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

Comments

[Holden Lewis]

Dick,
What's the difference between rate risk and early payoff risk?

Holden

[Dick Lepre]

Rate risk refers to the fact the the investor is lending the money at a fixed rate for 30 years but has no real way of knowing what rates will be in the future. If inflation gets out of hand there will be regrets on their part.

Early payoff risk refers to the fact that investors buy loans presuming that the cash flow will exist for some period of time, say, about five years. If the loan is paid off early they will have overestimated the value of the cash flow and in fact paid too much present value for it. If mortgage rates drop early payoffs occur.