by Anonymous on 5/01/2007 12:21:00 PM

The latest weather report is out on Pending Home Sales. Via CNN:

NEW YORK (CNNMoney.com) -- Problems in subprime mortgages caused a sharp drop in home sellers being able to find buyers for their homes in March, according to a trade group report Tuesday that showed the battered real estate market was much weaker than expected.

The National Association of Realtors' Pending Home Sales Index fell 4.9 percent in March, following a 1.1 percent increase in February. The index was down 10.5 percent from the March 2006 reading. . .

"Although the weather improved in March, we're starting to see the effects of a decline in subprime lending and tighter lending standards," said a statement from David Lereah, the chief economist for the trade group. "Home sales will be relatively sluggish in the second quarter, but a modest uptrend should resume during the second half of this year."

by Anonymous on 5/01/2007 08:00:00 AM

I really don't think apologists for the sorry state of business reporting should start in on me today. Nobody, I'm sure, forced Lynnley Browning of the New York Times to write a story on mortgage gain on sale accounting.

Let's remember the ground rules of media criticism. The success or failure of a given piece of writing depends on what it is intended to do and for whom. If it is intended, oh, say, to explain a fairly advanced accounting issue to non-accountants, who might care about that, say, because they are or might become investors in REITs, then the article is successful only if, by the end, the non-accountant understands the accounting issue and can apply this knowledge reliably to his or her own investments. If the purpose of the article is to accuse someone of violating accounting rules, just for purposes of entertaining people who like to read about corporate nefarious conduct, then, given the seriousness of the charge here, the article is not successful unless it is quite accurate and clearly makes the case for a willful violation of accounting rules rather than, say, a bad forecast of the market and lax due diligence on its own loans. Right?

The article, "Accounting Said To Hide Lender Losses," purports to discuss the misuse of gain-on-sale accounting. We begin:

The technique promoted by Mr. Gotschall, who stepped down as chief financial officer in 2006 but continued as vice chairman of the board of directors, allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors.

The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through door, were then used to make more loans to risky home buyers.

Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors.

Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.

You tell me: doesn't it sound here as if the claim is that "gain on sale" was reported in a case where no sale settled in cash happened? Does it not sound as if this has something to do with securitizing mortgages? If you were a non-expert, what would you think here?

The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.

Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.

“The thing about gain on sale accounting is that you can create a machine that just manufactures earnings out of thin air,” said Richard Benson, an expert on securitization and president of the Specialty Finance Group, a financial broker.

Still with us? This gain on sale thing sounds pretty shady, doesn't it? It was an Enron thing? That's bad.

New Century, of Irvine, Calif., made money in two ways, and it used gain on sale for both.

In the first way, called “whole loan sales,” it sold pools of loans to big Wall Street investment banks. New Century made money by keeping the difference between the higher interest rates paid by subprime borrowers and the lower rates offered to the banks.

In the second way, New Century chopped up its other loans to home buyers, repackaged them into securities for sale to investors, a process called securitization. New Century then kept the pieces expected to earn money in the future, called residuals, for itself.

I suppose that if you know nothing about the business, you might think that a "whole loan" is always part of a pool, and that a securitized loan must be something other than "whole," so that must mean that the loan gets "chopped up" and therefore these securities are full of loan fragments. Someone who knows might have explained to this reporter that the term "whole loan" means the loan has not been securitized; the owner of that note owns all of it. As opposed to a securitized loan, wherein an investor owns a pro-rata share of a pool of loans, not individual whole loans. But I couldn't guarantee that this explanation would stick, in the present context, since this reporter seems dead-set on being confused about how loans get sold.

For both types of business, gain on sale allowed New Century to accelerate its profits. In 2005, the last year for which it has reported annual figures, New Century recorded income from gain on sale accounting of nearly $623 million out of a gross profit that year of $1.4 billion, according to its securities filings.

For the whole loan sales, New Century recorded up front the cash gains.

At the same time, New Century guaranteed to Wall Street investors that if the whole loans did not make as much money as it predicted — if home buyers were late with or defaulted on payments — New Century would buy back the impaired loans from the banks.

But through overly rosy forecasts, New Century underestimated how many impaired loans it would have to repurchase and how much it would need to have on hand to do that.

"If the whole loans did not make as much money as predicted"? Someone is so desperate to tie gain on sale to inflated earnings that she is wandering way far off the reservation when it comes to repurchase warranties. In any case, we have conceded here that New Century did actually record a gain "when cash came in the door." Could you forgive a reader who isn't already expert in accounting issues for being mildly confused here? Were we to introduce the concept of reserves for future liabilities (those potential repurchase warranties that all sellers of whole loans have), this might possibly clear up a little: there are cash proceeds from a sale, and there are reserves for future liabilities, and one tends to reduce the other on the books. It's the general accounting idea that no sale of an asset is "final" until there is no longer any residual liability; if there is such residual liability, that must be reflected in the gain/loss calculation.

In its second use of gain on sale, New Century booked future earnings based on its estimates of what it expected to earn from the pieces left over from the securitizations.

New Century’s problem, according to Zach Gast, an analyst with the Center for Financial Research and Analysis, was how it used gain on sale for its whole loan business. In the late 1990s, in the last downturn for subprime lenders, most abuses of gain on sale involved the securitization side.

I give up. Did New Century book gain on sale for a residual tranche of a security, or not? (Really, I'd like to know.) Are we talking whole loans here, or not? Is someone confused about the difference between mark to market and gain on sale, or not?

As the subprime market started to melt down last fall, New Century was forced to honor its guarantees to investment banks and other institutional investors and repurchase the impaired loans. It resold the loans at a loss.

But, Mr. Gast said, when New Century repurchased the loans, it recorded them at values that exceeded the fire-sale prices. In other words, New Century did not recognize upfront the losses in the impaired loans.

Mr. Gast said that New Century has “a huge number of repurchased loans that they haven’t taken losses on.” Under gain on sale accounting rules, “you should be recognizing the loss at the initial sale of the loan,” Mr. Gast said, adding that if you underestimate potential losses, you have to recognize those losses when you are forced to repurchase the loans — something New Century did not do.

At the initial sale of a loan, I should recognize the loss I would take 1) if I had to buy it back at par and 2) if I then had to resell it for less than par? I certainly always reserved for losses. If my losses were more than I reserved for, I certainly recognized that additional loss. On no planet did I ever take that additional loss on the original sale at the time of the original sale, since if I'd seen it coming, I'd have reserved for it. I guess I should be in jail with those Enron guys.

Ah, but in the last two paragraphs of the article, we get this breath of fresh clue:

Stephen Ryan, an accounting professor at New York University and an expert on securitization accounting, said that last year New Century had “underestimated the allowance for repurchase losses, which means that they overstated the gain on sale.”

“They had had a history of doing so well previously, so it’s a question of whether they didn’t expect this or of something more nefarious on the part of senior management,” Professor Ryan said.

I coulda got an A in Professor Ryan's class. What I don't understand is why I waded through this long ridiculous article to get to the point where we finally realized that we are talking about insufficient allowance for loan loss reserves. Toss out all these sinister references to Enron and chopped-up loans and subprime lending and gain on sale involving future income and it comes down to New Century having had way too much confidence in their loans and in future price fluctuations in the secondary market to have reserved sufficiently. Well, that certainly did cause them some problems. It is possible--indeed, it is likely, in my view--that New Century probably knew it should have upped its reserves but did not do so. That is bad, bad, business. I have yet to figure out why we are insisting that it's really an accounting problem.

But what did we learn about gain on sale accounting anywhere in this article except for the fortunate last-paragraph intervention of the good Dr. Ryan? Maybe we'll get lucky and Dr. Ryan will start writing for the Times. Until then, I guess the blogs will be the place where we try to remember that bad economic and business forecasts and a failure to control your loan pipeline to minimize your repurchase liability are not the same thing as cooking the books, and it matters that we understand this distinction.

by Calculated Risk on 4/30/2007 04:51:00 PM

From CNNMoney: Bullish real estate economist to step down

Mentioned in the article: David Lereah Watch

by Calculated Risk on 4/30/2007 04:01:00 PM

From Bloomberg: U.S. Office Vacancy Rates for the First Quarter

The U.S. office vacancy rate rose in the first quarter, according to CB Richard Ellis. ... The rate was 12.8 percent in the first quarter, up from 12.6 percent the previous quarter. The rate was 13.6 percent a year ago.

Is this the beginning of the end for CRE? Let's connect a few dots:

1) Non-residential structure investment has been booming for the last few years. Commercial rents have been rising and office vacancy rates have been falling.

2) However, in the typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for four straight quarters (following two minor declines). So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

3) The WSJ noted earlier this month that demand was "sluggish" for office space. The current office space absorption rate is about 8 to 10 million square feet per quarter, but "... developers will open 76 million square feet of new office space by the end of this year." Since supply will grow significantly faster than the absorption rate, vacancy rates will rise.

4) Many banks are over-exposed to CRE lending. With rising vacancy rates, defaults will probably start to rise for CRE loans.

And remember, non-residential investment is the great hope of the soft landing view. That is why many economists are watching non-residential investment closely. From Professor Hamilton: Consumption smoothing and economic slowdowns

... the key thing to watch is nonresidential investment. I was very worried when this had made a negative contribution to 2006:Q4 GDP growth, and relieved that its contribution to 2007:Q1 is back into positive territory.

And from Paul Krugman at the NY Times: Another Economic Disconnect. (Note: Excerpts are available at Economist's View).

... with housing still in free fall and consumers ever more stretched, optimistic projections for the economy depend on vigorous growth in business investment. And that doesn’t seem to be happening.

And if office vacancy rates continue to rise, combined with a significant increase in supply coming this year and next, a further reduction in business investment (especially for structures) is probable.

by Anonymous on 4/30/2007 10:10:00 AM

For reasons I do not fully understand--I am just a mortgage punk, you know--AHM has lowered guidance for the second time in about a month, while it reports that the problems are stabilizing.

While I am disappointed by our company’s results, our company will always be susceptible to significant disruptions in the secondary mortgage market. It does appear that the secondary market is stabilizing. During April, more loan buyers have been bidding to buy our loan pools. Additionally, spreads on some junior mortgage securities have retraced a portion of the sharp widening that occurred in March, junior mortgage securities are trading in a more orderly fashion, and the ABX index is off its lows. We will have to see how market conditions develop as the year progresses. For now, however, our company’s working assumption, which is incorporated into our earnings guidance, is that our gain on sale margins, excluding delinquency related charges, will continue near the low levels we experienced during the first quarter.

While our company remains susceptible to disruptions in the secondary mortgage market, we can and have taken actions to reduce our delinquency related charges. It is important to note that most of our company’s delinquency related expenses are not due to delinquency in our portfolio, but instead result from early payment defaults on loans sold that we were required to repurchase, or on loans we hold pending sale. Indeed, 87% of the first quarter’s delinquency related charges stem from our loans held for sale, not our portfolio. Moreover, the vast majority of our delinquent loans held for sale are due to our previously offering a particular type of product, namely stated income loans where a high portion of a home’s value is borrowed. These types of loans have accounted for approximately 15% of our loan production, but resulted in 73% of our delinquent loans held for sale at March 31, 2007.

Our company discontinued offering the high loan-to-value, stated income loans that resulted in the great majority of our delinquency related charges, generally in late February. As a result, our company is now in a “tail” period that will include repurchasing loans that were recently sold and are still inside the period in which our sale is subject to repurchase, which is usually three months. As the tail period winds down, our company’s delinquency related charges should begin to diminish.

During the first quarter, our company’s delinquency related charges were increased both due to reserving for new delinquencies and due to reserving because we increased the loss severity assumption for all delinquent loans held for sale. Increased severity assumptions are due to ongoing weakness in home prices and long home marketing periods. This change in assumptions is the reason first quarter delinquency related charges were disproportionately greater than increases to delinquent loans held for sale. During the first quarter, our company increased the loss severity assumption associated with our contingent reserve for repurchases.

One bright note for the first quarter and for April of 2007 is that our loan application volume remains reasonably strong despite our no longer offering those products that resulted in higher delinquency. Our application volume appears to be benefiting from reduced competition and strong demand for refinancing. Based on current application run rates, our 2007 loan production volume guidance of $68 billion to $74 billion remains unchanged.

So the bright note is that AHM is picking up the apps that used to go to the real nuts, who are now out of the market, plus all those folks who really, really need a refi about now? 'Kay.

by Anonymous on 4/30/2007 07:02:00 AM

In case you missed this item in the comments over the weekend, here's Bloomberg on "Credit Suisse Sued Over Losses on Subprime-Loan Bonds (Update 3)":

April 27 (Bloomberg) -- Credit Suisse Group was sued by a Florida insurer that says it lost money on investment-grade bonds backed by subprime mortgages sold by the bank.

The suit, filed in Florida by Bankers Life Insurance Co., is ``one of three to five in the pipeline'' involving securitizations by Credit Suisse, Switzerland's second-largest bank, said Dale Ledbetter of Ledbetter & Associates P.A., one of two law firms representing the Bankers Financial Corp. unit.

``We suspect that once people understand what occurred here, there's going to be a lot more,'' Ledbetter said. A total of $302.6 million of bonds were originally issued in the deal.

Bankers Life, based in St. Petersburg, is seeking to recover about $1.3 million to make up for losses of principal, interest and market value on about $1.4 million of the 2001 bonds it bought in 2004, Ledbetter said. Other investors considering suits will probably seek between $500,000 and $3 million each, he said.

Credit Suisse units caused Bankers Life to lose money by overstating how much of losses after foreclosures on the loans insurance would cover; accepting ``shoddy, inferior'' loans; failing to buy back fraudulent ones; and covering up delinquencies, according to a complaint filed April 23 in Tampa. Payments were being advanced on borrowers' behalf to ``maintain the illusion'' defaults weren't occurring, Bankers Life claims. [Emphasis added]

There are days I actually wish I were an attorney with access to the right sort of legal filing; I'd love to read the complaint. And compare it to the servicing agreement attached to the prospectus of the bonds this outfit invested in.

However, I'm just a blogger, not a lawyer, so I will content myself with asking, so who is Bankers Financial Corp? Well, besides someone in need of a new web designer, it is a holding company with a group of businesses that includes:

Bonded Builders Risk Management provides warranties on new and remodeled homes through home builders and remodelers nationwide.

Bankers Surety Services markets and administers Bankers' bail bond product, providing coverage on bonds for the bail agents who write them.

van Wagenen Financial Services is a leader in property insurance and insurance compliance for nearly 75 years. They service millions of loan and lease accounts for clients in the US and Canada.

Gilchrist Executive Retreat & Conference Center is a private retreat located on the 23,000-acre Suwannee Lake Plantation in Florida. They are associated with Gilchrist Club, a private hunting club.

VAC Service Corp writes extended service contracts for manufacturers and retail dealers of electronics, furniture and other equipment.

There's a moral to a story lurking here somewhere, I think. Discuss. (And since you all were such cooperative little cats yesterday about staying on-topic, you are hereby given permission to discuss whatever you want to this morning. Don't say I'm unreasonable.)

by Anonymous on 4/29/2007 08:04:00 AM

How credible is the idea that up to 50% of recent subprime originations were loans that could have qualified for Fannie Mae, Freddie Mac, or FHA prime or near-prime programs? I don't have the exact data that Lewis Ranieri is referencing here, but here is some data I do have:

1. We looked at this chart a couple of weeks ago. It doesn't, of course, give all of the loan-level characteristics you would need in order to say for certain that some of these loans are "over-qualified" for a subprime program, but it is certainly not inconsistent with that idea. Note that it is referring to original CLTV and FICO, not current.

2. We also looked at this chart from Fitch on subprime loans that experienced first-year defaults, versus the ones that survived the first year. If you assume that most of the specuvestors, flippers, and outright frauds are in the former category, let's focus on the second half of the chart.

One thing it implies to me is that average FICOs are improving, over time, in these subprime pools. Certainly, if you posited that there are actually individual loans that resemble the average loan, you would have to wonder why a conforming-dollar 625 FICO 80/85 LTV/CLTV full doc that isn't in CA couldn't qualify for a GSE or FHA loan. You do have to ask why those average FICOs in subprime pools are improving over the vintages. Of course it is not clear from looking at averages like this whether the best loans in these pools are getting near-prime interest rates or not, but you still have an average coupon here that is significantly higher than an average prime coupon.

Fitch concluded that FICO isn't as important an indicator as it used to be. That may well be the case, but the question may also be that it is no longer a useful indicator of which loan a borrower gets. That, in turn, could be because there are other loan features that "overrule" FICO--the "risk-layering" argument--or because more and more "near-prime" borrowers are being steered down to subprime instead of up to prime or near-prime (here I include in "near-prime" both FHA and the GSE's "A Minus" programs). The data we're looking at here cannot decide these questions, but it is not inconsistent, as far as I can see, with the hypothesis that "steering down" is going on.

3. This is an excerpt from Fannie Mae CEO Daniel Mudd's testimony before congress:

Right now, we're getting at least 15,000 applications for subprime refinancing coming into our system per month. Because we have been adhering to our own prudent standards throughout, even before our new enhancements, 80 percent got a "yes." Altogether, we estimate that about 1.5 million homeowners who face resetting ARMs and potential payment shock this year and next could be eligible for our loan options. Certainly, lenders may choose someone else to buy or securitize the loans, but 1.5 million would be eligible for our options; we think this will also help establish a benchmark in the market for safe loans. These are also good alternatives for first-time homebuyers as the riskier "affordability" loans dry up.

Now, you can say any number of things about this, including wondering out loud how choosy Fannie is being lately; that's fair enough. I will simply observe that no loan ever gets a "yes" if it's a jumbo, remember, so we are not talking about the highest-balance loans in the bubble markets. Nor are we necessarily talking about "prime," here. Fannie Mae has a near-prime/better-than-average subprime program called "Expanded Approval" which will accept some of these loans with a healthy, but not outrageous, increase in the interest rate. My own experience with Expanded Approval tells me that the hypothetical conforming-dollar 625 FICO 80/85 LTV/CLTV full doc that isn't in CA is a loan it would love. But this isn't just a risk-shift out of a subprime pool into a Fannie Mae pool, since Fannie will not accept toxic loan terms in the Expanded Approval program. These loans are overwhelmingly fixed-rate, with some longer-initial-period hybrid ARMs (5/1 or 7/1) that amortize and don't have deep teasers.

It remains to be established, as far as I'm concerned, that there is a substantial number of loans which are in trouble only because they received toxic terms or predatory interest rates up front, and that would become reperforming if they were modified or refinanced down to a more reasonable rate and more stable terms. However, I can't say that I've seen any hard evidence lately that is inconsistent with this idea.

I think many of us in the comments to the Ranieri post were conflating subprime with Alt-A, so let's bear in mind the supposed difference between the two: Alt-A is billed as the place where the good credit but weird loan terms go. If we are finding good credit but weird loan terms in subprime, at minimum we should be asking why those loans didn't go Alt-A. I would further ask if there are good credit and perfectly normal loan terms in the Alt-A pools that should have gone prime, as well. Anyone with data, links, or other useful contributions to the question, please use the comments!

by Calculated Risk on 4/28/2007 07:27:00 PM

From the OC Register: Slow housing market predicted through 2008 (hat tip Brad)

Expect the housing slump to continue at least through 2008, building industry officials said Friday at an annual conference hosted by the Orange County chapter of the Building Industry Association.

Speakers focused on how the housing market has changed in the past year, citing declining sales, a drop in construction and a halt to land acquisitions.

The year 2008 "won't be so great," said Les Thomas, president of Shea Homes Southern California. "We hope things will be fine in '09."

If by "fine" Mr Thomas means a return to 2004 to 2006 sales volumes, then I think his hope is misplaced.

by Anonymous on 4/28/2007 03:00:00 PM

I thought we'd try something a little different this week, although I was tempted by the Gloria Gaynor idea (thanks, Alo!).

Consider it the cave-dwelling perma-bear uber-chart middle-manager signature econo-rock video. Whatever.

by Anonymous on 4/28/2007 08:45:00 AM

Our friend Brian sent me a Bloomberg transcript (no link yet) of comments made by Lewis Ranieri at the recent Milkin Institute Conference on financial innovation, subprime lending, and the housing market. Lewis Ranieri, if you don’t know, is generally given a large part of the credit for creating the private MBS market, and would have to be considered, by anyone’s standards, a highly-informed participant in the mortgage credit markets.

Ranieri isn’t a happy camper, it seems, about structural problems in the industry.

Note: This is a rush transcript, not a final one, of oral remarks. I have edited slightly only to remove a few repetitions and asides characteristic of spoken presentations and to correct a few phonetic transcriptions. All my editorial changes are indicated by ellipses and brackets.

People asked, you know, is financial innovation, you know, reaching a stabilization point in housing and I think the last four years shows that's not true. It's been a halcyon period in terms of taking financial innovation and using it to put housing much more deeply into the population. I mean, we've been able to franchise many, many more lower middle income and minority home--individuals into home ownership, over the last four years, than probably, in the 10 or 15 years prior to that.

Unfortunately, we're now facing a trial, which in many ways, I think, will determine how well we can continue to innovate into the future and part of it is [subprime] . . . And we also have the typical regulatory reaction to a potential series of risks, in terms of passing somewhat more restrictive legislation. And some might argue [this] is exactly the point in the cycle where we don't, particularly, need it but I think the real key of navigating through this is being able to deal with what is euphemistically called the subprime mess.

The subprime mess is simply - and first, I think the important thing to understand, is this a creature of a very narrow window. It starts at the end of the third quarter of '05 and carries through, principally, the fourth quarter of '05 and '06. And what it is, is that in those five or six quarters, a series of attributes which were largely in existence already, took on a life . . . of their own and in combination, created risk layering, which on one hand, enabled many, many people to get into housing who might not otherwise have.

And on the other hand, unfortunately, put many, many people into houses they couldn't afford and not simply lower middle income people but combination, the layering, was also attributable to many middle income borrowers. In fact, at - we had a two-day conference in Washington yesterday, which was called the Housing Round Table. It's all the participants in housing and we get together three times a year and at that there was an argument from a number of the economists in the room.

As I said earlier, we're in a housing recession but more importantly, they argued that looking at the production, the subprime production, in those five or six quarters that as much as 50 percent of that production could have gone to the agencies, meaning, Fannie, Freddie and FHA. That's a pretty profound statement because a subprime loan is, at best, [an] eight plus coupon.

And usually, there's a second mortgage with a 12 coupon, so you're talking about an average coupon, a little bit over nine and you know, an agency piece of paper would've been a 6.5, so if you translate that into what he said, in another way, he was arguing that half these loans, the homeowner could have been put into a coupon at 6.5 versus 9.5 and that led to the question, the 800-pound gorilla in the room we dealt with, is the system broke?

Is there a problem, you know that it's not simply a function of normal economics but is there a break in the system, you know, what is the responsibility of the system to deliver . . . the appropriate, you know, housing finance structure? The real dilemma for me and I think the real issue . . . will be, we've never had to do substantial restructurings in housing in mortgage securities.

They were always in portfolios, and that made it very easy or at least, we didn't have to get 409 people or we didn't have to rent the Nassau Coliseum to have a bondholders meeting; we could do it very quickly. The vast majority of these loans, all of these theoretically, problem loans, are in securities, which have been tranched and then tranched and then re-tranched . . . [in] mortgage securities and then some tranch is put in CDOs. In a very long meeting, last Monday, where we tried to collect virtually everybody in a room, it became evident that there are a whole host of unforeseen technical problems if you try to restructure or do large amounts of restructuring within the security, some of which, we had never even heard of or thought about.

One of the accountants - you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can't do that. If you restructure that many loans, you're going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you - when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you've just tainted 140 and Q election.

Boy that was a big deal and I'll use that as a simple example of one other I'll give you, is the ability to put everybody in a room, even if you could find them all and get their assent, is slim - I mean it's not very practical.

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don't know how long it would take us. I mean, you know you've just basically told us we now have a problem that we don't quite exactly know how we're going to fix - and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we've done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we're talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we're talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don't have that freedom because you've got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I've been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I'm doing that now, too and we were told, well you're doing it wrong. You've got to send out a 1099.

That's an incredibly dopey idea. We're restructuring a loan around a borrower; he can't afford the loan and now we're going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

So let’s consider Ranieri’s question: is the system “broke”?

There is a credible estimate that as much as half of recent subprime production could have qualified for a GSE-style loan at a much lower interest rate. That means, among other things, that the “risk premium” these borrowers are paying is likely causing their defaults; if they weren’t subprime the day they got the loan, they are now. The theorists of "perfect" pricing of credit risk have some explaining to do. It is not unlikely that they will have the opportunity to explain that in court, as I for one can think of few more likely class actions than a group of borrowers who qualified for a prime or near-prime loan and got steered to some subprime exploding ARM.

Someone who is considered “the father of MBS” did not anticipate the difficulties of modifying securitized loans, given the constraints of the true-sale requirement (which means that the sponsor/servicer cannot “control” the collateral, and you’d have to get 400 bond holders in the Coliseum to vote on a loan modification). This is to say that a mortgage financing mechanism intended to mitigate risk is less able to respond quickly enough and efficiently enough to stave off losses than an unsecuritized portfolio or a simple agency pass-through.

Bondholders who may well understand that it is in their best interest to allow modifications of loans will discover what it will cost in legal and accounting fees to do that, costs that are there only because these loans are securitized; a similar restructure of a portfolio would not have those costs. Risk “dispersion” means never being able to get all your risk holders into the same room to hammer out a plan.

Some senior bondholder is going to sue some issuer for SFAS 140 violations (modifications, with or without a 1099) that were intended to cut the losses for the subordinate holders, but which would have the effect of maintaining some credit support for the senior notes, too. Besides the simple extraction of legal fees here, you have a situation in which losses will simply continue to mount while each tranche and the sponsor argue in court about whose interest is or is not being served. Meanwhile, borrowers get further behind.

There is always, of course, the option of foreclosing rather than working out, but bondholders are likely to get paid less for that, even if they don’t happen to care about the homeowner or the macro effects of that much foreclosed property. Securitization of loans did not, actually, eliminate the risks inherent in property markets; it seems to be capable, in fact, of magnifying those risks.

I’d go for “broke.”