Saturday, April 28, 2007

Ranieri on the MBS Market: It's Broke

by Tanta on 4/28/2007 08:45:00 AM

Our friend Brian sent me a Bloomberg transcript (no link yet) of comments made by Lewis Ranieri at the recent Milkin Institute Conference on financial innovation, subprime lending, and the housing market. Lewis Ranieri, if you don’t know, is generally given a large part of the credit for creating the private MBS market, and would have to be considered, by anyone’s standards, a highly-informed participant in the mortgage credit markets.

Ranieri isn’t a happy camper, it seems, about structural problems in the industry.

Note: This is a rush transcript, not a final one, of oral remarks. I have edited slightly only to remove a few repetitions and asides characteristic of spoken presentations and to correct a few phonetic transcriptions. All my editorial changes are indicated by ellipses and brackets.

People asked, you know, is financial innovation, you know, reaching a stabilization point in housing and I think the last four years shows that's not true. It's been a halcyon period in terms of taking financial innovation and using it to put housing much more deeply into the population. I mean, we've been able to franchise many, many more lower middle income and minority home--individuals into home ownership, over the last four years, than probably, in the 10 or 15 years prior to that.

Unfortunately, we're now facing a trial, which in many ways, I think, will determine how well we can continue to innovate into the future and part of it is [subprime] . . . And we also have the typical regulatory reaction to a potential series of risks, in terms of passing somewhat more restrictive legislation. And some might argue [this] is exactly the point in the cycle where we don't, particularly, need it but I think the real key of navigating through this is being able to deal with what is euphemistically called the subprime mess.

The subprime mess is simply - and first, I think the important thing to understand, is this a creature of a very narrow window. It starts at the end of the third quarter of '05 and carries through, principally, the fourth quarter of '05 and '06. And what it is, is that in those five or six quarters, a series of attributes which were largely in existence already, took on a life . . . of their own and in combination, created risk layering, which on one hand, enabled many, many people to get into housing who might not otherwise have.

And on the other hand, unfortunately, put many, many people into houses they couldn't afford and not simply lower middle income people but combination, the layering, was also attributable to many middle income borrowers. In fact, at - we had a two-day conference in Washington yesterday, which was called the Housing Round Table. It's all the participants in housing and we get together three times a year and at that there was an argument from a number of the economists in the room.

As I said earlier, we're in a housing recession but more importantly, they argued that looking at the production, the subprime production, in those five or six quarters that as much as 50 percent of that production could have gone to the agencies, meaning, Fannie, Freddie and FHA. That's a pretty profound statement because a subprime loan is, at best, [an] eight plus coupon.

And usually, there's a second mortgage with a 12 coupon, so you're talking about an average coupon, a little bit over nine and you know, an agency piece of paper would've been a 6.5, so if you translate that into what he said, in another way, he was arguing that half these loans, the homeowner could have been put into a coupon at 6.5 versus 9.5 and that led to the question, the 800-pound gorilla in the room we dealt with, is the system broke?

Is there a problem, you know that it's not simply a function of normal economics but is there a break in the system, you know, what is the responsibility of the system to deliver . . . the appropriate, you know, housing finance structure? The real dilemma for me and I think the real issue . . . will be, we've never had to do substantial restructurings in housing in mortgage securities.

They were always in portfolios, and that made it very easy or at least, we didn't have to get 409 people or we didn't have to rent the Nassau Coliseum to have a bondholders meeting; we could do it very quickly. The vast majority of these loans, all of these theoretically, problem loans, are in securities, which have been tranched and then tranched and then re-tranched . . . [in] mortgage securities and then some tranch is put in CDOs. In a very long meeting, last Monday, where we tried to collect virtually everybody in a room, it became evident that there are a whole host of unforeseen technical problems if you try to restructure or do large amounts of restructuring within the security, some of which, we had never even heard of or thought about.

One of the accountants - you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can't do that. If you restructure that many loans, you're going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you - when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you've just tainted 140 and Q election.

Boy that was a big deal and I'll use that as a simple example of one other I'll give you, is the ability to put everybody in a room, even if you could find them all and get their assent, is slim - I mean it's not very practical.

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don't know how long it would take us. I mean, you know you've just basically told us we now have a problem that we don't quite exactly know how we're going to fix - and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we've done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we're talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we're talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don't have that freedom because you've got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I've been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I'm doing that now, too and we were told, well you're doing it wrong. You've got to send out a 1099.

That's an incredibly dopey idea. We're restructuring a loan around a borrower; he can't afford the loan and now we're going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

So let’s consider Ranieri’s question: is the system “broke”?

There is a credible estimate that as much as half of recent subprime production could have qualified for a GSE-style loan at a much lower interest rate. That means, among other things, that the “risk premium” these borrowers are paying is likely causing their defaults; if they weren’t subprime the day they got the loan, they are now. The theorists of "perfect" pricing of credit risk have some explaining to do. It is not unlikely that they will have the opportunity to explain that in court, as I for one can think of few more likely class actions than a group of borrowers who qualified for a prime or near-prime loan and got steered to some subprime exploding ARM.

Someone who is considered “the father of MBS” did not anticipate the difficulties of modifying securitized loans, given the constraints of the true-sale requirement (which means that the sponsor/servicer cannot “control” the collateral, and you’d have to get 400 bond holders in the Coliseum to vote on a loan modification). This is to say that a mortgage financing mechanism intended to mitigate risk is less able to respond quickly enough and efficiently enough to stave off losses than an unsecuritized portfolio or a simple agency pass-through.

Bondholders who may well understand that it is in their best interest to allow modifications of loans will discover what it will cost in legal and accounting fees to do that, costs that are there only because these loans are securitized; a similar restructure of a portfolio would not have those costs. Risk “dispersion” means never being able to get all your risk holders into the same room to hammer out a plan.

Some senior bondholder is going to sue some issuer for SFAS 140 violations (modifications, with or without a 1099) that were intended to cut the losses for the subordinate holders, but which would have the effect of maintaining some credit support for the senior notes, too. Besides the simple extraction of legal fees here, you have a situation in which losses will simply continue to mount while each tranche and the sponsor argue in court about whose interest is or is not being served. Meanwhile, borrowers get further behind.

There is always, of course, the option of foreclosing rather than working out, but bondholders are likely to get paid less for that, even if they don’t happen to care about the homeowner or the macro effects of that much foreclosed property. Securitization of loans did not, actually, eliminate the risks inherent in property markets; it seems to be capable, in fact, of magnifying those risks.

I’d go for “broke.”