After the subprime thing surfaced Countrywide stated that it might have problems (late payments, delinquencies) with seconds for borrowers who had good credit as well. Countrywide is a model of an originator which because of its size was to too large an extent able to dictate guidelines to the investors who purchased their loans. Everyone had been booking profits so too little attention was paid.

4) a combination of 2) & 3) created the realization on the part of investors that perhaps the value of the Jumbo mortgage pools which they held even for folks with good credit were less that they had previously thought.

5) Jumbo mortgages are pooled into securities and sold to investors as Mortgage Backed Securities - a form of collateralized debt obligation. Investors are provided with credit default insurance. The companies which provided this insurance are not household names. They are companies which have traditionally guaranteed mortgage and municipal debt.

These providers of credit default insurance are close to illiquidity. It may well be the case that they need to be replaced. This was underscored last week when Warren Buffet decided to start a business insuring municipal debt. In essence Buffet is competing for the profitable part of their business and leaving them with mortgage securitization.

5) foreclosures continue to rise especially for those folks whose mortgage payment was higher than their actual gross monthly income. If their actual income was what was on their loan applications they would have had less trouble. Discussion as to whose fault is makes little sense. This happened with full cooperation from borrowers to investors.

6) many originators of subprime went out of business. They were stuck in a situation where the loans they made had become unsellable but it was, in many cases, not their money that they loan but credit lines from large commercial banks which decreed that the loans had to be sold within so many days (45 or so) or the credit line had to be paid back. These entities were stuck in the middle of the liquidity crisis and for most shutting down was the only option.

7) the primary problem which exists at present is one of uncertainty. While the subprime loans that were made in the past few years were simply a bad idea and should be history the current problem is the perception of the value of Jumbo mortgage pools.

No one knows the true value of jumbo MBS because there is suspicion there are a lot of Jumbo loans for borrowers who had good credit but used "stated income" to qualify for those loans and that the foreclosure rates on those MAY be going up significantly as well.

In theory, the value of Mortgage Backed Securities should be determined by three risk factors: rate risk, default risk, and early payoff risk. While attention is currently focused on default risk it would appear to be the case that the other two factors are in play. While inflation (rate risk) is the ever present ogre there is heightened concern at present. The early payoff risk may be in play simply because the Jumbo mortgages that are being made now are at rates which are above where the "should be." What I mean is that the Jumbo loans which are presently being made are at rates higher than inflation and Treasury yields indicate. If liquidity returns many of these will suffer early payoff.

In essence no one has been buying MBS debt for Jumbos.

9) Two things need to happen to restore the Jumbo market: 1) there needs to be consensus that default rates on Jumbos will not increase above a certain level and 2) credit default insurance must be restored.

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Dick Lepre
RPM - SF

Keeping Confused Minds in 2007

I wrote last week about how to "Keep a Clear Mind in 2008." This past Monday I read Paul Krugman's NYT column titled "Innovating Our Way to Financial Crisis" and realized that there are some very widely read people like Mr. Krugman and Bill Gross who seem to be dedicated to agendas rather than merely explaining things in an objective manner.

Krugman describes the mortgage mess and the consequences thereof in these words "This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created" and "But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried."

I think that both of those sentences are essentially incorrect. Granted that individual participants in a market such as mortgages may not have a comprehensive understanding of the entire process. So what? I don't care that the guy who designed the engine in my car does not know how to design an automatic transmission. Implication that somehow the mortgage origination, securitization and derivative parts of the machine formulated incomplete models based on lack of understanding is entirely false. The totality of the problem is that inane mortgages were made with greed as the sole purpose. Everyone already knew how to make good mortgages and how to construct good MBS and credit derivatives they simply cast the models aside for short-term gain.

The heart of the problem is incredibly simple and I have been writing about this for months. Absurd lending standards were adopted and packages of ridiculous loans (with stated income, B-paper, 100% CLTVs leading the charge) were created and sold to suckers. When the folks who could never afford the payments stopped making them the suckers stopped buying the story and the mortgages.

As for "But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried" that is also incorrect. Everyone holding this "toxic waste" knows darn well how much of it they have. What we have at present is a poker game situation. The folks who hold mortgaged backed securities and mortgages intended to become mortgage backed securities want to maximize the price that they sell at and full disclosure of their exact positions is incompatible with maximizing profit (or in this case, minimizing losses).

Krugman then sidestreams into the "housing bubble" with this: "In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The runup of home prices made even less sense than the dot-com bubble." There are two glaring errors there. There is a big difference between these "bubbles." Folks actually need housing. No one needed dot-com stocks. Yes, speculation is condos which people never intended to occupy inflated prices but that is not and has never been the heart of the housing market. Also, Krugman has his cause and effect wrong. Housing prices are being negatively impacted by the mortgage markets incipient return to sanity. The lack of trust in funky mortgages is deflating values not the other way around.

Krugman does a wonderful service in this piece by bringing up the opinions of Bill Gross. Bill Gross manages PIMCO. PIMCO is the world's largest bond fund and Bill Gross runs it. PIMCO has something on the order of $680 billion is assets. Here is Gross's statement as quoted by Krugman, “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

Let me stop myself for a second. Who the heck am I to be criticizing Bill Gross? Seems foolish on the surface. I mean he should know 1,000 times more than me about these topics. Well maybe he does but there is an underlying problem that I have. Media should not freely quote Bill Gross because he has a large stake - no, not a large but a gigantic stake - in the market. It is in his interest to not have everyone as well informed as he is. In short, it makes no sense to listen to him because objectivity does not serve his interest. People should not get market advice from folks with a large stake in the market. Advice should be coming from neutral parties and Bill Gross is the opposite of neutral - he is highly vested.

That notion aside, go back and read what he says about Bernanke "a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August" the read Bernanke's speech in May 2006 about Hedge Funds and counterparty risk. I suppose that Mafia dons could give the head of the FBI a refresher course in hijacking cigarettes.

The point is that despite Gross's words our modern banking system is not breaking down. Is it being stress tested? Certainly. Breaking down? No. It is not breaking down for several reasons: 1) the large commercial banks have the capital to take these losses. Yes, decreased net worth will lower their ability to lend for a few years but this is happening just when the demand for mortgage debt is decreasing 2) housing is not a true "bubble" item because unlike useless dot-com stocks people actually live in houses and 3) the very fact that here in the good old USA we love to tear all of the wrapping off and look inside problems such as this serves us well. The problem is addressed and dealt with quickly. This may not be pretty but it serve well to identify problems and formulate remedies.

In his recent piece on his concerns over the risks associated with relatively unregulated hedge funds Gross make some excellent points in referring to them as a sort of "shadow banking" system. But it is not the case that any shadow banking system created the current mortgage mess. The greed and stupidity of people who knew perfectly well what good mortgages looked like but abandoned those standards for short-term profits was the heart of this mess.

Gross did write an interesting piece in September suggesting that fiscal policy (some sort of bailout) not monetary policy (lower Fed funds) was necessary to resolve the mortgage mess. This past week focus has shifted toward a negotiated freeze on subprime mortgages about to adjust. Assuming that whatever ensues here has a Safe Harbor to address the fact that the people who actually own the cash flows from these mortgage are going to be shorted then it may prove to be the case that this is really a delayed and somewhat disguised bailout. Personally, after I read what I could on the "teaser freezer deal" I see no way in which it can work. The cash flows are not owned by the parties to the deal (the Feds and the servicers). If this were 20 years ago I could have inserted a comment such as, "What is this? Russia?" but you get the idea.

Krugman's laments about the effects of innovation things such as CDOs and SIVs in not well founded. Crappy mortgages are the problem. Yes SIVs and CDOs helped obfuscate the effect of making those crappy mortgage but the truly silly thing is that all we have to do is to stop making the inane mortgage products which our industry has created in the past five years. Actually the problem is largely already solved. These products simply are not being made. We just need to clean up the litter made over the past few years.

- Dick Lepre

H.R. 3915

Moving through the House of Representatives is a bill intended to make less likely the probability that a "mortgage mess" such as we have recently had will occur again.

The intentions are fine but this legislation as it presently exists in committee has some provisions which are against the interest of homeowners.

I am going to address only one issue here. This legislation would do away with no point and no cost mortgages. That is not a typo. This legislation would do away with no point and no cost mortgages.

I wrote about this back in 2001.

Culpepper v Irwin Mortgage

Recently [this was written in June 2001] the U.S 11th Circuit Court of Appeals made a ruling, which, unless reversed, will have a dramatic effect of the mortgage business.

When I come to work each day I have a series of rate sheets from various lenders. Looking at only a 30-year fixed rate conforming loan from one lender and only at the pricing for a 30-day lock, I might see a column such as this:

Rate	Price
6.500	2.5
6.625	2.125
6.75	1.25
6.875	0.625
7.00	.25
7.125	-.125
7.375	-1.125
7.5	-1.375
7.625	-1.75

The prices without minus signs are costs.  The prices with minus signs are rebates or "yield spread premiums". The above are the wholesale prices.  If you want me to get you a 6.5% 30-year fixed it will cost me 2.5 points.  I add one point and charge you 3.5 points.  My experience is that no one wants such a loan. Borrowers are looking almost exclusively for no point loans.  If you wanted a no point loan I would quote you the 7.375% and make the 1.125 points. 

The problem is that someone saw these "yield spread premiums" (YSPs) and said "Hey wait,  lenders are giving fees to brokers for bringing them borrowers at higher rates."  This statement is true. Mortgage lending is a "you pay me now or you pay me later" proposition.  The more you pay in points, the lower your rate and payment.  The less you pay up front - the higher your rate is. This is a basic economic concept.

Culpepper is a class action suit.  The Appeals Court in its recent ruling affirmed certification of the class.  The class literally includes:

[a]ll persons who, from April 11, 1995, until this class is certified, [June 22, 1999], inclusive, obtained an FHA mortgage loan that was funded by Irwin Mortgage Corporation wherein the broker was paid a loan origination fee of 1% or more and wherein Irwin paid a "yield spread premium" to a mortgage broker.

Note that while this ruling pertains only to FHA loans made by one company it opens the gate to suits on all loans that used YSPs.

You can find the court's ruling at:
http://laws.findlaw.com/11th/9913725opn.html

The heart of the courts ruling is section 8 of RESPA (Real Estate Settlement Procedures Act) which:

"prohibits both the giving and acceptance of "any fee, kickback, or thing of value pursuant to any agreement or understanding, oral or otherwise, that business incident to or a part of a real estate settlement service . . . shall be referred to any person."

The finding of the original court was that YSPs were prohibited referral fees (or that a jury might so find) because they depended on the value of the referral (higher rate = higher rebates).

After the original court's finding Congress requested HUD to "clarify" its position concerning the legality of YSPs  HUD stated that YSPs are not illegal per se but can nonetheless be illegal.  (This next little bit is - I think - the heart of the matter.) HUD tests the legality of YSPs in two steps.  The first step is "whether goods or facilities were actually furnished or services were actually performed for the compensation paid."  HUD muddied the issue by stating "The fact that... services have been actually performed by the mortgage broker does not by itself make the payment legal." The second part of the test is "whether the payments are reasonably related to the value of the goods or facilities that were actually furnished or services that were actually performed."

The appeals court sides with the plaintiffs and concluded that YSPs are referral fees and not compensation for services rendered and that the second step - the reasonableness of compensation is irrelevant.

What's Wrong With This Picture?

The court seems to be totally unfamiliar with both the mortgage business and the wishes of the borrowers.  Borrowers want no point loans.  They understand that no point loans are at higher rate than loans with points. YSPs are not referral fees.  They are the only available mechanism for providing the broker with the same compensation on a no point loan that he would have received on a one-point loan.  If brokers made more on loans with YSPs than loans without YSPs then the court's conclusion might have some merit.

The conclusion of this court leaves only two possibilities:
1) mortgage brokers are supposed to get folks no points loans and do so with no compensation or 2) no points loan will vanish and borrowers will need to pay points on all mortgages.  Choice one ain't gonna happen.  Choice two creates the absurdity of abridging consumers the right to get, for example, no cost loans when rates drop.  The court's ruling has, then, the effect of being completely anti-borrower and increasing the value of present mortgage pools by making it difficult or impossible to refinance them. It is inane to believe that the intent of HUD was to screw borrowers to the benefit of investors in Mortgage Backed Securities.  Sadly, this is the conclusion that the appeals court reached.

The Solution

There are only three possible resolutions to this. 
1) This ruling will be overturned by SCOTUS - not a likely scenario at this stage
2) no point loans are going to disappear or
3) HUD will need to clarify for this court its position with regard to YSPs  No one believes that there is a legislative solution available.  Getting Congress to act is politically inexpedient.

HUD can merely clarify that YSPs give brokers no more compensation than they would receive on loans with points.  They are, in fact, not referral fees. They serve only the purpose of providing the borrower with what is desired - low cost loans.

The path that is being pursued by the mortgage lobby is going to HUD and getting them to indicate that YSPs are - in almost all cases - not referral fees.  This would "pull the rug out" from under the class action suit and require that each borrower who felt aggrieved would have to demonstrate that, in his case, a referral fee has been paid.

Semantics

Part of the problem is, I think, semantic.  The mortgage industry should not have used the term "yield spread premium".  That makes it sound like the broker is making "a premium" on this loan rather than a loan with points.  An expression such as "low cost bonus" might be construed as being more consumer friendly.

Some Non Sequiturs

The court's ruling leads to some illogical conclusions.  If I, as a broker, am getting you a no point loan and taking a YSP from the lender as my fair compensation and becoming a felon thereby, why can a person who works for a direct lender receive the identical compensation for doing the exact same work and delivering the exact same loan to the exact same borrowers?

The mortgage industry exists in its present form and size because of the ability of the secondary market to securitize pools of mortgages.  The YSP pricing starts at the top.  It is set by FNMA and FHLMC.  Mortgage brokers and lenders serve to connect individual with investors.  Should FNMA and FHLMC be held liable for offering "premium pricing"?  

Intent of RESPA

Presumably, the intent of RESPA was to eliminate "referral fees" because the borrower, in some way paid for them.  It is also intended to promote competition.  For example, escrow companies are unable to offer reduced escrow fees to some people to get their business because this is a "referral fee".  Yield Spread Premiums are merely an extension of the "you pay me now or you pay me later" nature of the pricing seen above. The sole intent is to provide no point loans to the consumer.  Lower cost now, higher payment later.  The details of this are spelled out on the disclosures that consumers are given.

Political Reality

HUD must be approached by the mortgage industry with the proposition that the present administration can clean up this mess with a clarification that the previous murky HUD ruling has been misconstrued by the appeals court and led to a consumer-unfriendly conclusion. 

Allowing this ruling to stand and allowing an untold number of class action suits to go forward will have a devastating effect on the mortgage industry and serve to eliminate what is the consumer's
"loan of choice". It will also prevent people who do not have enough money from becoming homeowners by forcing the to accrue the money to pay the points out of their own pockets.

This case is a perfect example of what goes wrong with our system of justice when judges divest themselves of any semblance of common sense and protection of the common good and reduce justice to the crafting of words on paper with insufficient regard for the real-world workings behind those words.  This is a topic which is forever discussed in legal circles:  are judges supposed to figure out what is the intent behind the law or merely interpret the letter of the law? 

That Was the Original Newsletter and Subsequently...

HUD issued a policy directive SOP 2001-1, reiterating its position that YSPs are not per se illegal and also clarified the test for the legality of such payments set forth in SOP 1999-1.

That put an end to the original Culpepper suit.

Culpepper continued to become something that the 11th Circuit Court of Appeals could not get off its mind. (If I were the suspicious type I might think that this had more to do with some law firm being disappointed that it had made a bad investment.) It continued even this year in what is called Culpepper IV (AKA Return of the Bride of Culpepper). In Culpepper v. Irwin Mortgage Corp. (11th Cir. 2007) (Culpepper IV), the Court reiterated that SOP 2001-1 constituted controlling authority carrying the force of law. The Court also held that its prior holding in Culpepper III was "clearly erroneous," such that it "would work manifest injustice" if followed.

What is intriguing is that if you read what the 11th District says it is obvious that they are utterly clueless about what YSPs are and why they are in the borrowers' best interest.

Generally, folks are inclined to believe that since it is November and Congress is something close to dysfunctional nothing will happen here. That is nuts. That is why I put my seatbelt on every time I am in a car.

Anyone interested should write to their Congressman or Congresswoman and state categorically that they want to be able to get no point or no cost loans and that the part of H.R. 3915 eliminating YSPs must be struck out.

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Dick Lepre
RPM - SF

The Upside of the Downslide

With rates high and housing values falling this is not a fun market but there are two questions which should be addressed. 1)Are there people who can benefit from this and 2) what should folks who were contemplating refinancing their ARM do?

Purchasing

It is easy to look at the housing market and panic. National average housing values are likely to continue to fall at least for the next year. Realtors and mortgage folks are not having their best year ever but there is a reality that is being overlooked. For folks who do not own, the opportunity to buy in a buyer's market is starting to occur. We have gone through a period of several years where sellers have controlled the market. I have had cases where buyers were offering 10% more than asking and found that they were the 14th highest offer. That market helped drive prices up and also made negotiation of thing such as splitting closing costs impossible. That era is over. Some sellers do not yet fully realize this and are holding out for last year's prices. They are not going to get them. This makes for even more homes on the market.

If you are buying currently you should be asking the seller to as least share the closing cost or perhaps to buy the rate down. Some of this has to do with the way jumbo mortgage have been priced lately. A year ago a 1 point cost would get you a rate 0.25% less than no point. Now that 1 point will get you closer to a 0.5% lower rate. This way you can, in effect, have the seller pay to get what jumbo rates might be if we were not faced with this liquidity mess.

This is and will become even more so a buyer's market. Here is what you should do as a potential buyer:

- find out what you can afford as a payment on a fixed rate loan. Stay away from anything that qualifies you to buy something which you cannot afford at something less that the going fixed rate.

- pay attention to the local housing market. We can talk about national or statewide values but housing is everywhere local. If values are falling where you want to buy then you can wait. Do not try to think that you can find the bottom but just get some sense that values are not plummeting.

- note that one strange effect is that with there being a lot of foreclosures there are more renters and rents are going up and buying income property is becoming more attractive in terms of debt service ratio.

- express only joy that lending is getting stricter. You will not be overbid by someone with overstated income. You are less likely to be victimized by unscrupulous lenders who had only their short-term profit in mind. Many of them will be out of business.

- this is all about supply and demand. Supply (homes for sale) will increase as foreclosures increase and demand has decreased since lending standards have returned to something close to sanity. Foreclosures tend to do serious harm to values. This will not only drive prices down but totally screw people who are trying to refinance when the appraiser finds that the value has been savaged by the sale of a foreclosure down the block. These are sales which take place under extreme duress and they really hurt valuations.

Refinancing

This is something which is not getting enough attention but with values falling some folks who can refinance today will not be able to refinance next year because their value will fall and their LTV will be over the guideline. Even though rates may be higher than they should be some folks who have ARMs adjusting next year should refinance soon because they may not be able to refinance next year. While the situation is hardly ideal the fact is that some people are about to face their last opportunity to refinance for the next, perhaps, five years. When I first got into the mortgage business in 1992 it was after a significant slide in values. The company that I worked for did a lot of media advertising and we got a lot of phone calls. My recollection is that almost a third of the people who called had properties which they could not refinance because values had declined.

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Dick Lepre

FHLMC, FNMA, Credit Derivatives

There has been and - for jumbo mortgages - continues to be a problem with lack of liquidity. This week we saw heavier than ever talk from Congress about what the GSEs (FHLMC & FNMA) should do. The Fed Chairman countered that.

I find myself is the uncomfortable position is disagreeing with them all.

Let's take a step outside the previous discussion first and let me tell you one of the great secrets of the mortgage industry. The most profitable segments (for loan officers, banks and everyone other than the borrower and the investor) have always been 1) subprime and 2) jumbo. The profits on conforming loans have always been less both in terms of points and absolute dollars than Jumbo. Remember that.

Now let's go to my previous suggestion about what the GSEs should do. The thesis here is that FHLMC & FNMA have displayed that they understand how to underwrite mortgages and to sell their product in the secondary market. Their risks (and this is something which simply does not get talked about) are largely hedging risks. They need to be covered for rate movements from the time they buy the loans until the time they sell the loans.

FHLMC & FNMA have caps on how large a portfolio they can hold. How that came to pass is really a twofold story. Part of it is that there has been pressure on the part of banks and Wall Street firms to keep the GSEs from expanding because the banks and Wall Street firms are the GSEs competition. Part of the problem was generated by the GSEs themselves as they incorrectly reported their quarterlies in an attempt to obfuscate the real variations in their income and the risks that they were taking.

I believe that FHLMC & FNMA have shown that they can create artificial intelligence underwriting systems which reduce the cost of generating loans without adding undue risks. We have been using these tools for years.

I would suggest that pressure should be applied to the mortgage industry to essentially say, "Fix the liquidity problem on Jumbo mortgages or we will have the GSEs do it for you." That is why I believe that the Fed Chairman is making a mistake at present. The mere threat to have GSEs "take over" a good chunk of the Jumbo market may well induce the banks which buy these loans and the Wall Street firms which make them into MBS and sell them to act. If they refuse then the GSEs should start taking over the Jumbo market.

This brings us to another problem. It really may not make a difference if FHLMC/FNMA start securitizing Jumbos or if the commercial bank/Wall Street model continues. Either requires the presence of credit derivatives to be able to offer the kinds of low rates which we have gotten used to. Let's try looking at that.

The Liquidity Thing From a Different Perspective

I have been writing that the mortgage business can be fixed by making some changes (no stated B-paper, higher adds for Jumbo stated) but my assumption is that the system which has fed this - the system of derivative risk being spread far away from the original lender can and will be fixed. For an entirely different and more doomsday perspective see this article from MSN this week. This is by an expert on credit derivatives.

Remember that Warren Buffet referred to derivatives as "financial weapons of mass destruction" and Greenspan defended them. To quote the Chairman: “By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives….. As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly. Should they succeed I am quite confident that market participants will continue to increase their reliance on derivatives to unbundle risks and thereby enhance the process of wealth creation.” Remarks at the Futures Industry Association, Boca Raton, Florida (19 March 1999).

Until the recent mortgage liquidity mess credit derivatives were seen as big-profit makers by the folks who sold them and the folks who bought them. Perhaps we are at at sort of post-Katrina for the insurance industry moment and the derivatives industry needs to decide if it want to go ahead based on the knowledge gained by this or if the investors want to pack it up and try some new adventure.

I do want to offer one comment to offset some of the concern that can arise when you read "popular" articles about something as complex as derivatives. While it is noted that the outstanding value of derivatives is some staggering amount like 8 times GDP one must recognize that is a notional amount. A much smaller number than that is "at risk." One could look at all on the money bet on individual craps rolls on the Las Vegas strip each year and conclude that it could bust the economy. The fact is that I might go there with a $1,000 bankroll and bet $100,000 in the course of a few hours. It is the $1,000 that is at risk not the $100,000. And the $1,000 is not destroyed. The casino now has my money. I may have lost some money but the economy lost nothing.

Dick Lepre

With Liberty and Low Rates for All?

Last week I tried to end the series of pieces on the mortgage liquidity crisis with as assertion that rates would get better. I still believe so but the problem in 2008 will be that some people will not be able to refinance and will be pained by their adjustables.

Whom will that affect?

Not exactly sure but here are some folks who will be totally annoyed with the mortgage industry next year:

- B-paper borrowers who will not be able to qualify for new mortgages with full documentation.

- some stated income A-paper folks who are not self-employed. "Stated" income used to be for self-employed folks only. The rationalization was that the self-employed sometimes beat the heck out of their Schedule-C in an effort to minimize their tax liability and that their "real income" is something higher than the bottom line on Schedule-C. For example, they might write off their car payment, gas, parking, medical insurance and some travel.

W2 people have incomes reflected on their W2s so it is a bit harder to conjure a rationalization as to why they should be allowed to go "stated." When all is said and done the question will be asked: are the default rates for stated W2 any different that the default rates for self-employed?

- folks who live in places where property values will decrease. Las Vegas, Miami, Phoenix and others will see drops in values simply because those places have seen significant amounts of speculative buying. I would think that the default rate on non-owner occupied A-paper is going to be a lot higher than owner-occupied A-paper.

The problem in these markets will be lack of equity. Lenders are not going to do 105% LTV refinancing.

Lurking here are some issues. There are going to be more people who have to sell and then rent. In some places that will be that rents will go up while values are going down. This can even translate into displacement as folks can only afford outlying communities.

Speaking of Disasters

If your lender goes out of business please pay attention to your impounds for taxes and insurance. This is one of those ugly stories. It has been alleged that recently-out-of-business American Home tried to used borrower's impounds for taxes and insurance to cover their overhead. The problem is compounded by the fact that no one has been able to get hold of the physical loan files to even ascertain which insurance companies have not been paid.

My point here is solely this. If your mortgage company goes out of business the ownership of the mortgage and the liability that you have to send the check continues but if a mess like this takes place please make sure on your own that your taxes and insurance are paid. If the lender scammed your money that is no excuse you still need to pay your insurance company. With taxes there is some "catch up" time but that does not exist for insurance.

The messages are 1) make sure that you make your mortgage payment even if the lender is going under and 2) make sure that your insurance and taxes are paid. Insurance must get first priority.

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Dick Lepre