by Tanta on 12/05/2007 08:07:00 AM

And it will be interesting to see what crawls out from under this one:

NEW YORK (Reuters) - New York state prosecutors have sent subpoenas to Wall Street firms seeking information related to the packaging and selling of debt tied to high-risk mortgages, the Wall Street Journal reported, citing people familiar with the matter. . . .

The probe appears to be examining the relationships between mortgage companies, third-party due-diligence firms, securities firms and credit-rating firms as they relate to the role securities firms played in the subprime mortgage crisis, the Journal said.

Well, well, well. I'm guessing there will be all kinds of interesting stuff on those potted plant reports. Somebody's aspidistra is going to be in a sling . . .

by Tanta on 11/29/2007 09:53:00 AM

Regular readers of this site will remember more or less constant outbursts of complaining about the lack of full-file due diligence in the securitization process. People look at data tapes and write contract warranties; people don't actually open up loan files and assess the accuracy of those data tapes, let alone go beyond the tape elements (quantifiable information like LTV and DTI and FICO) to qualitative aspects and conformity with "soft guidelines" (the rules of processing or evaluating documents or information that generates the quantities).

Well, glory be. Some analysts at Fitch rolled up their sleeves and sat down with a pile of loan files (45 of them, to be precise). What they discovered are the parameters of the the most innovative product the industry has ever offered, the NUNA (No Underwriting, No Accountability).

While we realize this was a very limited sample, Fitch believes that the findings are indicative of the types and magnitude of issues, such as poor underwriting and fraud, which are prevalent in the high delinquencies of recent subprime vintages. In addition, although the sample was adversely selected based on payment patterns and high risk factors, the files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding.

I suggest reading the whole thing, if you've got a few minutes to blow on mortgage credit risk assessment arcana. What is happening here, although Fitch doesn't state it in these terms, is that someone went through a pile of loan files that were originally processed and underwritten in the "innovative" (cheap) way, and subjected them to processing and underwriting in the traditional (less cheap) way. As far as I can tell, the results here did not come from "extraordinary" levels of investigation or even much in the way of hindsight data (that is, by working back from events that took place after the loan was closed).

What this little exercise of Fitch's shows is that doing things like working through a credit report, looking carefully at the ownership of accounts (sole, joint, authorized user) and the relationship of tradelines to the information listed on the application (matching mortgage tradelines to real estate owned and matching general debt usage and spending patterns to income claimed) provides you with vital information that leads you to reject a mere FICO score as either a sole determinant of credit quality or as a "magic offset" that can let you ignore other weaknesses in the deal. No, really. All that is what we used to do before we started relying on FICOs and AUS.

But don't think this is just an anti-technology rant: 22% of the files Fitch looked at had a "HAWK Alert" right there on the original credit report, visible to anyone who reads English. What's that? It's a warning message that the credit repositories print on a report when some combination of facts or transactions trigger one of its potential fraud algorithms. It does not prove fraud, but it is designed to make your average human underwriter sit up straight and start poring over documents at a much greater level of detail and skepticism than might be usual.

Computers are great for this kind of thing: they help you put your work into "buckets" right off the bat. Any loan with a HAWK Alert should be immediately routed out of the "automation" pipeline and onto the desk of a senior underwriter. The technology helps you direct your human expertise where it really pays off.

Yeah, right, except that as Fitch notes, there is no indication in any of these files that anyone even noticed the HAWK Alert. And the problems that caused that Alert were, apparently, quite visible in the original file documents, if you looked past the FICO score to the details of the tradelines or the relationship of the tradelines to the loan application. (Loan app says borrower is a first-time homebuyer, credit report says there are existing mortgage tradelines. Duh.)

And of course the ridiculousness of the whole stated income thing is here on display, but Fitch never quite gets to asking the question raised by it all: if stated income is such high risk that you need to develop all sorts of processes and practices for testing it, contextualizing it, and subjecting the rest of the file to a fine-toothed review to compensate for it, what, exactly, is the benefit, in cost and speed, of doing it in the first place? At some level Fitch's analysis reads like a medical school textbook on using expensive fifth-generation antibiotics to treat staph infections caused by failure of doctors and nurses to wash their hands between patients. It's nice to know that can be treated, but it would be even nicer--not to mention cheaper--if hand-washing became more popular in the first place.

The fact is that many mortgage shops did, actually, put all kinds of practices and processes and "risk management control points" in place over the last several years to compensate for the risk created by their reliance on AUS, stated income, FICO scores, AVMs, and so on. For a lot of these shops, all that compensating was at least as expensive as just doing it the old way from the beginning. Certainly it remains to be demonstrated what kind of originator the files Fitch found came from: newbies who never learned the old ways and hence never saw the risk? Thinly-capitalized budget operations who just couldn't afford to produce anything except NUNA loans? Cynical players who knew the stuff was junk but who also knew that neither the security issuers nor the rating agencies would notice, and who also knew that the game of representations and warranties, properly played, would insulate them from having to take it back?

The whole thing really begins to take on an amazing Rube Goldberg quality once you refuse to accept the beginning premise--that these "innovative" ways of underwriting loans are a given, it's the compensation mechanisms that are the question. You do not have to believe that traditional human underwriting is perfect to wonder whether the cure is worse than the disease when it comes to compensating for automation.

(Hat tip to some awesomely cool dood)

by Tanta on 11/17/2007 11:47:00 AM

This is going to be a long post. It is going to attempt to answer the question stated in the post title. It is also going to function as further proof of the old axiom that you can create quite a ruckus in 150 badly-chosen words, but it takes ten times that many words (at least) to return some sanity to the discussion. “Gotcha” reporters of course know this, which is why they do what they do. Most people don’t have the time or desire to wade through the high-attention span Nerd part to evaluate the reporter’s claim. That it’s a deadly serious business for anyone who owns shares in a publicly-traded company being compared to a criminal conspiracy on the basis of a misunderstanding of accounting rules doesn’t seem to bother writers who just want a “scoop.”

The ruckus started last week. On November 9, Fannie Mae released its 10-Q for the third quarter. This is the first time in years that Fannie has gotten a timely Q out; its 10-K for 2006 was released just in August, it never filed Qs for 2006, and the Qs for the first two quarters of 2007 were also just released in November. That little detail is important to this story. I assume everyone knows the long wretched saga of why Fannie Mae has been so far behind with its SEC filings. The point is that, in catching up, they have released a flurry of reports in a short period of time, which don’t have the same numbers on them (they shouldn’t; they are for different periods), and since they never reported quarterly numbers for 2006, we don’t have the by-quarter breakout that would provide details for some of the whole-year numbers reported in the 2006 K.

On November 15, Peter Eavis of Fortune Magazine published a breathless essay accusing Fannie Mae of having changed the method it uses to calculate its credit loss ratio in the Q3 filing. It is quite obvious that the presentation of this information has changed; the Q says so (page 54-55). Eavis, moving from a change in presentation to a change in calculation with intent to mislead at the speed of light, says “Uh oh. It’s Enron all over again.” Throughout the original article, he keeps referring to “bad loans” in such a way as to give the misleading impression that the metric in question, the credit loss ratio, is about reporting on delinquent loans, not on realized losses on defaulted loans in the current period. This allows him to accuse Fannie Mae of being “misleading” by not including fair-value write-downs on delinquent but not yet defaulted (not yet realized-loss producing) loans in the credit loss ratio.

Fannie Mae stock started to tank badly, and Fannie scheduled an analyst conference call for Friday morning to address this one very specific issue in one table in the Q. Fannie Mae explained, among other things, that the item excluded from the credit loss ratio calculation is, actually, included in net charge-offs on the consolidated financial statements. However, for the purpose of this specific metric, the credit loss ratio, fair value write-downs that have not yet produced an actual loss are excluded.

You can listen to the webcast here. Several analysts pointed out, quite nonconfrontationally, that they though Fannie could have provided more information to put this matter in context. Fannie agreed, and indicated that future disclosures would include more information. What’s amusing is that in two instances, analysts ended up asking whether in fact Fannie Mae wasn’t over-reserving for certain delinquent loans! Fannie Mae’s response was that they don’t think they’re under-reserving or over-reserving; they are simply applying GAAP rules for how fair-value write downs are taken. At no time in the conference call did anyone challenge this as a misapplication of GAAP rules.

So what did Eavis do, after the conference call and some delving into the credit loss ratio suggested that perhaps he merely misunderstood the math? He wrote a follow-up article on Friday, in which he continues to insist, even after Fannie Mae’s explanation of the issue, that the amount of exclusions from the credit loss ratio (that is, the amount of the fair-value write-downs on repurchased loans that are delinquent but not yet defaulted) is inexplicably large, and that these are forced repurchases, and that this is somehow sinister. This is after a conference call in which Fannie Mae explained, for those who have been living under a rock since last summer, why it is that write-downs on repurchased loans in Q3 can be many, many times the write-downs on loans repurchased earlier in the year, even if the total number of repurchased loans hasn’t grown all that much. There was this mere matter of a giant freeze in the mortgage secondary market, and spooked investors offering mere pennies on the dollar for delinquent mortgage paper, whether it was prime or subprime or something else. Eavis has to pretend to not remember that, I suspect, because his claim of “Enron all over again” is crumbling around his ears and he needs to keep kicking sand.

It is amazing to me that in light of all the real problems we have right now, we still want to go down expensive rabbit holes over “accounting tricks.” Nobody, least of all Fannie Mae, is trying to deny that there are severe problems in the housing and mortgage market, that large losses are being taken, and that this will hurt all over the place. I am not suggesting that Fannie’s Q is as clear as it could be, and I’m glad they indicated a willingness to report more color in future disclosures to make these numbers easier to evaluate. But writing a not completely helpful Q based on GAAP isn’t a crime in this country. I know a lot of people will argue that GAAP isn’t very helpful to the non-specialist. You get no argument from me about that, either. That still doesn’t make Fannie Mae Enron, and I for one would be livid if I were a Fannie Mae shareholder, and watched my money get flushed down the toilet for two days because, frankly, some reporter can neither read nor report. (I may well be a Fannie shareholder via indexed stock funds in one of my retirement accounts. But for disclosure purposes, I own no shares of FNM that I know about.)

Eavis could have gotten the same explanation from Fannie Mae that the analysts got in the call if he had asked for it, I am sure. No one forced him to write an article that makes accusations of willful dishonesty and implications of criminal behavior based on his inability to understand Table 26. He gave himself that assignment. And instead of apologizing for it, he continues to insist that the numbers don’t make sense.

Let me cut through the accounting archana (we can discuss that in the comments if we need to) to what I think is the real issue here. Fannie Mae has always had the option to repurchase seriously delinquent loans out of its MBS at par (100% of the unpaid principal balance) plus accrued interest to the payoff date. This returns principal to the investors, so they are made whole. If Fannie Mae can work with the servicer to cure these loans, they become performing loans in Fannie Mae’s portfolio. If they cannot be cured, they are foreclosed, and Fannie Mae shows the charge-off and foreclosure expense on its portfolio’s books (these are no longer on the MBS’s books, since the loan was bought out of the MBS pool).

Now, Fannie also sometimes has the obligation to buy loans out of an MBS pool. But we are—Fannie Mae made this clear both in the footnote to Table 26 of the Q and in the conference call—talking about optional repurchases. Why would Fannie Mae buy nonperforming loans it doesn’t have to buy? Because it has agreed to workout efforts on these loans, including but not necessarily limited to pursuing a modification. Under Fannie Mae MBS rules, worked out loans have to be removed from the pools (and the MBS has to receive par for them, even if their market value is much less than that).

There is, however, a little matter of accounting rules for booking these loans. Under GAAP, known internally to Fannie Mae as its SOP 03-3, the loan is taken onto the books at the lower of cost (par, in this case) or the fair market value of the loan at the time of repurchase. When the FV is lower than par, Fannie Mae has to charge-off the difference, at the time. This is not a true realized loss: it is a reflection of a mark to a real market value of a delinquent loan. You take the FV write-down at the time, even if you think that no loss, or a very much smaller loss, will actually end up occurring. That’s the rule. Anything else would be “mark to model” or “mark to myth.”

Now, anyone who hasn’t been living under a rock knows that bids for delinquent loans were either nonexistent or atrocious in July-September of this year. Certainly Fannie Mae knew that if it exercised its option to buy loans out of MBS in order to modify them, it, not the MBS, would have to take a nasty FV write-down. I don’t know about you, but I happen to think that a lot of private investors/servicers are refusing to do modifications of securitized loans precisely because they don’t want to have to buy them out of the pools and show that nasty write-down on their own books. They claim that it’s because securitization rules won’t let them modify loans, but I’ve never really bought that argument, nor have many regulators or the SEC.

The problem is that the market right now does not distinguish between a scratch & dent loan—one with a problem that could be cured with a modification—and defaulted nuclear waste that is facing 50% or more loss severity on imminent foreclosure. Whether it should be making that distinction or not—whether this is partly irrational panic or not—is not the point here. The point is that it just isn’t doing so, and so anyone who takes a loan to portfolio right now and uses a true market value instead of a fantasy is going to show the same huge write-down for the scratch & dent as for the nuclear waste. This will continue to be true until the market decides that everything isn’t nuclear waste any more.

So nobody wants outfits like Fannie Mae to mark to model; we want them to mark to market. We also want them to work out loans that can and should be worked out. Remember, we aren’t talking about horror subprime exploding ARMs here, we’re talking about troubled loans in typical Fannie Mae MBS. We’re talking about the kind of loans that would have taken a $60 million write-down in a past quarter, but that are taking a $600 million write-down in this quarter, solely because the market price of those loans has deteriorated so badly.

We also need to remember that Fannie has no intention of ever reselling these loans. If they can be cured, they will stay in Fannie’s portfolio. So establishing a market price is not about determining a loss Fannie would take if it cured the loan and then resold it. Establishing a market price is just a requirement of the accounting rules for a situation in which the price you must pay for a loan (par) is more than the market value of the loan. After all, what Fannie is doing here is making the MBS investor whole and taking the deteriorated asset onto its own books. The FV write-down means exactly that it is not hiding a loss this way.

Fannie Mae could avoid these write-downs by failing to exercise its option to buy the loans from the MBS. That would mean Fannie Mae refusing to work out loans with borrowers. Or, to put it another way, the price of Fannie agreeing to work with troubled borrowers is an out-sized hole in the current quarter’s charge-offs, not just because of the loan quality, but because of the total melt-down in the secondary market for nonperforming loans.

Fannie says that it does not expect most of these loans to default and produce large realized losses. You may or may not find that convincing. But Fannie does, because that’s why they bought them out of the pools. If they thought the stuff would go straight to the FC department, they’d have let the servicer take the loan out of the pool and foreclose, and let the losses hit the MBS guarantee fee income.

Fannie’s story is that in normal times, these FV write-downs of repurchased loans are included in total charge-offs, and therefore are reported in the credit loss ratio. In Q3 07, because of the enormous size of the FV write down, Fannie Mae backed out of the charge-offs the ones due to an up-front write down of delinquent but not defaulted loans. It added back any part of that write down that did, actually, become a realized loss, so that readers of the Q could get a true picture of how much the total charge-offs in Q3 were affected by repurchased loans.

Eavis is saying that this is inexplicable. Of course it’s explicable. You can and some analysts did on Friday ask Fannie Mae why it didn’t supply more information about what it was doing with those loans, and what its expected cure rate would be for these workouts. Fannie Mae acknowledged that such information would have helped and promised to provide more in future disclosures. But nobody on that conference call, as far as I remember, questioned the size of the Q3 07 FV adjustments. People who have been following the credit markets all year are not surprised here. Eavis is.

For the love of all that is holy, what does anyone think Fannie Mae (and Freddie Mac) are up to these days? The enormous pressure they are under by Congress and the public to modify as many loans as can possibly be saved has been so well-documented in the press that I’m sure they heard about it on Mars. It’s possible that Fannie is too optimistic about the cure rate of these loans. It’s possible that deep inside, they realize they are going to eat huge losses on all this stuff. But they were told in no uncertain terms to buy it out of the pools, take the FV write-down like a big kid, and start working out loans. Does anyone actually expect them to write a quarterly report that says “We think all this stuff will result in 100% losses in the next 90 days, but our regulators made us buy it anyway, so we’re reporting the worst possible credit loss ratio we can calculate, just to spite them”? On no planet, at no point in time, will that ever happen. You have to be willfully ignorant to think it would.

So there is, actually, a compelling story to be teased out of a couple of footnotes to a little table on page 55 of a 107-page quarterly report. It’s a story about political and market pressures and reactions; about the bottom-line impacts of workouts to investors like Fannie Mae; about the real-world effects on profitability numbers of things we see in fairly abstract forms, like those cliff-dives on the ABX and CDS charts or the dramatic ratings downgrades we post on regularly. There is a story that ties all of this together and shows how realized losses can be small compared to market losses, and how this ties into the debates over “mark to model” and other bad industry practices. There’s even possibly a story about how in certain unusual times, the old-fashioned GAAP rules fail to really tell investors what they need to know. These are fascinating and important subjects.

Eavis blew through all of those real issues to make a big deal about how Fannie projected losses in the 4-6 bps range for the year and might, actually, be at 7.5 bps as of Q3 if you calculate the number the way Eavis thinks you should. Think about this: he’s saying that it’s possible that credit losses on mortgage paper as of Q3 07 are worse than what was predicted at the end of 2006. OMG!!! No!! Really??? NEWS FLASH!! CALL THE POLICE!!!!! THE OBVIOUS!! IT IS BLINDING ME!!!

Sorry I let myself get out of control there, but come on. Anyone who has been reading USA Today on alternate weekends since February knows that losses are getting worse, and Fannie Mae did in fact explicitly report that losses were getting worse, even with the FV write-downs that were not realized losses backed out. What we are seeing is the whole problem with the “Another Enron” mentality: confusing the meaning of numbers with “accounting tricks,” and substituting some kind of gotcha for an honest attempt to understand the market mechanisms and economic reality that is creating those numbers. This mentality claims to be keeping companies honest, but it actually has the opposite effect, in my view, of inhibiting companies from presenting more detailed numbers, since the more you give people like Eavis the more they have to play gotcha with. And Eavis himself takes credit for his original article having lead to a 17% drop in Fannie Mae’s share price. I guess he’s proud of that. The other side of the Enron myth is the Famous Reporter Who Brought Down the Corporate Giant. It is worth not allowing oneself to get sucked into that sort of grandiose mythologizing.

I have to say I hate “blog triumphalism,” too. That’s the mindset too many internet writers have that us citizen journalists in our jammies are going to single-handedly bring down the Big Corrupt Media. I firmly believe in beating the press up a little when they do egregiously bad reporting, but that’s largely because I care about understanding what the real story is. And I hate being distracted by red herrings in my personal quest for understanding. Yesterday I spent over two hours rooting through SEC disclosures and listening to a 57-minute conference call trying to independently verify Eavis’s point; today I’ve spent a couple of hours writing this post. I am willing to believe that very few people have the time and the expertise to do what I just did. I therefore feel compelled to share my point of view with the rest of the world, in the interest of a worthwhile public discussion of financial and economic matters, which is the purpose of this blog. So I didn’t start out with the goal of catching Eavis being a lousy reporter; I started out with the goal of reading about Fannie Mae in a CNN Money article. But I believe that I did discover hyped, misleading, and ignorant reporting, and I believe it is fair to say so in public.

by Tanta on 11/15/2007 08:24:00 AM

So there was a pretty breathlessly hyped story on a blog about how the dismissal of a foreclosure filing meant that the entire MBS market is more or less toast. Then there was a tedious attempt by Tanta to sort through it and figure out what the real issue was and perhaps cool down some of the rhetoric. You know what had to happen next. Gretchen Morgenson got ahold of it.

Do read the whole piece. Perhaps I have gone temporarily blind, and there is somewhere in this article an acknowledgement that this story was "broken" on a blog. (Not mine, by the way: I Am Facing Foreclosure.com "broke" the story. I ignored it as long as I thought I could.) Query: is this where GM has been getting a lot of story juice lately? Could that be why some of her recent reporting, especially on Countrywide, is such a noxious mixture of fact and hype, information and innuendo?

All I know about journalistic practice tells me that if this story had originally been reported in the Podunk Inquirer, GM would have credited the ol' PI in her story. But you can fish in the blogs, it appears, without having to admit it. And without identifying the blog-source of your stories, you avoid having to confront the evaluation problem. There are great blogs and terrible blogs out there. There is carefully gleaned and analyzed information, and there is rumor, garbled gossip, and speculation masquerading as fact. There are people whose agenda and biases are perfectly clearly spelled out, and there are those who are talkin' a book or just shilling. If you want to seine the blogs for NYT material, you have to deal with this problem for yourself and for your readers. Identifying your sources is not simply professional courtesy, it's the beginning of the process of evaluating the source. Yes, I am not a professional reporter and this is a blog and I am lecturing the NYT on Journalism 101. I'm afraid to open the fridge to get milk in case there's a trout in there.

I said most of what I want to say about the issue yesterday. Let me just pause over this one tidbit in GM's article this morning:

When a loan goes into a securitization, the mortgage note is not sent to the trust. Instead it shows up as a data transfer with the physical note being kept at a separate document repository company. Such practices keep the process fast and cheap.

I rail endlessly about mortgage industry practices that are "fast and cheap" and that sacrifice risk management. You all have never heard me complaining about the practice of third-party document custody because it is one of the very few old-fashioned slow expensive risk management processes that the New Paradigm people have not yet managed to do away with. Document custodians are the Nerdiest Nerds there are, and their nerditude is in so many cases the only thing separating the current secondary market from a Wild West clown show. They are the thin red-tape line between us and chaos. I have never met anyone having anything to do with mortgage loans who has not at least once indulged in a major bitch-fest about dealing with some Iron-Fisted Custodian who won't just certify pools or mail notes around or change reports because some punk says to. They want appropriately-signed authorizations. They want Trust Receipts. They want originals, not copies; they want letters, not phone calls. They are, personally and institutionally, the kind of people who count the teaspoons after the dinner party guests leave.

And it costs money to use document custodians, who are, if you want to know, required to be financial institutions with a trust department that has direct authorization from its regulator to offer trust services. That does not make them perfect, but to call them "document repository companies" may give you all the impression that we're dealing with some fly-by-night Docs R Us outfit. I don't have exact numbers handy, but I would guess off the top of my head that after Fannie and Freddie, who are the custodians of most but not all of their own notes and mortgages, the single largest concentration of custody docs in this country is probably Wells Fargo. (I invite correction if I'm wrong about that.) Like anyone else who has ever certified pools, I've visited Wells's custodial operations center. I don't remember having to take my shoes off and put them in a basket before they let me in, but then again it was several years ago. At the time, Well's security was better than most airports'.

It has to be. Not only do they hold the documents collateralizing trillions of dollars of debt that belongs to someone else, but they do, in fact, hold those notes I was talking about yesterday that are endorsed in blank. Such a thing is rather more secure than a simple bearer bond, but not by much.

In the case of the DB foreclosure suit dismissal we looked at yesterday, there should have been a set of original notes and original recordable-form (but possibly not actually recorded) assignments of mortgage in the physical custody of a document custodian when DB went to file its FC action. It should therefore have been a matter of DB requesting the pertinent docs from the custodian, who would send them to DB's legal people in order to prepare the filing. Either this did not happen, or the custodian lost the docs, or DB lost the docs, or the docs were never there in the first place. If that last part is true, I want to know how a custodian certified those pools at issuance. If the custodian certified the pools on condition that some missing assignments get turned in later, then when and how did the custodian follow up on that? This is Deal, Big.

It is, mind you, possible that DB is acting as its own custodian. It's a bank, it has a trust department, it qualifies as a custodian. And if DB is acting as its own custodian, and certifying pools without having its hot little hands on the docs first, or it is misplacing those docs it had when it certified the pool to start with, then that, my friends, is a Story. It is a story that Deutsche Bank's regulators might be really really interested in. I know I am.

But this story will not get written by anyone who misunderstands what custodians are, how much they cost (real fee dollars), and how they are supposed to act like the Gatekeepers and SuperNerds of the whole process. In other words, they are supposed to be a check against "fast and cheap," not part of "fast and cheap."

by Tanta on 11/08/2007 09:46:00 AM

Via PJ at Housing Wire, I see that WaMu put a PR out yesterday on the matter of Mr. Cuomo's investigation into its appraisal practices. As PJ notes, this is the part that matters:

The contract with the vendor named by the NY AG requires that the vendor represent and warrant that appraisals are prepared in compliance with Uniform Standards of Professional Appraisal Practice and all guidelines issued by Fannie Mae and Freddie Mac. The contract also requires that the appraisals have been prepared without fraud or negligence on the part of the vendor, its employees or agents, including any appraiser.

Fewer than 5 percent of the appraisals performed under this contract were related to subprime loans.

WaMu has a very rigorous process regarding all repurchase requests and believes it is adequately reserved for such liabilities.

That last sentence is clearly a direct response to the last sentence of this part of Fannie Mae's PR from earlier yesterday:

It is against our interest to purchase or guarantee mortgages with inflated appraisals, and so it is in Fannie Mae's interest that these appraisal practices be investigated. The Attorney General has indicated that he also plans to subpoena Fannie Mae for documents and testimony related to the appraisal process. We intend to cooperate fully with the Attorney General. We also will appoint, with the Attorney General's approval, an independent examiner to review the appraisal practices cited in the complaint. If the examiner determines we own or guarantee mortgages with inflated appraisals, our guide states that the lender must buy back the loans that do not meet our standards and requirements.

In other words, Fannie Mae is saying that WaMu will take back any loans with dubious appraisals this "independent examiner" digs up. WaMu is saying that it will "rigorously" avoid doing so.

WaMu is also saying, in effect, that it signed a contract with eAppraiseIT that puts all liability for inflated appraisals on eAppraiseIT. Fannie Mae is saying, in effect, that it signed a contract with WaMu that puts all liability for inflated appraisals on WaMu. Cuomo, you note, is pursuing a civil complaint against eAppraiseIT and its parent First American, not against WaMu or Fannie Mae.

This is very interesting precisely because it isn't going to be about inflated appraisals. It's going to be about how far anyone can get away with two practices that are the lynch-pins of the mortgage industry: outsourcing regulatory liability to a third party bag-holder and doing business on a representation and warranty basis without pre-sale due diligence.

Neither Fannie Mae nor Freddie Mac nor most any other secondary market participant actually examines appraisals on individual loans prior to purchasing them. Some percentage of loans are chosen after purchase for a "Quality Control" review; if problems are found at that point, the investor demands that the seller repurchase (or indemnify) the loan.

This process works only to the extent that the representations made in the loan sale contract are clear, specific, and wide enough to capture all the serious problems an investor might have with a loan. In Fannie and Freddie's case, the loan seller represents that the loan meets every guideline currently published by the GSE or specified in the individual contract. The Fannie and Freddie guides themselves run to hundreds and hundreds of pages; in the case of something like appraisals, the GSE guidelines incorporate by reference things like USPAP (the standards promulgated by the Appraisal Foundation), which themselves run to a lot of pages.

Trust me; all of that stuff is detailed and specific enough that it isn't that hard to find contractual grounds to declare breach and demand repurchase of a loan. WaMu knows that perfectly well, as do all mortgage lenders: those loan sale contracts with all those warranties against all those representations add up to major potential repurchase liability. And the ugly thing is that it's repurchase liability. If your loans were all subject to 100% pre-purchase detailed QC review, your risk would be that the squirrelly ones get kicked out of the sale (you don't get to sell them). Post-purchase QC based on rep & warrant means you risk having to take them back in the future, at par, when they might be worth 90 cents on the dollar (or less), at exactly the wrong time to be owning nuclear waste. It's just like foreclosures: lenders don't make money on REO because they don't own much REO except in time periods when RE is worth a lot less, since they wouldn't be foreclosing so much if the RE market were hummin' along.

WaMu's statement is that it took all the "warranty" part of all of this off its own back and put it onto eAppraiseIT's. The plan all along was that if Fannie Mae (or anyone else) tried to force these loans back because of appraisal problems, WaMu would make eAppraiseIT take the losses. In essence, eAppraiseIT was writing an "appraisal default swap." Pity there's no public index for ADS like there is for CDS: I'm sure that would be some interesting cliff diving.

Anyway, this is why the whole flap is scaring the panties off everyone in the mortgage industry, far, far beyond any worry over stiffer appraisal regulation. The core issue here is a cornerstone of the whole "originate and sell" model that has created such a crisis. If Cuomo's suit makes any headway at all, it will put eAppraiseIT out of business one way or the other. That's because if appraisal management companies are no longer willing or able to write these liability swaps into their contracts, they won't be able to offer what the lenders really want from them. The advantage of doing business this way isn't really about saving a few dollars on outsourcing administrative work for the lenders, it's about getting out from under a huge expensive compliance and legal risk.

No wonder Cramer's head is exploding again. This thing really isn't about appraisals, it's about stopping the game of risk-layoff. The weakest (financially and politically) party in the chain, eAppraiseIT, appears to have taken on all the residual risks from WaMu and Fannie Mae, and now Cuomo is going to force those losses to materialize. You can bet that every General Counsel at every mortgage lender still operating is busy reviewing many, many contracts right now. The results will be very, very ugly.

by Tanta on 10/10/2007 09:40:00 AM

More unattractive little snips from my unattractive spreadsheet collection (earlier posts here and here). What can I say? UberNerds don't need no steenkin' fancy formatting.

Item one gives you some sense of the size of the residential first lien securitization market since 1988.

I have been avoiding the terms "agency" and "nonagency" on this blog, but I'm breaking down and using them here. These are an established and pretty old-fashioned way of describing things inside the biz, but they are traps for the unwary. In this particular context, "agency" means Ginnie Mae (which securitizes FHA, VA, and a few other government-insured loans), Fannie Mae, and Freddie Mac, even though only Ginnie Mae is actually an agency of the government (Fannie and Freddie are GSEs, Government-Sponsored Enterprises, not actual agencies). But we used to call them all agencies, and the term survived reality by about a generation and a half, so there. "Nonagency" just means any private issuer.

The column "Issues / Originations" is simply that: one annual number divided by another annual number. That is a very, very approximate way to describe the rate of securitization of originated loans. You would get a number much closer to reality if you used quarterly numbers with a one quarter lag, but I don't have quarterly origination numbers handy. So do throw this number around with a high degree of caution.

What we learn from this spreadsheet is something like the approximate size of the segment of mortgage outstandings that have been in the news lately. The nonagency category (in these charts) includes Jumbo A, Alt-A, and Subprime, primarily first liens. (It includes some MBS that have a small percentage of second liens in them, but excludes MBS that are exclusively second liens. I complain regularly about the "lumpy" or Bridge Mix nature of recent nonagency MBS issues, and this is one reason why.) Basically, all the reporting you are seeing that is based on securitized nonagency loans is discussing around a third of securitized loans outstanding, or 19% of all loans outstanding (as of Q4 2006). Because there is so little data available on unsecuritized loans, it is extremely difficult to answer the question of the extent to which "nonagency" unsecurtized (these are mostly but not exclusively bank and thrift portfolio loans) will perform like their securitized brethren. Most of us believe that the securitized loans were written to much riskier standards than the unsecuritized loans, although as I noted yesterday in reference to the C of the C's last exasperated speech, I do believe that portfolio lending standards have loosened significantly in the last several years. You may in any case draw your own conclusions.

Item two is all the information I have on the break-out of the nonagency category. I got nuthin' on outstandings prior to 2000, but you can guess from what's here that they were rather modest in relation to total mortgage outstandings in those years.

I do not have a refi mix breakout by product for Jumbo A and Alt-A, so I didn't include it. But you can get a sense for how much of new origination is refinance (turnover in the outstandings rather than net additions to it) by comparing issues to the change in outstandings in a given year.

You can also get an idea for why people like me have been snorting derisively for years over this claim that "Alt-A" has a stellar performance history. It barely has a "history" at all. Furthermore, the definition of "Alt-A" in 1995 bears little resemblance to the definition of "Alt-A" in 2006. Remember that "Alt-A" means "alternative" to "A," and so whatever it is, its composition will change as the definition of "A" or "prime," to which it is an "alternative," changes. Back in the mid-90s, SIVA (stated income/verified asset) or--gasp!--CLTVs of 95% were the big "alternatives" and "interest only" was the sort of thing you ran into in commercial lending. Not only do you have, nowadays, IO SIVA with 100% CLTV in "A" (conforming or Jumbo), you have stuff in Alt-A that was simply unimaginable in 1995. So as "A" gets more "alty" over time, "alt" gets waaay more "alty" over time. What people are trying to get at by asking how "Alt-A" can "revert to normal" is, as far as I'm concerned, not very clear. I have no idea what other people think "normal" Alt-A is.

by Tanta on 10/09/2007 10:04:00 AM

More stuff from the spreadsheet collection. This one looks at characteristics and some performance measures of securitized subprime loans from 2000-2006. Unfortunately, there is very little publically available data on unsecuritized subprime.

Comments:

1. Total MBS issued on this chart is mostly, but not exclusively, first liens. (It includes securities that have some second liens, but excludes securities that are exclusively second liens.)

2. The average loan amount is based on first liens.

3. WAC is weighted average coupon or "interest rate" in English.

4. "Reported" DTI simply means that's what was reported. While I have some doubts about the accuracy of that number when the full doc percentage is dropping, do notice that it is climbing even so. The historical maximum acceptable DTI for conforming agency-quality loans was 36%.

5. Historically, subprime was a refinance business, not a purchase money business. This chart shows that very clearly.

6. "Serious Delinquency" means 60 or more days delinquent, FC, REO, or BK. Because this is calculated on the current balance of these securities, this number will be much higher than what you see reported based on original balance. You should be aware that the remaining current balance of these older vintages is very low; the average "pool factor" or balance remaining for 2000, for instance, is around 5%, as opposed to 83% for 2006.

7. "Default" is a very specific technical measure here. A loan is reported as a default in a month when its balance is reported as zero and its last reported status was in foreclosure, REO, delinquent more than 150 days, or any other status and a loss of more than $1000 was recorded at payoff. In other words, "default" is the final disposition of a loan, and it includes things like short sales and short refis as well as foreclosures. It does not include active modifications or forbearances, since these loans still have a reported balance. It is a loss measure, and because it involves the final disposition of a loan, it is always much lower for new issues than for older issues, even if they are performing equally.

8. Cumulative loss is based on the original security balance, and is equal to default times severity.

Now, about that FICO average. On the one hand, the fact that the average FICO is rising can be filed under "I sure as hell hope so." When you look at the steadily rising risk factors of CLTV, documentation level, DTI, and so on, you would certainly expect that higher FICOs were being required as some kind of risk offset.

On the other hand, those average FICOs are getting awfully close to near-prime or even prime territory, depending on your definition (620-660 being the usual floor for prime). That means that a lot of these loans have FICOs clearly in prime range. In order to rule out the possibility of predatory steering, you have to trust that the subprime industry has been scrupulous about giving subprime loans to higher-FICO borrowers only when the other loan characteristics are clearly non-prime. This question cannot be solved by looking at averages or even really good stratifications; it takes loan-file-level reviews to really understand what's going on. As those loan-file-level reviews were, apparently, not done by aggregators and raters and investors, they are now being done by servicers and courts.

by Tanta on 10/02/2007 11:06:00 AM

No longer stunned and surpised, we are now overwhelmed with ennui:

The September remittance reports revealed that conditions in the mortgage market are worsening, although the rate of credit performance dislocation is mostly slowing, according to a UBS report.

Delinquency rates in the buckets - 30, 60+, FC+REO - have increased, according to UBS's data. However, while the delinquency increases for FC+REO continued unabated, the rate of delinquency increases for all 30DQ and three out of four 60+DQ indices have eased. UBS reported a "somewhat surprising" 1.83% increase in FC+REO rates among ABX07-1 deals.

Meanwhile, ABX06-1 deals saw an increase of 1.43%, which UBS analysts credited to the impact of resets and reduction in pool factors. Cumulative losses jumped to 13 basis points from 10 basis points on all indices except ABX07-02.

The September data, with their increased delinquencies and foreclosures, do not come as a surprise, as the subprime market remains unstable.

"Our whole stance on this entire debacle right now is that it's so perfectly predictable that it's boring," said Michael Bykhovsky, CEO of Applied Financial Technology. "If we feed current [Home Price Indices] and projected HPIs into the model, the resulting delinquency output is very much consistent with what we are observing."

So, um, the models really work after all? Now that is boring.

by Tanta on 9/28/2007 09:46:00 AM

Via Mr. Coppedge, I see Accrued Interest has a nice UberNerd (AccruederNerd?) on CDO structures that I missed first time around, with a follow-up here that will warm the heart of any poor downtrodden credit analyst who got stomped on by the quants. I recommend it; it makes a point I've tried but dismally failed to make clearly, which is that the big issue for a lot of these deals is timing of default, not level of default. If you're still confused about how a relatively low level of early default can hurt much more than a comparatively higher level of later default on a structured security, this post will certainly help you.

For contextual purposes, here's a set of charts from Moodys that you may ponder. (These are MBS/ABS issues, not CDOs, but they'll be the collateral in a lot of CDOs.) Notice how the slope of the 2006 vintage changes in just six months, as more of the deals in that vintage get old enough. Notice also that this chart is based on original balance (so the numbers won't match anything you see quoted based on current balances), and that the comparison is the 2000-2001 vintage. That's a meaningful comparison because, until 2005-2006 came along, the 2000-2001 vintages were about the ugliest anyone had seen in a long time.

by Tanta on 9/25/2007 02:49:00 PM

This is unpleasant news (from Bloomberg):

Sept. 25 (Bloomberg) -- Bond insurers, including those owned by AMBAC Financial Group Inc. and FGIC Corp., may need to raise capital to maintain their top credit ratings if losses worsen on subprime mortgage securities, Moody's Investors Service said.

Under what Moody's called its most stressful scenario, losses on securities backed by subprime mortgages could reach 14 percent, causing AMBAC, FGIC, Security Capital Assurance Ltd. and CIFG Assurance North America Inc. to fall short of the capital needed to keep their Aaa ratings. The most likely source of losses would be from guarantees on collateralized debt obligations, which may be backed by subprime mortgage securities. The stress test is higher than Moody's expected loss rate of 10 percent under which the guarantors experience no material losses.

And this is a curious turn of phrase:

``Because ratings are so important to the industry's value proposition, the rating agency believes that a highly rated financial-guarantor with a strong ongoing franchise would likely take whatever action is feasible to preserve its rating during times of stress,'' Moody's analysts led by Stanislas Rouyer in New York wrote in a report released today.

To which industry's "value proposition" are ratings so important? The bond insurers or the CDO managers?

by Tanta on 9/24/2007 09:22:00 AM

It used to be basically impossible to keep up with the terms of newly-issued mortgage deals, but you could at least stay up to date with downgrades. Now that the situation is completely reversed, I thought it might be interesting to look at the terms of one of the very few new issues out there.

This Bear Stearns deal (Asset Backed Securities I Trust, Series 2007-AC6) just got rated. With 7.90% credit enhancement to the AAA tranches for an Alt-A deal--that's more than you used to get in some subprime--I thought it might be interesting to look at the prospectus.

Remember the uproar earlier in the year about Bear buying delinquent loans out of securities in an attempt, it was alleged, to "manipulate" the market? This prospectus has a new bit I've never seen before that clarifies that:

[A]s described in this prospectus supplement, the sponsor has the option to repurchase mortgage loans that are 90 days or more delinquent or mortgage loans for which the initial scheduled payment becomes thirty days delinquent. The sponsor may exercise such option on its own behalf or may assign this right to a third party, including a holder of a class of certificates, that may benefit from the repurchase of such mortgage loans. These repurchases will have the same effect on the holders of the certificates as a prepayment of the mortgage loans. You should also note that the removal of any such delinquent mortgage loan from the issuing entity may affect the loss and delinquency tests that determine the distributions of principal prepayments to the certificates, which may adversely affect the market value of the certificates. A third party is not required to take your interests into account when deciding whether or not to direct the exercise of this option and may direct the exercise of this option when the sponsor would not otherwise exercise it. As a result, the performance of this transaction may differ from transactions in which this option was not granted to a third party.

You have been warned, I guess. There is also this:

The sponsor may from time to time implement programs designed to encourage refinancing. These programs may include, without limitation, modifications of existing loans, general or targeted solicitations, the offering of pre-approved applications, reduced origination fees or closing costs, or other financial incentives. Targeted solicitations may be based on a variety of factors, including the credit of the borrower or the location of the related mortgaged property. In addition, The sponsor may encourage assumptions of mortgage loans, including defaulted mortgage loans, under which creditworthy borrowers assume the outstanding indebtedness of the mortgage loans which may be removed from the mortgage pool. As a result of these programs, with respect to the mortgage pool underlying any issuing entity, the rate of principal prepayments of the mortgage loans in the mortgage pool may be higher than would otherwise be the case, and in some cases, the average credit or collateral quality of the mortgage loans remaining in the mortgage pool may decline. . . .

Modifications of mortgage loans implemented by the related servicer or the master servicer in order to maximize ultimate proceeds of such mortgage loans may have the effect of, among other things, reducing or otherwise changing the loan rate, forgiving payments of principal, interest or other amounts owed under the mortgage loan, such as taxes or insurance premiums, extending the final maturity date of the mortgage loan, capitalizing or deferring delinquent interest and other amounts owed under the mortgage loan, or any combination of these or other modifications. Any modified loan may remain in the issuing entity, and the reduction in collections resulting from a modification may result in reduced distributions of interest or principal on, may extend the final maturity of, or result in an allocation of a realized loss to, one or more classes of the certificates.

You have been even more warned. Furthermore,

The underwriter intends to make a secondary market in the offered certificates, but the underwriter has no obligation to do so. We cannot assure you that a secondary market will develop or, if it develops, that it will continue. Consequently, you may not be able to sell your certificates readily or at prices that will enable you to realize your desired yield. The market values of the certificates are likely to fluctuate, and such fluctuations may be significant and could result in significant losses to you.

The secondary markets for asset backed securities have experienced periods of illiquidity and can be expected to do so in the future. Illiquidity can have a severely adverse effect on the prices of certificates that are especially sensitive to prepayment, credit or interest rate risk, or that have been structured to meet the investment requirements of limited categories of investors.

In case you hadn't noticed, you're getting warned again.

As far as the mortgage pool? It's fixed-rate Bridge Mix: 18% full doc; WA FICO of 701 with range from less than 600 to more than 800; average balance just under $306,000 with a range from $33,000 to $2MM; 14% non-owner-occupied; 29% CA and 10% FL; 35% interest only. The sort of thing that would have skated by a year ago, in other words. The big difference here: only 28% of loans are purchase-money, and only 19% have subordinate financing.

The loans are also rather older than new production issues have been in the last few years--averaging 7-10 months--which suggests that it took a while to put this deal together. I'd say this is less an indicator of what kind of loans are being made today than it is what kind of loans have been parked in Bear Stearns' inventory since the first quarter, waiting for the RMBS market to revive. And with subordination levels of nearly 8.00% on fixed rate "Alt-A," it's quite clear that rates to consumers for "non-conforming" loans have nowhere to go but up.