by Tanta on 5/29/2008 07:10:00 AM

This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everywhere. Our own Uncle Festus sent me this decision, in which Judge Leslie Tchaikovsky ruled that a National City HELOC that had been "foreclosed out" would be discharged in the debtors' Chapter 7 bankruptcy. Nat City had argued that the debt should be non-dischargeable because the debtors made material false representations (namely, lying about their income) on which Nat City relied when it made the loan. The court agreed that the debtors had in fact lied to the bank, but it held that the bank did not "reasonably rely" on the misrepresentations.

I argued some time ago that the whole point of stated income lending was to make the borrower the fall guy: the lender can make a dumb loan--knowing perfectly well that it is doing so--while shifting responsibility onto the borrower, who is the one "stating" the income and--in theory, at least--therefore liable for the misrepresentation. This is precisely where Judge Tchaikovsky has stepped in and said "no dice." This is not one of those cases where the broker or lender seems to have done the lying without the borrower's knowledge; these are not sympathetic victims of predatory lending. In fact, the very egregiousness of the borrowers' misrepresentations and chronic debt-binging behavior is what seems to have sent the Judge over the edge here, leading her to ask the profoundly important question of how a bank like National City could have "reasonably relied" on these borrowers' unverified statements of income to make this loan.

And as I argued the other day on the subject of due diligence, it isn't so much that individual loans are fraudulent than that the published guidelines by which the loans were made and evaluated encouraged fraudulent behavior, or at least made it "fast and easy" for fraud to occur. Judge Tchaikovsky directly addresses the issue of the bank's reliance on "guidelines" that should, in essence, never have been relied upon in the first place.

*************

Here follow some lengthy quotes from the decision, which was docketed yesterday and is not, as far as I know, yet published. From In re Hill (City National Bank v. Hill), United States Bankruptcy Court, Northern District of California, Case No. A.P. 07-4106 (May 28, 2008):

This adversary proceeding is a poster child for some of the practices that have led to the current crisis in our housing market.

Indeed. The debtors, the Hills, bought their home in El Sobrante, California, twenty years ago for $220,000. After at least five refinances, their total debt on the home at the time they filed for Chapter 7 in April of 2007 was $683,000. Mr. Hill worked for an automobile parts wholesaler; Mrs. Hill had a business distributing free periodicals. According to the court, their combined annual income never exceeded $65,000.

In April 2006, the Hills refinanced their existing $100,000 second lien through a mortgage broker with National City. Their new loan was an equity line of $200,000; after paying off the old lien and other consumer debt, the Hills received $60,000 in cash. On this application the Hills stated their annual income as $145,716. The property appraised for $785,000.

By October 2006 the Hills were short of money again, and applied directly to National City to have their HELOC limit increased to $250,000 to obtain an additional $50,000 in cash. On this application, six months later, the Hills' annual income was stated as $190,800, and the appraised value was $856,000.

At the foreclosure sale in April 2007, the first lien lender bought the house at auction for $450,000, apparently the amount of its first lien.

The Hills claimed that they did not misrepresent their income on the April loan, and that they had signed the application without reading it. The broker testified rather convincingly that the Hills had indeed read the documents before signing them--Mrs. Hill noticed an error on one document and initialed a correction to it. No doubt because the October loan, the request for increase of an existing HELOC, did not go through a broker, the Hills admitted to having misrepresented their income on that application. The Court found that:

Moreover, the Hills, while not highly educated, were not unsophisticated. They had obtained numerous home and car loans and were familiar with the loan application process. They knew they were responsible for supplying accurate information to a lender concerning their financial condition when obtaining a loan. Even if the Court were persuaded that they had signed and submitted the October Loan Application without verifying its accuracy, their reckless disregard would have been sufficient to satisfy the third and fourth elements of the Bank’s claim.

This is not an excessively soft-hearted judge who fell for some self-serving sob story from the debtors. "Reckless disregard" is rather strong language.

Unfortunately for National City, Her Honor was just as unsympathetic to its claims:

However, the Bank’s suit fails due to its failure to prove the sixth element of its claim: i.e., the reasonableness of its reliance.6 As stated above, the reasonableness of a creditor’s reliance is judged by an objective standard. In general, a lender’s reliance is reasonable if it followed its normal business practices. However, this may not be enough if those practices deviate from industry standards or if the creditor ignored a “red flag.” See Cohn, 54 F.3d at 1117. Here, it is highly questionable whether the industry standards–-as those standards are reflected by the Guidelines–-were objectively reasonable. However, even if they were, the Bank clearly deviated to some extent from those standards. In addition, the Bank ignored a “red flag” that should have called for more investigation concerning the accuracy of the income figures. . . .

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its reliance was not reasonable based on an objective standard. In fact, the minimal verification required by an “income stated” loan, as established by the Guidelines, suggests that this type of loan is essentially an “asset based” loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank’s loss, and the Bank’s claim should be discharged.

In short, while the Court found that the Hills knowingly made false representations to the lender, the lender's claim that it "reasonably relied" on these representations doesn't hold water, because "stated income guidelines" are not reasonable things to rely on. In essence, the Court found, such lending guidelines boil down to what the regulators call "collateral dependent" loans, where the lender is relying on nothing, at the end of the day, except the value of the collateral, not the borrower's ability or willingness to repay. If you make a "liar loan," the Judge is saying here, then you cannot claim you were harmed by relying on lies. And if you rely on an inflated appraisal, that's your lookout, not the borrower's.

This is going to give a lot of stated income lenders--and investors in "stated income" securities--a really bad rotten no good day. As it should. They have managed to give the rest of us a really bad rotten no good couple of years, with no end in sight.

Read on . . .

by Calculated Risk on 5/27/2008 08:25:00 PM

From Ruth Simon at the WSJ: Investors Press Lenders on Bad Loans

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.
...
The potential liability from the growing number of disputed loans could reach billions of dollars ...

Tanta and I were discussing who the eventual bagholders would be way back in 2005 - while the bubble was still inflating - and although the picture is much clearer today, some bagholders still don't want to be, uh, bagholders! And who could blame them?

by Tanta on 3/27/2008 08:58:00 AM

This morning we have Vikas Bajaj in the NYT reporting on second-lien lenders refusing to go quietly:

Americans owe a staggering $1.1 trillion on home equity loans — and banks are increasingly worried they may not get some of that money back.

To get it, many lenders are taking the extraordinary step of preventing some people from selling their homes or refinancing their mortgages unless they pay off all or part of their home equity loans first. In the past, when home prices were not falling, lenders did not resort to these measures.

Um. This isn't really a very helpful way to put it, you know. In the very concept of the "lien" is the idea that the lender gets to demand payment if you sell the property that is securing the loan, and in the very concept of "refinance" lurks the idea that you pay off the existing loan with the proceeds of the new one. These concepts are not "extraordinary."

What we mean here, I take it, is short sales and short refinances (or subordinations behind a distressed first-lien refinance). If so, we really ought to say that, because "in the past, when home prices were not falling," we didn't have a lot of short sales and short refis, so the occasion for second lienholders to object to them just didn't arise much.

The reason to insist on some clarity here is that I don't think it helps much to build up certain people's sense of entitlement on the matter. Or at least their occasionally fundamental confusion about what rights you give up to a lender when you sign this mortgage thingy.

There is an example in the Times article, of a couple who attempted a short sale which was derailed because the second lienholder wouldn't play nice:

Experts say it is in everyone’s interest to settle these loans, but doing so is not always easy. Consider Randy and Dawn McLain of Phoenix. The couple decided to sell their home after falling behind on their first mortgage from Chase and a home equity line of credit from CitiFinancial last year, after Randy McLain retired because of a back injury. The couple owed $370,000 in total.

After three months, the couple found a buyer willing to pay about $300,000 for their home — a figure representing an 18 percent decline in the value of their home since January 2007, when they took out their home equity credit line. (Single-family home prices in Phoenix have fallen about 18 percent since the summer of 2006, according to the Standard & Poor’s Case-Shiller index.)

CitiFinancial, which was owed $95,500, rejected the offer because it would have paid off the first mortgage in full but would have left it with a mere $1,000, after fees and closing costs, on the credit line. The real estate agents who worked on the sale say that deal is still better than the one the lender would get if the home was foreclosed on and sold at an auction in a few months.

I'm not here to make up details not in evidence in a newspaper story, so bear that in mind. But my attention was caught by that detail about retiring due to an injury. As presented, the story seems to be that the McLains took out a HELOC in January of 2007, and at some point "last year" the borrowers fell behind in payments because of the disability. We aren't told by the Times whether the income troubles led to drawing down the HELOC, and then being unable to keep up payments, or if the HELOC had been drawn to the full $95,000 back in January of 2007, and subsequently the income troubles led to the McLains being unable to keep up the payments.

I bring this up only because the following item caught my eye yesterday (via Mish), from someone who apparently purports to be a source of personal finance advice:

As many readers know, I’m a proponent of keeping an untapped home equity line of credit (HELOC) at my disposal for major emergencies. This isn’t my emergency fund. It’s what I call my catastrophe fund.

I’ve always believed that keeping a HELOC readily available is the best insurance policy and the back-up plan for if / when the emergency fund runs empty. Think about it… being able to tap this money could buy us time in the event of job loss or illness. And time is money. . . .

The HELOC is there strictly as a backup plan. For a catastrophe. Period. End of story. But with that said, I’ve always looked at that line of credit as my money. Money I could access at any time. . . .

So it came as a surprise yesterday when we got the letter from Citibank about our $168,000 line of credit:

We have determined that home values in your area, including your home value, have significantly declined. As a result of this decline, your home’s value no longer supports the current credit limit for your home equity line of credit. Therefore, we are reducing the credit limit for your home equity line of credit, effective March 18, 2008, to $10,000. Our reduction of your credit limit is authorized by your line of credit agreement, federal law and regulatory guidelines.

Reduced to $10,000!? Hello!? Please don’t f-ck with my house in Newport Beach…

Of course, I’m calling them today to dispute it.

I left out the parts about how this writer is such a great credit risk now, and was when she qualified for the HELOC originally. I am merely struck by how unaware she is of the essential problem in her understanding of a HELOC as a kind of disability insurance: she is saying that she qualified for the line of credit as an employed, cash-flush borrower, but plans to use it only if she becomes . . . the kind of borrower who couldn't qualify for a HELOC.

Now, let me say that lenders were fully complicit in this idea; I heard more than a few sales pitches for HELOCs over the boom years based on this "do it just in case you need it" idea. But it was a self-defeating plan then and it is so clearly still one now: how do you get out of problems making your mortgage payment by increasing your mortgage debt--and not coincidentally decreasing your odds of selling your home should you need to?

More to today's point, how do you ask the HELOC lender to advance you money to pay the first lien lender with--I assume that's the idea of using the HELOC to "tide you over" in a bad patch, you're borrowing the first lien mortgage payments from the HELOC lender--knowing you aren't really (currently, at least) in any position to pay it back, and then ask the HELOC lender to let the first lien lender get all the proceeds in a short sale? Don't get me wrong: I fully understand why people hate lenders these days and think they're just getting what they "deserve." I'm just shocked at the naive assumption that they wouldn't fight back a little here.

As I said, I don't really know what the McLains' situation was, since we don't get much detail. But one can understand Citibank's near-total erasure of Ms. Newport Beach's unused HELOC as a sensible precaution on Citi's part, and not simply because home values are falling. Now is probably not a good time for HELOC lenders to be sitting on their duffs waiting for borrowers to run into financial trouble and use those HELOCs as a way to limp along to the point where the HELOC lender gets nothing in a foreclosure.

Of course Ms. Newport Beach believes that her potential use of a HELOC as "insurance" wouldn't be doomed to failure. Nobody ever believes that doubling down is doomed to failure; that's why they do it. But if in fact that's what the McLains did, it doesn't seem to have done anything for them except buy them time to negotiate a short sale that then fell through because CitiFinancial didn't like being the patsy at the table.

by Tanta on 3/25/2008 08:42:00 AM

Yves at naked capitalism had a good post yesterday on the infamous Bear Stearns Ten Buck Rechuck, that I think needs repeating:

According to Sorkin, the $2 price for Bear was the Fed's and Treasury's idea; JP Morgan was prepared to pay more, but they nixed the idea, saying they did not like the "optics" of the deal. The implication is that the officials overstepped their bounds. That is a pretty outrageous spin when the government is putting up taxpayer money.

Had it been an option, the Fed should have nationalized Bear. It was going to declare bankruptcy Monday if there was no deal; its shareholders would have been wiped out. Why am I so confident of this view? If bondholders, as rumored, were buying shares to make sure the JPM deal went through (and thus would take losses on their stock purchases when the deal closed), that meant that they thought their bonds were worth well under 100 cents on the dollar in a bankruptcy. Shareholders are subordinate to bondholders, so equity owners would have gotten zilch.

I can think of a host of reasons, however, why the Fed did not go the nationalization route, the biggest being that it lacked clear authority (it couldn't declare Bear to be insolvent, as it could a member bank). And letting Bear fail (and having accounts frozen) was what the Fed was trying to avoid, so letting it fail and then seizing control (even assuming it could do that) was never an option. No doubt, the central bank also did not want to assume administrative control of an entity that it had never regulated (ie, its supervisors had never kicked its tires) that dealt actively in markets in which the Fed has little expertise. Even in an orderly liquidation scenario, that it a lot to take on.

Sorkin nevertheless argues that the Fed did Bear a dirty because:

.....the night that Bear signed the original bid, the Fed opened what’s known as the discount window to companies like Goldman Sachs and Lehman Brothers — oh, yes, and to Bear, too. Except that the Fed didn’t tell Bear that it planned to open the window when it was signing its deal with JPMorgan.

This verges on being revisionist history. First and most important, the discount window was opened to keep the panic about Bear from spreading to other firms, most notably Lehman. It almost certainly would not have happened then if Bear was not on the verge of imploding. Remember, a mere week and a day ago, there was pervasive fear that the wheels were about to come off the financial system, particularly if counterparties started getting leery of dealing with Lehman.

Moreover, usage of the new discount window the first week was light due to worries about stigma. If Bear had gone and used it aggressively, it may well have reinforced rather than allayed fears about the trading firm's health. If other firms continued to refuse to deal with Bear, its collapse was assured. There was a very real possibility that even if Bear had remained independent and used the window, its bankruptcy merely would have been delayed a day or two. And it would have been well nigh impossible to put together a three party takeover deal between the close of business in New York and market opening in Asia on a weekday.

But the most appalling aspect of Sorkin's account: he acts as if Bear had the right to be informed of the Fed's plans. Sorkin seems to have forgotten the golden rule: he who has the gold makes the rules. The Fed had every right to be calling the shots. They were taking the biggest risk in this transaction. The notion that a firm about to fail is entitled to be treated as a being on an equal footing with its rescuers is absurd. And the fact that Sorkin (and presumably others on Wall Street) sympathize with this view says the industry badly needs to be leashed and collared.

This, frankly, is the reason why I am so incredibly appalled by this:

Wells Fargo CEO John Stumpf said the financial crisis is presenting the bank with more acquisition opportunities.

"I would not be averse to a Fed-assisted transaction," Stumpf said in a recent interview with the San Francisco Business Times. "Fixer-uppers don't bother us."

The San Francisco banker said any deal would have to meet the company's traditional acquisition targets and benefit the bank's acquired customers.

To even mention, in public, that one "wouldn't be averse to a Fed-assisted transaction" is to hint that the acquisition targets you are looking at are in as dire straits as Bear Stearns. What is Stumpf trying to do, start a run on an insured bank? Or, well, the other option is that Stumpf doesn't believe that Bear was such a mess--that, precisely, it is "on an equal footing with its rescuers."

Either way you slice it, the very fact that he could say such a thing in public tells you how far down the wrong road we've gone. I vote for the leash and collar, pronto.

by Tanta on 3/21/2008 08:17:00 AM

This, via Felix via Yves, is funny.

Floyd Norris ruminates on the the Bear business as well as the curious details of the Thornburg Mortgage deal:

The deal negotiated by Thornburg got the banks to promise there would be no more margin calls for a year, by which time, it is hoped, the securities would have regained value. The cost to Thornburg of getting that concession was to give warrants to the banks to buy a lot of stock at a penny a share, and to promise to raise at least $1 billion in cash within days. That cash would provide a margin of safety for the banks even if the mortgage securities market continues to decline.

To borrow that money, Thornburg is offering convertible bonds paying 12 percent annual interest. Add in some extra warrants, and buyers of the bonds will be able to get stock for less than 72 cents a share. If they convert, they will own 86 percent of the company, while the bankers will have an additional 3 percent — for which they will pay 1 cent a share. Existing shareholders will have an 11 percent stake.

If, that is, the bonds sell. On Thursday night, the bond offering was delayed until Monday, a sign that the underwriters may be having trouble rounding up buyers.

Logically, the shares should trade for 50 cents or less if these are the terms Thornburg must pay to borrow, but the price has stayed well above that level. So why did the shares not collapse?

Perhaps shareholders hope to vote the deal down, but that would remove only the conversion privilege from the bonds. Bondholders would still get warrants, and their interest rate would go up to 25 percent. It is hard to explain rationally, but perhaps some buyers heard the company had a plan to stay afloat, and ignored the details.

Thornburg officials would not talk to me, but it is not easy to understand how they expect to make this deal work for very long. Thornburg’s longtime strategy was to borrow at low rates to finance mortgage securities paying higher rates. Now it will pay 12 percent to help support securities paying a much lower rate of interest.

That negative carry trade thingy hurts.

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

This is what the Financial Times is reporting:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This does start out right, I think:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

by Tanta on 2/23/2008 08:02:00 AM

I have no particular qualms about hanging BoA's name on this proposal. For one thing, they seem to have sent the memo. For another, they just "bought" Countrywide. (Who knows what the price would be net of this proposed government buyout of all the bad loans?) Edmund Andrews in the New York Times:

WASHINGTON — Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for “financial innovation.”

But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

“We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market,” the financial institution noted.

So that answers the questions everyone had about the OTS-NEC proposal, such as how the hell it would work with securitized loans: it wouldn't. The government would buy those loans out of those pools first, so the NEC thingy wouldn't be owned by the security. But if you "position" it as a bailout of homeowners, nobody will "perceive" it to be a bailout of the bond market?

In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government’s $200 billion bailout of the savings and loan industry in the 1990s. The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

A rescue would also create a “moral hazard,” many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

If the government pays too much for the mortgages or the market declines even more than it has already, Washington — read, taxpayers — could be stuck with hundreds of billions of dollars in defaulted loans.

But a growing number of policy makers and community advocacy activists argue that a government rescue may nonetheless be the most sensible way to avoid a broader disruption of the entire economy. . . .

Ellen Seidman, a former director of the Office of Thrift Supervision and now a senior fellow at the moderate-to-liberal New America Foundation, said the government’s first challenge is to buy mortgages at their true current value. If the government overpaid or became caught by an even further decline in the market value of its mortgages, taxpayers would indeed be bailing out both the industry and imprudent home buyers.

“It’s not easy, but it’s not impossible,” Ms. Seidman said. “There are various auction mechanisms, both inside and outside government.”

A second challenge would be to start a program quickly enough to prevent the housing and credit markets from spiraling further downward. Industry executives and policy analysts said it would take too long to create an entirely new agency, as Bank of America suggested. But they expressed hope that the government could begin a program from inside an existing agency.

But even if the government did buy up millions of mortgages and force mortgage holders to take losses, the biggest problem could still lie ahead: deciding which struggling homeowners should receive breaks on their mortgages.

Administration officials have long insisted that they do not want to rescue speculators who took out no-money-down loans to buy and flip condominiums in Miami or Phoenix. And even Democrats like Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, have said the government should not help those who borrowed more than they could ever hope to repay.

But identifying innocent victims has already proved complicated. The Bush administration’s Hope Now program offers to freeze interest rates for certain borrowers whose subprime mortgages were about to jump to much higher rates. But the eligibility rules are so narrow that some analysts estimate only 3 percent of subprime borrowers will benefit.

Bank executives, meanwhile, warn that the mortgage mess is much broader than people with subprime loans. Problems are mounting almost as rapidly in so-called Alt-A mortgages, made to people with good credit scores who did not document their incomes and borrowed far more than normal underwriting standards would allow.

Borrowers who overstated their incomes are not likely to get much sympathy. But industry executives and consumer advocates warn that foreclosed homes push down prices in surrounding neighborhoods, and a wave of foreclosures could lead to another, deeper plunge in home prices.

Right or wrong, the arguments for rescuing homeowners are likely to be blurred with arguments for rescuing home prices. At that point, industry executives are likely to argue that what is good for Bank of America is good for the rest of America.

Nobody is going to create a functioning new agency with the relevant expertise and staffing and funding and clear mandate out of thin air fast enough to do what this wants to do, if what we want to do is stave off recession. FHA probably has the expertise to credibly attempt the loan-level workouts, but not enough hands to get saddled with $739 billion worth that has to be dealt with before everybody's lawns go brown. Ginnie Mae is, in my view, one of the most efficient and quietly professional government agencies ever: they run a highly successful program with a tiny staff. I can't imagine Ginnie Mae is ready to manage reporting and remittances on a brand-new government-owned pool o' junk of this size with existing resources.

So of course the whole thing would be outsourced to some private company. I'm sure there's a financial institution out there willing to write up a proposal for how the government can pay it a management fee to orchestrate the government's bailout of its last attempt to manage mortgage-lending-related program activities.

by Tanta on 1/31/2008 07:43:00 AM

PBS (thanks, ES!):

JEFF YASTINE, NIGHTLY BUSINESS REPORT CORRESPONDENT: You wouldn't call Sandra Sanchez a real estate speculator. The mother of two teaches at a private school. Two years ago, with a daughter headed off to college and the real estate boom in full swing, she purchased this house as an investment property. It seemed like a good idea at the time.

I have no idea why I wouldn't call Ms. Sanchez a real estate speculator, since as far as I can tell she was speculating in real estate. I'm sure she's an amateur speculator, but that's rather the point, isn't it?

YASTINE: Sandra Sanchez, struggling now to make payments on two homes, thinks the GOP and Democratic candidates are beginning to pay attention.

SANCHEZ: I think they're seriously thinking about the matter. And they know that a lot of the votes come from the average people, so you have to focus on the needs of the average people. You cannot sit back and let things happen to people.

YASTINE: With that in mind, Sanchez says she'll vote today and reevaluate come November. She hopes her homes haven't been foreclosed upon by then.

I'm guessing that we could, certainly, sit back and let things happen to speculators. Hence the fig leaf.

by Calculated Risk on 12/05/2007 12:19:00 PM

From Bloomberg: Orange County Funds Hold SIV Debt on Moody's Review

Orange County, California, bankrupted in 1994 by bad bets on interest rates, bought structured investment vehicles similar to those that caused a run on funds invested by local governments in Florida.

Twenty percent, or $460 million, of the county's $2.3 billion Extended Fund is invested in so-called SIVs that may face credit-rating cuts, said Treasurer Chriss Street. ...

Orange County's money is invested in commercial paper under review by Moody's that was issued by Centauri Corp.'s CC USA Inc., Citigroup Inc.'s Five Finance Inc., Standard Chartered Plc.'s Whistlejacket Capital Ltd. and Tango Finance Corp., according to Rodenhuis.

It doesn't sound like Orange County will suffer any significant losses, but I doubt they will be investing in any more SIV asset backed commercial paper.

by Calculated Risk on 12/03/2007 02:07:00 PM

Ahhh, I'm reminded of Tanta's post in early June: Reelin' In the Suckers

Once again, from David Evans at Bloomberg: Montana, Connecticut Hold SIVs Downgraded, Reviewed by Moody's (hat tip energyecon)

Montana and Connecticut state-run investment funds hold debt tainted by the subprime mortgage collapse that was cut or put under review by Moody's Investors Service, leaving local governments vulnerable to losses.

... Montana owns $50 million of the paper. Moody's put another $105 billion of SIVs on review for a possible downgrade, of which Montana holds $80 million and Connecticut holds $300 million, records show.

``This just reinforces the fact that we have a serious issue,'' said State Senator Dave Lewis, of Helena, Montana, a member of the Legislative Audit Committee.
...
The Montana pool, managed by the Montana Board of Investments, has 25 percent, or $550 million, invested in SIVs, all of which carried top investment ratings when purchased.
...
Connecticut's Short-Term Investment Fund, which invests cash for state agencies and municipalities, is holding $300 million in debt issued by SIVs that may be downgraded by Moody's. The state's $5.8 billion fund held notes issued by SIVs affiliated with Citigroup ...

Connecticut also holds $100 million in defaulted SIV notes issued by Cheyne Finance.

More bagholders found.

by Calculated Risk on 12/01/2007 11:23:00 PM

Update: here is an article from Aftenposten in Norway (sent to me two weeks ago, hat tip Impy): Townships caught up in international credit crisis

Officials in four northern Norwegian townships (Narvik, Rana, Hemnes and Hattfjelldal) went along with an alleged recommendation by Terra Securities to invest a total of NOK 451 million in what they're now calling "high-risk structured products" offered by Citibank and sold for Citibank by Terra.

The American commercial paper was also tied to bonds issued by local governments in the US, and Norwegian Broadcasting (NRK) reported that hedge funds were involved. To boost returns, the Norwegian townships also borrowed NOK 3.5 billion to invest in Citibank's products, which later lost as much as 50 percent of their value because of the US credit crunch.

News started leaking out about the troubled investments when the townships were ordered to pay in millions more, to satisfy guarantee requirements. Mayor Asgeir Almås in Hattfjelldal feels cheated.

From the NY Times: U.S. Credit Crisis Adds to Gloom in Arctic Norway

What is keeping [Karen Margrethe Kuvaas] awake are the far-reaching ripple effects of the troubled housing market in sunny Florida, California and other parts of the United States.

Ms. Kuvaas is the mayor of Narvik, a remote seaport where the season’s perpetual gloom deepened even further in recent days after news that the town — along with three other Norwegian municipalities — had lost about $64 million, and potentially much more, in complex securities investments that went sour.

Tanta and I (and many others) have been wondering for a couple of years who the bagholders would be. Add Narvik, Norway to the list.