by Tanta on 8/13/2008 08:17:00 AM

The Washington Post has a lengthy article up this morning on bank failures:

First the borrowers. Now the banks.

Federal and state regulators have closed eight banks this year, four since the start of July, as rising borrower defaults on residential and commercial real estate loans start to push some lenders into default, too.

Um, did we like take a Rip Van Winkle nap in late 2006 and just now wake up? As I recall the last two years, it was first the borrowers, then all the wacky securities, then the GSEs, then the banks.

In fact, as I recall things, we were once pretty much encouraged not to worry too much about the banks, because the storyline was that all the risky lending involved selling and securitizing loans, not stuffin' them on the old balance sheet. Here's a blast from the past, which I fondly remember as the day the NYT editorial board first learned about this thing called securitization. From September of 2006:

The housing boom would never have lasted as long as it did if mortgage lenders had to worry about being paid back in full. But instead of relying on borrowers to repay, most lenders quickly sell the loans, generating cash to make more mortgages.

For the past few years, the most voracious loan buyers have been private investment banks, followed by government-sponsored housing agencies, like Fannie Mae. The buyers carve up the loans into mortgage-backed securities — complex i.o.u.’s with various terms, yields and levels of risk. They then sell the securities to investors the world over, at breathtaking profit. The investors earn relatively high returns as homeowners repay their mortgages.

Back in 2006, the fashionable thing to say was that if banks had only held their loans rather than securitizing them, they would have controlled credit risk better because they had skin in the game.

I guess it was a bit more complicated than that.

by Tanta on 5/27/2008 04:49:00 PM

This is a sobering, if rather overstated, segment on mortgage loan sale due diligence and the pressures to accept even the most dubious of loans.

Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street. . . .

Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.

"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "

After a while, Warren says, her supervisors stopped telling her when she had been overruled.

I have no particular reason to question Ms. Warren's abilities or her take on the situation; I have no doubt that for any number of reasons marginal loans were pushed back into pools over the objections of perfectly competent auditors. I have also had experience with staff whose supervisors stopped telling them when they had been overruled, because . . . life is too short. I suspect I am not the only one who has had this experience. Whatever the merits of this story may be, this I think is an overstatement:

"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."

Forgive me for being a shill for Wall Street, but this strikes me as silly. The investment banks, including Bear Stearns, published loan underwriting guidelines detailing what they would accept in mortgage pools, and everybody in the industry had a copy at the time. The things came right out and said that things like stated income for a wage earner were acceptable. Was Mr. Peterson calling that "preposterous" at the time? I was. And I never had to look at a single loan file.

What I suspect Ms. Warren is overlooking is, precisely, that the due diligence on those Bear Stearns pools--like every other pool for every other investor--was based on evaluating the individual loans' compliance with the specific guidelines agreed to for the pool. If the guidelines allowed utter stupidity, it isn't likely that the project supervisors would kick out a loan for displaying that particular kind of stupid. If there's something preposterous here, it was in plain sight in the prospectuses to every one of these loan deals. I am having a hard time with the idea that "the smoking gun" didn't show up until this week.

And then there is this part, which has made it all over the web today:

A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.

If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.

"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.

Now, I actually plowed my way through that New Century report, and I have to say that there's a reason this claim was, um, "buried" therein. From page 135 of the report (Warning! Big Honkin' pdf that will take forever to download!):

[K]ickout data may not be a true indication of loan quality trends because New Century was able, particularly when the subprime market was strong and housing prices were rising, to negotiate understandings with certain loan purchasers to limit kickouts to a maximum rate, such as 2.5%. Flanagan [NEW's former head of loan sales] was explicit in stating to the Examiner that such understandings were reached. The Examiner was unable to establish corroboration for this statement. Nevertheless, such understandings may have limited kickouts, masking loan quality problems that existed but were not reported.

The report goes on to document that NEW's typical kickout rate was north of 5.00% and in many months much higher than that; except in securitization (not whole loan) deals where NEW retained residual credit risk, the kickout rate of 2.5% was, to quote the report, "probably more aspirational than real." The fact that no one could produce a contract or set of deal stips or e-mail or sticky note "corroborating" this claim suggests to me that it may have existed only in Mr. Flanagan's mind.

There are, of course, situations in the whole loan sale world in which people have perfectly respectable reasons to agree to limit "kickouts" up front. Occasionally pools are offered for bid with the stipulation of no kickouts: these are "as is" pools and it is expected that the price offered will reflect that. I have myself both offered and bid on no-exclusion loan pools. This is mostly an issue in the "scratch and dent" loan market, where one might have a mixed pool of pretty good and pretty botched up loans to sell. Allowing a buyer to "cherry pick" the deal just leaves you with all the botched up loans to sell separately, which is never anyone's preferred approach. Of course any buyer of loans can decline to bid on a no- or limited-kickout basis. Those who do bid on these deals tend to lower the bid price accordingly. The NEW report also documents the steady deterioration in NEW's profit margin on its whole-loan sales, and trying to get investors to take packages of loans with limited or no kickouts might explain some of that. My guess, from reading the report, is that while NEW might have thought it wanted a 2.5% kickout rate, it ended up accepting a much higher one because the price discount was more than it could face.

I am not trying to suggest that anyone is particularly innocent here. This all just has a sort of Captain Renault quality to it: we are shocked, shocked! that gambling went on in these casinos. The published underwriting guidelines that were available to everyone involved made explicit what was going on with these loans, and those guidelines were published with the deal prospectuses. Now we have a bunch of investors--including institutional ones with absolutely no excuse--wanting to grab hold of stories like Ms. Warren's about cruddy individual loans, as if the pool guidelines weren't themselves a big flaming hint that the loans were absurd.

by Tanta on 5/17/2008 09:49:00 AM

Floyd Norris thinks this Merrill Lynch subprime second lien security issued a year ago this month is "a candidate for the title of worst ever." I suspect there are measurably worse deals out there whatever criteria you happen to be using, but Norris's observation that this one closed right at the time when a number of ugly facts--like the bankruptcy of the major originator and Merrill's involvement in it--were actually all over the newspapers (not to mention the blogs) is quite relevant. If you were reading the daily paper, not to mention your Bloomberg terminal, you knew about the problem. But somebody bought this dog anyway.

If you care to know, the deal in question is Merrill Lynch Mortgage Investors Trust, Series 2007-SL1. Norris runs down the list of ugly characteristics of this deal, but here are a few additional uglies:

• 81% of the loans were purchase-money.
• Nearly 98% of them were fixed-rate loans (only slightly more than 2% were HELOCs).
• The weighted average Debt-to-Income ratio was 44.27%. As the overwhelming majority of the loans were stated income, and as it is likely that the first-lien mortgage payment used to calculate the DTI was based on a teaser-rate ARM, you can confidently assume that the true average DTI was significantly higher than that.
• The weighted average loan age was 7 months when the deal closed in May of 2007, meaning that most of the loans were originated in Q4 2006. By and large, this pool of loans would have had most of the "EPDs" (Early Payment Defaults) selected out of it.
• The A classes originally had 45.20% credit support and were rated Aaa by Moody's. As of last week, the A-1 bond is rated B3 and the A-2 bond is rated Caa1.

How fast did it all unwind? That, I think, is an interesting question given the reports we've seen in the last few days of an acceleration in losses on HELOC pools. Cumulative losses for the pool for its first twelve remittance months were: 0.00 0.01 0.01 0.15 0.95 2.70 5.50 7.81 10.59 13.37 16.00 19.40.

But nobody could have seen this coming.

by Tanta on 4/03/2008 04:04:00 PM

Sigh.

Some days all I can do is sigh.

The Wharton faculty interviewed for this piece, "Coming Soon ... Securitization with a New, Improved (and Perhaps Safer) Face," seem mostly to believe that securitization of mortgage loans isn't going to to away after the recent debacle, nor is it going to go unchanged. I certainly agree with both claims. But I hate stuff like this. Those of you who think my posts on the subject are much too long and tediously detailed might like it a lot. Certainly you can read it and make up your own mind.

This is where I started heaving the great sighs:

Allen believes financial markets will get back into the business of securitizing mortgage debt, but only after making some major changes. One new feature of future securitization deals, he says, could be a requirement that loan originators hold at least part of the loans they write on their books. Before the current crisis, loans were bundled into complex tranches that were passed through the financial system and onto buyers with little ability to assess the real value of the individual assets.

"The way the collateralized debt obligations (CDOs) and other vehicles are structured will change. They are too complicated," says Allen. "I'm sure the industry will figure out how to do it. There will be a lot of industry-generated reform and the industry will prosper. This is not, in my view, something that should be regulated."

This is the logic of the text (if not, perhaps, Professor Allan's logic):

1. Originators will be required to retain some credit exposure, [because?]

2. Investors have insufficient information to assess loan level risk, [because]

3. Securitization structures are too complex.

4. Therefore the industry will change these things and no regulation is needed.

Forget item four; that follows from any set of premises for some people. I just want to know how having originators (I do not think this means "security issuers" like investment banks) retain some exposure to the underlying credits will solve either the investor due-diligence problems or the complexity problems. I do not know why failing to distinguish between mortgage-backed securities and such vehicles as CDOs is being helpful in this context. I don't know why having simpler MBS structures will necessarily make investor due diligence any better: am I the only one who imagines that investor due diligence could be minimal on a plain old single-class pass-through if you waved a distracting enough coupon in front of them?

Well, the next expert brings that up:

According to Wharton finance professor Richard J. Herring, for decades, mortgage securitization was backed by government guarantees through Fannie Mae and Freddie Mac, and it worked well. Of course, these agencies were regulated and bound by less-risky underwriting standards than those that ultimately prevailed in the subprime market which was also, potentially, more profitable. Indeed, default rates were so low in the mortgage-based securities market that banks and other private financial institutions were eager to take a piece of the residential business.

Those GSE securities that worked so well for so long were quite simple in structure, and I'm still willing to bet that a lot of people invested in them without knowing much at all about the credit risk of the underlying loans. They relied on the guarantee, on the liquidity of the GSE MBS market, and on the "homogeneity" of the mortgage world back then.

And, you know, they didn't earn much. Conservative credit risk is not the sort of thing that generates princely yields. It was not, in fact, just that margins on originating subprime loans were fatter. (Even at the height of the subprime boom, subprime was never more than 20% of originations, as far as I know. Low volume and high margin.) It was that prime quality mortgage-backed securities don't have high yields, and they can't. In a "normal" market, they aren't risky enough to have juicy yield. And furthermore, everyone (more or less) has one. Including investors in MBS. There's a limit to how willing we all are to put high-yielding MBS in our retirement accounts if it means we can't afford our mortgage payments. We have met the source of the underlying cash-flow, and it is us.

The lurking concept here is "leverage." You want to make the big bucks investing in MBS? You leverage them. That's where those CDOs came from. A whole lot of this complexity is driven by the "need" to goose the yield, not by some essential opacity of the underlying credits or the failure of originators to retain residuals--which, in fact, they actually did quite a bit of in there. The complexity came in because you can't get a tranche paying 12% out of a bunch of loans that pay 8% unless you create complex cash-flow structures hedged by complex rate swaps leading to re-securitization of tranches in new vehicles (parts of the MBS become CDOs, for instance).

So are all the rest of you convinced that market participants are going to give up on the chase for mo' better yield without regulation?

Leverage does get a mention later on:

Wharton real estate professor Joseph Gyourko notes that significant differences exist in the performance of commercial and residential real estate securities. "Securitized commercial property debt will come back once the market calms down," he says, adding that there has been very little default in commercial real estate finance. "You'll be able to pool mortgages and securitize them, but almost certainly won't be able to leverage them as much as you did in the past."

The residential side, where there is significant default, is more problematic. Gyourko believes the residential market will go back to what it was in the mid-1990s and most borrowers will have to put
down at least 10% of the sales price. "We will get rid of the exotic, highly leveraged loans," he says. "That will lead to lower homeownership, but it should. We put a lot of people into homeownership that we shouldn't have."

Worry about commercial RE is just a side-effect of market tizzies? It's only individual homeowners who need to just get used to being left out of the party if they don't have the down payment? I begin to stop sighing and start to mutter . . .

Ah, but one distinguished professor has his eye on another party who could share some of the pain with the homeowner:

Wharton real estate professor Peter Linneman offers an intriguing prescription to bring prices down to the point where the industry can start to rebuild. He suggests that the government tell banks that if they want to maintain their federal insurance, they should fire their CEO by the end of the day, and the government will pay the CEO $10 million in severance. Ousting the former CEOs gives the new bank CEOs an incentive to write down all the bad assets immediately, so that any improvement will make them look good going forward. That would speed the painful process of gradual price declines.

"There's plenty of money out there waiting for these assets to be written down to bargain prices," says Linneman. In another quarter or two, the lenders would have new cash and be ready to lend again. Meanwhile, he says, the government should tell bankers it will keep interest rates down but raise them after the end of the year. "That says, 'Get your house in order in the next nine months because the subsidy ends at the end of the year.'" Linneman figures that 1,000 CEOs are accountable for about 80% of the current lending mess. If the government were to spend $10 billion to restore liquidity to the market in nine months with only 1,000 people losing their jobs, it would be the best investment it could make to restore the economy. "I'm only half-kidding," he quips.

Yeah, I'm only half-throwing up. If these CEOs are indeed "responsible" for 80% of the worst credit crisis we've seen in most people's lifetimes, and they've been doing quite well out of it, why do we need to pay them another $10 million to go away? Because it's "innovative"? Because the First Deputy Assistant CEO waiting in the wings has a whole nuther plan we haven't heard yet for some reason, but they will pipe up with it as soon as the Guilty 1000 are gone? And it's going to be about how to wean themselves off the leveraged carry-trade in nine months? Maybe that plan would be worth $10 million, but do we get the money back if we aren't satisfied?

I am trying to avoid suggesting that maybe we'd get better CEOs out of better business schools. I'm not trying that hard, but I'm trying. As is quite often the case, I never know if some of these things sound so half-baked because of the writing--the urge to simplify complex ideas into palatable chunks--or because of the paucity of the underlying material. But I'm happy to blame a lot of the bad writing I see on what they teach in business schools.

There is some sense in here--but you'll have to go dig it out yourself. I've sighed so much I need a good drink. I certainly agree that the CDO is dead. So, probably, is the SIV. I'm still wondering about the multi-class structured MBS, but that doesn't seem to be the article's particular interest.

(Hat tip Bill & Bill)

by Tanta on 2/27/2008 09:06:00 AM

This is what the Financial Times is reporting:

A leading Democratic lawmaker on Tuesday called for $20bn in public funds to be made available to the Federal Housing Administration to purchase and refinance pools of subprime mortgages. . . .

Mr Frank said “we can do it through an existing vehicle rather than a new vehicle”. But the underlying logic of the two proposals is similar.

Mr Frank said that under his plan, the FHA would “buy up packages of mortgages but at a substantial discount”. It would then refinance the loans.

This would require about $20bn up front, but Mr Frank stressed that “the FHA would be repaid” as the loans were refinanced. The ultimate cost of the scheme to US taxpayers, under Congressional scoring practices, would probably be about $3bn to $4bn.

Mr Frank also called for between $5bn and $10bn in loans to the states, which would be used to purchase and refurbish foreclosed homes, and extra funding for counselling services.

Mr Frank said the “lesser efforts” to tackle the mortgage crisis to date “have not been very successful”. The housing crisis was “getting worse not better”.

The externalities involved in foreclosures justified the commitment of public funds. “We are talking about terrible impact on society.”

The main difference between the Frank plan and some of the other proposals circulating is the scale of the intervention envisaged.

Alan Blinder, a professor of economics at Princeton, has called for a new government vehicle modelled on the Home Owners Loan Corporation of the 1930s to borrow between $200bn and $400bn to buy up and restructure distressed loans.

Mark Zandi, chief economist at Moody’s Economy.com told the House financial services committee that it would take about $250bn in upfront funds to purchase all 2m loans expected to end in foreclosure by the end of this decade.

Mr Frank said “reality constrains” and his plan was limited to $20bn for the FHA because of the budget deficit and the need to meet pay-as-you-go spending rules.

So far this morning, my attempts to find more details on the Frank plan have not succeeded. I did, however, find this recently published statement of priorities for the House Committee on Financial Services, of which Frank is the chair:

The Committee on Financial Services urges the congressional budget resolution to prioritize the following critical issues:

(1) Housing Initiative. Over the last six months, the nation has experienced a significant increase in the number of homeowners facing the risk of foreclosure, with estimates of as many as 2.8 million subprime and “Alt A” borrowers facing loss of their homes over the next five years. We have already experienced declining home prices in many areas of the country, and the physical deterioration of certain communities, as a result of waves of vacant homes that were foreclosed or abandoned.

The Financial Services Committee is developing a number of proposals to address these growing problems. Given the urgency to take action, a significant portion of the cost of such proposals will likely be incurred in the current fiscal year. However, there would be some loan activities, FHA administrative costs, and additional housing counseling funding that would be needed over the period of the Budget Resolution.

First, the Committee is working on a proposal to provide refinancing opportunities to save as many as 1 million distressed homeowners from having their homes go into foreclosure. Such a proposal will likely involve using FHA and may involve the federal government purchasing loans. It would be implemented through separate authorizing legislation. Any proposal will require the existing holder to write down the loan to a level that is consistent with the homeowner’s ability to pay, and would exclude investor-owned and second homes. The estimated credit subsidy cost could be as much as $15 billion over the next five years. The Committee is also exploring options to limit federal government exposure and thus reduce costs. We could, for instance, require a limited soft second mortgage to the government that would enhance recoveries resulting from future property sales.

Second, the Committee is working on a proposal to provide as much as $20 billion in the form of grants, loans, or a combination of the two, for purchase of foreclosed or abandoned homes at or below market value. The purpose would be to help stabilize home prices and to begin to reverse the serious physical deterioration of neighborhoods with high numbers of subprime borrowers, defaults, and foreclosures. The structuring of such an initiative as a loan program would help to minimize the cost of the federal government, through net recoveries from the subsequent sale of properties.

Third, a substantial expansion of FHA to help keep homeowners in their home will require the contracting out by FHA for independent expertise for the development of underwriting criteria for refinanced loans and for quality control of the loans as they are being made, as well as increased FHA personnel costs for such activities as loan processing. This will require additional FHA administrative funding in the Budget Resolution for FY 2009 and possibly in subsequent years, in an estimated range of several hundred million dollars a year.

Finally, it is important for Congress to increase funding over FY 2008 levels by at least an additional $200 million a year for federal housing counseling grants. Such grants would increase capacity, in order to ensure that sufficient numbers of borrowers are assisted in implementing these and other initiatives to keep people in their homes.

I still have no particular idea where the "one million distressed homeowners" figure comes from, but we can, I think, conclude that it would be a total number of all FHA-related initiatives, including FHASecure and other kinds of fairly straightforward refinance programs, not just a program that involves FHA purchasing an existing loan in order to refinance it.

If the FT has the number right, we're looking at $20 billion for loan purchases. It's hard to calculate how many loans that would be without knowing just what kind of a discount is on the table. If you assumed a 10% discount and an average original loan balance of $200,000, you'd get just over 100,000 loans. At a 50% discount you could buy around 200,000 loans. That's a long way from a goal of one million loans, however you slice it.

On the other hand, there's the potential of several hundred million dollars a year on the table for independent experts who want to write FHA's credit guidelines for them. We knew that was coming.

The sanity level of this kind of plan still depends on why it is we want FHA to buy these loans and then refinance them, as opposed to simply refinancing them. The risk in the buyout, of course, is always that FHA pays too much for the loan; if buyer and seller need to do the full loan-level analysis to calculate the amount of the necessary loan balance to write off before establishing a price, then the practical thing to do at that point is simply a refinance, without FHA ever owning the old loan. If the point is that there isn't time or capacity for current loan holders to do that analysis, then the amount of the discounted price FHA would pay is uncertain at best.

I am also still eager to hear how this proposes to work from the perspective, specifically, of buying loans out of REMIC pools--and that is, presumably, where the problem loans in question are likely to be, not in bank whole loan investment portfolios. REMICs just cannot sell loans at less than par under current rules; without a change to those rules, it seems likely to me that in the process of selling defaulted loans to the government at a discount, the sponsors of these securities are committing themselves to bringing the deals onto their balance sheets, and possibly facing taxation of the trust itself (not just the investors receiving pass-through income). This is one of the several important differences between the current situation and the old HOLC situation in the Depression (where loans were being purchased from banks and were not securitized).

At this point I'm tempted to think it's a lot of additional mess for $20 billion. The Securities Lawyer Full Employment Act probably wasn't what anyone had in mind . . .

by Tanta on 2/26/2008 11:54:00 AM

Some day I will learn to stop ignoring stuff. I saw this Bloomberg piece on the day it was published, my eyes rolled into the back of my head, and I realized that on a good day I haven't got the ability to unscramble this frittata of anecdote, conflation, fact and side-issue in less than 10,000 words. I certainly have a hard time doing that temporarily blinded. But I have now received a round dozen emails from you all drawing my attention to it, plus all the uncounted times it has come up in the comments. Okay, fine.

The thing starts off with its one and only specific example, and it's a doozy:

Feb. 22 (Bloomberg) -- Joe Lents hasn't made a payment on his $1.5 million mortgage since 2002.

That's when Washington Mutual Inc. first tried to foreclose on his home in Boca Raton, Florida. The Seattle-based lender failed to prove that it owned Lents's mortgage note and dropped attempts to take his house. Subsequent efforts to foreclose have stalled because no one has produced the paperwork.

``If you're going to take my house away from me, you better own the note,'' said Lents, 63, the former chief executive officer of a now-defunct voice recognition software company.

"Former CEO" seems a tad bit complimentary to Lents here--perhaps Bloomberg is afraid of getting sued by this particular piece of work. We do get this:

Lents is former CEO of Investco Inc., a Boca Raton, Florida-based developer of voice recognition software. In 2002, the U.S. Securities and Exchange Commission sanctioned Lents and others for stock manipulation, according to the SEC Web site. He lost his job, was fined and his assets were frozen. That's the reason he couldn't pay his mortgage, he said.

Well, I never miss an opportunity to go wade through the SEC website. As far as I can determine, Lents cooked up a pump-and-dump scheme, and then found a company he could take over to implement it. This part is amusing: "Investco, Inc. is a Nevada corporation headquartered in Boca Raton, Florida. Investco formerly purported to be a provider of voice recognition technology and now claims to be a provider of financial services." If it takes one to know one, we have one.

This article from January in the South Florida Business Journal gives us a touch more color on the Lents foreclosure:

Somebody has been trying to foreclose on Joseph Lents' Boca Raton home for five years. So far, they have been unsuccessful because he has legally fought them every step of the way. . . .

"I probably have been to the Palm Beach County courthouse 100 times or more over the last five years, just to observe," Lents said. "In 99 percent of the residential foreclosure cases, plaintiffs are asking the court to accept a promissory note copy as the original because it is presumed lost."

Resistance doesn't come cheap. Lents has paid more than $120,000 in legal fees and costs so far to save his 5-acre, $2.5 million home. . . .

The Lentses built their home in 1992 and, on May 15, 2001, according to public records, refinanced it for $1.49 million with Washington Mutual Bank (NYSE: WM).

Lents, a retired CPA, lost his corporate job in 2002 when the SEC charged the company he led (Ivesco/Intraco) with a pump-and-dump scheme, according to SEC documents. While the SEC agreed that Lents had not made money - he actually lost money on the transactions - the damage was done. His income stopped and he fell five months behind on his mortgage payments.

"I tried contacting WaMu [Washington Mutual] and couldn't get through to anyone who could help me reset or recast the mortgage," Lents said. He contacted the mortgage broker, Express Financial, which had helped him shop around for the best mortgage in 2001. "They contacted WaMu and were told it couldn't do anything because, even though they were servicing the mortgage, the loan had been sold. It was a Catch-22," Lents said.

In January 2003, WaMu filed for foreclosure against the Lentses.

Where's the note?

The first count of the complaint was curious, according to Lents. It said the $1.49 million promissory note was lost.

"Now, I have audited a number of banks and credit unions in my time, and I can tell you they don't lose million-dollar notes," Lents said. "If auto dealers can keep track of auto titles, surely banks can keep track of promissory notes."

West Palm Beach attorney Brook Fisher filed an objection, and WaMu filed an affidavit, swearing the note had been lost.

The employee who filed the lost note affidavit was deposed. Under sworn testimony, she said she hadn't searched for the note and just signed a stack of lost note affidavits.

WaMu's attorney filed for summary judgment in 2003. However, since the facts surrounding the allegedly lost note were in dispute, the judge set the case for trial and allowed discovery for records and depositions.

Lents acknowledged that he owed the money, but would only pay the legal note holder, whoever that might be.

In October 2003, WaMu dismissed the suit.

Nothing more happened until February 2005, when Donaldson Lufkin Jenrette (acquired in 2000 by Credit Suisse) filed a foreclosure suit against the Lentses.

In a September 2005 mediation meeting, the attorney representing Donaldson Lufkin Jenrette said it had paid a premium for the Lentses' mortgage, apparently purchased as part of a package of non-performing loans. . . .

The Lentses' case is coming to a head. A hearing is set for Jan. 8 in which Donaldson Lufkin Jenrette is seeking summary judgment. Their attorney, Miami-based Jane Serene Raskin of Raskin & Raskin, will probably be asking for the same thing. (She did not return calls for comment.)

I have so far been unable to find an update on the DLJ hearing. I cannot even tell, from this narrative, whether DLJ was the "investor" to whom WaMu had sold the loan at the time it defaulted, or if WaMu subsequently sold the loan to DLJ after it dismissed FC proceedings, as a "non-performing loan." If the latter is the case, I admit I'd like to know just how much "premium" DLJ paid for it. (Note to the irony impaired: no, I don't want to know that. I sleep better not knowing that.)

So here's what seems to be the deal. Lents, who knows a little something about obfuscation and has a lot of free time since the SEC took care of his employment opportunities, hung out at the courthouse long enough to notice that FCs are routinely filed with either a certified true copy of the promissory note or a Lost Note Affidavit (LNA), which in every instance I have ever personally seen is a sworn statement that the original note is lost, and is accompanied by a certified true copy of the lost original. (It is theoretically possible to submit an LNA without a copy, if there were a case that both the original and all copies of the note were lost. However, there would have to be other documents attached to the LNA that would provide evidence that it once existed, such as other closing documents, the loan payment history, a sworn statement of the notary or escrow officer, etc. As I said, I've never actually seen an LNA without a copy of the note attached to it.)

Having noticed that, Lents filed an objection to the FC based on the dubious standing of the LNA; discovery proceeded and it turned out, not surprisingly to me, that there was no particular evidence that WaMu had lost the note. Someone simply decided that the quick and easy way to process a batch of foreclosure filings was to grab the copy of the note that was easily available in the servicing file, slap an LNA on it, and go with that, rather than going through the process of locating the custodian who held the original note, filing the paperwork required to have it released to WaMu, etc. Based on the article, it seems possible to conclude that the original note really was lost, but since WaMu made no effort to find it in the first place, it's a no-brainer to conclude that at least one statement in that LNA was false. (They all say something to the effect that all practicable efforts to locate the original have been made and have failed, and that the affiant has personal knowledge of this.)

What this article does not say is whether DLJ has an original note or not. If DLJ owned the note at the time WaMu, the originator and servicer, tried to foreclose on an LNA, that might be why WaMu didn't have it: DLJ had it and either WaMu didn't try to get it from them or DLJ failed to produce it. If DLJ purchased the loan subsequently, as "non-performing," then either DLJ bought with an LNA (it allowed the sale to go through with only an LNA to evidence the note), or WaMu found some note for DLJ. It really drives me nuts that these news reports bring all this stuff up, and then never really report all the relevant details. My best guess is that DLJ bought a pool of junk loans and accepted an LNA instead of requiring the original note. That's probably why DLJ is having to bring other evidence into court, such as the evidence of its purchase of this pool.

I note for y'all that I have personally executed one or two LNAs in my day, and have therefore had all known hard file folders associated with this loan (the servicing file, the branch's copy, the custodial file, whatever there is), as well as all correspondence with the warehouse bank or custodian or whoever else might have had it brought to my desk, so I could personally root through it all once more before I put my officer's signature on an LNA. In all but one of the LNAs I can remember executing, I had documentation from FedEx or some other shipper that a package had indeed been lost, plus clear documentation in the loan file that this specific note had been included in that specific lost shipment. (My shipping department always put the copy of the airbill in the loan file. Always.) And of course I always had a certified true and correct copy of the note to attach to the affidavit.

I bring all this up because, Lents' self-serving nonsense aside, not only can original notes be lost or damaged, so can car titles and any other piece of paper. (I have a friend who once had to execute over 100 LNAs after a fire in an adjoining office suite triggered the sprinkler system in her post-closing department. Those LNAs were accompanied by copies of sodden bits of semi-readable paper that had been patched together on the copier plate, one at a time.) A financial institution in the business of making mortgage loans has no business routinely losing or damaging original promissory notes, and any institution that does so should be shut down by the federal regulators and I mean that.

But if consumer attorneys want to create a situation in which the simple fact of loss of or irreparable damage to an original note vacates the debt, I can promise you you will not like the consequences of that. If it turns into Total War here, don't ever lose an original cancelled check. You should know that there is actually one fairly respectable reason for doing FC filings with note copies, besides servicer laziness or loan sale screw-ups: taking your original note out of the custodian's vault to send to some local attorney to attach to a court filing creates several more opportunities for it to get lost. If it becomes a requirement that FC can proceed only with the original note in the courtroom, and the presence of an LNA always means dismissal, then the things are going to have to be handled and shipped and received with the same level of security as a million-dollar bearer bond. Like, a Brink's truck and a bonded courier carrying a briefcase handcuffed to his wrist. You want to pay the cost of that? No. You don't. But you will.

The problem here, I suspect, is that the jurisdiction in question does not provide for a legitimate way to file with a true and correct certified copy of the original note; the only way servicers can get by without giving up their original notes to the county clerk is by filing an LNA, which at minimum makes them look bad (and involves false statements). I'll leave it to the lawyers to argue about the wisdom of forcing servicers to hand over original notes at the same time they are offered no legal remedy if counsel or clerk or FedEx misplaces it. I am simply observing, once again, that this kind of half-serious half-frivolous objection to a foreclosure action can end up having consequences nobody is going to be happy with.

To return to Bloomberg, though, you will notice that an article that goes on and on at length about the dangers of the secondary market in mortgage loans and originators going out of business and so on has exactly one example, which appears to be of a loan with a note that doesn't seem to have been lost in a loan sale and the originator in question is still in business. Meanwhile, some slick operator for whom $120,000 in legal fees is cheaper than five years of mortgage payments and whose hobby is hanging out at the courthouse is creating a precedent for FC filings in Florida that will no doubt be hailed by so-called consumer advocates as a victory for the little guy.

Lost in all of this is the apparent fact, once again, that WaMu was and probably still is exceptionally sloppy with its handling of original notes; that an outfit like DLJ will apparently buy loans with nothing other than a note copy (and pay premium, too!); and that in the absence of the industry getting serious about confronting its true operating costs and failed "efficiencies," its practices are being "criminalized." Back to Bloomberg:

Borrower advocates, including Ohio Attorney General Marc Dann, have seized upon the issue of missing mortgage notes as a way to stem foreclosures.

``The best thing to do is to keep people in their homes and for everybody to take steps necessary to make that happen,'' said Chris Geidner, an attorney in Dann's office. ``These trusts are purchasing these notes, and before they even get the paperwork, they foreclose on people. They become foreclosure machines.''

Joe Lents is not the victim of a "foreclosure machine." He's a deadbeat who has found a way to go five years without making a mortgage payment. He can apparently afford $120,000 in legal fees. But little people who cannot afford the mortgages they have are being convinced to let a lawyer fight their foreclosure on the grounds that the original note wasn't in the courtroom, and all that's going to do is delay the inevitable, add legal fees and even more accrued interest to the deal, and draw this whole horrible unwind of the RE bust out into years and years of hell.

I'm sorry, but AG Dann needs to go after predatory lenders who took advantage of borrowers. If he has evidence that loans were originated with the intent to foreclose--which is predatory by definition--then he should go after that. Intervening to stop a foreclosure because an assignment was filed after the loan purchase is just pandering and grandstanding and wasting resources.

The WaMu problem needs to be taken care of by the OTS: how, I want to know, does anyone pass a safety and soundness examination with a pattern of being unable at any given time to tell you where its notes are? With a pattern of requiring some low-level employee to fill out LNAs with false declarations in them to "save time"? If this isn't a pattern, then what's with all the insinuations in the Bloomberg article that it is? If it is a pattern, it's unsafe and unsound and WaMu's charter should be in danger. This is not the kind of problem you "solve" by challenges to individual FC cases, particularly ones like Lents's--the man by his own admission hasn't made a mortgage payment in five years. He deserves to lose that house, yesterday. I wouldn't go on record defending DLJ's loan purchase due diligence practices here, but DLJ deserves to win.

The rest of us deserve to have this kind of crap prevented, rather than enabled. The regulators and the investment community have to stop putting up with sloppy operations and cavalier attitudes toward document custody. At the risk of repeating myself once more, the true costs of the secondary market in mortgages has to come onto somebody's income statement sooner or later. We are seeing what happens when you claim to have careful operations at the same time you go on a cost-cutting spree to get rid of all that back-room stuff. This problem will not be solved by enriching foreclosure-avoidance attorneys.

I suppose I should end with a nod to this one, which got featured yesterday at The Big Picture and which many of you have also emailed to me. From the Chicago Tribune:

The new buyers of a rundown graystone on the South Side showed up Jan. 9 to look at the house they won at a foreclosure auction. They took the plywood off the front door and went inside to make sure the utilities had been shut off. Then they called the police.

Sitting upright in the corner of a bedroom off the kitchen was a human skeleton in a red tracksuit. Next to him lay a dead dog. Neighbors told police the corpse was almost certainly Randy Johnson, a middle-age man who lived alone in the North Kenwood house.

The cause of Johnson's death has not yet been determined, but it is just one of the mysteries about 4578 S. Oakenwald Ave. Somehow, Johnson's house was transferred three times to new owners without anyone noticing he was inside. It's a story involving forged deeds, a corrupt title company and a South Side family that has been under investigation for mortgage fraud.

Keep reading, and you'll find that Countrywide made a 100% financing deal on this thing, either without requiring an appraisal with a physical inspection, or by having relied on a fraudulent appraisal made by an appraiser who never entered the premises, or that corpse wasn't there until after the loan was made. You really can't conclude anything with the evidence we've been given. I confess I'm a bit more startled by this part:

When Johnson hadn't appeared outside for weeks in early 2006, neighbors called the city's non-emergency number asking for well-being checks, fearing he might have had an accident. Firefighters broke down the front door and searched but didn't locate Johnson. His death remains under investigation.

Sure, the thing is worth a few bad jokes at Countrywide's expense, but honestly. If the fire department broke in and searched and didn't find a corpse in 2006, nearly a year before the CFC mortgage was made, you have to wonder when the corpse got put there. As there is evidence that the 2007 purchase with the CFC loan was entirely fraudulent, there's certainly reason to suspect that the body was hidden in the home after the loan was made and the conspirators skipped out with the money. Until we get more information, I'm not inclined to see this as "three transfers without anyone noticing."

But consider it useful evidence that the mortgage mess has gotten bad enough that absolutely any insinuation against lenders, especially Countrywide, is now considered plausible. I'm personally a bit more concerned that certain parties have figured out that foreclosed properties are great places to hide corpses in. Those green pools may not end up being the neighbors' biggest complaint . . .

by Tanta on 2/24/2008 12:15:00 PM

I am generally impressed with the quality of Andrew Davidson & Co.'s analysis of mortgage securitization issues. This particular instance, however, leaves me shaking my head. Certainly I give them credit for trying to find constructive suggestions to make, but I don't think we've drilled down far enough into the issues yet.

This does start out right, I think:

The standard for assessing securitization must be that it benefits borrowers and investors. The other participants in securitization should be compensated for adding value for borrowers and investors. If securitization does not primarily benefit borrowers and investors rather than intermediaries and service providers, then it will ultimately fail.

The trouble is that the standard case for how securitization of mortgages benefits borrowers is simply the observation that it makes capital available for lending at reasonable rates of interest. But that's hardly a benefit if it makes too much capital available for lending at too cheap a cost: supply chases down ever more implausible types of borrowers with ever more implausibly "affordable" mortgages, with ever more aggressive solicitation tactics. We're all learning a lot about the costs to all of us of unlimited mortgage money being provided to the financially weakest of us. Therefore securitization's benefits have to be more than just the provision of capital and the lowest possible interest rates; if securitization cannot function to rationalize lending practices by creating "best practice" lending guidelines and loan product structures outside of which its generous capital is not available, then it always has the potential to blow devastating bubbles.

There's a lot in this essay, but for the moment I just want to focus on the analysis and recommendation for dealing with the front-end part of the problem:

At the loan origination stage of the securitization process, there was a continuous lowering of credit standards, misrepresentations, and outright fraud. Too many mortgage loans, which only benefited the loan brokers, were securitized. This flawed origination process was ignored by the security underwriters, regulators, and ultimate investors. . . .

First, originators should be held responsible for the quality of the origination process. Investors in mortgage‐backed securities rely on the originators of loans to create loans that meet underwriting guidelines and are free of fraud. Borrowers rely on originators to provide them with truthful disclosures and fair prices.

Notice how, in the first paragraph, we slip in the first two sentences from "the quality of the origination process" (something quite obviously under the control of the originator) to "underwriting guidelines," which in any securitization practice I know of are either outright stipulated by the issuer in all respects (Ginnie Maes, standard-contract Fannies and Freddies, a lot of private pools) or are at best negotiated between lender and issuer (most private pools, some GSE business). Once the guidelines are either published by the issuer or agreed to in negotiation between issuer and originator, then it is indeed the originator's job to meet them.

But a whole lot of these loans that are failing right now were originated as 100% CLTV stated-income loans, because the guidelines agreed to by the issuer allowed that. I am scratching my head over the logic here: I spent most of the early years of this decade, just as a for instance, blowing my blood pressure to danger levels every time I looked at the underwriting guidelines published by ALS, the correspondent lending division of Lehman. ALS was a leader in the 100% stated income Alt-A junk. And I kept having to look at them because my own Account Executives keep shoving them under my nose and demanding to know how come we can't do that if ALS does it. I'd try something like "because we're not that stupid," and what I'd get is this: "But if ALS can sell those loans, so can we. All we gotta do is rep and warrant that they meet guidelines that Wall Street is dumb enough to publish." Every lender in the boom who sold to the street wrote loans it knew were absurd, but in fact they had been given absurd guidelines to write to. What on earth good did it do to have those originators represent and warrant that they followed underwriting guidelines to the letter, when those guidelines allowed stated income 100% financing on a toxic ARM with a prepayment penalty?

Currently, investor requirements are supported by representations and warranties that provide for the originator to repurchase loans if these requirements are not met. However, when there is a chain of sales from one purchaser to another before a loan ends up in a securitization, investors may find it hard to enforce these obligations. Similarly, borrowers who have been victimized by an originator may have nowhere to go to seek redress if the company that originated their loan goes out of business. Some in Congress are proposing “assignee liability” as a solution to this problem.

Investors don't "find it hard to enforce these obligations" unless they did zero financial due diligence on the last party in the chain. The way it works, your contract is with the last party to own the loan. If you bought loans from Megabank who bought them from Regional Bank who bought them from First Podunk who bought them from Loans R Us who funded the application for a broker, your contract is with Megabank and if the reps are false, Megabank supplies the warranty (the repurchase or indemnification). Megabank can go collect from Regional, who can go collect from Podunk, as far back as it takes to find the original misrep. It's always possible, of course, that the broker made true reps to Loans R Us, who made true reps to Podunk, but it was Podunk who misrepped to Regional (because Podunk bought under a set of guidelines that might have worked with some other investor, but then decided to slip these loans into a deal with Regional, even though Regional published different rules). The assumption that it is in fact always the first originator (the one who closes the loan) who fails to follow guidelines is a huge logical flaw. The contract theory underlying this--that A in contract with B can enforce terms against D who was in contract with C who was in contract with B--startles me as well.

This necessity of "chained pushbacks" certainly does cause grief: eventually, bad loans get back to the originator, but not nearly soon enough. It could take two years for the thing to work through, and delaying negative consequences is never a good thing in terms of keeping incentives aligned properly. But it doesn't hurt investors: they get paid back at par right away from the first party in the chain. In fact, that may explain why, as a rule, they've never particularly cared about the whole problem of "aggregating," or having whole loans work their way from small local originators into the hands of large financial institution counterparties before they are securitized. The investors think, more or less correctly, that their risk is covered because while the loans might have been originated by Loans R Us, net worth $37,000, they were sold to the investor by Megabank, net worth o' billions, and that takes care of the counterparty risk. Which is to say, it puts the counterparty risk on Megabank, who puts in on Regional, etc.

The obvious thing for security issuers to do, if they want direct liability of the loan originator, is to buy the damned loan from the loan originator. Or, maybe:

Assignee liability, however, may create risks for investors and intermediaries that they are unable to assess. As an alternative to assignee liability, an updated form of representations and warranties – an origination certificate – would be a better solution. An origination certificate would be a guaranty or surety bond issued by the originating lender and broker. The certificate would verify that the loan was originated in accordance with law, that the underwriting data was accurate, and that the loan met all required underwriting requirements. This certificate would be backed by a guarantee from the originating firm or other financially responsible company.

The origination certificate would travel with the loan, over the life of the loan. By clearly tying the loan to its originators, the market would gain a better pathway to measure the performance
of originators and a better means of enforcing violations. Borrowers would also have a clear understanding of whom to approach for redress of misrepresentations and fraud.

While risk arising from economic uncertainty can be managed and hedged over the life of the loan, the risks associated with poor underwriting and fraud can only be addressed at the initiation of the loan. Such risks should not be transferred to subsequent investors, but should be borne by those who are responsible for the origination process.

Wall Street security issuers don't want to buy loans directly from any given originator, because that would require them to have loan purchase and sale agreements with a bazillion little counterparties. They like the idea that Megabank has agreements with one hundred counterparties, who each has agreements with one hundred counterparties, etc. The cost of all this managing of relationships and moving loans up into the biggest buckets--the "aggregator" bucket--never goes away, it just isn't carried operationally by Wall Street.

So the idea here is to keep the middle-men and intervening aggregation of whole loans, but to make sure the original party who closed the loan never gets off the hook by having that party issue some kind of surety bond that would be guaranteed by somebody. So Loans R Us, assuming it has enough capital to back a guarantee, issues this certificate stating that it followed ALS underwriting guidelines to the letter. The loan blows up because ALS underwriting guidelines are stupid. Now what?

And of course this is simply meaningless in the context of originators who go out of business. Go ask the monolines how much a credit guarantee is worth if the counterparty doesn't have any money. As it currently is, regulated depository loan originators are required to reserve for contingent liabilities on loan sales: if you have the risk you might have to repurchase a loan, you have to reserve something for that. State-regulated non-public non-depositories may not have such strict requirements, or may not have them enforced. So if you want to assure that originators appear to have the financial strength to make reps and warranties, then you need to look into financial and accounting requirements for originators. Forcing them to come up with a surety bond--putting investors ahead of the originator's other creditors in a potential bankruptcy because said investors don't want counterparty risk--is a bit much.

That's one of those few cases were you can, in fact, pretty much guarantee that credit costs to consumers will rise unnecessarily. If you just want originators to keep skin in the game, there's this old-fashioned way of securitizing loans called "participations" that you might look into. In that case, the investor only buys a fraction of the loan asset (not a fraction of a security, a fraction of a loan), with the originator retaining some percentage interest. That shares the risk between two parties, but also the reward: if you retain a 10% participation interest in a loan you sell, you get 10% of the monthly payment. If you buy 100% of a loan and collect 100% of the payment, and yet you force the seller of the loan to warrant its risk forever, that seller will find some way to be compensated for that--meaning more points and fees to borrowers.

The idea of assignee liability is that you did, in fact, agree to a set of underwriting guidelines when you bought loans or invested in a pool of loans. If you agreed to guidelines which are harmful to borrowers, then this capital you are pouring into the mortgage market is not helping borrowers. The essential confusion here is between failure to follow responsible guidelines and faithful following of irresponsible guidelines. My sad news for the investment community: a whole lot of what you are suffering from is the latter, not the former.

How can anyone possibly require more proof of that? Starting in 2007, investors rapidly pulled out of the 2/28 ARM subprime product. They just announced they wouldn't buy it any longer. And it went away. You do not have a bunch of mortgage brokers still selling 2/28s to borrowers, or correspondent lenders still throwing 2/28s into new securitizations. As you might have noticed, you don't have new securitizations. You always had the power to click your heels together three times and return to the land of just not buying the paper, but I guess you didn't know that until the pink witch showed up.

And you will note that what immediately happened after you all stopped agreeing to those goofball underwriting guidelines was that a bunch of marginal originators immediately went belly-up. That's all the business they could get: writing junk paper for foolish investors. You put them out of business. You should not be sorry about that, except for the part about how you did business with them for so long that now you might have a bunch of worthless contractual warranties. This is called learning by doing. The solution to it is not to go back to buying any old dumb loan that you can get someone to offer a warranty on.

The solution is for investors to refuse to get within 20 feet of a mortgage-backed security that is backed by dumb loans. If you do not know what a dumb loan is, you might want to consider investing in a different kind of instrument. If the guidelines are not dumb, then by all means hold those originators to every last dotted i and crossed t in their contracts, because it is true that the quality of the process is what the originators control. But if you tell them it's OK for them to make loans without seeing docs, without requiring down payments, without worrying about ability to repay, then that is what you get and what we all get.

by Tanta on 2/13/2008 08:20:00 AM

I will have you know I did not make that up.

Aside from the small trickle of deals, UBS highlighted a new structuring technique for Alt-A hybrid deals, which involves carving out ultra high-quality bonds out of the super senior triple-A classes and calling them super duper senior bonds.

"Many investors are reluctant to buy MBS backed by Alt-A collateral including super senior paper, as they fear credit losses," UBS analysts wrote.

In a hypothetical super duper triple-A deal, the bonds have twice the credit enhancement of the super senior triple-A bond and four times the credit support of the straight triple-A bond. After running the structure through hypothetical scenarios, UBS determined that the super duper senior Alt-A hybrids offer great value relative to prime jumbo super senior hybrids and agency hybrids, and virtually eliminate the credit component.

Some market participants, however, were not as delighted with the prospect of the new structure. "I don't think it will be anything big," one trader said. "I don't think anyone is overwhelmed by it."

I'd think not. "Super Duper" sounds like the kind of thing you hear at a Junior League luncheon (not that I've ever been invited to one, you know, but you hear stories). I think they need a better name for this.

Belt and Suspenders Bonds? Belt and Suspenders and Duct Tape Bonds? Belt and Suspenders and Duct Tape and Airbag Bonds? Belt and Suspenders and Duct Tape and Airbag and Flame-Retardant Jammies Bonds? If we're going to act like we found the recipe for a quintuple-A rating, we might as well be vivid.

by Tanta on 2/07/2008 10:02:00 AM

P.J. at Housing Wire reports that FASB (the Financial Accounting Standards Board) is threatening to end the arguments over "the Q election" by simply eliminating QSPEs entirely:

In an accounting standards session at this past week’s American Securitization Forum, FASB director Russell Golden told audience members that the standards board has since decided to eliminate QSPEs altogether; the focus now is now on how to best to handle the issues created by so doing.

You could have heard a pin drop among audience members after Golden said FASB would “eliminate QSPEs.”

Attempting to fix one problem kept causing other problems to pop up, Golden said. He also hinted that the recent SEC letter by chief accountant Conrad Hewitt, which apparently gave the green light to fast-track loan mods, understated the real discussions that have been taking place in private between SEC and FASB officials.

Bloomberg’s Weil suggests that FASB officials have been irked at what they saw as the SEC undermining FASB due process — a line of motiviation that I think misses the truth behind what’s really been going on.

It’s probably fairer to say that FASB had been letting sleeping dogs lie in this area after shoring things up in the wake of the Enron scandal in 2001; and those dogs are no longer sleeping — or lying down — thanks to the ARM rate freeze plan. Forced to address the issue of loan servicing, FASB apparently decided it was easier to eliminate the concept of a QSPE altogether than to try to modify the rules under which it should be allowed to exist.

It’s unclear, exactly, how a ‘Q-less’ world ultimately would affect the secondary markets; many of the details have yet to be nailed down. One thing, however, would seem to be crystal clear: loans would, in all likelihood, no longer be able to be transferred off of a lender’s balance sheet. Golden said that FASB is still working through details of a proposal in this area, however, and would want input from market participants.

At this point, I take this to mean that mortgage loan (and other asset-backed) securitizations would have to be treated as financings, rather than sales, of the underlying assets. Therefore both the assets and the corresponding liabilities would be reflected on the issuer's balance sheet, with the (presumed) effect of increasing the issuer's capital requirements as well as the cost of financing (investors would have to be compensated for the loss of the "bankruptcy remote" vehicle structure). I think we can pretty much guess what the "input from market participants" is going to be.

In case you missed this in yesterday's New York Times:

Until the banks rebuild their capital, they will not have the wherewithal to lend money and support economic growth. If banks of all sizes could regain their capital immediately and easily, it would be a tremendous benefit to the American economy.

The federal government could make this happen by entering into an arrangement with American banks that hold subprime mortgages, in which homeowners typically pay a low interest rate for two or three years then face much higher payments. Here’s how it would work: The government would guarantee the principal of the mortgages for 15 years. And in exchange the banks would agree to leave their “teaser” interest rates on those loans in effect for the entire 15 years.

This would instantly give the lending banks new capital. As these mortgages would be guaranteed by the Treasury, they would suddenly be assessed, on bank balance sheets, at their original value — and a significant amount of the banks’ lost capital would be restored. Plus, the banks would receive, from most of the homeowners with subprime mortgages, up to 15 years of teaser-rate payments.

Certainly a government guarantee of principal--with no guarantee fees, insurance premiums, or interest income to the guarantor, like those mean GSE and FHA alternatives require--would take care of the capital problem.

by Tanta on 2/05/2008 10:10:00 AM

I don't know why seeing the Chairman of the FDIC--that'd be the government agency that provides deposit insurance to banks and thrifts--on CNBC arguing with a billionaire investor about what is really in the best interests of billionaire investors is so damned funny, but this is classic teevee.

The Ross Plan, by the way, appears to involve the taxpayers buying a one-third participation interest in defaulting mortgages. That would mean that a private investor gets one-third of its principal back immediately, while the taxpayers get the right to collect one-third of a payment that isn't being made or one-third of foreclosure recoveries. But the beauty is that we know servicers will work harder to collect payments or maximize recoveries when the government is an investor in the pool, because it always works out that way, doesn't it?

OTOH, it's certainly more efficient than "mortgage food stamps."

Thanks, number2son!

by Tanta on 1/31/2008 12:26:00 PM

So far at least a dozen people have emailed me the link to Jonathan Weil's latest egregiousness in Bloomberg. I have no idea how many times it has come up in the comments. My response?

What P.J. said.

Weil's whole argument rests on the original assumption that pools of mortgage loans can be "wind-up toys" or "brain dead" from a servicing perspective. The reality is that they cannot, they are not, and anyone who pretended otherwise was an idiot (I'm lookin' at you, Wall Street). The prohibition on actively managed pools is there to prevent the issuer or servicer from buying and selling loans in and out of the trust and passing through gain-on-sale to investors while calling it "interest income," or securitizing loans with "putback" provisions that mean the issuer can repurchase loans out of the pools whenever it wants to at a price that is below market in order to take advantage of the bondholders. It was never and is not a prohibition on servicing mortgage loans. That is, in fact, what the SEC just said.

There is and has always been the recognition that mortgage loans, unlike, say, Treasury notes, need to be "serviced." There are therefore long and involved servicing agreements and absolutely not trivial servicing fees specified in all these deals. A couple minutes' worth of reflection would lead you to this: perhaps there is a debate about where you cross the line between servicing a pool and managing it. That would be a debate about when "loss mitigation" (working out a loan in order to minimize loss when loss is inevitable) becomes "loss creation" (a servicer creating a loss to the investor in order to increase servicing income or something like that). But to have that debate you'd have to accept that real loss mitigation is acceptable, and you'd have to look at more facts than just the presence of workouts as such. Such a debate doesn't have jack to do with the SEC handing out "accounting favors" to anyone.

I simply hope that someday Weil wants to drop escrows or make a curtailment and get a payment recast or deed off an easement or something on his home mortgage and he calls his servicer and the servicer says, "Sorry, dood. You're brain dead to us. All we do is collect your payment. Have a nice day. Click."

Maybe that has already happened to him, and it's making him bitter. Beats me. All I know is that a bunch of geniuses on Wall Street did, actually, fall for the idea that residential home mortgages were "wind-up toys," just "asset classes" instead of messy complicated things that involve real people (good, bad, and indifferent, lucky and unlucky, high-maintenance and low-maintenance) on the other side of the cash flow, who don't always behave the way your models said they would. And here we are. Demanding that we continue the delusion in order to make the accounting work out is mind-boggling. Demanding that issuers take it all back onto their balance sheets as punishment for trying to mitigate losses to bondholders is beyond perverse.

by Tanta on 1/12/2008 09:33:00 AM

Here's an update from Vikas Bajaj and Jenny Anderson of the NYT on Cuomo's "due diligence" investigation, "Inquiry Focuses on Withholding of Data on Loans."

But as home prices surged, subprime lenders, which market to people with weak credit, relaxed their guidelines. They began lending to people who did not provide documents verifying their income — so-called no-doc loans — and made exceptions for borrowers who fell short of even those standards.

The New Century Financial Corporation, for instance, waived its normal credit rules if home buyers put down large down payments, had substantial savings or demonstrated “pride of ownership.” The once-highflying lender, based in Irvine, Calif., filed for bankruptcy last year.

William J. McKay, who was the chief credit officer at New Century, said the company usually made exceptions so homeowners could borrow more money than they qualified for under its rules. In most cases, the decisions raised borrowers’ credit limits by 15 percent, he said.

New Century measured pride of ownership in part by how well buyers maintained their homes relative to their neighbors, Mr. McKay said, adding that this usually was not enough on its own to qualify a borrower for an exception.

Investment banks often bought the exception loans, sometimes at a discount, and packaged them into securities. Deutsche Bank, for example, underwrote securities backed by $1.5 billion of New Century loans in 2006 that included a “substantial” portion of exceptions, according to the prospectus, which lists “pride of ownership” among the reasons the loans were made.

Nearly 26 percent of the loans backing the pool are now delinquent, in foreclosure or have resulted in a repossessed home; some of the securities backed by the loans have been downgraded.

Mr. McKay defends the lending and diligence practices used in the industry. He said Wall Street banks examined exception loans carefully and sometimes declined to buy them. But they often bought them later among mortgages that New Century sold at a discount, he said.

Some industry officials said weak lending standards, not exceptions, were largely to blame for surging defaults. “The problem is not that those exceptions are going bad — you don’t have a lot of exceptions in the pools,” said Ronald F. Greenspan, a senior managing director at FTI Consulting, which has worked on the bankruptcies of many mortgage lenders. “To me it’s a more fundamental underwriting issue.”

To vet mortgages, Wall Street underwriters hired outside due diligence firms to scrutinize loan documents for exceptions, errors and violations of lending laws. But Jay H. Meadows, the chief executive of Rapid Reporting, a firm based in Fort Worth that verifies borrowers’ incomes for mortgage companies, said lenders and investment banks routinely ignored concerns raised by these consultants.

“Common sense was sacrificed on the altar of materialism,” Mr. Meadows said. “We stopped checking.”

And as mortgage lending boomed, many due diligence firms scaled back their checks at Wall Street’s behest. By 2005 , the firms were evaluating as few as 5 percent of loans in mortgage pools they were buying, down from as much as 30 percent at the start of the decade, according to Kathleen Tillwitz, a senior vice president at DBRS, a credit-rating firm that has not been subpoenaed. These firms charged Wall Street banks about $350 to evaluate a loan, so sampling fewer loans cost less.

Furthermore, it was hard for due diligence firms to investigate no-doc loans and other types of mortgages that lacked standard documentation.

“Years ago, it used to be, ‘Did the due diligence firm think it was a good loan?’ ” Ms. Tillwitz said. “We evolved into the current form, which is, ‘Did I underwrite these loans to my guidelines, which can sometimes be vague and allow exceptions?’”

"Pride of ownership" isn't actually the dumbest "compensating factor" I've ever run across, but it's up there. (The ultimate is always the old depository's standby, "existing bank relationship," which generally means we need to make sure this borrower has some more cash so he can make installment payments on all the other dumb loans we made to him last year. In comparison to that, making a dumb loan because the borrower appears to spend it all at HomeDepot seems almost sensible.)

While I have to agree with Ronald Greenspan that it's the rules, not the exceptions, that are the biggest problem, I do appreciate someone pointing out that some pools apparently got issued with 5% due diligence review. I used to buy whole loan pools for a federally-chartered depository and I can remember buying a prime-quality pool from another well-capitalized depository "preferred counterparty" from whom I had bought loans for years with "only" 10% pre-purchase credit due diligence (100% pre-purchase "collateral" or closing document review). Five percent for subprime loans from New Century? That boggles the mind.

But that's the thing; I can also remember losing deals because I wanted 20% or 30% due diligence and some other bidder would allow 10%. All over the mortgage world in 2003-2006 there were credit analysts being backed into corners by furious salespeople and traders and everyone else whose visions of the deep end of the bonus pool were evaporating when the credit people wouldn't race to the bottom on due diligence levels. You can try telling these people that you don't want to own loans that someone else doesn't want you to look at closely beforehand, but that won't work. It certainly didn't work well back in 2005 when nobody was taking any credit losses and the RE party was still white-hot. There was always someone saying, "Look, those geniuses on Wall Street will take it with 5%. What exactly is it you think you know that they don't?"

Wall Street basically set a standard--a terrible one--that everyone else had to compete with. I calculated a while ago, using numbers provided by the MBA, that fraud costs in 2006 were around 18 bps on gross 2006 mortgage production. A $350 due diligence charge on a $200,000 loan is, um, 17.5 bps. Of course the real fraud costs don't show up until much later, and looking at it now that 17.5 bps on due dilly looks like quite the bargain. But it didn't look like it then to too many people.

And, of course, the whole point of AUS/low-doc/brokered transactions was to shave the $350 or thereabouts off the transaction; this is the much-vaunted "cost savings" of "innovations." Once you close a loan, no further costs can be charged to that borrower (unless, um, you get "creative" with your servicing practices). The overall logic of the situation dictated that spending that $350 out of the lender's pocket was a "waste of money."

In the case of New Century, I'd probably have been willing to believe that it was. Why pay $350 to verify that this stuff is toxic waste when a casual perusal of the data tape makes that pretty damned obvious? But that wasn't quite the reasoning the Street was using. It is, however, why I am skeptical about how far Cuomo's investigation is going to go on this "failure to disclose" grounds. The prospectus did in fact say that the pools were full of third-party originated subprime loans with no docs, absurd LTVs, and toxic product terms. If you can swallow all that, why would you have been kept up at night by the thought that a few of them exceeded even these rules?

The reality of the situation is that "pride of ownership" was a concept that made sense to buyers of securities. And a whole bunch of other rubes, dupes, scoundrels, and pigs. New Century might as well have called them "Ownership Society™ Loans" and made it a product rather than an exception. Probably they were working on that very thing (with a lot of $350 flip charts) when BK interrupted the meetings.

by Calculated Risk on 12/28/2007 07:00:00 PM

From Adam Ashcraft and Til Schuermann: Understanding the Securitization of Subprime Mortgage Credit

See page 13:

Several point raised in this section were first raised in a 20 February 2007 post on the blog http://calculatedrisk.blogspot.com/ entitled “Mortgage Servicing for Ubernerds.”

Note: there is link in the menu bar for Tanta's UberNerd series: The Compleat UberNerd.

Here is the introduction:

How does one securitize a pool of mortgages, especially subprime mortgages? What is the process from origination of the loan or mortgage to the selling of debt instruments backed by a pool of those mortgages? What problems creep up in this process, and what are the mechanisms in place to mitigate those problems? This paper seeks to answer all of these questions. Along the way we provide an overview of the market and some of the key players, and provide an extensive discussion of the important role played by the credit rating agencies.

In Section 2, we provide a broad description of the securitization process and pay special attention to seven key frictions that need to be resolved. Several of these frictions involve moral hazard, adverse selection and principal-agent problems. We show how each of these frictions is worked out, though as evidenced by the recent problems in the subprime mortgage market, some of those solutions are imperfect. In Section 3, we provide an overview of subprime mortgage credit; our focus here is on the subprime borrower and the subprime loan. We offer, as an example a pool of subprime mortgages New Century securitized in June 2006. We discuss how predatory lending and predatory borrowing (i.e. mortgage fraud) fit into the picture. Moreover, we examine subprime loan performance within this pool and the industry, speculate on the impact of payment reset, and explore the ABX and the role it plays. In Section 4, we examine subprime mortgage-backed securities, discuss the key structural features of a typical securitization, and, once again illustrate how this works with reference to the New Century securitization. We finish with an examination of the credit rating and rating monitoring process in Section 5. Along the way we reflect on differences between corporate and structured credit ratings, the potential for pro-cyclical credit enhancement to amplify the housing cycle, and document the performance of subprime ratings. Finally, in Section 6, we review the extent to which investors rely upon on credit rating agencies views, and take as a typical example of an investor: the Ohio Police & Fire Pension Fund.

We reiterate that the views presented here are our own and not those of the Federal Reserve Bank of New York or the Federal Reserve System. And, while the paper focuses on subprime mortgage credit, note that there is little qualitative difference between the securitization and ratings process for Alt-A and home equity loans. Clearly, recent problems in mortgage markets are not confined to the subprime sector.

This report is recommended reading to understand the entire securitization process. Congratulations to Tanta, and hopefully she will comment on the report.

Also note the last two sentences of the introduction: "... while the paper focuses on subprime mortgage credit, note that there is little qualitative difference between the securitization and ratings process for Alt-A and home equity loans ... recent problems in mortgage markets are not confined to the subprime sector."

by Tanta on 12/22/2007 11:10:00 AM

Our friend P.J. at Housing Wire did the world a big favor last night by sorting out the details of Fitch's giant $5.3 billion heap o' RMBS downgrades yesterday. Go here for the handy list of what deals were included in that.

What jumped out at me, of course, was that $783MM WaMu deal. This little puppy (2007-HE3) was closed on May 10, 2007. That's a whopping seven months before the first downgrade. (It's too young, of course, to have noticeable realized losses, but the 60-day delinquency is up to 9.17% already, for loans originated primarily in the first quarter of this year. Wowsers.)

I haven't been paying enough attention, I confess, to recent downgrades to know if that's a record for fastest downgrade or not. Does anyone else know? It's fair-to-middlin' pointless, of course, in the grand scheme of things, but I do think that issuing the fastest-downgraded mortgage-backed security in history is an accomplishment that should be given recognition.

by Tanta on 12/11/2007 11:08:00 AM

There have been some questions about what this means (thanks, Ramsey, for bringing it to my attention):

MCLEAN, Va., Dec. 10 /PRNewswire-FirstCall/ -- Freddie Mac (NYSE: FRE - News) announced today that the company will generally purchase mortgages that are 120 days or more delinquent from pools underlying Mortgage Participation Certificates ("PCs") when:

-- the mortgages have been modified;
-- a foreclosure sale occurs;
-- the mortgages are delinquent for 24 months;
or
-- the cost of guarantee payments to security holders, including advances
of interest at the security coupon rate, exceeds the cost of holding
the nonperforming loans in its mortgage portfolio.

Freddie Mac had generally purchased mortgages from PC pools shortly after they reach 120 days delinquency. From time to time, the company reevaluates its delinquent loan purchase practices and alters them if circumstances warrant.

Freddie Mac believes that the historical practice of purchasing loans from PC pools at 120 days does not reflect the pattern of recovery for most delinquent loans, which more often cure or prepay rather than result in foreclosure. Allowing the loans to remain in PC pools will provide a presentation of its financial results that better reflects Freddie Mac's expectations for future credit losses. Taking this action will also have the effect of reducing the company's capital costs. The expected reduction in capital costs will be partially offset by, but is expected to outweigh, greater expenses associated with delinquent loans.

Attentive readers Calculated Risk addicts will remember the big tizzy last month over Fannie Mae's presentation of its credit loss ratio, and the confusion-party in the press that it engendered. As you recall, the issue was that Fannie Mae had been exercising its option (not obligation) to buy delinquent loans out of its MBS in order to pursue workout efforts with them. Because that requires the MBS to be paid off at par, but the accounting rules require Fannie to take these loans to their portfolio at the lower of cost (par) or fair market value, and since "fair market value" right now for a delinquent loan, even one you think can be cured (made reperforming with a workout), is terrible, doing this means that Fannie booked big write-downs at the time. Fannie then backed some, but not all, of that write-down out of its credit loss ratio on the portfolio, to distinguish between true foreclosure-related charge-offs and these fair value adjustments, and uproar ensued, with Fortune's Peter Eavis implying that they were cooking the books and hiding losses.

It appears to me that Freddie Mac has decided it doesn't want to go there. It is therefore doing what, presumably, Peter Eavis wants it to do: leave the delinquent loans in the MBS pools unless and until that becomes more expensive than taking them out.

The accounting here is rather complex (which won't stop some people from having a cow over it, but I can't help that). The somewhat simplified view is this: the GSEs guarantee timely payment of principal and interest to MBS investors. They do not guarantee that investors will earn interest forever, but only as long as principal is invested. If a loan payment is not made by the borrower, either the GSE or the servicer (depending on the contract) has to advance scheduled principal and interest payments to the MBS until such time as the loan catches up (the borrower makes up the past due payments) or is foreclosed and liquidated.

The GSEs collect guarantee fees from seller/servicers (it works like servicing fees: it comes off the monthly interest payment). They also collect some other lump-sum fees when pools are settled. This is revenue to the GSEs, with a corresponding liability (to make the advances, with the risk that the advances will not be reimbursed completely at liquidation of the loan).

Therefore, when there are deliquent loans in an MBS, and the servicer is not obligated to advance for them, the GSE has a choice: it can buy the loan out of the MBS, put it into the GSE's own portfolio, and take any and all losses directly as any other investor would (and also any income). Or, it can leave the loan in the pool, while advancing the scheduled P&I to the pool investors. Only in some specific cases is the GSE obligated to take out a loan: when mortgages are modified, when the foreclosure sale occurs, or when the loan has been delinquent for 24 months or more. In other situations, it comes down to the question of which is cost-effective for the GSE: to leave it there and continue to advance, or to take it out with portfolio capital and do the fair value write-down.

Do note that if Fannie Mae had adopted this policy that Freddie has just announced--basically, that buying the loan out of the MBS will be the last rather than the first resort--it would not have shown big fair value write-downs, those would not have affected the credit loss ratio, and a big dust-up would not have occurred. There would still have been an effect on the financials, but just in a different place: in advances (coming out of G-fees received). So you either have expense (P&I advanced to bondholders) or you have expense (capital used to buy out the loans).

Insofar as everyone has been all worked up about the GSEs' capital ratios, this should be good news: they are levering investors' capital to carry delinquent loans until they can be cured (or liquidated). Insofar as investors want principal back faster, it's maybe not good news. But you can't really have it both ways.

I think it is important to understand that the GSEs are supposed to cover guarantee costs out of g-fees, not with portfolio purchases. You might have noticed that both Fannie and Freddie are increasing the g-fees and postsettlement/loan level pricing adjustments they charge seller/servicers. So they are beefing up the funds they have to cover MBS losses with. Nothing guarantees that will be enough; I don't think anybody knows right now what will be enough. But for what it's worth, I don't see this as "playing games" with capital requirements. I guess we'll have to see what Fortune Magazine thinks.

by Tanta on 12/06/2007 04:20:00 PM

A lot of people are very worked up over the idea that the New Hope Plan is, in essence, the government mandating a kind of reneging on private contracts (the PSAs or Pooling and Servicing Agreements that govern how securitized loans are handled). I personally think you can all stand down on that one. From what I have seen about the plan to date, it is clear to me that it is in fact structured with the overarching goal of making sure that it stays on the allowable side of the existing contracts. I proceed from the assumption that nobody could write such a convoluted and counter-intuitive plan if that wasn’t the goal. So everyone who is thinking, “Gee, we’re violating contracts and we still don’t get much out of it!” is thinking the wrong thing, in my view. It’s more like “Gee, we don’t get much out of it when we don’t violate contracts.”

American Banker has a summary of The Plan details up here (it’s free this week if you register, and the registration process is painless). The basic outline is that loans are put into three segments:

1. Borrower appears (from fairly superficial analysis of the data, not any deep digging) to be eligible for a refinance. These borrowers are to be encouraged to refinance.
2. Borrower appears able to make payment at current rate, but appears (again, from fairly superficial analysis) to be unlikely to be able to refinance (generally because LTV is too high with FICO too low). These borrowers are eligible for the “fast-tracked” mod (the rate freeze) if they meet some FICO and payment increase tests.
3. Borrower appears unable to make payment even at current rate; these borrowers are presumed to be unable to refinance. They are not eligible for the “fast track” rate freeze mod; they may be eligible for some kind of work out, but it would have to be handled the old-fashioned fully-analyzed case-by-case way.

There’s some detail about the FICO and payment tests used in segment 2.

I’m guessing that structuring of things will strike folks as weird. To me, it says that a rule of thumb is being created that puts borrowers in three categories:

1. Not in default and default not imminent
2. Not in default and default reasonably foreseeable
3. In default or default imminent

As it happens, the PSAs for these deals will nearly universally contain language that says loans can only be modified if they are in default, or default is imminent, or default is reasonably foreseeable. Therefore, what The Plan does is simply provide a kind of standard definition of those categories for the vintages of loans in question. That’s why the Group 1 borrowers—those who could be eligible for a refinance—are never eligible for these “fast track” mods. It is hard to say that default (in the current pool) is reasonably foreseeable for a loan that has a refinance opportunity. No, it doesn’t make any difference that the refinanced loan might be highly likely to default at some fairly soon point in some new pool. This isn’t about solving the borrower’s problems permanently in the best possible way (a mod might be a better permanent solution than a refi for the borrower). It’s about solving the problem while staying inside the security rules.

And the rules in question are really important ones, not just idiosyncratic servicing rules that could probably be waived in a crisis by the trustee with the consent of the rating agencies.

First, REMICs (go here if you have no idea what a REMIC is). REMIC election involves the tax treatment of principal and interest payments and is much too complex to summarize here. The basic issue is that it creates a trust that owns the underlying pool of loans. The trust issues two classes of securities, regular interests and a residual interest. Interest income is taxable (as ordinary income) to the holders of regular interests. Gain/loss for tax purposes is also taken by the residual holder. The trust itself is not taxed; it’s just a pass-through entity. That prevents a “double taxation” from arising, in which the trust would have to pay taxes on interest income and then the regular class holders would also pay taxes.

One of the qualifying requirements of REMIC status is that the underlying pool of loans is “fixed.” REMICs do not acquire new loans after their pools are established; they do not account for any loans on a “held for sale” basis and they do not sell any loans. (Putbacks for breach are an exception, and always transact at par, not at market value.) If at any time the trust starts taking actions that can be interpreted as “actively managing” the underlying pool, the REMIC status is in jeopardy (the trust might have to start paying taxes, which would make the whole deal uneconomical).

So while the legislation and IRS rules authorizing and dealing with REMICs are not really about defining default servicing practices, they have affected default servicing practices (loss mitigation) because they have defined a kind of transaction that might look like active management of the pool but really isn’t: modifications (or other workouts) for defaulted or about-to-default loans. In essence, the REMIC law creates an exception for these loss-mit practices, so that servicers can use them without endangering the REMIC status of the trust. This is how what might seem like unrelated issues—how to best service a mortgage loan, how trust entities are or are not taxed by the IRS—get related.

The issue is further complicated by the off-balance-sheet nature of these trusts. (They don’t have to be off-balance sheet, but most of them are.) To be accounted for off the issuer’s balance sheet, the trust must be “qualifying” under the SFAS 140 rules. The “Q status” is similar to the REMIC status: the pool must be “static” or fixed or not actively managed or, in the charming industry parlance, “brain dead.” If it is determined that a pool is being actively managed, it “loses its Q” and gets forced onto the issuer’s balance sheet. SFAS 140, like the tax code, isn’t designed to be about good mortgage servicing practices, but it, like the tax code, has to include some definitions of acceptable “managing” of individual loans that are exceptions to the “brain dead pool” rule.

There was a bit of a dust-up earlier this year over the SFAS 140 issue. In a nutshell, while the REMIC law says that modifications are OK when the loan is in default or default is reasonably foreseeable, there was some concern that SFAS 140 only allows modifications if the loan is in default. That would mean that if you modified a loan that was current today, but that you had reason to believe would default next month (say, at reset) if you didn’t do anything about it, you’d be OK with your REMIC status but not OK with your Q status. The waters were calmed when the SEC published an official opinion that “reasonably foreseeable default” was an acceptable basis for modifying a loan under SFAS 140 as well as IRS 860D.

The takeaway point: a great deal of more-or-less informed commentary and blather you will find on whether securitizations “allow” modifications is based not on a question of what verbiage is or is not in the PSA, but rather on an interpretation of what is or is not required for REMIC tax treatment or off-balance sheet accounting. All the PSAs say, somewhere, that servicers will not do things that would jeopardize REMIC status or Q election. The whole point of the letter opinion released by the SEC this summer was to create a kind of regulatory “safe harbor” here: it said that if servicers use the “reasonably foreseeable default” standard that they are already allowed to use for REMIC-status purposes, they are OK with Q-status.

This “safe harbor” for Q-status did not and does not “override” any explicit contractual limitations on modifications that might be in any given PSA. In other words, if the PSA says explicitly that mods are allowed only for loans in default, but not for loans that are current (but likely to default), then that’s the standard. If a servicer went ahead and modified a current loan (under the “reasonably foreseeable” standard), then the servicer could be in breach of the PSA contract, even though the servicer is OK on the REMIC status and Q status. This raises the interesting question of whether there are actually any PSAs that so explicitly forbid this kind of modification, and if so, how many; that’s our next subject. But I know of no informed, sane observer who is claiming that the SEC letter, for instance, was a form of government abrogating of existing contracts. It was simply a case of a regulator ruling that if the PSA allows a certain class of modifications (implicitly or explicitly), the servicer’s exercise of the option to pursue those mods would not create an accounting nightmare. You may, if you like, interpret that as a regulator removing an obstacle to the enforcement of contracts as written.

So what do the PSAs say?

This is a hard question to answer definitively, because the PSAs for mortgage-related securitizations have not been forced to be uniform on this (or about 100 other) subjects. It is possible that some verbiage related to loss mit and modifications differs between contracts because someone somewhere really thought it was important; it is possible that some of it differs just because different law firms with different styles were used to draft the PSAs; it is possible that some of this is a matter of a lapse of attention somewhere. I think it never pays to underestimate the extent to which the industry does certain things because they did it that way back when they did their first securitization, and at no time since then has it ever become an issue, and nobody makes bonuses by making issues out of things that aren’t issues. Certain people have reacted to proposals for “safe harbor” legislation involving mortgage modifications by assuming, not necessarily wisely, that the contractual provisions in question are always and everywhere something that the parties to the contract have a real interest in defending or enforcing. The possibility that both servicers and investors are going back, reading these things, slapping themselves on the heads and saying, “Damn, why’d we put that in there?” is very real. Unfortunately, “investors” are so diverse and numerous and diffused that you just don’t get two parties sitting down and amicably agreeing to amend these PSAs to clear up a little problem.

So we get back to the apparently empirical question of what these PSAs actually do say. I have read many of them, but I sure haven’t read all of them. I am therefore willing to take the American Securitization Forum’s word for it here:

These agreements typically employ a general servicing practice standard. Typical provisions require the related servicer to follow accepted servicing practices and procedures as it would employ “in its good faith business judgment” and which are “normal and usual in its general mortgage servicing activities” and/or certain procedures that such servicer would employ for loans held for its own account.

Most subprime transactions authorize the servicer to modify loans that are either in default, or for which default is either imminent or reasonably foreseeable. Generally, permitted modifications include changing the interest rate on a prospective basis, forgiving principal, capitalizing arrearages, and extending the maturity date. The “reasonably foreseeable” default standard derives from and is permitted by the restrictions imposed by the REMIC sections of the Internal Revenue Code of 1986 (the “REMIC Code”) on modifying loans included in a securitization for which a REMIC election is made. Most market participants interpret the two standards of future default – imminent and reasonably foreseeable – to be substantially the same.

The modification provisions that govern loans that are in default or reasonably foreseeable default typically also require that the modifications be in the best interests of the securityholders or not materially adverse to the interests of the securityholders, and that the modifications not result in a violation of the REMIC status of the securitization trust.

In addition to the authority to modify the loan terms, most subprime pooling and servicing agreements and servicing agreements permit other loss mitigation techniques, including forbearance, repayment plans for arrearages and other deferments which do not reduce the total amount owing but extend the time for payment. In addition, these agreements typically permit loss mitigation through non-foreclosure alternatives to terminating a loan, such as short sales and short payoffs.

Beyond the general provisions described above, numerous variations exist with respect to loan modification provisions. Some agreement provisions are very broad and do not have any limitations or specific types of modifications mentioned. Other provisions specify certain types of permitted modifications and/or impose certain limitations or qualifications on the ability to modify loans. For example, some agreement provisions limit the frequency with which any given loan may be modified. In some cases, there is a minimum interest rate below which a loan's rate cannot be modified. Other agreement provisions may limit the total number of loans that may be modified to a specified percentage (typically, 5% where this provision is used) of the initial pool aggregate balance. For agreements that have this provision: i) in most cases the 5% cap can be waived if consent of the NIM insurer (or other credit enhancer) is obtained, ii) in a few cases the 5% cap can be waived with the consent of the rating agencies, and iii) in all other cases, in order to waive the 5% cap, consent of the rating agencies and/or investors would be required. It appears that these types of restrictions appear only in a minority of transactions. It does not appear that any securitization requires investor consent to a loan modification that is otherwise authorized under the operative documents.

The ASF goes on to propose model contract language that it encourages the industry to adopt. This would go a long way to preventing this kind of chaos in the future. But even with existing documents, you will note that it appears that very few have explicit restrictions on modifications (aside from the “golden rule” standard of generally accepted servicing practices, with the expectation that the servicer will treat the pooled loans in the same way it would treat its own portfolio of loans). Those that do have explicit restrictions have mechanisms for those restrictions to be amended, in most cases by less than 100% concurrence of all investors.

So is all this uproar over contractual provisions just a tempest in a teapot? Well, some of it is. The issue around “safe harbor” and enforcement of contracts heated up once we moved from the proposition of doing mods the old-fashioned “case by case” way, and into this new idea of the “freeze” or a kind of across-the-board approach to modifications. It is that, specifically, that appears to some people to be a violation of contract provisions; therefore, to give servicers “safe harbor” for using the “freeze” approach would, it seems to many people, be a case of the government invalidating contracts.

Whether this is really a serious issue or not depends on how the “freeze” thing works out in detail. It seems likely to me that Sheila Bair’s original proposal for the “across the board” freeze of all ARM rates would, in fact, have run into this very serious problem. It’s not that in that case the number of modifications would exceed the set caps in the contracts; it would clearly do so for those contracts with caps, but as we’ve seen those caps can be waived or amended in most cases. The problem with the Bair proposal is that it doesn’t measure each modification against the standard of benefit to or neutral effect on the trust, and that loans that are probably not in any reasonably foreseeable danger of default would get included. That would cause the REMIC and Q status problems to come back into play.

The Hope Now proposal is intended to be an improvement on the Bair proposal by limiting the “freeze” precisely to the “in reasonably foreseeable danger of default” category. That solves the REMIC and Q-related problems. The difficulty that remains is whether, in any given case, the default that is in foreseeable danger of happening would cost more to the security than the modification. That is where the rubber meets the road.

That’s the rationale for excluding loans that could qualify for a refinance. The presumption is always that the trust would lose less by a refinance (since it would get paid off at par) than a mod, and so you can’t say that modifying one of these loans shows a net benefit to the trust. The rationale for defining the modification-eligible group, number 2, as “not refinanceable” is that that creates a presumption that a mod would be a net benefit or neutral to the trust (since the only other option, given that we believe default is reasonably foreseeable, is foreclosure).

So it’s not that we’re necessarily replacing the old-fashioned case-by-case mods with the fast-track “freeze” mods. We’re creating a way of segmenting the borrower class so that one class of borrowers can be presumed to meet all the requirements in the PSAs for modifications. If the borrower isn’t in that group (2), then a modification could still be done, but it doesn’t have the presumption of meeting the rules, you still have to determine whether a mod is less loss to the trust than not modifying (and therefore letting the loan default and foreclosing), you have to examine the borrower’s circumstances (to make sure that they are no longer in reasonably foreseeable danger of default after the mod), get a new appraisal or AVM or broker price opinion on the property (to estimate losses in event of foreclosure), and run the comparative numbers.

At the end of it, then, it gets a lot easier to figure out the rationale of some of the details of the Group 2 process (FICOs here or there, income verified or not, etc.). None of that is about figuring out whether the borrower "needs" or "deserves" to be helped. It is about figuring out whether the borrower has any realistic option of refinancing, given current contraints in the mortgage market and the HPA outlook. That, in turn, is crucial because to modify a loan that could have refinanced opens up the servicer to liability for contract violations (and potentially loss of REMIC tax status and Q-status, too).

There isn't, as far as I can see, any "safe harbor" provision in all of this. That tells me, at this point, that the authors of this plan believe it is liability-proof (that it basically meets the requirements of the existing PSAs, with the caveat that it isn't a legally binding mandate on all servicers and securities, so a deal with a very restrictive PSA that this isn't compatible with can just opt out).

Is it all kind of anemic after all the build-up? Yep. Does it mean contracts are now invalidated in the U.S.? Not as far as I can see; in fact, I'd say the contracts were the part of this that got the most thorough protection. In my reading of this, giving a deal to a borrower almost seems incidental.