The Economy

Mortgage Fraud

This week I received a memo (see this) from an attorney who works for the Federal Public Defenders Office he in San Francisco. It appears to be a "heads up" that the U.S. Attorneys office for Northern California may be starting an initiative to prosecute more mortgage fraud cases. These have been vigorously prosecuted in some other districts: Charlotte, Dallas, Sacramento and Anchorage.

There was a recent (May 13, 2008) 9th Circuit Court of Appeals decision which sets the tone for these cases. That decisions had two aspects. In the "bad news" for the defendants department this case (US v. Crandall) regards what is a common defense in such cases and is called the Mens rea defense. Mens rea addresses not the facts of a case but the defendants state of mind. Generally the defense is that the individual did not intend to commit a crime but was actually pursuing some other purpose. This is the classic defense in tax protest cases when the individuals swear that they are pursuing some agenda aimed at a high minded purpose of setting straight the IRS which - in their view - is an unconstitutional construct. These folks will insist that they are not really cheating the IRS but upholding the real law. They are almost always found guilty.

In this particular case the defense wanted a mens rea jury instruction that required "knowing and conscious" engagement in "criminal wrongdoing" for a prosecution. The judge said "no" are required an "intent to defraud."

I will not even attempt to explain the rational behind mens rea and mortgage fraud but invite lawyers who read this to e-mail me with their explanations for follow up.

There are two good sources for what is happening in the world of mortgage fraud. This is a mortgage fraud blog. (http://www.mortgagefraud.org/journal/) and this is our friends at the FBI

There is a variety of types of mortgage fraud and the blog at http://www.mortgagefraud.org/journal/ covers them all but they fall into at least four different classes:

1) mortgage companies repeatedly funding loans with bogus income and assets documents. Sometimes this is a systematic corporate thing and sometimes just one of a small set of individuals in a company.

2) identity fraud and property theft cases where folks either misrepresent their ownership interest in the property or actually fraudulently gain title to property with bogus grant deeds.

3) foreclosure prevention scams. These are generated by public noticed of intent to foreclose and the typical scenario is one where someone who is slick on the phone calls the property owners and scams them out of $2,500 with a guarantee that they can prevent the foreclosure.

4) fake buyer transactions where the transaction looks like a sale but is really an attempt by the owner to suck all of the equity out of a property by "selling" it to cohorts at an inflated price and having said cohorts never intending to make a mortgage payment.

I do not see it as likely that individuals who overstated their income on "stated income" loans will get in trouble. There are "bigger fish to fry."

The good news for defendants in the 9th Circuit decision was that sentencing should be base on the net economic loss not the total amounts of the loans. The size of the loss can affect the sentence and persecutors were seeking sentences based on total loan amounts. The Court said "no way." The loss is the loan amount less what is recovered in a foreclosure sale - the real economic loss.

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

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

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

Lower Rates Ahead

Lower mortgage rates are about to happen. We are going to continue the bullish cycle which started last last year and was interrupted. Subprime will never be the same but with appropriate adjustments for stated income Jumbo rates should soon (within a month) return to some more appropriate levels.

The bad news is that we will likely see GDP stagnation and lower corporate profits and equity prices and well as perhaps 5 years of flat housing prices. The good news is that we will see lower mortgage rates.

Lower Rates in 4th Quarter

Mortgage liquidity is starting to return. I would think that well before the end of this month we will see changes to subprime and jumbo stated guidelines and/or prices which will, for practical purposes, restore liquidity to the market.

We have a most interesting picture with the technicals in as much as the long-term (monthly) tech has re-upcrossed (Spell-Check be darned). Couple that with the bearish macro trend (lower GDP growth) which will result from a slowdown of home building and home buying and we have the makings of a serious bull market and low rates in the fourth quarter.

That said I want to attempt to close out the ongoing story about subprime and illiquidity. The great story from the subprime thing is the resilience of the U.S. economy and the ability of the Fed to provide liquidity in a quiet, orderly manner.

From my point of view the story in the media about the subprime mess has been one of utter cluelessness. Let me try to give some history.

After World War II home ownership spiked dramatically going for about 45 to 65% in one decade. But that was a more traditional sort of lending usually requiring 20% down payment.

In about 1980 two things happened which enabled the subprime industry. First the Depository Institutions Deregulatory and Monetary Control Act of 1980 was passed. That, in essence, abolished usury laws on first mortgages. It made it legal to make relatively high interest rate mortgages to borrowers who could not qualify for what we now call "A paper."

Second, the Mortgage Backed Securitization was invented. This was enabled by computer power and modeling and had the value of spreading the risk. I wrote about this last week: "The securitization of mortgages into mortgage backed securities is attributed to what Salomon Brothers did for Bank of America starting in the late 1970's and coming to fruition in 1981. The folks who hold mortgage backed securities get others to take the risks associated with default."

Until the past 5 or so years subprime had made sense (at least it had made sense to me). Subprime was for folks with bad credit histories but always required full documentation. It made sense to see if someone with a history of not always paying their bills on time as least had the ability to make their mortgage payments.

In the last few years many absurd loans have been made. It did not, does not and never will make sense to make a subprime loan with "stated income." This is what the subprime mess is all about. Period.

Is someone to blame? I suppose. Blame everyone: the Wall Street folks who enabled securitization, the mortgage banks who made these loans, the brokers and loan officers who pitched them and the borrowers who lied about their income. In short no one is innocent.

There is one very important distinction here. Subprime lending is that made to people who's income, credit history and equity translate into risk. This risk can be measured objectively by models such as FNMA's Desktop Originator. Predatory lending is less well-defined but for I would describe it an making a loan which the borrower has little real chance of being able to make the payments on.

The Mortgage Bankers Association defined predatory lending as "intentionally placing consumers in loan products with significantly worse terms and/or higher costs than loans offered to similarly qualified consumers in the region for the primary purpose of enriching the originator and with little or no regard for the costs to the consumer."

The problem that I have is that I find this difficult to define objectively but the difficulty of any law or regulation is getting the details right. Am I guilty of predatory lending if I make 0.5 point more on one loan that an average of "similarly qualified consumers in the region." Or is it 1 point, 2 points?

In the mortgage business it has long been the case that, on the average, loan officers made more on a subprime loan than a prime loan. It has also be the case that Jumbo loans are more profitable to mortgage banks than agency (FHLMC & FNMA) loans. I am not talking about size related rewards but "points." The ultimate fact is that it is the responsibility of the borrower to search for the best deal. No amount of regulation will substitute for that.

For me the solution is painfully obvious. All subprime loans should be full doc and the lender must underwrite the ability of the borrower to make the payments.

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Dick Lepre

Why the Mortgage Business Will Recover

For weeks I have been writing about the mortgage mess and its causes and solutions.

Almost every bit of talk inside the mortgage business is something like "the mortgage business will never again be the same." Assuming that implies that there are a lot of loans which will never again be possible all that I have to say is "hogwash."

We will in less than a year see the return of almost every type of loan. Yes subprime but maybe not quite so liberal as it was. Yes stated jumbo. Yes Alt-A.

Why?

Real simple. In the past 20 years the mortgage securitization business has become sophisticated through the use of derivatives. In short the risk is spread out so that the lenders and ever the holders of mortgage backed securities and having other parties insure their positions.

This has been massively important to the housing industry because without the ability to pass the risk on mortgage debt along banks and S&L's would not have had the ability to make as many real estate loans as they have.

But What Went Wrong?

In short what went wrong with the recent collapse is that defaults were higher than modeled and the folks who were providing the insurance to pools of mortgage backed securities suffered an abrupt change in their perception of risk. The sharp spike in the cost of credit swap insurance contributed largely to the illiquidity of Jumbo mortgages.

The model is there. It is simply the case that in light of what has happened new parameters regarding rates of delinquencies and foreclosures needs to be input. New costs for credit risk insurance will be calculated and the mortgage machine will be running again. What is needed is simply stability in the costs of insuring the risk on Jumbo mortgage pools. It should be noted that it is not that Jumbo mortgages have really experienced higher late payments rates similar to subprime. It is that the subprime thing created this concern. The concern is probably valid but overstated.

In a real sense what we have is not a liquidity crisis per se as in there is no money out there to lend on mortgages. It is a crisis in the perception that the risks were underestimated and the prices of the increased perception of risk need to be factored in.

Some History

The securitization of mortgages into mortgage backed securities is attributed to what Salomon Brothers did for Bank of America starting in the late 1970's and coming to fruition in 1981. The folks who hold mortgage backed securities get others to take the risks associated with default.

But Isn't This, like, Nuts

Warren Buffet once described derivatives as "financial weapons of mass destruction." While I do not often find comfort in disagreeing with Mr. Buffet I will say this: derivatives do provide for a spreading of the risks associated with the issuance of certain type of risky credit. In that sense they create possibilities. The problem is that some derivatives are complex mathematical entities and few people have the math ability to understand them.

Let me back up and try an example. We all know what a stock is. An option is a derivative of the simplest sort. The ability to buy or sell shares of a stock at a certain price at some future date.

It is accepted that the Black-Scoles model mathematically describes the correct price of an option. This is for some folks an intimidating mathematical model. A lot of folks know what is about and option traders who really do not understand the math can nevertheless calculate the price of an option because they have access to a computer which does it for them.

But equity options are small is total size compared to interest rate risk derivatives. The concerns that folks have about derivative is due to 1) the sheer size of the derivatives market and 2) a lack transparency about who is taking these positions and to what extent they are leveraged. In short, is undercapitalized entities are doing this with borrowed money they might not be able to perform and a counterparty (a large dealer bank) may inherit the liability. In that sense the fear is that derivatives could create cascading failures and magnify into an event which threatened the banking system.

The question will be asked after this episode is over if derivatives performed as advertised mitigating the risk to holders of MBS. The best analogy is the LTCM collapse & Russian debt default of 1998. One deleterious effect was that the relationship between mortgage rates and the 10-year Treasury became so loose (it had widened unexpectedly) that would-be hedgers lost both on the derivatives and the underlying asset that the derivatives was designed to protect.

In addition some of the nuances related to hedging have solely to do with accounting and accounting standards. To some extent this reflects the idea that some of these are relatively new and FASB (Financial Accounting Standards Board) may need to rethink the rules regarding the accounting of derivatives held by banks. I caution here that I am at the edge of my own understanding regarding this and this paragraph should be regarded as speculative.

The recent mortgage mess can be viewed as having been cause by a dramatic increase in the cost of credit default swaps. Lack of stability in the cost of credit default swaps meant that fewer entities were willing to buy mortgage backed securities and that is what caused the mortgage liquidity problem.

Stabilization in the cost of credit default swaps will result from a better understanding of what the real risk with, say, jumbo stated mortgages are. My own notion is that this is solvable entirely by increasing the cost (points) or rate for jumbo stated. I have been suggesting a 0.625% increase in rate for Jumbo stated. I think that is more than sufficient to cover any increased cost in credit swaps.

In short everything will likely return to the way it was before with two exceptions: 1) subprime will be more restrictive and 2) the adds for Jumbo stated will be larger.

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Dick Lepre

Getting the Mortgage Mess Behind Us

I am getting tired of writing about this every week but, like Sysyphus, I shall try again.

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

2) this problem has come 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. The mortgage business did not have smoke detectors. It did notice large burning buildings.

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. Investors started buying smoke detectors.

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.

6) the primary problem which exists at present is one of uncertainty. No one knows the true value of jumbo MBS (Mortgage Backed Securities) 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. This is the truly seditious point here. Even someone wanting to know the truth would have trouble because of the commingling of Jumbo stated with Jumbo full doc. This will go down in history as one of the "it seemed like a good idea at the time" practices.

7) The suspicion in 6) has led to a situation where the pools of recently made Jumbo mortgage are not liquid and there is, in effect, no market for the pools of already existing Jumbo mortgages. That is what has caused the sharp increase in Jumbo rates offered by most lenders.

8) Until there is a lot more consensus (and I mean "put your money where your mouth is" consensus) about foreclosure rates on Jumbo A-paper the Jumbo market will remain illiquid.

9) The Fed has been working on the problem by providing liquidity. That means purchasing securities or lending short-term cash on securities. Liquidity is what is important but that has been extremely poorly reported in the media which instead emphasized the Fed lowering the discount rate and discussing when it should lower the Fed funds rate. The Fed seems this week to be encouraging more use of the Discount window in lieu of repos and outright purchases.

I have every confidence that the Federal reserve (and I mean the whole darn thing not just the chairman) knows what it is doing and has no agenda other that the health of the economy. Every time I hear someone on TV say, "Bernanke is making rookie mistakes" or "Greenspan would never have allowed this to go on" I think, "Well there's another jerk." I am not saying that Bernanke is a god. I am saying that he knows more that all the media commentators put together. One more point: Bernanke did not invent stated income, 100% CLTV, B-paper lending.

10) Moving the Discount rate and even lowering the Fed funds rate will do little to solve the liquidity problem. Yes, lowering the Fed funds rate will create the perception that "things will get better" and that will help the confidence of potential buyers on MBS but it will ultimately be the foreclosure rates which determine the fate of Jumbo rates. This may seem odd but I do find it strange that perception is as important in running the economy as it is in buying jeans. Maybe that is just me.

11) What's done (in terms of bad lending) is done. The irony is that the damage is almost entirely to investors but the media concentrates its attention of the fate of the borrower who, having had bad credit and perhaps lied about their income cannot now make the payments.

12) Losses have to be taken. These losses are sizable. The parties taking the losses are mortgage originators, commercial banks, hedge funds and, in short, anyone who is holding assets which are worth a lot less than they thought.

Delaying taking those losses will delay the solution and delay the return of liquidity.

The pain of these losses will be significant: companies will go out of business, people will lose jobs, people will lose their houses to foreclosure and investors will suffer very large losses.

13) the solutions going forward are remarkably simple. I proposed them last week:

a) No loans to folks with bad credit (<640 credit score) without full documentation that they at least have the potential to make the payment.

b) stated income A-paper (good credit) should be bumped up about 0.625% in RATE above full doc.

c) The GSE's (FHLMC & FNMA) should be more adequately capitalized and the Federal government should clarify whether or not it is standing behind FHLMC/FNMA debt. Adequately capitalized GSE's need to up their loan limits and securitized jumbo mortgages. This is a major point and one which requires much more discussion that I can provide here. The negatives are the fact that politicians must intervene and that will likely mitigate the correct solution with some sort of political compromise inanity. Also FHLMC & FNMA picked a bad time to be "on probation" subsequent to their creative accounting.

14) a combination of the losses suffered and the stricter mortgage guidelines is going to depress housing values in general. It may take 5 years for values to return to where they were at the start of 2007. That means pain for Realtors and folks in the mortgage business but it will be good for some young folks who have been shut out of the housing market by prices.

15) allowing the free market to work its course is the best solution. The hope is that we will have learned something from it. This mess was created by foolish lending practices and it is the parties to those practices: the borrowers, the investors and the intermediaries who should pay the price not anyone else.

16) There is an historical lesson somewhere in all of this. Our economy has been altered since the early 1980's by computerization. Consequently we have complex derivatives to, in a sense, spread the risks while creating the opportunity for reward. My point is that there is nothing wrong with this as long as the models are accurate and correct assessments of things such as defaults are plugged in.

What we are seeing is not the failure of the model of things such as credit insurance but the consequences of humans inaccurately plugging assumptions into the model. Whether their mistakes were deliberate or not makes little difference. The models need better data.

17) will all of this cause a recession? I don't know. No one really knows. This reminds me of being at the Super Bowl in 1977 with a very good friend of mine (Raider fan) who despite the fact that the Raiders were ahead would follow every negative thing with "well, we're gonna lose now."

The mortgage mess and oversupply of new homes is absolutely, certainly going to take a bite out of GDP. The housing sector and mortgage businesses will be hurt. To revert to a sports analogy this is like a baseball game when you have the bases loaded and one out and the batter hits into a double play. While it is most certainly not the prescription for defeat it is a step in that direction.

In addition to GDP mitigation from New Home Sales and the buying of stuff to go into existing sold homes we are also facing the fact that too many people have took out too much money on HELOCs and spent it. That is also going to hurt GDP.

18) What caused this mess? This may be an oversimplification but this problem is like may others we have seen in out economy in the past 20 years. The emphasis on short term profit and success rather than long-term profit and viability has caused exactly that. The short term profits that were made by folks in the mortgage business, the real estate business and by real estate speculators are over and those of us who are interested in mortgages and the mortgage business will have to deal with it.

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Dick Lepre