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Showing posts with label UberNerd. Show all posts
Showing posts with label UberNerd. Show all posts

Saturday, August 16, 2008

Default Statistics, Or Mortgage Math Is Hard

by Tanta on 8/16/2008 09:15:00 AM

I am very pleased to offer you this post, which is actually a "Guest Nerd" offering by our regular commenter and expert mort_fin, who works on undisclosed mortgage matters in an undisclosed location and often straightens us out in the comment threads when the conversation gets to technical matters of statistical analysis of mortgages. I helped a little bit with this post (any errors in the tables are mine), but the bulk of this is mort_fin's.

Some important context for the genesis of this: it came about after dear mort_fin, and a number of our other regulars, spent most of a frustrating Saturday afternoon arguing with another commenter about this post on the FHA "DAP" program (the infamous seller-money-laundered-downpayment-assistance-program). We basically came to the conclusion that a lot of people who defend the DAPs are not arguing in good faith about the performance of these loans--they pick out statistics they don't ever define clearly and wield them in misleading ways.

Because things like the FHA DAP are such important public policy questions, it seemed to mort_fin that there was much to be gained by helping non-specialists get a better grip on the various default statistics that are available and what they do (and do not) actually tell you. This is UberNerditude at its finest, and I thank mort_fin for taking the time and effort to help us move the intellectual ball a few yards in the never-ending battle with the DAP shills.

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Mort_fin says:

A recent flap in the comments surrounding default rates in FHA, especially with respect to down payment assistance programs, showed how easy it is to misunderstand and abuse mortgage default rates. So I thought I’d take a shot at writing The Fairly Intelligent Person’s Guide to Default Statistics.

The first issue to note is just the words. Default, as Tanta has noted in a previous excellent UberNerd, has a fairly precise legal definition, and a fairly vague usage in the popular and financial press. To a lawyer, if you move and rent out your abode you are probably in default, even if you keep making your mortgage payment every month, since you have violated the clause in the note that says you will occupy the premises. When reading the trade press, delinquency usually means not paying the mortgage, and default might mean that foreclosure proceedings have started, have finished, are being negotiated, etc. You can’t understand the analysis if you don’t read the fine print in the definitions. I’m going to stick with default meaning “foreclosure has happened” for the following examples.

To keep everything clear, and countable on fingers without resorting to toes, let’s say 10 people all get mortgages in a year (a group all getting mortgages at the same time is a “vintage” or a “cohort”). All the initial examples will relate to these 10 people. They are color coded based on their mortgage status. The first thing to notice is that life is complicated, and there are a lot of possible outcomes. Some loans end in foreclosure (default), some are refinanced into another mortgage (which can then end in a variety of ways), some people sell the house and pay off the mortgage, and some people just sit there paying the monthly nut for 10 years or more. And you don’t follow people forever—who knows what happened to any of these folks after 10 years?


In our sample pool of ten loans, each originated in 2000, we have the following outcomes:

• Fred: Purchase mortgage for 1 year, 1 year foreclosure process, foreclosed, becomes renter
• Matilda: Purchase mortgage for 1 year, refinanced mortgage for 2 years, 1 year foreclosure process, foreclosed, becomes renter
• Jose: Purchase mortgage for 3 years, refinanced mortgage for 5 years, sells home, becomes renter
• Rashid: Purchase mortgage for 4 years, foreclosure for 1 year, foreclosed, becomes renter
• Seamus: Purchase mortgage for 4 years, foreclosure process for 2 years (stayed because of a bankruptcy filing), foreclosed, becomes renter
• LuAnne: Purchase mortgage for 4 years, refinanced mortgage for 1 year, refinanced mortgage again for 1 year, foreclosure process for 1 year, foreclosed, becomes renter
• Saty: Purchase mortgage for 2 years, purchases new home
• Mitko: Purchase mortgage for 5 years, refinanced mortgage for 5 years
• Bob: Purchase mortgage for 10 years

This may or may not be a “typical” set of outcomes for any given pool of ten mortgages. But these are all very possible outcomes, and the point of this little exercise is to see clearly just how these possible outcomes are—or are not—reflected in the default statistics we have come to rely on for measuring mortgage performance.

A vintage of loans something like this would get sliced and diced in various ways by analysts. You might see a “lifetime projected default rate” or a “cumulative to date default rate” or a “conditional default rate” or a “foreclosure initiated rate" (also sometimes call the “foreclosure inventory”). None of them is right or wrong, but any of them can be misunderstood or abused.

Start with the “cumulative to date default rate.” (Remember that this counts foreclosures completed, not started.) If these are loans originated in December of 2000, you might ask in 2000 or 2001 “what percent have gone bad?” and the answer would be zero. For most borrowers, it is rare to miss payments in the first year (the fact that it wasn't rare starting about 2 years ago should have been an enormous alarm bell for people), and it takes very roughly a year between the time people stop missing payments and the time they finish foreclosure (timeline varies widely by state). But at the end of the 2002, you have one default, Fred, for a cumulative to date default rate of 10% (1 in 10). At the end of 2003 it’s still 10%, but by the end of 2004 it’s risen to 20% because Matilda has also gone bad. But, wait a minute, Matilda refinanced in 2001, so she never defaulted on a 2000 originated mortgage. I guess it stays at 10%. The “to date” cumulative rate eventually rises to 30% as first Rashid, and then Seamus, go to default.

At the end of 2009 the “to date” is 30%, and assuming that these are 30 year mortgages, we still do not know the “lifetime projected default rate” since Bob is still out there with an active loan. You know that the lifetime cumulative rate will be at least 30% since it can’t go down (well, actually in states with rights of redemption, it theoretically could go down, but those are pretty rare events) and it can’t be more than 40%. If Bob stays good it’s 30% and if he goes bad it’s 40%. Since few people go bad after 10 good years you would probably project a 30% lifetime cumulative default rate for these loans. Matilda and LuAnne don’t count, since they refinanced and are a “success” as far as the original lender is concerned (although they might be failures from the perspective of a policy to promote homeownership). And if you’ve taken comfort in the fact that the “to date” cumulative default rate is zero at the end of 2002 you’re in for an uncomfortable surprise next year.

Note that if you want to assess what these things will cost you from a credit cost perspective, the relevant figure is lifetime cumulative defaults. When you originate the loans (which is the date that matters, since you can’t retroactively up the interest rate or the insurance premium, the horse is out of the barn at that point) all you have are projections. You don’t know what anyone has done, since they just started. After 5 or 6 years you can make a pretty good projection, but it’s far too late at that point. In this business you have two and only two options: highly uncertain knowledge when it’s useful, or very precise knowledge long after it’s useful. That’s why this business is so much fun. And the projections are sensitive not only to the quality of the underwriting (how did Fred manage to get a loan in the first place???) but also to future house prices and unemployment rates, and refinancing opportunities (a rolling loan gathers no loss).

But cumulative defaults aren’t the only, or even the most commonly presented, statistics. The commenter in the aforementioned Haloscan thread was led astray by the Foreclosures Initiated (or Foreclosure Inventory) statistic. This counts how many foreclosures are “in process.” Foreclosure is a process, not an event. The details vary by state, but a common method of judicial foreclosure is the filing of a “notice of default” in which the servicer tells the seriously delinquent borrowers that they are headed to court. This may start the foreclosure clock. Motions and countermotions are filed, court dates are scheduled and postponed, and a date for the sale of the property is set. This is the process that can take, in very rough terms, a year to play out.

In 2001 the foreclosure initiation rate in our example pool would be zero, but in 2002 it would be 11%. Why 11% you ask? Well, one loan (Fred) is in process, and there are 9 loans still active (Matilda refinanced, remember). So 1 out of 9 is 11% (with a little rounding). In 2005 the foreclosure initiation rate is 40%. Only 5 loans are still active, and two of them are in the process of being foreclosed upon.

Note that the foreclosure initiation rate tells you very little about how much of an insurance premium you needed to charge to cover the credit risk, or even whether you had a bunch of good loans or bad loans. This rate depends on the denominator as well as the numerator, and the denominator can change for all sorts of reasons, like borrowers moving and borrowers refinancing, that don’t have any direct bearing on whether these were good loans or bad loans. The inventory rate has its uses, but summarizing credit quality or expected costs isn’t one of them. It is a pretty sensitive number for summarizing current conditions – it tends to rise rapidly when things get bad, and fall back to earth when things get good.

The other commonly cited statistic is the CDR, the Conditional Default Rate. It is “conditional” because it is “conditioned by survival.” The denominator consists of all the loans that have survived until today, neither prepaying in the past nor defaulting in the past. Again, for the first two years, the CDR is zero. In 2002 it is 13% since 8 loans are still alive, and 1 is defaulting. In 2003 and 2004 it is back to zero, and then in 2005 it skyrockets up to 33%, as only 3 loans still survive, and one of them has gone bad. The CDR is useful as an input to complicated cash flow models, but by itself it doesn’t tell you much about credit quality, since, again, it depends on the denominator as much as it does on the numerator, and for older pools of loans the denominator can be pretty small.

Returning to our little pool of ten loans, these are the values we get for these three measures over ten years. (Click on the table to enlarge.) You can see how confused a conversation at any given point in time would be that tossed these numbers around without context:


The big analytical mistake you do not want to make here, of course, is the one Tanta likes to complain about in the work of various apologists for high-risk lending: assuming that if 30% of the loans in a given vintage fail, then 70% of the borrowers were “successful.” Here’s another way of looking at our example pool that contrasts the results of a standard vintage analysis (what happened to the loans that were originated in 2000?) with an actual borrower analysis (what was the mortgage performance of these ten borrowers over ten years?). You get very different numbers:


Now try a more complicated graphic, which looks a lot more like an active portfolio of loans than a static vintage. Imagine that 10 people a year are flowing into your sights as an analyst, and the world looks boringly the same from year to year—each new vintage performs just like the previous one.


Here's the tabular result:


In the first year, foreclosures (cumulative to date, inventory, and CDR) are all zero again. In year 2 the foreclosure rate, cumulative and CDR, are still zero, but the inventory is now 1/19. There are 9 loans still active from the first cohort, and 10 new loans have come into the picture. Of course, new loans are almost never in foreclosure, so letting new loans flow into the picture lowers the foreclosure inventory rate substantially. It is still the case that 30% of loans in each vintage and 50% of borrowers will ultimately go bad, but now the foreclosure inventory is a little over 5%, and the cumulative default rate and CDR are still zero. Go out one more year, and 10 new loans have flowed into the picture. 30 loans have come in, 3 have left via prepayment, and 1 of the remaining 27 is a foreclosure that has happened in that year. So the CDR is now a little under 4% (1 out of 28), and the cumulative claim rate is a little over 3% (1 out of 30). Interpreting the numbers from a dynamic pool of mortgages (loans constantly flowing into the system) is harder than interpreting a static pool (always looking at the same set of loans).

A great real-life example of cumulative (to-date and projected) default rates and CDRs can be found in FHA’s Actuarial studies. Go down to Appendix, and click on Econometric Results in Excel. There are tabs for All_Orig_CumC (All Originations Cumulative Claims – to FHA, a foreclosure is a claim, since they are an insurer, not a mortgage investor) and tabs for All_Orig_ConC for the Conditional Claim Rates. In the cumulative tab, note that FHA projects 15.89% of 2007 originations will ultimately go bad, and this is entirely a projection. For 2000, they project 7.61% will go bad – as these loans are now 7 years old, this is based on actuals of 6.73% having gone bad, and a projection that there will only be a few more foreclosures left to go. On the Conditional Claims rate tab, note that the expectation over the next year is that 0.5% out to 3% of loans are expected to go bad in the next year, depending on how old the loans are (which cohort they are in). It is these annual rates, properly accumulative (you have to adjust the figures so your denominator is always originated loans, not surviving loans), that get you anywhere from 6% to 22% lifetime foreclosure rates, for the good years vs. the bad years. You may want to revisit the HUD site next year to see how projections get revised. These are based on an August 2007 house price forecast. I suspect that has now been rendered inoperative.

The lesson to learn here is to ask questions. 1) What are the definitions in use? 2) Are you looking at a static or a dynamic population? 3) What are you trying to measure? 4) What is happening to the denominator in your ratio?

If you’re trying to ascertain credit costs, failures to date or failures over the past year won’t get you where you want to go. And if you’re trying to ascertain homeownership success, mortgage failures alone won’t give you an answer. Matilda and LuAnne “succeeded” on their first mortgages, but still had a sheriff evict them eventually. Jose and Tania didn’t get foreclosed—the statistics would simply count them as a “voluntary prepayment”—but it’s hard to say that homeownership was a success for them since they ultimately found the cost of owning impossible to maintain and were simply “lucky” enough to sell before they were foreclosed. And even if you’re trying to do an apples to apples comparison—like “Did the CDR for this pool exceed the CDR for that pool?”—it’s important to keep in mind that numerators and denominators can shift because of prepayments, not just defaults. We really don’t know what was motivating the refinances in our pool—lowering interest rates? Taking cash out? We don’t really know whether the refinances improved or worsened the borrower’s actual financial position, but we do know that higher or lower prepayments in a pool can certainly make statistics like CDR “look” more or less frightening.

The unfortunate truth is that mortgage analysts simply do not in any normal circumstances have access to a dataset like the one we have made up for this post. Whether you are looking at a static pool with a single vintage or a dynamic portfolio with multiple vintages, you are tracking loans, not borrowers or properties, and you are tracking “prepayments” of those loans. You simply do not know whether that prepayment was a refinance or a sale of the home; you don’t know what that borrower did after the prepayment. This information simply isn’t in the standard databases. The bottom line about making claims regarding borrower “success” by reference to mortgage default statistics is “you can’t necessarily get there from here.”


Click here for Guest Nerd Special!

Monday, August 11, 2008

Reflections on Alt-A

by Tanta on 8/11/2008 03:30:00 PM

Since for media and headline purposes "Alt-A" is the new subprime--the most recent formerly-obscure mortgage lending inside-baseball term to become a part of every casual news consumer's working vocabulary--it seems like a good time to pause for some reflection on what the term might mean. Much of this exercise will be merely for archival purposes, as "Alt-A" is now pretty much officially dead as a product offering and is highly unlikely to return as "Alt-A." Eventually, after the bust works itself out and the economy leaves recession and the bankers crawl out from under their desks and stretch out those limbs that have been cramped into the fetal position, a kind of "not quite quite" lending will certainly return. I am in no way suggesting that the mortgage business has entered the Straight and Narrow Path and is going to stay on it forever because we have Learned Our Lessons. Credit cycles--not to mention institutional memories and economies like ours--don't work that way. It's just that whatever loosened lending re-emerges après le deluge will not be called "Alt-A."

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Subprime will eventually come back, too. The difference is that it will come back--in some modified form--called "subprime." That term is too old, too familiar, too, well, plain to ever go away, I suspect. "Subprime" is a term invented by wonky credit analysts, not marketing departments. It is not catchy. It is not flattering nor is it euphemistic. You may console yourself if your children "have special needs" rather than "are academically below average." If you get a subprime loan, you may console yourself that you got some money from some lender, but you can't avoid the discomfort of having been labelled below-grade.

Actually, the term "B&C Lending" used to be quite popular for what we now universally refer to as "subprime." (It was also called "subprime" in those days, too. We didn't have to pick one term because nobody in the media was paying any attention to us back then and there were no blogs and even if there had been blogs if you had suggested that a blog would generate advertising revenue by talking about the nitty-gritty of the mortgage business you would have been involuntarily institutionalized.) In mortgages as in meat, "prime" meant a letter grade of A. These were the pre-FICO days, when "credit quality" was determined by fitting loans into a matrix involving a host of factors--whether you paid your bills on time, how much you owed, whether you had ever experienced a bankruptcy or a foreclosure or a collection or charge-off, etc. "B&C lending" encompassed the then-allowable range of sub-prime loans that could be made in the respectable or marginally respectable mortgage business. It was always possible to find a "D" borrower, but that was strictly in the "hard money" business: private rather than institutional lenders, interest rates that would make Vinny the Loan Shark green with envy. "F" was simply a borrower no one--not even the hard-money lenders--would lend to.

As in the academic world, of course, there was always the problem of grade inflation and too many fine distinctions. You had your "A Minus," which is actually the term Freddie Mac settled on back in the late 90s for its first foray into the higher reaches of subprime. Discussing the difference between "A Minus" and "B Plus" was just one of those otiose pastimes weary mortgage bankers got into over drinks at the hotel bar when the conversational possibilities of angels dancing on the head of a pin or whether "down payment" was one word or two had been exhausted. More or less everyone agreed that there wasn't but a tiny smidgen of difference between the two, except that "A Minus" sounded better. Same with the term "near prime," which wasn't uncommon but never became as popular as "A Minus." "Near prime" is also "near subprime." "A Minus" completed the illusion that it was nearer the A than the B, even if the distances involved were sometimes hard to see with the naked eye.

But all of that grading and labelling was still basically limited to considerations of the credit quality of the borrower, understood to mean the borrower's past history of handing debt. Residential mortgage lending never, of course, limited itself to considering creditworthiness; we always had "Three C's": creditworthiness, capacity, and collateral. "Capacity" meant establishing that the borrower had sufficient current income or other assets to carry the debt payments. "Collateral" meant establishing that the house was worth at least the loan amount--that it fully secured the debt. It was universally considered that these three things, the C's, were analytically and practically separable.

That, I think, is very hard for people today to understand. The major accomplishment of last five to eight years, mortgage-lendingwise, has been to entirely erase the C distinctions and in fact to mostly conflate them. For the last couple of years, for instance, you would routinely read in the papers that "subprime" meant loans made to low-income people. Or it meant loans made to people who couldn't make a down payment or who borrowed more than the value of their property--that is, whose loans were very likely to be under-collateralized. This kind of characterization of subprime always struck us old-timer insiders as bizarre, but it seems to have made sense to the rest of the world and it stuck. After all, the media didn't really care about or even notice this thing called "subprime" until it began to be obvious that it was going to end really really badly. It therefore seemed perfectly obvious to a lot of folks that it must primarily involve poor people who borrow too much.

Those of us who were there at the time tend to remember this differently. In the old model of the Three C's, a loan had to meet minimum requirements for each C in order to get made. We didn't do two out of three. The only lenders who ever did one out of three were precisely those "hard money" lenders, who cared only about the value of the collateral. This was because they mostly planned on repossessing it. Institutional lenders' business plan still involved making your money by getting paid back in dollars for the loans you made, not by taking title to real estate and selling it.

The difference between a prime and a subprime lender was simply how low you set the bar for one of the C's, creditworthiness. Unless you were a hard-money lender, you expected to be paid back, so you never lowered the bar on capacity: everybody had to have some source of cash flow to make loan payments with. Traditional institutional subprime mortgage lenders were even more anal-compulsive about collateral than prime lenders were, a fact that probably surprises most people. Until very recently, historically speaking, institutional subprime lending involved very low LTVs and probably the lowest rate of appraisal fraud or foolishness in the business.

That isn't so surprising if you think about the concept of "risk layering," which is also an industry term. In days gone by, with the three C's, you didn't "layer" risk. If the creditworthiness grade was less than "A," then the capacity grade and the collateral grade had to be "summa cum laude" in order to balance the loan risk. It wasn't until well into the bubble years that anybody seriously put forth the idea that you could make a loan that got a "B" on credit and a "B" on capacity and a "B" on collateral and expect not to lose money.

Of course there has always been a connection between creditworthiness and capacity. Most Americans will pay back their debts as agreed unless they experience a loss of income. People rack up "B&C" credit histories most commonly after they have been laid off, fired, disabled, divorced, or just generally lost income. But this was true at any original income level: upper-middle-class people can lose income and become "B&C" credits. Lower-income folks may well be most vulnerable to income loss--first fired, first "globalized"--but then lower-income folks until recently had smaller debts to pay back out of reduced income, too. What is so dishonest about the association of "subprime" and "poor people" is that it simply erases the fact that a lot of rich people have terrible credit histories and a lot of poor people have never even used credit. The "classic" subprime borrower is Donald Trump as much as it is "Joe Sixpack."

Traditional subprime lending was what you might think of as "recovery" lending. That is, while the borrower's past credit problems were due to some interruption in income or catastrophic loss of cash assets with which to service existing debts, the subprime lenders didn't enter your picture until you had re-established some income. If you want to know what a "D" or "F" borrower was, it was basically someone still in the financial crisis--still unemployed, still underemployed, still unable to work. "B" and "C" borrowers had resumed income, but they still had a fresh pile of bad things on their credit reports--charge-offs, collections, bankruptcies. Prime lenders wouldn't make loans to these borrowers because even though they had resumed capacity, their recent credit history was too poor. Prime lenders want to you "re-establish" your credit history as well as your income, which pretty much means that those nasty credit events have to be several years old, on average, without recurrence in the most recent years, before you can be an "A" again. Absent subprime lenders, that means going without credit for those years.

This is where the idea came from--much promoted by subprime lenders during the boom--that subprime loans were intended to be fairly short-term kinds of financing that helped a borrower "re-establish" his or her creditworthiness. The whole rationale for the famous 2/28 ARM was that after two years of good payment history on that loan, the borrower could refinance into a prime loan and thus never have to pay the "exploding" interest rate at reset. (If you didn't keep up with the payments in the first two years, you were thus "still subprime" and deserved to pay that higher rate.) That was a perfectly fine rationale as long as subprime lenders used rational capacity and collateral requirements--reasonable DTIs during the early years of the loan, low LTVs--to make those loans. When all the "risk layering" started, it was less and less plausible that these borrowers would ever "become prime" in two years by making on-time mortgage payments, and what we got was a class of permanent subprime borrowers who survived by serial refinancing, each time into a lower "grade" loan product, until the final step of foreclosure.

You're probably still wondering what all this has to do with Alt-A. Alt-A is sort of a weird mirror-image of subprime lending. If subprime was traditionally about borrowers with good capacity and collateral but bad credit history, Alt-A was about borrowers with a good credit history but pretty iffy capacity and collateral. That is to say, while subprime makes some amount of sense, Alt-A never made any sense. It is a child of the bubble.

"Classic" subprime lending worked because, while it always charged borrowers a higher interest rate, it found a way to restructure payments such that the borrower's overall prospects for making regular payments improved. A classic "C" loan, for instance, was also called a "pre-foreclosure takeout." The borrower had had a period of reduced or no income, got seriously behind on her mortgage payment, and was facing loss of the house. Even though income had resumed, it wasn't enough to make up the arrearage while also making currently-due payments. So the subprime lender would refinance the loan, rolling the arrearage into the new loan amount, and offset the higher rate and larger balance with a longer term or some kind of "ramping up" structure. The "ramp-up," by the way, was not, historically, mostly by using ARMs. There were all kinds of old-fashioned exotic mortgages that you don't hear about any more, like the Graduated Payment Mortgage and the Step Loan and the Wraparound Mortgage and so on, all of which involved some way of starting off loans with a lower payment that slowly racheted up over three to five years or so into a fully-amortizing payment. It certainly wasn't always successful, but its intent was exactly to enable people to catch up on an arrearage and then actually begin to retire debt.

Alt-A, we are regularly told, is a kind of loan for people with good credit but weak capacity or collateral. It overwhelmingly involved the kind of "affordability product" like ARMs and interest only and negative amortization and 40-year or 50-year terms that "ramps" payment streams. But it doesn't do this in order to help anyone "catch up" on arrearages; people with good credit don't have any arrearages. Alt-A was and has always been about maximizing consumption, whether of housing or of all the other consumer goods you can spend "MEW" on. If subprime was supposed to be about taking a bad-credit borrower and working him back into a good-credit borrower, Alt-A was about taking a good-credit borrower and loading him up with enough debt to make him eventually subprime.

The utter fraudulence of the whole idea of Alt-A involves the suggestion that people who have managed debt in the past that was offered to them in the past on conservative "prime" terms must therefore be capable of managing debt in the future that is offered to them on lax terms. FICOs or traditional credit analyses are good predictors of future credit performance, but only if the usual terms of credit-granting are similar in the past and in the future. Think of it this way: subprime borrowers had proven that they couldn't carry 50 pounds, so the subprime lenders found a way to restructure their debts so that they were only carrying 40. Alt-A lenders took a lot of people who had proven they could carry 50 pounds and used that fact to justify adding another 50 pounds to the burden.

This has not worked out well.

The "Alt" in Alt-A is short for "alternative." Alt-A is one of the purest examples of a "new paradigm" thingy you can find. The conceit of Alt-A is that there is another way to approach "prime" lending that is equivalent in risk (assuming risk-based pricing) but--amazing!--way more painless. Toss out verifications of income and assets, and you are no longer evaluating capacity. Toss out down payments and careful formal appraisals and analysis of sales contracts and you are no longer evaluating collateral. But lookit that FICO!

A lot of folks see the failure of Alt-A as a failure of FICO scores. I don't see it that way. FICO scoring is just an automated and much more consistent way of measuring past credit history than sitting around with a ten-page credit report counting up late payments and calculating balance-to-limit ratios and subtracting for collection accounts and all that tedious stuff underwriters used to do with a pencil and legal pad. I have seen no compelling evidence that FICO scoring is any less reliable than the old-fashioned way of "scoring" credit history.

To me, the failure of Alt-A is the failure to represent reality of the view that people who have a track record of successfully managing modest amounts of debt will therefore do fine with very high amounts of debt. Obviously the whole thing was ultimately built on the assumption that house prices would rise forever and there would always be another refi. There was also the assumption that people are emotionally attached to their FICO scores--in more old-fashioned terms, that borrowers care about their "reputation" and don't want to ruin it by defaulting on a loan. The trouble with that assumption was that we were busy building a credit industry in which there was plentiful credit--on easy terms--for people with any FICO, any "reputation." A bad credit history is only a strong deterrent to default when credit is rationed, granted only to those with acceptable reputations, or--as in the case of "classic" subprime--granted only to those with poor reputations but strong capacity and collateral, and at a penalty rate. Unfortunately, the consumer focus (encouraged, of course, by the industry) on monthly payment rather than actual cost of credit meant that for a lot of people the fact of the "penalty rate" just didn't register. In such an environment, the fear of losing your good credit record isn't much of a deterrent to default.

I should point out that besides the "stated income" and no-down junk, the other big segment of the Alt-A pool was "nonstandard" collateral types. One of the biggies in that category were what insiders call "non-warrantable condos." (The warranties in question are the ones the GSEs force you to make when you sell a condo loan; in essence a non-warrantable condo means one the GSEs won't accept.) What was wrong with these condos? Not enough pre-sales. Not enough sales to owner-occupants rather than investors. Inadequately funded HOAs with absurd budgets. Big blocks of units owned by a single entity or individual. In other words, speculator bait. This kind of thing isn't an "alternative" to "A." It is commercial or margin lending masquerading as long-term residential mortgage lending. It may well be "prime" commercial lending. It just isn't residential mortgage lending.

Part of the terrible results of Alt-A lending is that this book took on risks that historically were taken only on the commercial side, where the rates were higher, the cash-flow analysis was better, and the LTVs a lot lower. (Not that commercial real estate lending didn't also have its dumb credit bubble, too.) The thing is, as long as the flipping of speculative purchases worked--and it did for several years--it worked. Meaning, those Alt-A loans prepaid quite quickly with no losses. That masked the reality of Alt-A--that it was largely a way for people to take on more debt than they ever had before--for quite some time.

Of course we all know now--I happen to think a lot of us knew then--that Alt-A is chock-full o' fraud. My point is that even without excessive "stated income" or appraisal fraud, the Alt-A model was essentially doomed. "Alt-A" is the kind of lending you would only do after a real estate bust, not during a real estate boom--that is, when housing costs and thus debt levels are dropping, not rising. Unfortunately, we're going to have a hard time using something like Alt-A to stimulate our way into recovery once the housing market has actually bottomed out, because Alt-A is too implicated in the bust. I don't think anyone is going to be allowed to get away with moving all that REO off their books by making loans on easy terms to someone who managed to maintain a good FICO during the bust, even though that might actually make some sense.

One of the main reasons we are in a mortgage credit crunch is that two possible models of "recovery" lending--subprime and Alt-A--got used up blowing the bubble. I think it will be a long time before lending standards ease significantly, and I think subprime will come back first. But I do suspect we've seen the last of Alt-A for a much longer time.


I want the rest of a VERY long post! And I want it now!

Sunday, August 03, 2008

Freddie Mac Foreclosure Timelines

by Tanta on 8/03/2008 09:38:00 AM

I had intended to write a follow-up to CR's post the other day on Freddie Mac's changes to its foreclosure timelines, but . . . I had to extend my timeline. So sue me instead of Freddie Mac.

I was going to suggest that my friend P.J.'s (of Housing Wire fame) use of the term "whopping" to describe those timeline changes is a little hyperbolic. But it takes some major UberNerdity to show why that is. As I was winding up to a major Nerdfest on the subject, I see that Mish and Aaron at Implode-O-Meter have seen P.J.'s "whopping" and raised it to "doubling" in the great game of GSE Scold 'Em. I have no idea where "doubling" came from, although it appears that Mish just misread the original sentence from the Housing Wire report:

The mortgage finance giant also said that it was increasing its allowable foreclosure timeline in 21 states to a whopping 300 days from last of date payment, and 150 days from initiation of foreclosure, effective on Friday.
This is not saying that the total FC timeline used to be 150 days in these states and is now 300, and you cannot make the English language make it say that. It says that the total allowable (which word does not rhyme with "required") timeline is 300 days in total from last payment made to FC sale. Within that total 300 days, the allowable time from actual referral to an FC attorney to the FC sale is 150 days. Which means that the allowable time from date of last payment to referral to an FC attorney is 150 days. 150 plus 150 equalling 300 in base ten.

But what does all this really mean? Is it significant? Why? Are these measures expressed in terms you are used to seeing, or in rather specialist terms that may mislead the unwary? And why would only 21 states be affected? Can we have some context, Tanta?

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The first thing we need to clear up is the question of what a "foreclosure timeline" is and why Freddie Mac (and Fannie Mae) have them.

Foreclosure law is made by the states, and there are 50 different sets of state FC law out there, plus one for DC and three for the territories Freddie Mac buys loans in, giving them a total of 54 sets of laws. It is very hard to generalize about FC law, given that many different approaches, but you can basically say that all jurisdictions set a minimum timeline for completing a foreclosure (meaning, from the original filing to the FC sale) by virtue of the requirements that the law makes for various steps in the process and when they must be initiated and what has to happen before they are completed. For example, most states have some requirement that notice of the FC sale be published for three consecutive weeks prior to the actual sale date. Obviously this cannot happen until the FC sale is scheduled, which may take a long time (in a judicial FC state) or a fairly short time (in a non-judicial or "deed of trust" or "statutory FC" state). Therefore, the "timeline" always has a matter of 21 days or so added after one thing happens (sale is scheduled) and before another thing can happen (sale is held). If a given state lacked this requirement, or had a much longer or much shorter publication requirement, that state's minimum legally allowable timeframe would be longer or shorter.

I know of no state or jurisdiction that legislates "maximum" timeframes. By this, I mean that the law might say you cannot hold an FC sale less than 21 days after the sale date is determined (to allow for publication), but that doesn't mean you cannot hold the sale more than 21 days afterwards. The law might say you cannot initiate FC filings until a borrower is at least 30 days past due, but that doesn't mean you have to do that, and in reality few servicers initiate FC until a borrower is at least 90 days past due.

It helps, then, to think of FC laws as a matter of setting the shortest possible timeline for foreclosures. This will never be equal to the actual average timeline in a given state, nor will it be equal to the "optimal" or "best practices" timeline for a given state. What Freddie Mac and other investors care about is an "optimal" FC timeline.

Before we talk about this issue of what is "optimal," we also need to clear up the issue of when FC is initiated. Most states do not legislate a minimum number of days of delinquency before an FC action can be filed; there must simply be a legal default under the note and security instrument. Theoretically, in most states you can start FC when a borrower is only one month down, but it is very rare to see servicers do that, and in fact most of us would probably call such a practice "predatory servicing." FC is your last resort for resolving a delinquency, not your first resort.

On the other hand, no investor wants a servicer who dorks around and doesn't commence FC filing until the borrower is a whole year down. Therefore, investors like Freddie Mac set maximum timelines for servicers to commence FC. That deals with the dorking around problem. They do not set minimum timelines for commencing FC other than the statutory minimum, on the whole. The way they deal with the problem of a servicer foreclosing too quickly is by compensating servicers for successful foreclosure avoidance: they pay up in bonuses to servicers who resolve modest delinquencies with collection efforts, repayment plans, or other workouts, and they penalize servicers whose FC rates are much higher than they should be (since that costs investors money).

In order to establish investor timelines, there must be some definition of the starting point. Freddie Mac's rules on this subject are and have always been based on the time elapsed from "Due Date of Last Paid Installment," or DDLPI. There are very good reasons for this; it's a more dependable number than days of delinquency, and given that mortgage interest is always paid in arrears, a number of days since DDLPI will tell you exactly how many days of past-due interest have accrued on a loan. But you do not want to confuse it with days of delinquency. If a borrower makes his May payment, skips his June payment, and today is June 30 or July 1, depending on how you calculate these things, the borrower is 30 days delinquent and 60 days from DDLPI. Thus, if Freddie Mac says that a servicer must initiate FC by 150 days from DDLPI, that means by no later than the 120th day of delinquency.

It does not mean that a servicer may not initiate FC before 150 days DDLPI/120 days DQ. "No later than" means "no later than." I remarked earlier that in general servicers initiate FC around the 90th day of delinquency on average. This is true. Freddie does not require the servicer to wait until the 120th day; it allows the servicer to wait that long and still be considered acceptable to Freddie Mac.

The fact of the matter is that Freddie's timeline for DDLPI-to-initiation has been 150 days on most first lien loans since more or less forever. This is not something new. Freddie did just "standardize" this so it is now true for all loans. It used to be that second liens and some weirder first liens (like previously modified loans) had a 120 day DDLPI rule (90th day of DQ). For that small group of loans, the timeline has extended by 30 days. For the overwhelming majority of Freddie-owned loans, the pre-filing timeline has not changed.

What has changed, for 21 states, is the maximum acceptable timeline for initiation of FC to completion of FC. In Freddie-speak, "initiation" means "referral to FC attorney" and "completion" means FC sale completed. (In some states, it isn't over on the day of sale; there may be a "validation" period afterwards before title actually transfers, or there may be a post-sale redemption period. So a foreclosure sale is "completed" on or sometimes after the "sale date," but never before.)

Again, we need to bear in mind that there are three timelines floating around here: the statutory minimum (the quickest a foreclosure can be in a given state under the law), the real-world average (which is always greater than the statutory minimum, given backlogs and bottlenecks and holidays and other real-life stuff), and the recommended maximum (which is best understood as how high your "average" can get until your investor considers you inefficient or not trying hard enough).

Freddie has always published for its servicers a table of timelines for each state. They vary by state because some states have very short statutory minimums and some have very long ones. The idea was that servicer expectations would take into account those legal limits. I assume this idea is uncontroversial.

According to a very important paper published earlier this year by Freddie Mac economists Amy Crews Cutts and William A. Merrill, Interventions in Mortgage Default: Policies and Practices to Prevent Home Loss and Lower Costs, the national average "optimal statutory timeline" from FC referral to completion as of 2007 was 120 days from FC referral to sale date; taking into account post-sale issues like redemption or confirmation periods, and adding pre-referral days since DDLPI, the national average optimal statutory total timeline was 292 days. The actual average (real world) number of days was 355. ("Optimum statutory" here is a kind of hybrid of statutory minimums and practical additions; the authors calculate a plausible number of days for certain steps in the process to take that aren't controlled by law. For instance, in calculating these timelines they provide for five days for title work to be completed. The law simply requires that title work be completed; it doesn't say how long that will take.)

But nobody works to national averages; everybody works to a timeline for a given state. Per Cutts and Merrill, the longest timeline belongs to Maine, with "optimal statutory" days from FC referral to completed sale of 209 days, "optimal" total number of days from DDLPI to completion of 359 days, and "actual average" of 598 days DDLPI to completion. (Freddie Mac's current allowable maximum for Maine is 505 days, which means that on average servicers are not doing that well in Maine.)

The shortest timeline belongs to Tennessee, with "optimal statutory" days from FC referral to completed sale of 33 days, "optimal" total number of days from DDLPI to completion of 183 days, and "actual average" of 248 days DDLPI to completion. I do not know what Freddie's old timeline used to be for TN, because the current online Servicing Guide has now been updated and I don't have access to the old version. But TN is one of the 21 states that just got changed to 300 days total (150 days from referral to completion), which means the old timeline for TN was less than 300 days.

Since TN had the shortest timeline, I think we can conclude that of the 21 states that got an increase to 300 days, TN got the biggest increase. California, for instance, per Crews and Cutts had a "statutory" total timeline of 266 days and an average total, again as of last year, of 268 days. Freddie's new timeline for CA is 300 days. Given that it is possible that the average has increased markedly since 2007 with record numbers of foreclosures, it seems possible to me that CA's actual average as of mid-2008 is now pretty darned close to 300 days, or even more than that. This provides some context for how "whopping" the increase in the allowable timeframe for CA is.

So now we can think about why it might be that Freddie decided to increase the timelines in the fast-foreclosure states. Obviously, the main rationale is to allow servicers to continue to make workout efforts during the FC process, which will in the nature of things increase the time a loan spends in the FC process, without penalizing them for failing to meet Freddie's standards.

Perhaps, though, the better question is why Freddie upped the limit on these 21 states to only 300 days. Why not give everyone 400 days? Or 505 days, like Maine gets? What's so special about 300 days?

I suspect the answer to that is found in the research that Cutts and Merrill did on foreclosure timing:
[T]he costs associated with foreclosure rise significantly with the length of the foreclosure timeline, by as much as 12 percent for every 50 days added to the timeline. Perhaps more importantly, we find that the likelihood a borrower will reinstate her loan out of foreclosure falls as the length of time in the legal foreclosure process increases – by our estimates, states with excessively long legislated foreclosure timelines could increase the probability of successful reinstatement of delinquent borrowers by 3 to 9 percentage points by shortening their statutory timelines to match the national median timeline. Timelines that give the borrowers too much time in the legal foreclosure process tip the balance from the threat of imminent home loss from perfected foreclosure towards the benefit of “free” rent for the duration of the process, providing an incentive for borrowers to forego reinstatement of the loan even if they have the means to do so. By the same reasoning, some very short timeline states may find that lengthening their legal foreclosure timelines may improve cure rates out of foreclosure by giving delinquent borrowers enough time to cure the delinquency once the formal legal foreclosure process has been initiated.
The authors posit that the "sweet spot" for foreclosure timelines--long enough to allow borrowers to cure, short enough to correct incentives and control costs to investors--is "roughly 270 days" from DDLPI to completion.

It looks to me like Freddie just rounded up "roughly 270" to 300. In other words, for the states with a too-short statutory timeline, Freddie set its timeline into the "sweet spot." Because it is not really possible for Freddie to set the too-long states into the "sweet spot," they are unchanged. Only state legislatures can shorten the statutory process; Freddie Mac can't.

But why have this distinction between pre-filing (150 days from DDLPI in the "short states") and post-filing (another 150 days)? Well, any investor wants servicers to focus their loss mitigation efforts early in the delinquency process. In Freddie Mac's view, if you make the FC referral too early in the process, you are incurring unnecessary legal expenses for a lot of loans that will "cure" short of foreclosure. You may also be putting too much pressure on borrowers. That's a fine line to hold: if you don't threaten some borrowers with FC, they'll never do anything about the problem they have. On the other hand, if you start the judicial machinery too soon, some borrowers who could cure will give up because they think it's hopeless. Economically and psychologically, it's a delicate balance.

I realize that for a lot of people (like Mish), nothing any of the GSEs do will ever be anything except wrong. But still. It would be helpful to try to understand what they are actually doing before going off on doomsday scenarios. I am not claiming that the Freddie Mac changes were just a "nothingburger," but they are hardly anything to freak out over in my view. If you want to freak out, you need to at least read the reporting correctly.


Yes, children, you can have some context.

Wednesday, March 19, 2008

HUD Proposal on Good Faith Estimate I: The Context

by Tanta on 3/19/2008 04:48:00 PM

HUD has just released yet another proposal for changing the disclosures required under the Real Estate Settlement Procedures Act (RESPA), a federal law that is implemented by regulations promulgated by HUD. I’m not terribly impressed by the proposal, but it’s hard to say why without a lot of background rambling. So I’m going to ramble. Those who aren’t up for it should skip this. In a future post, I’ll get into the specifics of what I don’t like about the proposed new GFE.

A quick recap: RESPA requires a lot of things, two of the most important of which being the Good Faith Estimate of settlement costs, known as the GFE, and the HUD-1 or HUD-1A Settlement Statement, the exact accounting of closing costs and settlement charges given to borrowers when the loan closes. The GFE is given at application. The idea when RESPA was first enacted was to prohibit lenders from giving low-ball estimates of costs up front, only to shock the borrower with a lot more costs at closing, when it was often “too late” for a purchase-money borrower (or a refi borrower with a rate lock expiring) to back out. The estimates of costs on the GFE have to match what’s on the HUD-1 within a certain tolerance, or else you have a regulatory problem. The GFE/HUD-1 rules have been around for decades. In the last few years HUD (the agency, not the document) has made a few attempts to revise them, all of which have failed for one reason or another. The current proposal is just the most recent in a long line of unsuccessful attempts to get control of the disclosure of financing costs to borrowers, most specifically in the case of brokered loans (although the new rules would apply to retail lenders as well).

In some ways, what HUD is doing is formalizing the brokered application model into the RESPA disclosure scheme, a decade or two after certain problems and concerns first arose. One of the troubles that wholesale lenders have had for a long time is making sure they’re meeting RESPA rules for when the GFE has to be given to the applicant; the rule has for a very long time been that the disclosures must be provided within three business days of “application.” But what is the date of “application”? The date the broker takes an application from a borrower, or the date the wholesaler receives an application from the broker? From the borrower’s perspective, of course, this is easy: it’s the day you gave the broker sufficient information to complete the application. This implies that it is the broker’s job to provide you with the GFE. (And for what brokers charge borrowers, you might well think providing a written estimate of closing costs isn’t so much to ask.)

But the wholesaler has always had a problem here, because the wholesaler is going to close that loan and the wholesaler is going to have the “RESPA risk,” or the risk that the disclosure was inaccurate or not provided in a timely fashion. As with other things, it has never especially mattered that it might be the broker’s “fault”; brokers haven’t got the money to make you whole on fines, penalties, recissions and re-closings of loans, or sales of loans as “scratch and dent” because the higher-paying investors won’t buy a loan with iffy RESPA docs in the file. So wholesalers developed this habit of simply “redisclosing” or providing a GFE for the borrower within three days of getting the application from the broker, even if the broker had already supplied one. This was supposed to assure that whatever the broker did, the wholesaler complied with RESPA and made sure that the fees disclosed on the GFE were fees the wholesaler was comfortable with charging on the final settlement statement.

That meant several things, one of which is that borrowers were usually waiting the three full business days to get a GFE, and were paying application fees before getting one. At minimum, borrowers were paying for credit reports, since in these days of risk-based pricing, you don’t get a GFE until we know what your rate/points are, and we don’t know that (even approximately) until we know what your FICO is. RESPA, which predated such practices, was based on the assumptions of an older way of doing business, in which an application could be submitted and an estimate of costs given well before any “processing” on a loan, like ordering a credit report, commenced. Of course, once a borrower has paid a fee to get a GFE, it’s much less likely that borrower will “shop around” and pay several other lenders the same fee to get alternative GFEs.

It also pretty much erased—and then some—the wondrous efficiencies we had achieved at least since the mid 90s with cool technology. I am hardly the only person to have spent centuries of her life she’ll never get back in meetings and task forces and committees and piles of documentation and user testing working on rolling out “point of sale” (POS) technology that would allow loan officers armed with laptops and a portable printer to take a complete application right there, on the granite countertops, at the open house, and print out a pretty, complete GFE, right there on the granite countertops. With a dial-up connection, the LO could run the loan through an AUS and even hand out a commitment letter (subject to getting the appraisal and so on). Ah, the glorious days of progress, when we congratulated ourselves on providing a GFE to applicants in three business minutes.

It’s not exactly an accident that the acronym “POS” means both point-of-sale and piece of . . . stuff. There were any number of problems with the POS technology, not the least of which was those portable printers, which were “portable” as long as you didn’t expect them to be “printers” and vice versa. Many lenders got gung-ho about giving their loan officers the authority to issue commitment letters at POS, and found themselves committed to making loans that the underwriting department wouldn’t have approved on PCP. There was also, it transpired, a little problem with those pesky consumers. It turned out that what they really wanted out of life wasn’t always to stand around at an open house giving personal information to an LO and getting not just “estimates” but a commitment letter they were feeling pressured to sign without any cooling-off period or shopping around. As is often the case, the industry told itself customers were really interested in speed, when in fact the industry was really interested in speed and the customers had to be made to see reason about it. I can remember at one point a local competitor of mine proudly announcing it didn’t offer that “high-pressure tactic” of POS technology, and that competitor took a lot of our business.

The issue for retail originators was having an LO out there like a loose cannon with a laptop, making quickie commitments often based on quickie evaluation of the borrower’s seriousness or capacity. Those commitments were always supposed to be “subject to” finally getting all the real documentation and verifications and so on, but some loan officers figured out that such a heavily-conditioned commitment is hardly much of a commitment—it just encouraged people to “shop around”—and so “competitive pressures” led to leaving out a lot of those conditions. In fact, at least one of us believes that the “stated income/stated asset” phenomenon really began here. The Official Story in the industry is that it grew out of perfectly reasonable ways to underwrite self-employed borrowers with complicated financial lives, and somehow spread to W-2 borrowers with a single checking account when we weren’t looking. I don’t personally remember it happening that way.

The issue for wholesale lenders was even worse, since the brokers often weren’t quite sure which wholesaler they’d be closing this loan with—it would depend on who paid the richest premium, often, and that couldn’t be established until they got back to the office and checked rate sheets. So the brokers would hand out GFEs based on wild-arsed guesses of the fees required by the wholesalers, leading to endless situations in which the fees charged on the final settlement statement were pretty far off the original estimate, leading to endless situations in which regulators and consumer attorneys had to remind everyone what the “good faith” part of GFE meant. That was when the broker actually bothered to hand out a GFE, or do it within the holy three days. The wholesalers concluded it would be better for them to “re-disclose” on receipt of the application package (later, the electronic submission) from the broker. Aside from the monumental customer confusion that creates—which GFE is the “real one”?—it began to dawn on at least a few wholesalers that duplicating too much of the work the broker was supposed to be doing was approaching the same operating cost structure of a retail lender. It wasn’t just the disclosure issue, after all. You had to re-verify the broker’s verbal verification of employment and order (and review) a field review appraisal to reality-check the appraisal you let the broker order and so on until there wasn’t much the broker did that you didn’t also do.

The obvious answer to that was to make the borrower pay for it all. You began to find GFEs showing “underwriting fees” and “document preparation fees” all over the place, for instance. Now, underwriting your loans and drawing up your closing documents used to be considered basic overhead, you know, and lenders covered that in an origination fee charged to borrowers (or in the margin on the interest rate). The only time you ever charged a “doc prep fee” to a borrower was a situation in which you actually had to draw up unusual, complex documents—like a convoluted trust agreement or one of the gnarlier “hold harmless” agreements—that you needed to actually pay outside counsel for. You never charged anyone a separate fee for standard mortgage docs; that was like charging them for the air conditioning in the closing room. But in the wholesale model, you had to find some way for the broker to draw up GFEs and the wholesaler to then do it again and the whole thing to remain profitable for everyone. All kinds of other things, like flood hazard determinations and tax service contracts, that we always had to obtain for loans but that we always just covered out of the origination fee, started to appear as separate items on the GFE and HUD-1.

It was and still is argued all over the place that these practices are really pro-consumer, since it’s a clearer “itemization” of the real cost of credit than some all-in “origination fee” or “broker fee.” Had the origination fees shrunk proportionally to the newly added itemized fees, that might have been plausible. But in way too many cases, you were paying the same origination point you had always paid, plus $40 for a flood cert and $75 for a tax service contract and $100 for doc prep and on and on and on. In fact, you were paying so much in fees at closing that you were in real danger of not being able to scrape up that much cash—or increase your loan amount enough—to cover them and get a loan closed. This was (pre-RE bubble) a huge problem with refis. Refis are brokers’ bread and butter in low-rate environments, and it’s hard to convince people to refi for a 25 bps drop in rate—which people did—with that nasty cash requirement.

The solution was obvious: find a wholesaler who is willing to price a higher interest rate at a “premium,” and use that premium to “credit” the borrower, or to do the now-ubiquitous “no cost closing.” Of course it’s plenty of “cost”; it’s really just a “no-cash” closing. Obviously there are only certain actual historical rate environments in which this kind of thing will work in the prime lending world: if you’ve got borrowers wanting to “take advantage” of new, lower interest rates to refinance, you can’t always charge them the highest rate out there in order to produce enough premium to pay inflated closing costs with. It’s the kind of thing that might work in the beginning of a steep rate drop, like the 2002-2003 period, when existing loans on the books had a high enough interest rate that they could refinance into a current “premium” rate and still show a rate reduction. The trouble is, if you do too much of that on a wide scale—and the turnover in the entire nationwide mortgage book in 2002-2003 was enormous--it gets harder to do it again. Once the prime mortgage book had “reset” itself to very low current rates via a refi boom, it was hard to tempt them with a premium to current market, unless fixed rate mortgages hit 4.00%. They didn’t, so someone had to invent a mortgage product that seemed like a lower rate to borrowers but that also paid enough hefty premiums that closing cost inflation could be masked. The Option ARM, among others, stepped into the breach and here we are.

The comments to this thread will be choked with outraged mortgage brokers who will once again give you the same old story that “premium” closing cost credits are a god-send to us average schmucks who don’t have several grand sitting around to pay closing costs with, but who oughta get the benefit of lower rates just like the Big People, etc. They will tell you that there are too many “competitive pressures” preventing brokers and wholesalers from larding up settlement statements with both origination fees and a boat-load of “itemized” fees. They will tell you that there are all kinds of perfectly “legitimate” reasons why the final settlement statement you get has all these fees and charges on it that weren’t on the GFE, most of which are your fault for delaying the process or not following what you were told. They will tell that they shop around to get the best rate for you, and deserve to be compensated for that, but that it is the consumer’s responsibility to shop around for several shop-arounds so that they can assure themselves of getting the cheapest deal on the fees. They will tell you that while they don’t do it, retail lenders do it too, so we should stop picking on brokers.

My problem here is with the basic mechanism of, in essence, financing your closing costs in this way (by taking the higher rate to get the “credit” that reduces the amount of cash you bring to closing). It is simply ripe for abuse because there is (now) such a large segment of the borrower world who do not already have prime-quality fixed rate loans, who are desperately focused on monthly payment, not total cost over the term of a loan, and who simply do not have the basic financial skills necessary to do the cost/benefit analysis of fees versus interest rate, even if they could afford to pay three separate credit report fees at $40 a pop to several different brokers in order to amass several different GFEs so that they could find a way to save back the $80 in “wasted” fees and then some. Not to mention the fact that they are, as a group, generally the most susceptible to high-pressure sales tactics (this is true generally of a lot of people with heavy consumer debt and thus low FICOs; they are just incapable of saying “no” when the clerk at Macy’s offers “10% off today’s purchase with Instant Credit!”).

To be honest with you, too many people in this business do not fully understand its cost structure. There’s just a massive confusion all over the place about the difference between “financing costs that are paid up front at the closing of a loan” (as distinguished from interest charges that are paid in the future) and “settlement costs.” There are quite a few things you have to cough up money for at the settlement of a mortgage that are really “prepaid items,” not finance charges. For instance, the money you bring in to fund your tax and insurance escrow accounts. You have to pay real estate taxes and homeowner’s insurance anyway; you either pay it yourself once or twice a year or you pay it on the “installment plan” by paying your lender one-twelfth of it a month. In order to get an escrow account established up front, you’ll probably have to put two months or so worth of escrow payments in the account to start it out (because the annual bills will be due the first time before you’ve managed to make twelve payments, basically, given the lag between closing a loan and the first payment due date). Escrow funding is a relatively large-dollar item on most loans compared to things like a $75 tax service fee, but it’s not the kind of thing shopping around will do you any good with, since it is what it is (assuming lenders get their hands on a realistic estimate of RE taxes) and there’s no “markup” in it—it’s your money, the lender is just taking it up front as a deposit into your escrow account.

It is easy enough, unfortunately, to low-ball the estimated escrow funding amounts on a GFE while larding up on actual finance charges. If borrowers are only comparing this lender’s total to another lender’s total, they can be highly misled about who has the cheapest “closing costs.” And almost all lenders charge a higher rate (or more points) to borrowers who are allowed to get a “waiver” of escrow accounts. If you aren’t paying attention, you might be comparing a GFE from one lender that includes two months’ worth of tax and insurance payments in “closing costs” to a GFE from another lender that includes no escrow dollars but increases your interest rate by 12.5 bps.

The same thing goes, on a less expensive plane, with things like surveys and pest inspections. It might be a lender requirement that you get one of these things, and you might be willing to play dice with your hard-earned money by ignoring survey lines or signs of termite damage if you weren’t required not to by some lender. But the fact remains that (unless the lender is conspiring with the surveyor or exterminator/inspector to get a “kickback”) you’re paying for a real good or service there that doesn’t benefit the lender only. A tax service fee, on the other hand, benefits the lender and investor, not you. You will get your tax bills directly from the county; you don’t need to pay someone to track them. A tax service fee is a classic case of a “finance charge” in the regulatory sense: it is a cost you incur because you are financing the property, that you wouldn’t incur in a cash purchase of the same home. This is why mortgage insurance, unlike your homeowner’s insurance, is considered a “finance charge.”

There are other things you might pay at a mortgage settlement that are a little murkier, conceptually. You wouldn’t pay for a lender’s title insurance policy in a cash sale, but you would (if you were sane) pay for a title search and an owner’s policy. You wouldn’t pay for an attorney to prepare a deed of trust (a “mortgage”) in a cash sale, but you’d pay for a grant deed (otherwise you wouldn’t have legal ownership of the home you’re buying). Appraisal charges aren’t considered “finance charges” for regulatory purposes, on the assumption that a reasonably competent cash buyer would also get an appraisal, although I’m willing to bet that most people think of them as “finance charges” or things you wouldn’t have to pay if the lender didn’t make you and that benefit only the lender.

All this matters for regulatory purposes—the rules about how lenders disclose “finance charges” as distinct from “settlement costs”—but it also matters because there has for some time been something very important getting lost in discussions of “closing costs” or the cost of mortgage credit. A lot of those costs are real estate transaction costs. We have been hearing for years on end, during the boom, that people “who are only going to stay in the house for two years” shouldn’t be “having to pay for a 30-year fixed rate.” We don’t hear many people wondering why you’d buy a home in that situation in the first place.

The reality in most markets across nearly any time period you care to name is that it’s almost never worth buying a house to live in for two years. It pretty much requires a bubble for the RE agent commission and the title search and the survey and the pest inspection and the deed recording fee and so on, let alone the true “finance charges,” to pay for themselves in two years. But there has been a shift in rhetoric and terminology that seems to lump “transaction costs” into “financing costs,” allowing people to “make sense of” buying a house you plan to live in for only two years because you can find some lender who will let you finance the transaction costs through this premium-rate “closing cost credit” deal.

The reality of things is that no lender makes any money charging premium interest rates to recover costs it didn’t charge the borrower at settlement if the borrower pays the loan off in a short period of time (unless it was a really really big premium). This is where your “prepayment penalties” came from; it’s also where all these expensive post-settlement fees (like the notorious fee for getting a payoff quote or a release of the old lien in a refi) come from. The economics of making “bridge loans” (short-term loans) at “permanent loan” terms just doesn’t work if you don’t collect fees up front. You can get by with a small enough percentage of your loans behaving like that—credit card lenders can get by with a small enough percentage of people who pay in full every month, and Best Buy can get by with a small enough percentage of people who do the “one year same as cash” thing and pay it off before a finance charge is imposed. But nobody can handle everybody behaving like that. Not for long.

And it’s not just home buyers, it’s refinances. It simply isn’t rational for an investor to “pay up” for a high interest rate if said loan is going to refinance at the next little market bump. But people will refinance, these days, for amazingly small rate increments, for two reasons. First, loans are a lot bigger than they used to be, while incomes haven’t been growing. That means that the dollars at stake in monthly payment savings become more significant even with small decreases in the interest rate.

The second reason is where this gets into a vicious cycle: people refinance at the drop of a hat because they don’t pay the closing costs in cash. They either roll the costs into the loan—driving balances up over time and creating even further incentive to refinance again—or they get that “premium credit” thing, which means that the borrower has a built-in incentive to refinance the new loan as quickly as possible. This dynamic creates regular income for brokers who get paid for each refi, but it doesn’t always do much for investors.

A great deal of this business over the last several years of refinancing people out of perfectly affordable fixed rate loans into these toxic ARMs came about because there was no longer any way to price a premium-rate fixed rate loan at a lower rate than what the borrowers already had. However, the market was full of “dumb money” that would pay 105 for a “high quality” Option ARM—not to mention the “low quality” ones. Many people focus on “YSP” as broker compensation, and that’s a big issue. Some of the sleazier brokers took those five points from the wholesaler and the borrower didn’t see a five point credit on the HUD-1. My point, though, is to question whether the ones who did get a closing credit really got such a great deal.

Would borrowers have balked at doing the refi to start with if they had had to pay at least some of the closing costs in cash? Would they have paid a touch more attention to those prepayment penalties they were signing up for if it had occurred to them that the only way a “no cost closing” can be profitable to a lender is by extending the life of the loan long enough for the costs to come out of the interest paid each month? Would borrowers have been more likely to catch on to an ARM masquerading as a fixed rate or nasty ARM terms “hidden” in a big pile of legalese if they had a realistic sense of how low 30-year fixed rates are likely to go on any given day? There is something terribly wrong with lenders who give out misleading disclosures, and I don’t blame borrowers for lender sleaziness. But there is also something terribly troubling about the apparent fact that a lot of people thought they were getting a 30-year fixed rate loan at 1.95%. That is much too good to be true. Why didn’t it occur to anyone that that’s much too good to be true?

To see this as strictly a “disclosure” issue is to simply cop out, as far as I’m concerned, on the question of a very old-fashioned view of what loan officers and brokers were supposed to be doing, which is explaining things like the fee/rate tradeoff, the point of prepayment penalties, and the likely range of prevailing market rates on fixed-rate loan quotes. “Educating” your borrowers is just off the table. All we’re left with is “disclosing” loan terms that truly educated borrowers probably wouldn’t have anything to do with, and relying on borrowers to “shop around” in a market in which they still have no idea what the “going rate” is.

We’ve gone, just in my career in this industry, from taking three whole business days to get a GFE into a consumer’s hands, because we did them with adding machines and typewriters and snail mail, to taking three whole minutes to do that with only reasonably fancy technology, and back to taking three whole days again because there are too many intermediaries in the process (all of whom have to get paid). And HUD is, after years and years of this practice going on, finally working up a way to disclose premium-rate closing cost credits right when the terrible market distortions partially due to that practice are melting down the credit markets. Behind the whole thing lurks the ideology that regulators are not there to tell anyone what is an allowable business practice; they’re there to just make sure you “disclose” what you’re up to. It is aided and abetted by a “consumer advocate” lobby who frequently seems to believe that “complexity of disclosures” is the problem, rather than unrealistic expectations consumers develop based on the onslaught of marketing they get from the industry, which tries to tell you there is a free lunch if you act now.

Once you and I have recovered from this post, we’ll look at some of the details of the new proposed GFE. I do hope it will make more sense after this ramble.

Tuesday, January 29, 2008

Options Theory and Mortgage Pricing

by Tanta on 1/29/2008 11:02:00 AM

One of the hot topics of conversation lately is the idea of a mortgage “put option.” There seem to be more than a few people—including those who don’t exactly use the language of options contracts, like that weird couple featured recently on 60 Minutes—who are slightly confused about what the “optionality” of a mortgage contract is. There are also lots of folks who are wondering what will happen to mortgage pricing in general should a substantial number of folks decide to “exercise the put” on their mortgages. It seems wise to me to try to tease out what’s going on here.

First, mortgage contracts in the U.S. are not, actually, options contracts. You may peruse your note and mortgage at length now, if you didn’t do so when you signed them, and you will not find any “put” or “call” in there. Your note is a promise to pay money you have borrowed, and your mortgage or deed of trust is a pledge of real estate you own (or are buying with the borrowed money) as security for that note. That means, in short, that if you fail to keep your promise to pay the loan in cash, the lender can force you to sell your property at auction (to produce cash with which to pay the loan in full). Because the mortgage instrument gives your lender a “lien,” any sales proceeds are first applied to the mortgage debt before you get any of it.

People get very confused about this because it is often the lender who ends up buying the property at the forced auction. When that happens, it is basically because the lender simply wants to put a “floor” bid in the auction: the lender bids an amount based on what it is willing to lose (if any). Typically, the lender bids its “make whole amount” or the loan amount plus accrued interest and expenses. If someone else bids more than that, the lender is happy to let the property go to the higher bidder.

The lender might bid less than its make-whole amount; it might bid its “probable loss” amount. If the lender is owed $300,000 and doesn’t think it could ever end up recovering more than $200,000, it might bid $200,000 at the FC auction. The lender doesn’t actually want to win the auction; lenders are not really in the business of real estate investment or property management. However, the lender would rather buy the home at the auction and pay itself back eventually by re-selling the property later (as a listed property in a private sale instead of a courthouse auction) than let the property go for $50,000 (meaning the lender would recover only $50,000 on a $300,000 loan instead of $200,000). Nothing ever stops any third party from bidding $1 more than the lender’s bid and winning the auction (except, of course, any third party’s own inclinations).

We need to remember, then, right away, when anyone talks about “giving the house back to the bank” or “mailing in the keys,” we are already in the land of metaphorical language. The only situation in which “giving the house back to the bank” would literally be possible is if you bought the house from the bank (say, it was REO) and the contract explicitly gave you an option to sell it back to the bank, whenever you wanted to, at a price equal to your loan balance. Nobody writes REO sales contracts that way. In most cases, of course, you bought the house from someone other than a bank. You have no option to “put the house back” to the seller. You win only if it's "heads."

A “put option,” in the financial world, is a contract that gives the buyer of the put the right, but not the obligation, to sell something (a commodity, a stock, a bond, etc.) in the future at a predetermined price. On the other side of the deal, the “writer” of the put is obligated to buy the thing in question if the put buyer exercises the option. Some of you may already be a bit confused about “buyer” and “seller” here, but that’s an important point. You don’t get “free puts.” You buy puts. There is a fee or a “premium” that you pay for the option contract. If you do not exercise the option, the put-writer pockets that fee. If you do exercise your option, the put-writer pockets that fee (to offset his loss on the deal) and your gains on the ultimate sale of the thing are net of the option premium.

The point of a put is that you buy them when you want to be protected from falling prices: if you think there is a good chance that the value of something will fall in the future, buying a put that allows you the option of selling it next month at this month’s price might well be worth paying that option premium. But you do always pay an option premium and you do not get it back.

The opposite of the put option is the call option: it is the option to buy something in the future at a predetermined price. You buy calls when you think the value of the thing is likely to rise. You also always pay some premium or fee for a call.

Residential real estate sales and mortgage loans do not, actually, literally, have puts and calls in them. If you buy a home today, you assume the risk that its price may fall in the future. Your contract does not include an option for you to sell the house at the price you paid for it. Nor does the seller of the house have a “call”; the seller cannot force you to sell the house back to him at the original price if its value rises.

Your mortgage loan contract does not give you the right to simply substitute the current value of the house for the current balance of the loan: you do, in fact, risk being “upside down.” (The only time this isn’t true in the U.S. is with a reverse mortgage; those are written explicitly to have this kind of a feature, where the balance due on the loan can never exceed the current market value of the property. But of course reverse mortgages aren’t purchase-money loans.) Nor does the mortgage contract give your lender the right to buy your house from you for the “price” of the loan amount when that is less than its value. Mortgage lenders never do better than paid back. If the real estate securing your loan increases in value, that appreciation belongs to you (as long as you make your loan payments).

So why is it that people keep talking about “puts” and “calls” in terms of mortgage loans? That’s because mortgage contracts have features that can affect their value to the writer of the contract (the lender or investor) in a way that is analytically comparable, in some ways, to classic options. Options theory is applied to mortgages in order to price them as investments. (Strictly speaking, this is a matter of analyzing them so that a price can be determined.) The interest rate, then, that you get on a mortgage loan will depend, in part, on how the lender/investor “priced” the implied options in the contract.

The “implied put” in a mortgage contract is the borrower’s ability to default (walk away, send jingle mail, whatever you want to call it). We do not, generally, consider “distress” (that’s actually the formal term in the literature, for you Googlers) as an “implied put.” Some borrowers will fall on hard times and be unable to fulfill their mortgage contracts. This is a matter of “credit risk” and it is, analytically, a different matter of mortgage contract valuation. The “implied put” analysis is trying to capture the possible cost to the lender/investor of what we call the “ruthless” borrower. “Ruthless” isn’t really intended to be a casual insult; it is in fact the term we use to describe borrowers who can pay their debts but choose not to, because there is a greater financial return to that borrower in defaulting as opposed to not defaulting. It is “ruthless” precisely because there is not a contractual option to do this: the only way you can exercise the “implied put” is to default on your contract.

Many many people are very confused about this. When we talk about the “social acceptability” of jingle mail, what we are talking about is at some level the extent to which there is or ought to be some rhetorical or social “fig leaf” over ruthlessness. It seems to be true, after all, that most people are more likely to behave ruthlessly if they can call it something other than ruthlessness. (There are always people who have no trouble with ruthlessness; they often get the CEO job. Most of us have at least moderately strong inhibitions about ruthless behavior.) There is, therefore, a process in which the ruthless put is re-described in various alternative terms, or has alternative narrative contexts built up around it, such that it no longer “feels” ruthless. The borrower was victimized (by the lender, the original property seller, the media, the Man). The put premium was actually paid (“they charge me so much they can afford this”). The ruthless borrower is actually the distressed borrower (redefining what one can “afford” or what is necessary expense so that a payment you can make becomes a payment you “can’t” make).

Before anyone starts in on me, let me note that these fig leaf mechanisms are effective precisely because victimization, predatory interest rates, and truly distressed household budgets do really exist. They wouldn’t be very convincing otherwise. (Very few ruthless borrowers will claim it’s because of, say, alien abduction or something equally implausible.) I am not, therefore, asserting that all claims of predation or distress are “false.” I am simply pointing out that it is, after all, a hallmark of the not-usually-ruthless person who is nonetheless acting ruthlessly to rationalize his conduct.

I don’t offer that as some startling insight into human psychology. I offer it as an attempt to get some analytic clarity. When CR talks about lenders fearing that jingle mail will become socially acceptable, he’s not exactly saying that lenders fear that society will no longer stigmatize financial failure (“distress”). They are afraid that rationalization mechanisms will become so effective that true ruthlessness (which is historically pretty rare in home mortgage lending) will become a significant additional problem (in addition to true distress). And they fear this because, delusions to the contrary, those loans did not have enough of a “put premium” priced into them to cover widespread “ruthless default.”

In fact, the very language of options theory can function, for a certain class of ruthless borrowers, as the fig leaf. To say “Hey, I’m just exercising my put” is a retroactive reinterpretation of your mortgage contract to “formalize” the “implied put” so that you do not have to describe what you’re doing as “defaulting.” This strategy is apparently popular with folks who have some modest exposure to financial markets jargon and an unwillingness to lump themselves in with the “riffraff”—victims of predators and financially failing households and other “weaklings.” (Sadly, a lot of people who have a very high degree of exposure to financial markets jargon don’t need no steenkin’ rationalization. Like most sociopaths, they don’t understand why “ruthless” would be considered insulting or what this term “social acceptability” might mean. So if you’re hearing the “put” excuse, you are probably in the presence of a relative amateur.)

The other side of the problem in valuation of mortgage loans and mortgage securities is the “implied call.” The “call-like feature” in a mortgage contract is the right to prepay. In the U.S., all mortgage contracts have the right to prepay. (Some, but not all, have a “prepayment penalty” in the early years of the loan, but “penalty” here means a prepayment fee, not an actual legal prohibition on prepayment.) The reason the right to prepay functions like an implied call is that it gives the borrower the right to “buy” the loan from the lender at “par,” even if the value of the loan is much higher than “par.” If you refinance your mortgage, you are required only to pay the unpaid principal balance (plus accrued interest to the payoff date) to the old lender in order to get the old lien released. Unless the loan specifically has a prepayment penalty, you are not required to further compensate the old lender for the loss of a profitable loan. So a loan with a prepayment penalty has an implied call and a real call exercise price. A loan without a prepayment penalty, or past the term of its prepayment penalty, has a “free call.” (In the original lender’s point of view. There is always some price to be paid to get a new refinance loan; the borrower’s calculation of the value of refinancing always has to take that into account. Among other things, this fact results in mortgage “call exercise” being much less “efficient” than it is on actual call contracts, which makes the call much more difficult to value, analytically, for mortgages.)

While ruthless default might, historically, be rare, refinancing has been ubiquitous for decades now. It wasn’t always so easily available; your grandparents might never have refinanced a loan not because their existing interest rates were never above market, but just because there weren’t lenders around offering inexpensive refinances. In fact, refinances have been so ubiquitous for so long now that many people have come to think of the availability of refinancing money as somehow guaranteed. This isn’t just a naïveté about interest rate cycles, although it is that too. It is a belief that credit standards and operating costs of lenders never change, so that if someone thought you were “creditworthy” once, they’ll automatically think of you as creditworthy again, and that lenders can always afford to refinance you without charging you upfront fees.

People who price mortgage-backed securities have always known that the prepayment behavior of mortgage loans is impacted not just by prevailing interest rates, but also by the borrower’s creditworthiness, the lenders’ risk appetites, and the cost (time and money) of the refinance transaction. We were talking the other day about the prepayment characteristics of jumbo loans in comparison to conforming loans; the fact is that people who have the largest loans are the most likely to refinance at any given reduction in interest rate, since a reduction in interest rate produces more dollars-per-month in savings on a larger loan than it does on a smaller loan. Considering these types of things is very important to people who price MBS, because in fact prepayment behavior is both hard to “price” and absolutely critical to “pricing” mortgages as an investment.

MBS, unlike other kinds of bonds, are “negatively convex.” I have been threatening to talk about convexity for a while and I keep chickening out. It’s actually useful to understand it if you want to understand why mortgage rates (and the value of servicing portfolios) behave the way they do. The trouble is that convexity involves a whole bunch of seriously geeky math and computer models and normal people probably don’t want to go there. (I don’t even want to go there.) So as a compromise, this is a very quick and simple explanation of convexity.

The convexity of mortgages is a result of the “implied options” in them. Most people understand intuitively that the higher the interest rate on a loan, the more an investor would pay for that loan: if you had the choice today of buying a bond that paid you 6.00% and one that paid you 6.50%, you would probably not offer the same price for each of them. With a classic “vanilla” bond, the price you would offer would be a matter of looking at the term to maturity, the frequency of payments, the interest rate, and some appropriate discount rate.

The trouble with mortgages is that while they have a maximum legal term to maturity, they have an unpredictable actual loan life, because they have the prepayment “calls” implied in the contracts. The return on a mortgage is uncertain, because you might get repaid early, forcing you to reinvest your funds at a lower rate. On the other hand, the loans might just stay there until legal maturity, at an interest rate that is now below the market rate on a new investment. The problem, obviously, is that borrowers refinance most often when prevailing market rates have dropped (right when the investor might want the loans to be long-lived) and don’t refinance when prevailing rates have risen (right when the investor would like to see you go away). “Vanilla” bonds don’t behave this way. Vanilla bonds, like Treasury bonds and notes, are “positively convex.” Mortgages are “negatively convex.”

Here’s a comparative convexity graph prepared by Mark Adelman of Nomura (do pursue the link if you want more detailed information about MBS valuation). This graph plots three example instruments all with a face value of $1,000 and a price of par ($1,000) at 6.00%. The vertical axis reflects the change in price of the bond. The horizontal axis reflects the change in prevailing market yields. As you move to the left of 6.00%, you see that the price of the bond increases (it has an above-market yield); as you move to the right it decreases.



However, the three instruments do not increase or decrease in price in the same way. The 30-year bond has a steeper curve than the 10-year note, which is a function of the difference in maturities of the two instruments. The MBS isn’t just not as steep; it is a different shape. The 30-year bond and the 10-year note price functions create an upward-curving slope when you plot them against price/yield changes like this, and the MBS price functions create a downward-curving slope. The term “negative convexity” means, exactly, that downward curving slope.

What’s going on here is that when market yields fall (moving to the left in the graph), average loan life in an MBS pool will shorten markedly, as borrowers are “in the money” to refinance. At a relatively modest fall in market yields, the price of the MBS does increase (but the increase is much less than the increase in the other bonds). At a larger drop in market yields, the MBS price gets as high as it will ever get and then stops increasing at all. What happens here is that the underlying mortgage loans have become so “rate sensitive” that any additional decrease in market yield (increase in the spread between the bond’s coupon of 6.00% and current market coupons) is entirely offset by shortened loan life: loans will pay off so fast at this point that this “officially” 30-year bond really returns principal to the investor the way a 1-year or even 6-month Treasury bill would. No investor is going to pay more for the MBS at this point than it would for the very shortest-term alternative.

On the other side of the graph, you see that the MBS price declines more slowly than the vanilla bonds, although its curvature at this point is very like the 10-year. At this side of the chart, average loan life is increasing. (Mortgage bonds never go to zero prepayments or actual average loan life = 30 years.)

What all this implies is that, analytically, mortgages do have some sort of “option price” built in. (There is actually a name for this, the OAS or Option Adjusted Spread, a method of comparing cash flows of a mortgage bond across multiple interest rate and prepayment scenarios. It’s heavy math and modeling.) In the case of voluntary prepayment (refinancing or selling your home, basically), your “call” option has, in fact, been priced—it’s in the interest rate/fees you pay to get a refinanceable mortgage loan. Investors accept the uncertainty of mortgage duration by (attempting to) price it in.

All that, however, is about trying to price the full return of principal (which, in the case of a mortgage loan, is also the point at which interest payments cease). It isn’t trying to model the return of less than outstanding principal, which is what the “put” or ruthless default is. A refinancing borrower pays you back early at par. A defaulting borrower pays you back early at less than par. Standard MBS valuation models that were developed for GSE or Ginnie Mae securities (that are guaranteed against credit loss) do not “worry” about ruthless puts in terms of principal loss, since that loss is covered by the guarantor. What is causing some trouble these days with the “ruthless put” in the prepayment models is simply that this is an unexpected source of prepayment that isn’t correlating with “typical” interest rate scenarios. (We are seeing increased defaults in a very low-rate environment, because of the house price problem, which isn’t built into the prepayment models for guaranteed securities. Historically, prepayment models “expect” non-negligible numbers of ruthless puts only in higher-rate environments.)

It may help you to understand that we have been talking about how an investor might price an MBS coupon, which isn’t the same thing as the interest rate on a loan. In a Fannie Mae or Freddie Mac MBS, the “coupon” or interest rate paid to the investor might be, say, 6.00%. That means that the weighted average interest rate on the underlying loans in the pool is substantially more than 6.00%. There is the bit that has to go to the servicer, and there’s the bit that has to go to the GSE to offset the credit risk. The mortgages must pay a high enough rate of interest to provide 6.00% to the investor after the servicing and guarantee fees come off the top. In essence, then, MBS traders set the “current coupon” or the coupon that trades at par, the GSEs set the guarantee fee and/or loan-level settlement fees that cover the credit risk, the servicer sets the required servicing fee, and all that adds up to the “market rate” for conforming mortgage loans (plus mortgage insurance, if applicable, which is conceptually an offset to the guarantee fee).

One way of describing the situation we’re currently in is that borrowers are continuing the short loan life of the boom (which was made possible by easy refi money and hot RE markets) by substituting jingle mail for refinancing. That increases credit losses to whoever takes the credit loss (the GSEs and the mortgage insurers), decreases servicer cash flow (a refi substitutes a new fee-paying loan for the old loan; a default substitutes a no-fee-paying problem for the old loan), and makes everyone’s prepayment models go whacky-looking. This is one reason why it obviously wasn’t a good time for MBS traders to be told they’d be suddenly getting jumbos in their conforming pools; at some level the response to that could be summed up as “we don’t need one more thing that defies analysis.”



Ultimately, there is no way anyone can mobilize “social acceptability” as a defense against the ruthless put (even if you wanted to). The industry has, in fact, created the conditions in which it’s rational, and as long as it’s rational it will go on. Just as it was rational to buy at 100% LTV. The only possible way to get back to an environment in which ruthless default is rare is to abandon the “innovations” that give rise to them: no-down financing, wish-fulfillment appraisals, underpriced investment property loans, etc. The administration is currently pushing for increasing the FHA loan amounts and the FHA maximum LTV up to 100%. This is not likely to remove the incentive to take another reckless loan on a still-too-high-priced house. If we aren’t going to ration credit with tighter guidelines and loan limits, then it will have to be rationed with pricing: eventually the models will “solve” the problem by increasing the costs of mortgage credit. You cannot simply keep writing “free puts.”