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Saturday, March 31, 2007

Take a Calculated Risk on Me

by Tanta on 3/31/2007 04:07:00 PM

Because you all need something else to talk about.

Yes, I remember what I was doing when this song came out.

Yes, I used to have a bat-winged blouse that tied at the hip just like that.

You wanna make something of it?

Washington Post on Michigan Foreclosures

by Tanta on 3/31/2007 10:53:00 AM

From "Housing Crisis Knocks Loudly in Michigan":

For most of the past year, Michigan has ranked among the three states with the highest percentage of late mortgage payments and foreclosures, surveys by the Mortgage Bankers Association show. In the fourth quarter, it came in third, behind Ohio and Indiana, with 2.39 percent of its loans in foreclosure.

Many economists say, and union officers agree, that those hardest hit are not auto workers who lost jobs. Many received buyouts that should keep them afloat for a while. And because they tend to be older, some have paid off their mortgages.

Those feeling the worst squeeze, rather, are workers at the auto supply companies, such as Max, 44, an engineer who spoke on condition that his last name not be used because he is embarrassed by his situation.

Max bought a condominium in the Detroit suburb of Plymouth using a traditional fixed-rate mortgage more than five years ago. But three years later, his firm took away company cars from its workers, hiked insurance premiums and cut raises and bonuses -- raising Max's monthly living expenses and reducing his pay.

Max responded by refinancing his condo twice. Though he did not realize it then, the second loan was adjustable. Over time, his monthly payments rose from $1,500 to $1,800 to $1,950.

"I wasn't even reading the paperwork," said Max, who makes $106,000 a year.

Weeks ago, Max turned in his keys to his lender. The bank paid him $500 and took possession of the condo earlier than it otherwise could under Michigan law.

Fulton Financial Alt-A Repurchases

by Tanta on 3/31/2007 08:46:00 AM

Hat tip to jmf!

Fulton Financial reports on repurchases of loans originated through its Resource Bank subsidiary:

In recent months, Resource has experienced an increase in the rate of EPD and corresponding requests to repurchase such loans, primarily related to one specific product sold to one investor. This product, referred to as the 80/20 Program, involves financing of up to 80% of the lesser of the purchase price or appraised value for a first lien mortgage loan and up to an additional 20% of the lesser of the purchase price or appraised value for a second lien home equity loan. Investor underwriting requirements for the 80/20 Program do not require independent verification of the borrower's income. To be eligible for loans under the 80/20 Program, borrowers are generally required to have a credit score of 620 or greater.
Fun facts:

  • Loans originated for sale under the 80/20 Program in 2006: $247MM
  • Pending repurchases of 2006-originated 80/20 Program loans: $22MM
  • Remaining 2006 80/20 loans still subject to potential repurchase: $72MM
  • Average FICO on requested repurchase loans: 653
  • Percent of repurchase requests due to Early Payment Delinquency: 80%
  • Date Resource quit offering this loan program: February 2007

These are fairly small absolute numbers for a lender of this size. The point is that this is under any definition Alt-A, not subprime.

Friday, March 30, 2007

Bank says Alt-A loan woes will hurt earnings

by Calculated Risk on 3/30/2007 07:16:00 PM

From Reuters: M&T Bank says Alt-A loan woes will hurt earnings

M&T Bank Corp. said on Friday that problems with mortgages that have limited income documentation will hurt first quarter profit.

The bank, based in Buffalo, New York, said the carrying value of its Alt-A loan portfolio that had been held for sale was reduced by $12 million in the first quarter.
...
Meanwhile, the bank also said it would have to repurchase problem loans sold to investors.
Added: Just to make this clear, the problem loans that M&T will repurchase are Alt-A. From the M&T Bank press release:
In addition, M&T is contractually obligated to repurchase previously sold Alt-A loans that do not ultimately meet investor sale criteria, including instances when mortgagors fail to make timely payments during the first 90 days subsequent to the sale date. Requests from investors for M&T to repurchase Alt-A loans have recently increased. As a result, during the first quarter of 2007, M&T accrued $6 million to provide for declines in market value of previously sold Alt-A mortgage loans that are expected to be repurchased.

OCC: Record Bank Trading Revenues of $18.8 Billion for 2006

by Calculated Risk on 3/30/2007 02:17:00 PM

OCC Reports Record Bank Trading Revenues of $18.8 Billion for 2006

Insured U.S. commercial banks posted a record $18.8 billion in trading revenues in 2006, up 31 percent from the previous annual record of $14.4 billion set in 2005, the Office of the Comptroller of the Currency reported today in the OCC Quarterly Report on Bank Derivatives Activities. In the fourth quarter, commercial banks generated revenues of $3.9 billion from trading cash instruments and derivative products, off slightly from the $4.5 billion in trading revenues for the third quarter of 2006.

“Bank trading revenues have been strong the past few years due in large part to robust client demand, especially from large institutional investors such as hedge funds,” said Deputy Comptroller for Credit and Market Risk Kathryn E. Dick.

The OCC also reported that the notional amount of derivatives held by insured U.S. commercial banks increased $5.3 trillion, or 4 percent, to a record $131 trillion in the fourth quarter, 30 percent higher than year-end 2005.

The report noted that a fast-growing area has been credit derivatives, which increased to $9.0 trillion at year-end 2006, representing a 55 percent increase from the $5.8 trillion reported at year-end 2005. ...
Here is the report: OCC’s Quarterly Report on Bank Derivatives Activities: Fourth Quarter 2006

Construction Spending

by Calculated Risk on 3/30/2007 11:42:00 AM

From the Census Bureau: February 2007 Construction Spending at $1,170.8 Billion Annual Rate

The U.S. Census Bureau of the Department of Commerce announced today that construction spending during February 2007 was estimated at a seasonally adjusted annual rate of $1,170.8 billion, 0.3 percent above the revised January estimate of $1,167.7 billion. The February figure is 2.4 percent (±2.2%) below the February 2006 estimate of $1,199.9 billion.

During the first 2 months of this year, construction spending amounted to $159.9 billion, 2.4 percent (±2.2%) below the $163.8 billion for the same period in 2006.
Click on graph for larger image.

This graph shows the YoY change for the three major components of construction spending: Private Residential, Private Non-Residential, and Public.

While private residential spending has declined significantly, spending for both private non-residential and public construction have been strong. This will probably be one of the keys for the economy going forward: Will nonresidential construction spending follow residential "off the cliff" (the normal historical pattern)? Or will nonresidential spending stay strong. I'll revisit this discussion soon.

Dr. Goolsbee: I’ll Stop Impersonating an Economist If You Quit Underwriting Mortgage Loans

by Tanta on 3/30/2007 09:31:00 AM

I have described borrower-initiated fraud-for-housing loans as “self-underwritten.” The idea is that the borrower knows what the lender’s qualification standards are, knows he doesn’t meet those standards, and knows he cannot negotiate those standards away. His choices are, then, to accept the denial of credit, buy a cheaper house, or to lie or misrepresent the facts of his income, assets, employment, occupancy, and so on such that he appears to meet the standards. I call this “self-underwritten” because it rests on the borrower’s belief that he is a better judge of his prospects for carrying the loan successfully than the lender is; this belief allows him to justify his behavior as something other than criminal.

The fact that there have been so many “self-underwritten” loans in an environment of exceptionally lax standards for lender-underwritten loans is the key to puncturing this self-justification. It isn’t like we’ve had a credit crunch for years perpetuated by extremely risk-averse lenders, so that only perfect borrowers—or those who misrepresent themselves as perfect—can get a mortgage loan. Another way of putting this is that given how ugly so many of the lender-underwritten loans have been lately, there’s reason to think the self-underwritten ones are mostly butt-ugly. I take data on EPD rates for stated-income and zero-down loans, for instance, as some confirmation of this view.

Such a simple-minded perspective on things does, however, beg for additional complexity, and where else would you go for such additional analytic firepower than the New York Times? I offer you a third option: economist-underwritten loans.

Dr. Austan Goolsbee, a Real Economist™, presents the third way of understanding the issue in “’Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded":

A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, "Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market" (National Bureau of Economic Research Working Paper 12967), shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”
The first time I read this I was, actually, so speechless that I could only respond with a quotation from our wise commenter mp: toad bones. Also, dog balls.

After thinking about it overnight, I have come to the conclusion that that’s still the wisest response, but you don’t get a good blog post out of simple incantations. In the “permanent income hypothesis” on which the economist-underwritten loan is based, the borrower’s belief that he will always be able to earn more money in the future, which justifies over-consumption of housing in the present into which he will grow, renders mortgage market “efficient” to the extent that it does away with such artificial constraints as down payment and DTI requirements—which are based on “the amount of money they have right now,” and adopts innovative standards depending on an individual borrower’s confidence in the amount of money he might have in a couple of years.

The evidence for this view is that economist-underwritten loans in the period 1970-2000 didn’t do so badly. Sure, a few of them went down, but it’s important to understand why:

Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. Sometimes people even have to sell their properties because they cannot make the numbers work.

The traditional causes of foreclosure, even before there was subprime lending, were job loss, divorce and major medical expenses. And the national foreclosure data seem to suggest that these issues remain paramount. The latest numbers show that foreclosures have been concentrated not in places where real estate bubbles have supposedly been popping, but rather in places whose economies have stagnated — the hurricane-torn communities on the Gulf of Mexico and the industrial Midwest states like Ohio, Michigan and Indiana, where the domestic auto industry has suffered. These do not automatically point to subprime lending as the leading cause of foreclosure problems.
So in this period of happily performing economist-underwritten loans, there were some losers. Apparently the causes, job loss, divorce, and major medical expenses, which could be understood to mean situations in which current expenses are substantially greater than current income—have nothing to say about the idea that it is wise to take a loan that ignores one’s current income and expenses. Lenders, it appears, may consider future income; servicers, it appears, still keep refusing to accept aspirations rather than negotiable instruments to apply to a past-due balance.

Of course it’s not surprising that Goolsbee ignores the evidence of a house-price bubble, since there can apparently be no bubbles in perfect markets. Theories do that to you. But I don’t think theory can really explain the revolting disingenuousness at the end of his op-ed:
The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups.
“Drastic”?

This is actually what CRL has to say on this topic:

According to the Fed report, even after adjusting for differences in the borrower characteristics contained in the HMDA data, African-American and Latino borrowers were more likely to receive higher-rate loans. Furthermore, a recent study released by CRL shows that disparities tend to persist even after additional adjustments were made for differences in credit scores, equity, and other risk factors not available in HMDA data. The Fed authors also adjust for originating lender. Though this adjustment reduces the disparities substantially, significant differences remain. . . .

The CRL study found that, even after controlling for legitimate risk factors, African-American and Latino borrowers were still more likely to receive higher-rate subprime loans than similarly-situated non-Latino white borrowers. With raw disparities in higher-rate loans between groups basically unchanged from 2004 to 2005, there is little reason to believe that legitimate risk factors would account for all of the disparity evident in the 2005 data.
In other words, CRL is suggesting that a pattern of finding subprime loans given to minority borrowers with similar credit, income, and equity profiles to non-Latino whites who get prime loans may imply a certain “inefficiency” in the mortgage market somewhere. For Goolsbee to use this data to buttress an unregulated free-for-all by claiming that it helps out the traditionally disadvantaged is, well, dishonest.

If you look hard at the data compiled by folks like CRL, you do have to face the problems inherent in the lender-underwritten mortgage market: when lenders are allowed to apply standards without public review, they certainly can end up applying those standards in a discriminatory fashion. When “reputable lenders” are allowed to exit entirely certain minority markets, leaving them to the tender embrace of the loan sharks, the “innovative” subprime market can quickly become mere predation. I have no beef with anyone who wants to see regulation of lenders to prevent these social evils.

However, if I had to choose between lender-underwritten and economist-underwritten loans? No contest.

Thursday, March 29, 2007

Dallas Fed: Comparing 2001 to 2006

by Calculated Risk on 3/29/2007 05:00:00 PM

Evan Koenig at the Dallas Fed writes: Vive la Différence (hat tip Mark Thoma)

"There are several disturbing similarities between the U.S. economy's recent behavior and its behavior in 2000–01, but also some reassuring differences."
See the above links for the details.

I'd like to expand the periods for Koenig's chart 4 and 5.

Click on graph for larger image.

The first graph (compare to Koenig's chart 4) shows Koenig's method for projecting changes in residential investment is reasonable. There is no question that residential investment will fall much further, and will decline in every quarter in 2007.


The second graph (compare to Koenig's graph 5) compares changes in new orders for durable goods with changes in manufacturing employment. Once again, Koenig's approach is reasonable.

Based on this analysis, Koenig is expecting the net loss of 53K manufacturing jobs per month over the next 6 months. This is in addition to the residential construction job losses that I'm projecting will be in 75K+ per month range.

No wonder Koenig concludes:
"The big question is whether the drags from housing and manufacturing will let up before weakness there begins spilling over to the rest of the economy."

Indymac on Alt-A and Subprime Lending

by Calculated Risk on 3/29/2007 03:01:00 PM

From Indymac: Additional Credit Loss Analysis on Alt-A and Subprime Lending

“Based on an objective analysis of the facts, talk of the ‘subprime contagion’ spreading to the Alt-A sector of the mortgage market is, in our view, overblown. Cumulative mortgage industry Alt-A loan losses over the last five years are 1/17th the loan losses for subprime loans based on the FALP data. In addition, as of Dec. 31, 2006, the 30+day delinquency percentage for Alt-A loans in the mortgage industry was 5.0 percent as compared to 21.7 percent for subprime loans, suggesting that the differential in loan loss performance for Alt-A versus subprime will continue into the future.”
Michael W. Perry, Indymac’s Chairman and CEO, March 29, 2007
I don't think anyone was suggesting that Alt-A delinquency rates would be as high as subprime. So Mr. Perry is creating a strawman here.

The suggestion is that Alt-A would see a substantial increase in delinquency rates, and, as a result, the sector specific credit crunch (with tighter lending standards) would also impact Alt-A. This is already happening. Yesterday I posted the analysis from ResCap of their new lending standards on 2006 originations. ResCap estimated that their new guidelines would have eliminated 20% of Alt-A loans in 2006.

The subprime contagion is already here.

AP: Late Payments on Consumer Credit

by Tanta on 3/29/2007 01:15:00 PM

The AP reports on delinquencies for consumer credit:

The American Bankers Association, in its quarterly survey of consumer loans, reported Thursday that late payments on home equity loans rose to 1.92 percent in the October-December period. That was up sharply from 1.79 percent in the prior quarter and the highest since the first quarter of 2006. . . .

A separate survey released earlier this month by the Mortgage Bankers Association showed a big jump in late mortgage payments in the final quarter of last year, news that caused stocks on Wall Street to swoon.

The American Bankers Association's survey, meanwhile, also showed that the delinquency rate on “indirect” auto loans, which are arranged through dealerships, shot up to 2.57 percent in the fourth quarter, the highest since the second quarter of 2001, when the economy was in a recession. Late payments on other auto loans, however, dipped slightly.

The survey also showed that the percentage of credit card payments past due was 4.56 percent in the fourth quarter, down slightly from 4.57 percent in the third quarter.

Late payments on boat loans rose, while delinquent payment on mobile homes went down.

San Diego: Home loan defaults skyrocket

by Calculated Risk on 3/29/2007 01:08:00 PM

From the San Diego Union: Home loan defaults skyrocket in county

Homeowners throughout San Diego County are defaulting on their loans and losing their properties to foreclosure at an increasingly rapid pace, a shattering event that nevertheless remains far less extensive here than the mortgage problems arising elsewhere in the nation.

In the first two months of the year, there were four times more default notices issued in the county than in the first two months of last year, while foreclosures tripled over the same period, according to an analysis of data provided by locally based DataQuick Information Systems.

ARM Disclosures: This Is Only a Test

by Tanta on 3/29/2007 06:57:00 AM

My post yesterday on Sandra Braunstein's remarks on subprime lending brought up the issue of disclosures to consumers. As you may or may not know, there is an existing Regulation Z that requires lenders to provide ARM loan program disclosures to consumers no later than the time of application for an ARM loan. These disclosures are supposed to help the borrower understand the mechanics of the loan. Reg Z does not require specific text, although it does supply example text. It does spell out in some detail what issues must be addressed in the disclosures. Lenders usually choose to have different disclosure documents for different ARM types; a lender using a very long "multipurpose" disclosure risks having its good faith challenged.

Reg Z has been around forever; that's important to remember given the current situation we have of borrowers (not to mention brokers) who clearly don't understand the terms of these loans. The item on the agenda of someone like Braunstein is whether and how Reg Z may need to be supplemented or superceded with new disclosure requirements. Politically speaking, lenders generally lobby against any such changes to the regs, if for no other reason than that they don't want to go to the additional effort and expense of changing all the disclosures they currently use. You may conclude that at least some lenders have other reasons to object, namely that--theoretically, at least--a clearer disclosure of loan terms might lead some borrowers to refuse to accept some of these products.

I will be the first to admit that it's a struggle for someone like me to judge the adequacy of a Reg Z disclosure. Obviously, I can and do review them for accuracy. But there's a big difference between a statement being true and a statement being comprehensible or useful to a non-expert. And experts can quickly lose their ability to appreciate the difficulties of non-experts. In my view, that's one of the biggest problems with regulatory disclosure requirements: the "final sign off" is from some lawyer, not from the sort of non-lawyer non-expert for whom the document is designed.

Furthermore, these documents need to be viewed not just in terms of their intended readers' expertise, but also in the context in which they are provided. Over the years so many different disclosures and documents have accumulated in the "application package" that you cannot really judge the accessibility of a single document without bearing in mind all the other documents for the borrower to absorb.

And, of course, that borrower has only some period of time in which to absorb things. Those who are all in favor of the 12-second approval using high-speed technology are always those who counsel the borrower to take his time, take the docs home over the weekend, consult a friend about them, do some web-surfing, there's no hurry here, make sure you understand this before you cough up a nonrefundable application fee . . . right? I'm not anti-technology or anti-AUS, but I continue to have huge problems with using it at point of application, and selling the speed as an advantage. The assumption that any borrower should be in that much of a hurry to borrow that much money at that complicated a set of loan terms makes my skin crawl.

But perhaps I underestimate the borrower? Well, you tell me. Here's Thornburg Mortgage's 1-Month LIBOR Option ARM disclosure, and here's the corresponding Note. I chose these not just because they're freely available on the web, but also because in my opinion Thornburg's disclosure is as well and clearly written as they tend to come. So this is not a test of the worst disclosures out there.

I would be truly interested in what you all make of these documents. If you read my UberNerd post on neg am, or you've had one of these before, or you're in some part of the mortgage business, please bear in mind that you have more background information than the intended reader of the disclosure. If it only makes sense to an expert, or even just to a more than usually informed non-expert, then it isn't doing what Reg Z intended it to do.

Wednesday, March 28, 2007

ResCap Investor Forum

by Calculated Risk on 3/28/2007 05:30:00 PM

Here is the presentation from the ResCap / GMAC Financial Services 2007 Investor Forum.

ResCap evaulated the impact of the their new underwriting guidelines on their 2006 vintage portfolio (hat tip Brian). The new guidelines would have eliminated 58% of subprime loans, 20% of Alt-A loans and 35% of all 2nds. Wow!

Braunstein Testimony on Subprime: Supply or Demand?

by Tanta on 3/28/2007 12:00:00 PM

There was some outrage in the comments recently about Sandra Braunstein’s recent testimony on subprime lending. Braunstein is the Director of the Division of Consumer and Community Affairs for the Federal Reserve.

There are many things one can say about Braunstein’s testimony. I want to drive a few little conceptual wedges into her nice smooth characterization of the current mortgage market in general and subprime lending in particular.

It starts early, in the fourth paragraph of the written statement:

Today, the mortgage lending business has changed dramatically with the development of national markets for mortgages, technological changes, and the advent of securitization. The traditional book-and-hold model of mortgage lending has shifted to an originate-to-distribute model.

So far, so good, except something important seems to be missing from the “national, technological, and securitized” holy trinity of major market forces. Braunstein continues:

While commercial banks still have a significant role in the mortgage origination and distribution process, they are no longer the leading originators or holders of residential mortgages. Securitization has allowed many financial institutions to use increasingly sophisticated strategies to package and resell home mortgages to investors. This has resulted in increased competition and a wide variety of mortgage products and choices for consumers, in a market in which mortgage brokers and mortgage finance companies compete aggressively with traditional banks to offer new products to would-be homeowners. [My emphasis]

In what strange world are mortgage brokers “competitors” of banks? Let us remember what a broker is: not a lender. A broker brings a borrower and a lender together, and pockets a commission of some sort for so doing. The broker has no capital to lend. The “competitors” of brokers are direct retail lenders, meaning those lenders with loan officer employees who offer loans directly to consumers without requiring the services of brokers.

But for any bank with a wholesale origination model (which could, you know, be related to its “securitization” model in some fashion), brokers are not competitors, they’re sources of business. The wholesaler’s competition is other wholesalers, some of which are not depositories. Why am I making such a big deal about this? Because brokers have no “new products” to “offer” to “would-be homeowners.” They go out and find products offered by wholesalers to offer to would-be homeowners. Is this an unimportant distinction? I don’t think so.

Two paragraphs later, the lurking problem gets even worse:

One of the products of this new mortgage market is subprime lending. Subprime lending has grown rapidly in recent years. In 1994, fewer than 5 percent of mortgage originations were subprime, but by 2005 about 20 percent of new mortgage loans were subprime. The expanded access to subprime mortgage credit has helped fuel growth in homeownership.

It’s certainly questionable that subprime has really directly fueled homeownership to the extent Braunstein here assumes. As commenters have pointed out, there is evidence that subprime is still mostly a refinance business, not a purchase money business. To say, for instance, that record numbers of new home purchases have been made with subprime loans is not to say that most subprime loans are for purchases. Subprime on the whole, as far as I can see, has been fueling the MEW machine, and only indirectly the ownership machine. It is hard to build a MEW market with a bunch of renters.

But that aside, I am puzzled by the phrase “expanded access to subprime mortgage credit.” This assumes that “access” is a question of borrowers having access to creditors, rather than, perhaps, a question of creditors having access to borrowers. The whole idea of “predatory lending,” which is a subset of subprime lending, is that there are lenders who want to lend going after borrowers who may not have supplied the “demand” until someone fast-talked them into it. Even in the more “respectable” parts of the subprime and Alt-A business, I would argue, the "disintermediation" of “national markets, technology, and securitization,” which rely to a large extent on the “intermediation” of brokers, can function as much as supply creating demand than the other way around.

Those who wish to throw the Econ 101 textbooks at me will have to explain to me just how, exactly, borrower demand for loans they obviously do not understand, and that are not anywhere close to being in their best interest, gets created. Are we talking about a demand for credit or a demand for income-substitutes? And those who want to say that it’s all a matter of borrowers substituting short-term interest for long-term interest need to explain this EPD epidemic to me. Either those EPD loans were 100% fraudulent—borrowers who never intended to own the property or make the payments—or some of them were borrowers who never stood a chance of receiving even short-term benefit from the loan. I’m not sure which case is more comforting, but I surely can’t see here unambiguous evidence for pent-up demand that simmered for years until the “new mortgage market” Braunstein discusses suddenly offered the product everyone had been waiting for. Next thing you know, someone is going to tell me about the invention of advertising.

Quite honestly, after the first couple of paragraphs I just lost interest in anything else Braunstein had to say. It isn’t even, in my view, that her other testimony is wrong or worthless. It’s simply that I no longer care to hear anyone, and especially regulators, continue to talk about the mortgage “market” without talking about the mortgage business. I’m not interested in people talking about securitization and other forms of “disintermediation” until they address wholesale and correspondent originations and telemarketers and other kinds of “intermediation.” At some point these regulators are going to have to quit with the executive summaries and get into the UberNerd weeds with the rest of us, or else we’re going to keep getting this "disclosure" regulation (you can do pretty much anything as long as you slip in a disclosure that says so in the mice type) that works nicely in Econ 101 and doesn’t do diddly when the Borg adapts. Until they’re willing to recognize that a demand “bubble” exists, and that intermediation is not "competition," nothing they come up with in the name of “consumer access” is going to help much.

Bernanke's Forecast

by Calculated Risk on 3/28/2007 10:57:00 AM

Back in February, Bernanke suggested the following risks:

The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected.
Chairman Bernanke, Feb 14, 2007
Now compare to Bernanke's testimony today:
This forecast is subject to a number of risks. To the downside, the correction in the housing market could turn out to be more severe than we currently expect, perhaps exacerbated by problems in the subprime sector. Moreover, we could yet see greater spillover from the weakness in housing to employment and consumer spending than has occurred thus far. The possibility that the recent weakness in business investment will persist is an additional downside risk.
Yet the forecast remains the same: "the economy appears likely to continue to expand at a moderate pace".

Bernanke on Housing

by Calculated Risk on 3/28/2007 10:42:00 AM

From Federal Reserve Chairman Ben Bernanke: The economic outlook

The principal source of the slowdown in economic growth that began last spring has been the substantial correction in the housing market. Following an extended boom in housing, the demand for homes began to weaken in mid-2005. By the middle of 2006, sales of both new and existing homes had fallen about 15 percent below their peak levels. Homebuilders responded to the fall in demand by sharply curtailing construction. Even so, the inventory of unsold homes has risen to levels well above recent historical norms. Because of the decline in housing demand, the pace of house-price appreciation has slowed markedly, with some markets experiencing outright price declines

The near-term prospects for the housing market remain uncertain. Sales of new and existing homes were about flat, on balance, during the second half of last year. So far this year, sales of existing homes have held up, as have other indicators of demand such as mortgage applications for home purchase, and mortgage rates remain relatively low. However, sales of new homes have fallen, and continuing declines in starts have not yet led to meaningful reductions in the inventory of homes for sale. Even if the demand for housing falls no further, weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels.

Developments in subprime mortgage markets raise some additional questions about the housing sector. Delinquency rates on variable-interest-rate loans to subprime borrowers, which account for a bit less than 10 percent of all mortgages outstanding, have climbed sharply in recent months. The flattening in home prices has contributed to the increase in delinquencies by making refinancing more difficult for borrowers with little home equity. In addition, a large increase in early defaults on recently originated subprime variable-rate mortgages casts serious doubt on the adequacy of the underwriting standards for these products, especially those originated over the past year or so. As a result of this deterioration in loan performance, investors have increased their scrutiny of the credit quality of securitized mortgages, and lenders in turn are evidently tightening the terms and standards applied in the subprime mortgage market.

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.

Business spending has also slowed recently.

MBA: Mortgage Applications Decrease Slightly

by Calculated Risk on 3/28/2007 09:38:00 AM

The Mortgage Bankers Association (MBA) reports: Mortgage Applications Decrease Slightly in Latest MBA Survey

The Market Composite Index, a measure of mortgage loan application volume, was 671, a decrease of 0.2 percent on a seasonally adjusted basis from 672.1 one week earlier. On an unadjusted basis, the Index decreased 0.2 percent compared with the previous week and was up 16.6 percent compared with the same week one year earlier.

The Refinance Index decreased 0.5 percent to 2197.7 from 2208.6 the previous week and the seasonally adjusted Purchase Index increased 0.1 percent to 411.1 from 410.6 one week earlier.
Mortgage rates were mixed:
The average contract interest rate for 30-year fixed-rate mortgages decreased to 6.04 percent from 6.06 percent ...

The average contract interest rate for one-year ARMs decreased to 5.84 from 5.88 percent ...
Click on graph for larger image.

This graph shows the Purchase Index and the 4 and 12 week moving averages since January 2002. The four week moving average is up 0.6 percent to 410.3 from 407.9 for the Purchase Index.
The refinance share of mortgage activity decreased to 45.1 percent of total applications from 45.3 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 20.2 from 20.9 percent of total applications from the previous week.

Housing: Ruined Dreams

by Calculated Risk on 3/28/2007 12:30:00 AM

Here are two related stories: the first from the perspective of borrowers facing foreclosures, and the second from a macro perspective of the housing bust.

From Kareem Fahim and Ron Nixon at the NY Times: Behind Foreclosures, Ruined Credit and Hopes.

His monthly payments are now more than $2,600.

Earning about $2,000 a month on his salary, he quickly fell behind.
And from Rex Nutting at MarketWatch: Will 'lemming loans' drive economy off the cliff?
For the first time in the nation's history, a significant number of Americans are being threatened with the loss of their home even though they still have a steady, good-paying job.

It's not just an issue for people with poor credit, those with subprime loans. It also affects people with good enough credit to qualify for a prime loan. Known as Alt-A mortgages, these loans were written for 1 in 5 U.S. mortgages and could have a big impact on the economy and on credit markets -- bigger, perhaps, than the effects of the recent shockwaves buffeting the subprime-lender market, economists say.
...
In the past, homeowners have generally lost their home to foreclosure only when they suffered a major life-changing event, such as loss of their job, a major illness or death of a family member. A big jump in foreclosures was unheard of outside a recession that brought high unemployment.

But now, because of the recent popularity of loans geared to let people buy a more expensive home than they can truly afford, all it will take is the passage of time to trigger a default. At some point, all these loans are adjusted to switch from a low, subsidized monthly payment to the full amount required to pay off the loan.
Hmmm ... lenders making "loans geared to let people buy" more than they can afford? Like the example in the NY Times, with payments of $2600 per month and an income of $2000 per month? I'm still trying to do the math. How was that supposed to work?

Tuesday, March 27, 2007

Feds Are Investigating Homebuilder Beazer

by Calculated Risk on 3/27/2007 05:01:00 PM

From BusinessWeek: Feds Are Investigating Homebuilder Beazer

Amid the meltdown of the subprime housing sector, mortgage lenders and brokers have come under fire from state and federal officials for predatory lending practices with those risky borrowers. Now one national homebuilder is feeling the heat. BusinessWeek has learned that federal investigators have opened a broad criminal probe into lending practices, some financial transactions, and other dealings at Beazer Homes USA.

OCC: "concerned in 2002 with the growth of exotic mortgages"

by Calculated Risk on 3/27/2007 04:46:00 PM

Emory W. Rushton, Senior Deputy Comptroller and Chief National Bank Examiner of the Office, of the Comptroller Of The Currency (OCC) provided testimony today to the House Committee on Financial Services. From Rushton's oral testimony:

OCC became concerned in 2002 with the growth of exotic mortgages that have the potential for a big payment shock, and we responded in an escalating fashion, both formally and informally, privately and publicly. By 2005, we were instructing our examiners to more aggressively address the risks of these products during examinations of national banks – at a time, I might add, when home prices were still rising – because we concluded that standards had slipped far enough. That intervention is one reason why you will find few payment-option ARMs in national banks today. Shortly after that, we initiated the interagency process that resulted in the nontraditional mortgage guidance that was issued last Fall.
And from Rushton's written testimony:
[T]he vast majority of subprime loans are not originated in the national banking system or supervised by the OCC. While some national banks and their subsidiaries help to serve the credit needs of the subprime market, their subprime lending last year amounted to less than 10% of the total of subprime mortgage originations by all lenders. ... National banks and their subsidiaries that engage in subprime lending are subject to extensive oversight by OCC examiners and must operate in close compliance with the OCC’s rigorous safety and soundness and consumer protection standards. ... Some have said, perhaps not surprisingly, that there is a direct connection between the rigor of the OCC’s supervision of subprime mortgage lending and the low level of this activity in national banks. Indeed, there have been recent instances in which banks have decided against converting to a national charter for this very reason.
In some ways this is comforting; apparently the national banks engaged in very limited option ARM and subprime lending.

Lennar CEO: Worst Not Over

by Calculated Risk on 3/27/2007 02:11:00 PM

From Reuters: Lennar says worst may not yet be over for inventory

Here is a real Time transcript of Lennar CEO Stuart Miller's comments (hat tip Brian):

“Let me begin by saying that these are difficult times for the home-building industry. We have recently completed our quarterly operation reviews with our division management team, and based on these extensive business plan and execution reviews, I can say first hand and with certainty that market conditions are very difficult across the country. As I listen to many of the leaders in the industry speak, that is our competitors and as I listen to economists and analyst and is investors, the message is becoming very unified and that is although we see some sporadic indications of firming in some markets, and we all look forward to seeing a firm foundation from which we can build forward, the reality is that market conditions are still challenging at best and in some markets continuing to deteriorate. Homes available for purchase has continued to climb while demand has been surely reduced. The market once driven by speculative build-up in demand and purchases that over the past years spurred more recent build up in inventory supply from speculators then put increased supply as they put homes back on the market and created the supply over hang and overall climate of customer caution.

On the demand side, the investor/purchaser part of demand has all but evaoprated. Primary purchasers on are on the side lines or demanding better pricing before purchasing. Because of the rapid deterioration of subprime lending market, an additional component of demand has now been sidelined because of the inability of a customer to qualify for a mortgage or because the purchaser of a customer's home needed for closing cannot qualify. What is clear is supply and demand have shifted and had are continuing to shift in some markets more rapidly than expected, and the inventory over hang will have to be absorbed before conditions normalize.

This is not new information. There remains a sizable amount of work to be done before our market finds any equilibrium. We have not seen evidence that the much anticipated winter/spring selling season has yet taken. Home pricing is continuing the process of being recalibrated in many markets through the use of incentives, brokers commission and price reduction, and the industry is continuing to be challenged to adjust home prices and land values as well. This recalibration process has not yet stabilized.

Further more, it is unclear today whether there is another shoe to drop. Questions remain as to whether our economy will weaken and the housing led recession or perhaps it is the supply and inventory over hang will be exacerbated by the resetting of mortgage rates on many adjustable rate mortgages that have fueled the market over the past years. Rate adjustments are creating payment stress concurrent with home prices falling and equity evaporating. On the other hand, the liquidity that exists in today's financial market is a real wild card and could be a critical mitigating factor alleviating negative market forces and restoring balance.

Lennar's strategy has been certain and consistent as we have seen these market conditions unfold over the past year. We have consistently focused primarily on protecting our balance sheet first and foremost. We have maintained day by day focus on our business operations. We have continued to refine our business model in each of our markets. We've mapped out a strategy to regain our margin in this new market environment, and we are determined to be possible positioned for recovered market conditions. Our overriding strategy is defined by our focus on our balance sheet. Our company has intensified the focus on generating strong cash flow at the expense of maintaining margins.”

The Other Shoe About to Drop: Subprime Servicing

by Tanta on 3/27/2007 10:19:00 AM

Fitch has a new publicly available Special Report, Impact of Financial Condition on U.S. Residential Mortgage Servicer Ratings. It identifies a high-risk class of servicers and points to some of the sources of increased risk:

To date, the financial difficulties of the various parties have been caused mainly by liquidity, overcapacity, margin pressure and poor asset quality, all of which are directly origination/ seller focused. However, for servicers who are captive to an origination shop and/or issuer, and who do not have either a diversified product mix or a financially strong parent or partner, difficulties experienced at a corporate level will undoubtedly impact the servicing operation, eventually if not immediately. For third-party subprime servicers, this impact is less. However, these servicers could also experience a loss of new loan volume, as well as the potential for higher default levels in current portfolios. Much of this increase could be caused by the defaulting subprime borrowers being unable to obtain refinancing, both due to flat or decreasing home price appreciation and the tightening of credit standards on new originations. Any servicer, whether captive or third party, which has predominantly subprime credit quality loans in portfolio, could find its timelines and overall cost to service facing increased levels not seen in recent history.
. . .
The major areas of concern for some originators/issuers of subprime products, and therefore their captive servicers, are liquidity, overcapacity, margin pressure and asset quality. Although in recent periods some reduction in liquidity capacity could be managed, based on declining volumes, current liquidity trends are primarily a result of tripped covenants and liquidity providers’ rapidly declining risk appetite. To date, when covenants have been tripped, the profitability covenants are frequently the first to be triggered. Previously, the liquidity providers were more willing to extend maturities for a short period in order to provide a company an opportunity to repair the breach. It now appears that these banks’ flexibility is declining, and margin calls have begun in earnest. Margin calls, combined with early payment defaults (EPDs), have eroded some firms’ financial position to the point that several are on the brink of bankruptcy, necessitating them to stop funding new originations and/or seek potential sale or partnership arrangements.

In recent years the industry has seen new participants enter the market, which has led to overcapacity. This overcapacity has begun to ease, with several players exiting the market, or at a minimum tightening underwriting guidelines and eliminating certain products. More consolidation is expected before the industry will be appropriately sized for expected ongoing mortgage market dynamics. In addition, extremely aggressive competition, rising funding costs and slowing origination volume have pressured profitability. Margins on whole loan sales have sharply deteriorated due to supply/demand imbalances, as well as the declining risk appetite among investors. Aggressive competition has also been a contributor to the deterioration of asset quality as evidenced by EPDs and rising default rates on subprime loans. . . .

Currently servicers are challenged with rising expenses, shrinking margins and fluctuating origination, and therefore portfolio, volumes. In addition, servicers are dealing with the complexities of natural disasters, compliance to varying federal and state regulations, as well as servicing a number of new and unique products. Further, the increasing delinquency environment may stress those servicers that are not adequately staffed or prepared to manage seriously delinquent loans with flexible default management solutions.


The entire report is fairly brief—five pages—and certainly worth a read. Bear in mind that the “historical” experience in the mortgage industry is that servicing income is counter-cyclical: you make more on servicing in those periods in which you make less on originations. History may be refusing to repeat itself for some people right when that would be convenient.

Monday, March 26, 2007

New vs. Existing Home Data

by Calculated Risk on 3/26/2007 05:30:00 PM

Some people are wondering why existing home sales were up and new home sales were down. In the long run these two series correlate very well.

New and Existing Home SalesClick on graph for larger image.

This graph shows the annual new and existing home sales since 1969. Use the left scale for existing home sales and the right scale for new home sales. Clearly, using annual data, the two series move together.

Note: Rsquare is 0.87.

However there are some timing differences as to when the data is reported. From the Census Bureau:

New home sales and existing home sales are released each month at about the same time. Many comparisons are made between the two series, but before doing any comparisons, one must be aware of some definition differences that affect the timing of the statistics.

The Census Bureau collects new home sales based upon the following definition: "A sale of the new house occurs with the signing of a sales contract or the acceptance of a deposit." The house can be in any stage of construction: not yet started, under construction, or already completed. Typically about 25% of the houses are sold at the time of completion. The remaining 75% are evenly split between those not yet started and those under construction.

Existing home sales data are provided by the National Association of Realtors®. According to them, "the majority of transactions are reported when the sales contract is closed." Most transactions usually involve a mortgage which takes 30-60 days to close. Therefore an existing home sale (closing) most likely involves a sales contract that was signed a month or two prior.

Given the difference in definition, new home sales usually lead existing home sales regarding changes in the residential sales market by a month or two. For example, an existing home sale in January, was probably signed 30 to 45 days earlier which would have been in November or December. This is based on the usual time it takes to obtain and close a mortgage.
The shorter answer: new home sales have been crushed, existing home sales are about to be crushed.

For the general economy, new home sales are far more important, because of the related employment and spending on materials. However, for those directly impacted by existing home sales (real estate agents, appraisers, mortgage brokers, home inspectors, etc.), the coming slump in existing home sales will have a larger impact.

More on February New Home Sales

by Calculated Risk on 3/26/2007 11:15:00 AM

Please don't miss Tanta's post this morning: Unwinding the Fraud for Bubbles

For more graphs, please see my earlier post: February New Home Sales: 848 Thousand

Click on graph for larger image.

The first graph shows New Home Sales vs. Recession for the last 35 years. New Home sales were falling prior to every recession, with the exception of the business investment led recession of 2001. This should raise concerns about a possible consumer led recession in the months ahead.


The second graph shows Not Seasonally Adjusted (NSA) New Home Sales for February.

Sales have fallen back close to the levels of '96 and '97.


The third graph shows monthly NSA New Home sales. This provides a different prospective of the housing bust.

NOTE: For existing home sales, February is typically a very weak month. However, for New Home sales, February marks the beginning of the spring selling season. This is because New Home sales are reported when the contract is signed - and buyers are hoping to move during the summer. Existing home sales are reported at the close of escrow - so the early summer months are usually the strongest months of the year.

March is typically the strongest month of the year for New Home sales. And this graph shows that 2007 is starting to shape up like 1982 with no surge in spring sales.

February New Home Sales: 848 Thousand

by Calculated Risk on 3/26/2007 09:33:00 AM

According to the Census Bureau report, New Home Sales in February were at a seasonally adjusted annual rate of 848 thousand. Sales for January were revised down to 882 thousand, from 937 thousand. Numbers for November and December were also revised down.


Click on Graph for larger image.
Sales of new one-family houses in February 2007 were at a seasonally adjusted annual rate of 848,000 ... This is 3.9 percent below the revised January rate of 882,000 and is 18.3 percent below the February 2006 estimate of 1,038,000.


The Not Seasonally Adjusted monthly rate was 71,000 New Homes sold. There were 88,000 New Homes sold in February 2006.

On a year over year NSA basis, February 2007 sales were 19.3% lower than February 2006. February '07 sales were the lowest since February 1997 (69,000).


The median and average sales prices were up. Caution should be used when analyzing monthly price changes since prices are heavily revised.

The median sales price of new houses sold in February 2007 was $250,000; the average sales price was $331,000.


The seasonally adjusted estimate of new houses for sale at the end of February was 546,000.

The 546,000 units of inventory is slightly below the levels of the last six months. Inventory numbers from the Census Bureau do not include cancellations - and cancellations are at record levels. Actual New Home inventories are much higher - some estimate about 20% higher.


This represents a supply of 8.1 months at the current sales rate.


More later today on New Home Sales.

Unwinding the Fraud for Bubbles

by Tanta on 3/26/2007 08:10:00 AM

There is a tradition in the mortgage business of distinguishing between two major types of mortgage fraud, called “Fraud for Housing” and “Fraud for Profit.” The former is the borrower-initiated fraud—inflating income or assets, lying about employment, etc.—that is motivated by the borrower’s desire to get housing (not the same thing as “real estate”), by means of getting a loan he or she doesn’t actually qualify for. It may require some collusion by the loan originator or appraiser, but it may not. It is usually the least expensive kind of fraud to lenders and investors, since the goal is getting (and keeping) the property, so the borrower is at least usually motivated to make the payments. The problems come about, of course, because these borrowers failed to qualify honestly for a reason. Borrower-initiated fraud loans may be considered “self-underwritten,” and such loans do have a much higher failure rate than the “lender-underwritten” ones. Their only saving grace is that the lender tends to recover more in a foreclosure than in a fraud for profit case. Penalties to the borrower rarely ever come in the form of prosecution; losing the home and becoming a subprime borrower for the next four to seven years—with the credit costs that implies—are the borrower's punishment.

Fraud for profit is simply someone trying to extract cash—not housing—out of the transaction somewhere. If it is borrower-initiated fraud, it’s not a borrower who wants a house; it’s a borrower who wants to flip a piece of real estate or launder money or in some other way grab the cash and leave the lender holding the bag. Most of it, however, is initiated by a seller, real estate broker, lender, or closing agent (or all of them in collusion). It generally requires additional collusion by bribable appraisers, although it can certainly be initiated by a corrupt appraiser looking for a kickback, or can merely take advantage of a trainee or gullible appraiser. This is the flip scam, straw borrower, equity skimming, misappropriation of payoff funds, identity theft kind of fraud. It may not be as common as fraud for housing, at least in some markets, but it’s much, much more expensive to the bagholder. At minimum, the fraud-for-housing borrower wants to take clear, merchantable title to the property and maintain it at an acceptable level. That’s either unnecessary expense or (in the case of title) a hurdle to be gotten over by the fraud-for-profit participant.

The problem with this traditional distinction is that, recently, we seem to have an epidemic of predator meeting predator and forming an alliance: a borrower willing to commit fraud for housing meets up with a seller or lender willing to commit fraud for profit, and the thing gets jacked up to a whole new level of nastiness. Consider the “cash-back purchase” scam we keep hearing about: that’s a perfect example of a borrower who wants a house, a seller who wants an illegitimate profit, and a broker or appraiser or settlement agent who wants a kickback all conspiring to defraud the lender: it’s hard to call it either fraud for housing or fraud for profit because it’s both.

What, in the past, might have kept the two fraud types separate—the fact that a normal borrower would not see it in his or her best interest to borrow more money than necessary to pay more than fair market value for a home—disappeared in the mania of buy-more-borrow-more and pass the “screwing” on to the next sucker who buys it from you. As soon as borrowers became convinced that paying substantially more for the property than the current seller did just a few months ago is always and everywhere a good sign, you could no longer rely on the “rational agent” borrower to at least limit his fraudulent tendencies to lying on the loan application in order to get away from apartment life. You actually see them agreeing to sign “secret” sales contract clauses that will require them to borrow more than the fair market value of the property, and then give the excess loan proceeds to someone who won’t be helping to repay the debt. Or accepting “down payment assistance” from an interested party, in order to buy a property whose price is inflated by the amount of the “assistance.” That this doesn’t seem to strike them as self-defeating tells you a lot about how uninformed or misinformed we are, how far into a true mania we’ve gotten. In the old days, you used to be able to count on RE frauds to display basic self-interest, naked or camouflaged.

Telling the difference between the victims and the victimizers, the predators and the prey, and the fraudulent and the defrauded, is getting a lot harder when you have borrowers not required to make down payments able to lie about their incomes in order to buy a home the seller is overpricing in order to take an illegal kickback. The lender is getting defrauded, but the lender is the one who offered the zero-down stated-income program, delegated the drawing up of the legal documents and the final disbursement of funds to a fee-for-service settlement agent, and didn’t do enough due diligence on the appraisal to see the inflation of the value. Legally, of course, there’s a difference between lender as co-conspirator and lender as mark, utterly failing to exercise reasonable caution, but it’s small comfort when the losses rack up. With tongue only partially in cheek, I’m about to suggest a third category of fraud: Fraud for Bubbles.

Everybody likes to hear lurid or merely entertaining stories from veterans of the Loan File Wars about weird fraud cases.
A recent CNN piece quotes a Clayton analyst as having found a mortgage note signed by “M. Mouse” (hat tip, Andrew!). How did anyone miss that? I have my own war stories, but to be honest with you, I’m still hesitant to share much about them. I realize that in the internet era it’s a losing battle, but still: every time you talk publicly about a fraud scenario, you’re giving someone an idea—either to try to perpetrate the scam, or to evade the tricks people like me use to find their traces in a loan file. I can remember training loan officers to look carefully at a W-2, and to recalculate the withholding taxes, since so many fakers of W-2s would either forget to do that, or wouldn’t do it right. Imagine how distressed I was when one of my loan officers went home and fixed that bug in his fake W-2 template.

What I want to do instead is to make some general observations about why so much fraud is missed by lenders. Obviously, there are lenders who are colluding with borrowers, or who are defrauding investors or borrowers or some other party; that’s either “fraud for housing” or “fraud for profit” or the new hybrid of the two. To me, that’s the least interesting problem (although it’s an important one). I want to talk about the extraordinarily widespread “insufficient caution” problem in this industry: the lenders who are just too easy to defraud. It seems to me that this problem gets to the heart of a lot of the issues we keep talking about here: toxic mortgage products, loose standards, out of control home price bubbles, and the endless chain of “disintermediation,” outsourcing, temping, dumbing down, fragmenting, and otherwise morphing of the business of home mortgage lending into a big fraud magnet. It often seems as if the industry just stopped believing that it could ever really be at risk.

My theory of the Fraud for Bubbles is, in a nutshell, that it isn’t that lenders forgot that there are risks. It is that the miserable dynamic of unsound lending puffing up unsustainable real estate prices, which in turn kept supporting even more unsound lending, simply masked fraud problems sufficiently, and delayed the eventual “feedback” mechanisms sufficiently, that rampant fraud came to seem “affordable.” So many of the business practices that help fraud succeed—thinning backoffice staff, hiring untrained temps to replace retiring (and pricey) veterans, speeding up review processes, cutting back on due diligence sampling, accepting more and more copies, faxes, and phone calls instead of original ink-signed documents—threw off so much money that no one wanted to believe that the eventual cost of the fraud would eat it all up, and possibly more.

On the one hand, everyone does know that you can’t run a mortgage lending business with the same level of anti-fraud measures they use at Domino’s to keep from wasting pizzas on prank calls. On the other hand, we are starting to see—and I predict we will start to see a cascade of—stories of lenders with such lax internal controls that if they did remember the risks, you have to conclude they just tried to repress those memories. Go back and read the Cease and Desist order for Fremont. Does it sound like an operation that believes in the reality of risk? Is everyone still convinced that “hey, we sell the risk to someone else” still means squat when it comes to fraud and misrepresentation?

I said I didn’t want to get into too much detail, but I’ll tell you right now that some kinds of fraud are so easy to spot it’s pathetic. You don’t need to have the borrower sign “M. Mouse” on the note. Asking for income documentation, ordering tax return transcripts prior to closing, requiring settlement agents to fax the final purchase contract to the lender for approval prior to close, enforcing arm’s-length transaction rules: this stuff isn’t hard to do, and it will not catch everything but it will sure catch a lot, and it’ll catch it before you close, which is really the cool part. So what’s the response whenever you suggest these things? It costs too much. It takes too long. It drives up transaction costs and therefore puts a drag on home prices. It “unfairly” takes its bites out of our favorite new borrower segment: first time homebuyers, self-employed entrepreneurs, real estate “investors.” It makes loans harder to sell and securitize instantly and cheaply. It makes it harder for an originator to make those representations and warranties based on the bliss of ignorance. It could bring down the whole secondary market as we know it!

So I’ve heard all that before; you need not hand it to me again in the comments. You need, if you are inclined to find any of that compelling, to tell me in somewhat more detail how your cost/benefit analysis works. You can always find one anecdote of one legit, deserving borrower who wouldn’t get a loan if I controlled for fraud as much as I’d like to. You can’t always get me to believe that it’s worth it to originate or buy 49 fraudulent loans in order to get that one good one. You certainly can’t get me to believe that I’m the one who is risking everyone’s “confidence” in the secondary mortgage market.

I suspect most of us feel, generally, that fraudsters—borrowers, lenders, anyone else—who get burned just got what they deserved. True enough. But lending fraud, like warfare, creates quite a bit of “collateral damage,” in all senses of the term. Those honest homeowners watching their neighborhoods collapse after the fraud-bombs finally detonated are not probably very comforted by the fact that it wasn’t their fault. So when we debate the question of potential “bailouts,” we keep running up against the question of who needs or deserves the bailout. If you want to do something to assist the honest homeowner who bought with an 80% loan but is now upside down because of the neighbors’ fraud, how do you do that without, inevitably, helping out the lender who facilitated that fraud, too? If you want to do something to protect the stability of the honest lenders, how do you do that in a way that doesn’t, inevitably, also protect the scumballs and incompetents?

Getting into a bubble is easy. Getting out?

Sunday, March 25, 2007

Housing: Short Sales and Taxes

by Calculated Risk on 3/25/2007 03:41:00 PM

From the LA Times: 'Short sale' brought them relief -- which IRS is going to tax

Question: I understand that a "short sale" means the mortgage lender agrees to accept as payment in full a sale for a home's market value even if it is below the mortgage balance. ... The lender agreed to accept a short sale for $183,785 though our mortgage balance was $210,000. But we received IRS Form 1099 from the lender showing we had taxable "debt-relief" income of $26,215. How can we be taxed on money we didn't receive?

Answer: As an alternative to foreclosure when a mortgage borrower stops making payments, some lenders will accept a "short sale" of the property for less than the mortgage balance. ...

However, the IRS says debt relief is taxable. ...
I believe this is also true when a homeowner resorts to jingle mail. A common scenario might be a homeowner who refinanced their home with cash out, and then discovers they can no longer make the payments, and that they have no equity in their homes. If the homeowner then just mails the keys to the lender - jingle mail - I believe the homeowner will receive a tax bill for the difference between what what the house sells for in foreclosure and what they owed. I also believe the lender might pursue the homeowner for any losses (the 2005 Bankruptcy Law made it more difficult for homeowners to declare Chapter 7 bankruptcy).

UPDATE: In the comments, attorney Bill McLeod writes:
... there are some new forms and new requirements, and I have to make my clients gather far more documents than I ever had to before BAPCPA became law, but a struggling homeowner can still file Chapter 7 if this [is] the option they are considering.
Anyone in this difficult situation should consult with an attorney and tax advisor.

Charlotte Observer: The Power of the Press

by Tanta on 3/25/2007 11:37:00 AM

With a deep curtsey to Mozo Maz, as I'm not wearing a hat to tip:

The Charlotte Observer seems to have gotten the right party's attention ("Loans builder arranged will get federal review"):


Federal housing officials will review whether Beazer Homes USA complied with federal rules in arranging government-insured loans for buyers in its subdivisions.

The Department of Housing and Urban Development,
responding to an Observer investigation, will look at lending records from Charlotte and other cities where a large share of Beazer loans ended in foreclosure, officials said Friday.

The review casts Beazer into the growing pool of lending-industry participants under government scrutiny for the
way they sold mortgage loans to low-income families in the past decade.


Good on the Charlotte Observer's team of reporters and editors for doing what journalism is supposed to be. Good on HUD for responding the Observer.

Now if only we could get HUD onto these problems before they end up in the newspaper. . . .

Freddie Mac Reports

by Tanta on 3/25/2007 08:34:00 AM

David S. Hilzenrath reports in yesterday's Washington Post:

Freddie Mac, still fixing weaknesses that came to light in 2003, yesterday issued its first timely annual report in five years, which showed that the giant mortgage funding company lost $480 million in the fourth quarter. That compared with a profit of $684 million in the comparable period a year earlier.
. . .
"Families are finding it hard to stay in their homes as deteriorating house prices, regional job losses and increasing mortgage payments are making their homes less affordable," chairman and chief executive Richard F. Syron said in a prepared statement.

Last year, Freddie experienced a slight deterioration in the creditworthiness of loans "as more loans transitioned through delinquency to foreclosure" and as "the expected severity of losses" on individual homes increased, the company said.
. . .
Freddie reported that the delinquency rate on its single-family home mortgages -- the percentage of loans at least 90 days past-due or in foreclosure -- declined to 0.53 percent last year, from 0.69 percent the year before.

There were also less favorable developments. The company lost $126 million last year on loans it had to repurchase from other investors because they were late 120 days or more. In 2005, there were no such losses, spokesman Michael Cosgrove said.

For a company the size of Freddie Mac, $126 million is not a crippling loss. But it shows that the repurchase problem--in this case, apparently, of loans sold with recourse--is affecting everyone in the food chain. Freddie's report also may indicate that the problem for prime and near-prime will be loss severity, not loss frequency. Subprime, it seems clear, faces the same or worse severity problems, but of course at much higher frequencies.

Saturday, March 24, 2007

FHA: Out of the Dark Ages

by Tanta on 3/24/2007 01:51:00 PM

I had meant to post something on this a while ago; it’s a March 15 press release from HUD.

Assistant Secretary for Housing - Federal Housing Commissioner Brian Montgomery today reaffirmed the need to modernize the Federal Housing Administration (FHA) and give homeowners a better alternative to exotic high-cost mortgages. . . .

The National Association of Realtors reports that last year 43 percent of first-time homebuyers purchased their homes with no downpayment. Of those who did make a downpayment, the majority put down two percent or less. Modernization legislation, which overwhelmingly passed the House last year, would replace the FHA's stringent three percent minimum cash investment requirement with a flexible plan that allows homeowners to put down almost no money down, one, two or even ten percent.

To prevent the FHA from being priced out of many housing markets, the FHA's modernization legislation would also increase loan limits. Today, few buyers of homes in California or much of the Northeast have been able to use FHA financing because FHA's loan limits aren't high enough to meet the cost of most homes in those regions. By increasing and simplifying loan limits, FHA would once again be a major player in high-cost areas.

FHA modernization legislation would also create a new, risk-based insurance premium structure that would match the premium amount with the credit profile of the borrower. It would replace the current structure, in which there is standard premium amount for all borrowers, while still protecting the soundness of its Insurance Fund.


So, we have some interesting new terms to work with:

“Flexibility”: This is a good idea because a program that “allows” no down payment can also “allow” a 10% down payment. The old program “required” a 3% down payment, and “allowed” anything larger than that. That was inflexible, you see.

“Simplicity”: This is a good idea because a “simple” definition of a moderately-priced home—and thus a maximum FHA loan—can allow FHA to be a “major player” in the game of helping house prices keep going up and up and up. The “complex” definition of a moderately-priced home, on the other hand, might allow FHA to function as a drag on runaway home price appreciation by limiting financing options and thus helping to force prices downward.

“Modernization”: This is a good idea because having a large, fairly homogeneous risk pool, with some individual variation in credit quality, that is all priced the same way for insurance purposes, only worked in the Dark Ages. The new, modern, risk-based approach is much cooler, because there is no question that we know, precisely, how to price that risk, and that whole “group insurance policy” thing is never cheaper than individually-underwritten policies.

You may add those terms to the “Ownership Society” dictionary.

Friday, March 23, 2007

Housing: Supply Demand Imbalance

by Calculated Risk on 3/23/2007 07:19:00 PM

"[T]he persistent imbalance in housing supply and demand ... is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets."
Jeffrey Mezger, CEO, KB Home, March 22, 2007
The above comment raises the question: Why not adjust the price to balance supply and demand?

Housing Supply Demand This diagram shows the normal Supply and Demand relationship. When supply shifts (dark blue to light blue) then the price falls from P0 to P1.

And when demand shifts, perhaps due to the changes in lending standards (from dark red to light red), the prices falls again, this time from P1 to P2.

So, with the current changes in supply and demand, we would expect falling prices, but no "imbalance in housing supply and demand".

In fact new home prices have been falling. KB Home reported their average selling price declined 5% in Q1 2007 (compared to Q1 2006). And most homebuilders have been providing incentives (upgrades, free landscaping, etc.) that can be viewed as price reductions too.

The above diagram works well for commodities, like corn, but the housing market is far more complicated. First, housing markets are local - most housing services aren't transportable - and one area of the country might have different dynamics than other areas. Second, there are reasonable substitute goods for new homes (mostly existing homes and some rentals) that compete with homebuilders for purchasers of housing services.

Note: usually existing homes compete directly with rentals. However this impacts new home sales too because of the typical chain reactions that occur in the housing market.

During periods of weakness, prices in the existing home market typically exhibit strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices. This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes.

This sticky price phenomenon in the existing home market is actually good for new home sales. The homebuilders can lower their prices, and stimulate demand. This probably helped the builders in 2006. However when existing home supply reaches a certain point, prices start to fall in the existing home markets too. Also, when lenders start taking short sales, and banks are selling REOs (bank Real Estate Owned), this puts additional pressure on prices.

Monthly Existing Home Supply Click on graph for larger image.

This graph shows monthly existing home inventory since January 2004. The National Association of Realtors (NAR) noted today: "Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October." However, NAR didn't note that inventories usually increase through mid-summer, and inventories will probably be well over 4 million this summer.

In fact, if inventories grow at the same percentage rate as last year, inventory levels will reach 4.8 million in August. If inventories grow by the same quantity as 2006, inventories will be over 4.6 million by August.

With tighter lending standards, demand will probably fall too. Credit Suisse recently estimated new home sales would fall by 21% in 2007. BofA estimated a decline of 15% for new home demand in 2007. We will probably see a similar decline in existing home sales.

Existing Home Sales and Inventory This graph shows annual existing home sales and inventory for the last 30 years (2007 estimated). The graph shows an estimated inventory increase to 4.5 million units, and sales falling to 5.7 million units (my estimate is 5.6 to 5.8 million existing home sales in 2007).

Inventory of 4.5 million units, and sales of 5.7 million, means 9.5 months of supply this summer. For the more optimistic, use 4 million units of inventory, and sales only falling to 6 million units, giving 8 months of supply.

Usually 6 to 8 months of inventory starts causing pricing problems, and over 8 months a significant problem. With current inventory levels at 6.7 months of supply, inventories are now well into the danger zone. By mid-summer, months of supply will likely be a significant problem.

And this takes us back to the supply demand imbalance. The huge overhang of existing home supply makes the market appear to be out of balance to the new home builders.

Housing: Subprime Machine and Impact on Communities

by Calculated Risk on 3/23/2007 12:31:00 PM

From the NYTimes: The Subprime Loan Machine. This story describes the rise of automated underwriting; both the benefits and the pitfalls.

“Automated underwriting put the credit score on such a pedestal that it obscured the other important things, like is the income actually there,” said Professor Retsinas of Harvard. “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.”
This article is very good, but Tanta notes that it doesn't mention Nicolas Retsinas previously "served as Assistant Secretary for Housing-Federal Housing Commissioner at the United States Department of Housing and Urban Development, and as Director of the Office of Thrift Supervision."

The following two articles look at the impact of the housing bust on communities (hat tip: Wayne):

From the NY Times: Foreclosures Force Suburbs to Fight Blight
“It’s a tragedy and it’s just beginning,” Mayor Judith H. Rawson of Shaker Heights, a mostly affluent suburb, said of the evictions and vacancies, a problem fueled by a rapid increase in high-interest, subprime loans.

“All those shaky loans are out there, and the foreclosures are coming,” Ms. Rawson said. “Managing the damage to our communities will take years.”
From the Charlotte Observer: Failed mortgages fly under the radar
An Observer analysis of county records found 35 Mecklenburg developments of low-priced homes built in the past decade with foreclosure rates of 20 percent or higher. Dozens of residents say the concentrations have damaged their communities. Prices fell. Renters moved in. Crime sometimes rose.

February Existing Home Sales

by Calculated Risk on 3/23/2007 10:07:00 AM

The National Association of Realtors (NAR) reports: Existing-Home Sales Rise Again in February

Click on graph for larger image.

Total existing-home sales – including single-family, townhomes, condominiums and co-ops – rose 3.9 percent to a seasonally adjusted annual rate1 of 6.69 million units in February from a downwardly revised level of 6.44 million in January, but are 3.6 percent below the 6.94 million-unit pace in February 2006.
The above graph shows NSA monthly sales for 2005, 2006 and 2007. This shows that March is the first key month of the year.

Total housing inventory levels rose 5.9 percent at the end of February to 3.75 million existing homes available for sale, which represents a 6.7-month supply at the current sales pace compared with a 6.6-month supply in January. Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October.
A few key points:

1) March is the beginning of the spring selling season.

2) Inventory is at a record levels for February (30% above Feb 2006).

3) Existing home sales are reported at the close of escrow. This means these contracts were mostly signed in December and January. So these numbers are prior to the subprime implosion of mid-February.

Thursday, March 22, 2007

Private Mortgage Insurance for UberNerds II: Flows, Pools, Bulks, and Captives

by Tanta on 3/22/2007 10:24:00 PM

In our last episode, we found our hero, MI, throwing itself in front of our hapless lender, bravely absorbing the first impact of the real estate train wreck. Before we go on to talk about other issues, let’s make sure we understand what “loss position” means. If you’re used to thinking of insurance in terms of things like auto or health, you’re used to being "the insured." You're also in the first loss position: that’s what a “deductible” is. It means that in an insurable event, you will take the first loss up to your deductible amount, and only if the losses exceed that limit will the insurer step up and take the rest of it. MI doesn’t work that way (with the possible exception of “captive reinsurance” issues, which we’ll talk about below).

MI is designed to be the first loss position: it covers losses up to the coverage level amount, and only if losses exceed that amount will the lender (who is “the insured”) take the rest of it. It's rather like the reverse of a deductible. The lender/investor doesn’t spend its own money until the MI has spent all the money it is contractually obligated to spend first.

This may answer the questions some people had about how the insurer and the lender might be somewhat differently motivated when it comes to mitigating losses on a loan. The MI will be pushing for collection efforts, forbearance, modifications, and so on, whenever it’s prudent (in the MI’s perspective), because the MI pays first in a foreclosure and doesn't want to do so unnecessarily. The lender might want to foreclose sooner rather than later, because in an early foreclosure, most losses are likely to be covered by the MI. Who gets its way is a question of how the fine print in the policy reads. The lender/servicer is not obligated by law to follow the MI’s requirements. It is obligated by sheer self-interest: if you don’t follow the MI’s servicing rules, the MI won’t pay the claim.

Mortgage insurance policies can come in several flavors. The most common is the primary policy. This is a policy that insures some percent of the losses on an individual loan. Primary policies can be written on a flow basis or a bulk basis. “Flow” means that policies are written on a loan-by-loan basis, as they are originated. An originator could then take a pool of loans that have already been covered with flow primary policies, and securitize them. If the amount of coverage on the existing flow primary policies is sufficient, no further insuring of the pool of loans is necessary. “Bulk” means that policies are written to cover individual loans, but they are written all at once, after the loans have already been closed, on a big portfolio of loans.

Flow primary policies can be “borrower paid” or “lender paid.” Bulk primary policies are always “lender paid.” This part is confusing, because in real-world terms, the borrower is always paying for the MI somehow. The difference is really in how the borrower pays it (which can impact how well the risk is priced, as we’ll see).

When we use the term “borrower paid,” we mean that the mortgage insurance premium for the individual loan is set by the insurer before the loan is closed, according to the insurer’s underwriting guidelines, and is paid out of the borrower’s monthly loan payment (the “T&I” or “escrow” portion). Some premiums are paid monthly; the servicer takes the monthly part out of the borrower’s payment and remits it to the MI each month. Some are paid annually; the servicer puts the monthly part of the borrower’s payment into an escrow account, and then remits the annual premium to the MI when it is due (after sufficient funds have built up in the escrow account). The borrower never pays the MI premiums directly; this is important. The borrower is not the insured; the lender is. The servicer must collect premiums from the borrower and then send them to the MI. The borrower is not responsible for making sure that happens; the borrower is only responsible for making the MI part of the monthly payment to the servicer as specified in the loan closing documents. The MI’s job is to make sure the servicer is doing its job.

The industry term “lender-paid” refers to a situation where the borrower’s closing docs do not specify a monthly premium portion to be paid into escrow. Instead, the borrower just pays a higher interest rate on the loan, and the lender pays the MI premium out of its interest income, which (ideally) reduces the yield on a lender-paid loan to the equivalent of the yield on a borrower-paid loan. In this regard, it works like servicing fees: the servicer takes the required slice off the interest payment needed to pay the MI premiums, and then passes through the remainder to the investor. You can see why it’s still really paid by the borrower: it comes out of the interest payments the borrower makes. It’s called “lender-paid” because it does not come out of an escrow account funded directly by borrower T&I payments.

Lender-paid primary flow insurance (LPMI) got really popular for a while, because it was marketed as “tax advantaged.” (Countrywide’s product is actually called “TAMI,” Tax Advantaged Mortgage Insurance.) The idea is that mortgage interest is tax-deductible but mortgage premiums are not (although that’s changing); the borrower could make more or less the same monthly payment on the lender-paid plan, but deduct more on the tax return because it was interest instead of premium.

Some of us think this wasn’t always such a great deal for the borrower; it depends on the fine print in the closing documents. Specifically, the higher-rate lender-paid deal is OK as long as you get a nearly free option to modify your loan back to market rates once your LTV drops under 80%. (“Nearly free” would mean you paid only the cost of a new appraisal to verify LTV; you would have to pay that to cancel borrower-paid insurance, too.) If you aren’t given such an option, lender-paid MI can cost you more over time even with the deduction, since it’s costlier to get rid of it (you’d basically have to pay refinance costs and hope rates are low at the time). Anyone who wishes to insist that LPMI is a great deal for the consumer should ponder the fact that rating agencies and securitizers tend to prefer it to borrower-paid MI precisely because it is marginally more persistent, meaning that borrowers pay higher rates longer than they pay monthly insurance premiums. If and when prevailing rates rise substantially, some borrowers will find it difficult or unpleasant to try to “refi” out of LPMI.

Bulk policies, of course, are all LPMI (since the MI is added to the loans in bulk transactions, after they’re closed, they have to be LPMI instead of borrower-paid. You can’t go back to a borrower after you’ve closed the loan and say, hey, we decided you need to start paying MI.) There are two important issues for bulk: first, these are still loan-level policies; it’s really just a matter of writing a whole lot of individual policies at once, rather than on a flow as-the-loans-close basis. Second, from the insurer’s perspective, bulk policies are nearly always of weaker average credit quality than flow policies. It’s rather like the difference between pork loin and sausages. Bulk loan portfolios are the “sausages,” and they’ll always have some percentage of “filler.” As long as they still taste something like pork loin—that is, as long as the averages across the portfolio of loans is OK—then they’re still insurable. But the premium structure for bulk is different from flow, to take the credit quality differences into account.

What is called “pool insurance” is a pig of a different color. Pool insurance is a way of covering a big group of loans, like bulk, but unlike bulk, pool insurance is not a primary policy. A primary policy covers a maximum percent of the losses on an individual loan. It is not “cross-default” insurance, meaning that if you don’t lose the whole maximum claim amount on a given loan, you can’t apply the remaining claim amount to another defaulted loan. With pool insurance, you can apply the total policy maximum to different loans. Pool insurance can be applied to a pool of loans that already have primary policies, a pool of loans that do not have primary policies, or a mixture of the two. It generally has a maximum dollar amount or percent of pool balance that it will cover; individual loan losses are applied to that limit until it is reached, and then the remaining pool balance is uninsured. When there is a loss on a loan with a primary policy, the primary policy pays first to its maximum claim amount, and then the pool insurance kicks in for any remaining loss.

So pool insurance can either supplement or replace primary coverage, depending on the pool, the agreement, and the underlying loans. Pool insurance is often called “lender paid,” but it’s really mostly used in securitizations and so it’s more properly considered “bondholder paid.” It’s a form of credit enhancement, and like any other credit enhancement, its cost comes out of the yield of the underlying loans. It is cost-effective to the bondholder only to the extent that the underlying loans 1) throw off enough income to leave a reasonable net yield after the cost of the credit enhancement and 2) are of high enough credit quality themselves to be eligible for relatively inexpensive premiums.

Bulk and pool insurance can be like a belt added to the primary flow policy suspenders. You will sometimes hear of lenders—we’re hearing quite a bit of this lately—adding MI to a portfolio of loans that they’ve held for some time. The idea is that they sniffed the wind and decided perhaps more insurance coverage would be a good idea. This may make the shareholders of those portfolio lenders feel better.

Before getting too warm and fuzzy over it, though, shareholders might remember two things: MI companies can smell change in the air just as much if not more than lenders can; being on the hook for losses does tend to sharpen one’s wits. Buying insurance while you’re young and healthy (flow primary) tends to be cheaper than buying it when you’re sicker and older (bulk or pool policies acquired after “sniffing the wind”). Furthermore, “lender-paid” MI is a profitable proposition to the lender only insofar as the lender originally set the borrower’s interest rate at closing to a level high enough to cover the insurance costs. Having to go back and insure an originally uninsured or underinsured portfolio can mean having to spend interest income that did not originally “budget” for insurance. Ouch. So a lender who announces that it has just insured (or increased the insurance on) some part of its portfolio is telling you that 1) it thinks the outlook is worse than what it predicted when it closed the loans and 2) it just reduced its income on that portfolio and 3) it thinks that loss of income is worth it, which tells you, in essence, how much worse the outlook is.

Today’s final topic is this “captive reinsurance” thing. In short, that’s a setup in which a lender forms a subsidiary which “captures” part of the mortgage insurance premium. In exchange, it agrees to take some part of the MI’s exposure. A typical arrangement might involve the lender’s captive taking 25% of the premium in exchange for covering 25% of the first loss.

The devil, with these things, is always in the details; whether this is a good deal or bad deal for either party depends on which 25% the captive is taking. It could involve a split, meaning the captive pays 25 cents for every 75 cents the insurer pays, starting with the first dollar paid. Or, it could mean the captive pays the first 25% of losses, and then the MI pays any remaining losses up to 75% of the maximum claim. Or the MI could pay the first 25%, the captive the second 25%, and the MI the last 50%. You have to read the agreement; these things aren’t exactly standardized.

Suffice it to say that, in the boom years, they were a real money-maker for lenders, since losses were so low what with bubble prices and endless refis. Whether they will continue to be, and whether some lenders may yet re-discover the meaning of that old phrase about chickens coming home to roost, is yet to be seen. On the whole, my personal view is that if there’s a sucker at the table somewhere, it probably isn’t the MI. They are in the business of insuring against losses, and most of them have been at it long enough to have been there, done that, got scars to show for it. A few of these “new, quickly growing mortgage lenders!” who emerged more or less in the boom may not necessarily be pricing their risk quite exactly right, in my view.

So far, we haven’t addressed the big question of how, then, the MI’s underwriting guidelines stack up against everyone else’s. That’s a critical question, if you want to know how much risk the MIs have taken on, and how likely they are to withstand the losses they might have to take. But it’s also a subject for the next installment.