by Anonymous on 5/08/2007 11:40:00 AM

CR used to like to quote this one every now and again, back in the days when this blog was just a little back-water hand-wringer in a sea of housing and mortgage bulls:

"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."

John Maynard Keynes, "Consequences to the Banks of a Collapse in Money Values", 1931

It's amazing how ever-fresh this particular avoidance of blame is. There's the CEO of Countrywide:

"I've been doing this for 54 years," Mozilo recently said during a speech in Beverly Hills, California. For many years, he said, "standards never changed: verification of employment, verification of deposit, credit report."

But then new players came in with aggressive lending policies. Names like Ameriquest, New Century, NovaStar Financial and Ownit Mortgage Solutions set a new, lowered standard, changing the rules of the game, Mozilo said.

"Traditional lenders such as ourselves looked around and said, 'Well, maybe there's a (new) paradigm here. Maybe we've just been wrong. Maybe you can originate these loans safely without verifications, without documentation,"' Mozilo said.

There's Tom Marano of Bear Stearns:

But Tom Marano, who heads the mortgage business at Bear Stearns, disputed the contention that Wall Street pressure led to the loosening of credit standards. Investment banks, he said, do not directly make many loans.

“If enough independent companies set standards, that becomes the market,” he said. “Wall Street’s role is largely one where we assess risk, we purchase loans.”

And there is our famous Bill Dallas of Ownit Mortgage:

Bill Dallas, chief executive of Ownit, the nation's 20th-largest subprime lender in 2006, said he saw the handwriting on the wall in April 2005 after he overheard a rival account executive tell a customer how to get a better rate by committing occupancy or income fraud.

"I just went, 'We are hosed as an industry,"' Dallas said. "I told our guys, 'We're the problem."

The structure of the industry was part of the problem, he said: "Our account reps are talking to the mortgage broker, the mortgage broker is talking to the borrower, and they're teaching them all the wrong things."

Sound bankers, to a man.

by Anonymous on 5/08/2007 10:11:00 AM

Sorry I'm up so late this morning. Those of you who were hanging out here yesterday may already be tired of this new genre of news story, but I'm not. I read everything by Vikas Bajaj on principle, and today I was once again not disappointed. "A Cross Country Blame Game" is chock-full of good stuff. It gives us the touching story of Bill Dallas, owner of the now-defunct Ownit Mortgage:

That desire to expand homeownership fed Mr. Dallas’s own entrepreneurial fire.

“I am passionate about the normal person owning a home,” said Mr. Dallas, who is also chairman of the Fox Sports Grill restaurant chain and manages the business interests of the Olsen twins. “I think owning a home solves all their problems.”

As he discusses homeownership, Mr. Dallas becomes animated and his voice rises. He fetches copies of a booklet, “Strategic Financing: A Survival Guide for Loan Originators,” he helped write for loan officers and brokers, and points to charts and tables to help explain his thinking. His speaking style seems part revival preacher and part courtroom lawyer.

Mr. Dallas created Ownit from a small mortgage company he and his partners bought in 2003 for $30 million. Two years earlier, he had left First Franklin, a lender he co-founded in 1981 and which was then owned by National City. (Merrill Lynch bought First Franklin last year for $1.3 billion.)

Ownit was different from other subprime lenders. About 70 percent of the company’s loans were made for the purchase of homes, while about 60 percent of all subprime loans were used to refinance existing debts.

Mr. Dallas, a native of Ohio who moved to California as a young adult, said he created Ownit to serve borrowers who earned less than $100,000 and had less than $100,000 in assets, a group he calls the “mass nonaffluents.”

I think we've just figured something out about that "subprime serves the poor" argument.

by Calculated Risk on 5/07/2007 03:09:00 PM

From the BEA:

Investment in residential structures consists of new construction of permanent-site single-family and multi-family units, improvements (additions, alterations, and major structural replacements) to housing units, expenditures on manufactured homes, brokers'commissions on the sale of residential property, and net purchases of used structures from government agencies. Residential structures also include some types of equipment that are built into residential structures, such as heating and air-conditioning equipment.

The breakdown by each category is available in the BEA underlying detail tables. The only significant categories are: permanent site (single and multi-family structures), improvements and broker's commissions.

Click on graph for larger image.

This graph shows that investment in single family structures is the most important category of residential investment. This amount is based on the Census Bureau data: Construction Spending and is included when the value is put in place.

A few things to note: Broker's commissions and improvements tend to track investment in single family structures, and investment in multi-family structures are not correlated with single family structures. In the current downturn, investment in improvements has only just started to decline as a percent of GDP, and will probably decline much further as MEW declines. Investment in multi-family structures will probably stay fairly low since the vacancy rate for rental units is still near the all time highs (this is definitely a local issue - some areas will have a low vacancy rate and see more multi-family construction).

by Anonymous on 5/07/2007 10:27:00 AM

Holy Em Dash, Batman, I'm saying nice things about the press two posts in a row. Did anyone buy lottery tickets today?

From the Washington Post's David Cho, "Pressure at Mortgage Firm Led To Mass Approval of Bad Loans":

Traders familiar with the bidding process said competition for mortgages from New Century began to heat up in 2005. Mortgage-backed securities based on New Century loans had been performing better for investors than those from other subprime lenders, in some cases producing two or three times the return of a U.S. Treasury bond. Many banks felt they had to loosen their standards and agree to return fewer bad loans in order to win the auctions, the traders said.

The head of a large Wall Street bank's mortgage group contended that his firm regularly lost out on New Century's business because its due diligence process was stringent and it had been returning a high number of loans. New Century wanted the bank to ease its standards, and the issue became a source of friction between the companies.

"The entire industry, over time, became more lax," he said, speaking on condition of anonymity because he was not authorized to talk about his company's inner workings. "The more [loans] you accepted, the better relationship and the better price you would have. The name of the game was definitely volume."

A New Century spokeswoman said negotiating with banks to reduce both their due diligence and the number of loans they returned was a "generally accepted practice" that was "always a matter of discussion." . . .

Although there were variations in their descriptions of the atmosphere in their offices, most said they were pushed to approve questionable loans. Several of the interviewed employees said they faced "unofficial quotas" of loans that had to be approved each day. The pressure to meet these expectations was so unrelenting that a worker in Foxboro, Mass., collapsed from stress and was taken to the hospital, two employees said. In the firm's Long Island branch, the atmosphere resembled a fraternity, largely because the average age was 23, an appraiser there said.

That's more interesting than a fake Enron story.

by Anonymous on 5/07/2007 07:32:00 AM

As it is not possible these days to pick up a paper--any paper, it seems--without reading yet another sorry anecdote about some sorry subprime borrower who never should have gotten a mortgage in the first place, I must say I'm refreshed by Lynda V. Mapes' approach in The Seattle Times ("Borrower Beware"). Here, we get the other side of the anecdote, the sorry story of some sorry broker who put this sorry deal together.

Mills specializes in clients like Fultz and Swartz. At it for 17 years, she caters to people with bad credit, low incomes and no savings.

"Hey, babe, it's Kathy, " Mills said on a recent workday, dialing up one of the dozens of lenders she says she works with regularly to hook her clients up with a loan. Mills is adamant that she explained the terms of the deal to Fultz and Swartz, just as with her other clients.

"We do this with all varieties of people, all nationalities, every brain level," Mills said. If anything, she remembered the lengths she went to, talking the couple through the deal. "They were very high maintenance," said Mills, swiveling in her leopard-print office chair.

She sees herself as serving a real need for borrowers struggling month to month with their bills, who want a home of their own, just like everyone else.

"I feel sorry for anyone who can't get into a house," Mills said. "We beg the banks to give us their turn downs. I help people; that's the bottom line."

And as for those borrowers?

Reviewing documents Fultz and Swartz provided, Huelsman concluded the couple's credit scores should have qualified them for a better loan, with a lower interest rate, especially on their second mortgage. She also found it odd that several different applications for the loan reported varying income levels, even on documents faxed the same day.

Asked about that, Mills said, "We only write down what the borrower tells us." For his part, Fultz said he never reviewed his final loan documents or looked to see what Mills wrote down.

Huelsman said she found some of the documents incomplete and confusing.

Based on what she knew so far, Huelsman said, "I don't think there is any way in the world they could have understood what they were getting into."

Asked about the forms Huelsman questioned, Mills said, "I agree, it isn't explaining it in full." But Mills said she makes up for that as she talks to borrowers: "It's explained to the client 47,000 freaking times."

Broker sounds a little on edge, doesn't she?

The pullback has cratered the business model for brokers like Mills. She used to write 10 to 15 loans a month. In March, she wrote two. In February? None.

"I didn't make my own mortgage payment this month," Mills said in April. "But nobody feels sorry for me."

Nor does she feel sorry for Fultz and Swartz, Mills said.

"We didn't do anything wrong," Mills said of her firm. "She quit her job and now they can't make their payments. Well, I didn't make mine this month, either. How do you help someone like that? I wish I could help myself."

Perhaps the next time we are dragged into some pointless "debate" about subprime that degenerates into "We're helping the poor!" "Are not!" Are too!", we could remember this one. If we have to make social and economic policy based on sorry stories and anecdotes, let's get all the sorry stories and anecdotes out on the table.

by Calculated Risk on 5/06/2007 08:00:00 PM

Crux: an essential point resolving an outcome.(m-w online 2)
The predominant view on Wall Street is that the current economic sluggishness is a mid-cycle slowdown, and that slow growth would bottom in Q1 2007, and then improve over the remainder of the year.

Click on graph for larger image.

This graph shows the YoY change in GDP and employment since the early '60s. Most forecasters believe the current period is similar to the mid-cycle slowdowns in the '80s and '90s.

Other less common views include: a weaker economy going forward, with a possible recession; and the view that a hard landing is almost unavoidable. My view is that the economy will be weaker, with the probability of a recession in 2007 about a coin-flip.

Although the last two views still have time, the next couple of quarters are critical for the consensus view. Further weakness in Q2, and the consensus view on the economy will have been too optimistic. For these forecasters, the economy is at the crux.

by Calculated Risk on 5/06/2007 12:27:00 PM

David Streitfeld writes in the LA Times: Better-heeled failing home economics too

... in recent months [Sheriff's Deputy Mike Strickland] has begun venturing into neighborhoods with spacious homes and groomed yards, bringing his legal warnings to those who have fallen hopelessly behind on their mortgages.

These people typically bought a home they couldn't afford or drained their equity through incessant refinancing. If they had a chance to sell, they passed it up.

Eventually, the lender foreclosed on the property. When it was over, the home was auctioned off.

Now there's a new owner. But they still won't leave.

In some cases it's denial; in others, unwarranted hope.
...
That's when Strickland shows up.

"You see me coming. You know I'm not exactly bringing tidings of joy," the deputy says. "I'm the grim reaper."

The problem is worse in the lower income areas with subprime loans. Ronald Campbell writes in the OC Register: Who's at risk from subprime implosion?

The Orange County Register analyzed all 920,000 home purchase mortgages made in California in 2005, the last year for which complete data is available. The analysis showed a strong geographic pattern to subprime loans:

Buyers in fast-growing areas such as the Inland Empire and in lower-middle-class neighborhoods like Santa Ana were far more likely to sign subprime mortgages than buyers elsewhere.

Subprime areas are getting hit the hardest, but I doubt the evicted homeowner, described in Streitfeld's piece as living in "a gated community in Chino Hills", was a subprime buyer. This is more than a subprime problem.

by Anonymous on 5/05/2007 02:55:00 PM

Because some days you just need something to take the taste away . . .

by Anonymous on 5/05/2007 11:16:00 AM

Prior Installments:

MBS For UberNerds I: GSE Pass-Throughs
MBS For UberNerds II: REMICs, Dogs, Tails, and Class Warfare

Last episode, we looked at the classic multi-class mortgage-backed security, the REMIC, from the perspective of its distinctive cash-flow issues. REMICs can and do take an existing GSE-guaranteed single-class pass-through MBS, or several of them, and “tranche them up” into multiple classes with differing payment, prepayment, maturity, and yield to investor characteristics. That’s relatively easy to do, because the underlying collateral is guaranteed from the perspective of credit risk and timely payment of principal and interest. But REMICs (and REMIC-style CMOs) can most assuredly be backed by whole loans, or by single-class MBS that are not agency-guaranteed, such as Alt-A, subprime, HELOCs and HELs, scratch and dent, reperforming, seasoned (old loans), even nuclear waste (nonperforming). How do you deal with not just the cash flow but the credit risk of that?

From a loan quality perspective, the pool backing a simple GSE MBS is a bag of Raisinettes—whatever serving size you take, you get the same candy in it, with the natural variation God gave a raisin. A REMIC pool, on the other hand, is more like a bag of Bridge Mix. There can be jellies in there. There can be a lot of them, and some of those “raisins” are possibly, um, insufficiently raisin-like. As a matter of fact, some of these private-issue pools can go out of their way to add a substantial chunk of poor-quality loans to a pool, because the pool “needs” the higher interest rate those loans pay in order for its cash-flow calculations to work out (we’ll get into that below).

What is required is “credit enhancement” (CE): something that makes up for the greater likelihood of default in the underlying mortgages. No private-issue REMIC is guaranteed, the way GSE MBS are. They all have at least potential risk to the investor of loss of principal, as well as uncertain timing of payment of principal or interest. But because they are structured, they end up with tranches of varying degrees of credit risk. This allows each tranche to receive its own rating, and the rating of the tranche can be much higher than the rating of the underlying mortgages. As this fact has caused more confusion than nearly anything else I’ve seen lately, we will go into some detail.

First, do remember that individual loans can be “credit enhanced”; that’s what mortgage insurance is. Some individual loans are credit enhanced by, basically, being tranched themselves: that’s what an 80/20 deal is. (Which is why CE on a HELOC pool is a whole different bowl of chocolates from a first-lien mortgage pool.) Whole pools can also be enhanced with MI: that’s a pool-level policy.

There can also be other kinds of insurance on the security, such as a letter of credit or surety bond, although these forms of “external” CE are less and less common. Part of the reason for that is the rating issue: with an externally-enhanced security, the rating of the security can be no better than the rating of the guarantor. (Remember that GSE MBS get their AAA rating not because each individual loan is AAA—mortgages to just plain folks like us don’t get better than “A” ratings—but because the guarantor, the GSE, has an implicit AAA rating.) You don’t find enough AAA-rated banks writing letters of credit against subprime pools for that kind of credit enhancement to work out. And the best of the MIs are AA or A; that’s not enough, by itself, to get you an AAA rating on any part of your security.

What you get, then, is generally “internal” credit enhancement. Remember the “sequential pay” idea? We went through that from a perspective of cash-flow and time-to-maturity, but it has, actually, an imbedded or implicit credit enhancement function. Think of a sequential-pay security as a line at the teller window: the top tranche is first in line for payments, then the second, and so on. All tranches might get scheduled payments of principal and interest, but prepayments (voluntary ones, like refis and property sales, as well as involuntary ones like recoveries from foreclosure or even put-back of a loan to the originator) are directed first to the topmost tranche until it is retired. That means that, all other things being equal, the first-to-be-retired tranche is least likely to ever lose principal. Of course, it means that the last-paid tranche becomes the bag-holder: by the time it gets eligible for principal payments there may be none left.

If you just left the credit risk issue as luck of the draw like that, you wouldn’t get far with the rating of the various tranches, nor would you get anybody sufficiently fired up about owning the bottom tranche. So this kind of CE is actually formalized in the security structure in a feature called “subordination,” or “senior/sub” structure. In essence, the tranches become liens on the underlying loans, and just like mortgages, each lien has a legal priority. Furthermore, the issue of loss timing cannot be just left to chance. Remember that, historically, most mortgage losses do not occur in the first two years of the loan. (Yeah, I know it’s different right now. That’s why what is happening right now is so scary.) Mortgages have a loss curve, and predicting that curve is hugely important and hugely difficult.

Besides the loss curve, you also have a prepayment curve—or vector—or explosion—or collapse—take your pick. Prepayments are as difficult to model as losses. Prepayments return principal to investors, so in that sense they reduce credit risk, but they don’t necessarily randomly represent the underlying pool. It is possible, indeed, it is likely, that the fastest prepayments in a given pool are the best-quality loans (those with refi opportunities). Insofar as there is significant variation of credit quality in the underlying pool, once we’re out of the GSE cookie-cutter business, you can end up with a pool that is paid down, but the remaining loans are the dregs. If you relied simply on prepayments to control credit quality, you’d end up with constant downgrades of the remaining tranches over time. That would not make these tranches attractive to investors, particularly to institutional investors who have to have, by law or bylaw, high-rated securities in their portfolios.

Therefore, what you generally get in a REMIC backed by first lien Alt-A or subprime is a combination of subordination, sequential pay, “overcollateralization” (OC), and excess interest. OC is simply a case of having an underlying pool that is larger than the face value of the security. If you issued a $100MM security backed by a $105MM pool of loans, you would have OC. The OC portion is sometimes called “equity,” and that’s what it is: just like in a mortgage loan, that’s the part that takes the first loss. Keep in mind that it’s not a separate pool. It’s not that there’s a special $5MM piece that does or does not experience loss. OC means that the issuer of the security did not get funded at “100% LTV,” as it were; it got funded (sold bonds to investors) for only 95% of the pool it created.

And like homeowner’s equity, OC is not constant: there is an initial OC amount, and also a “target” OC amount on these pools. OC can grow (and shrink). With REMICs, it doesn’t grow by having more loans added after the cut-off date (that can happen with some ABS home equity deals). It grows because that OC portion earns interest, and if that excess interest is not needed to cover losses, it can be used to increase OC.

Here’s a simple chart (I’m not an artist, you know) of an actual new Option ARM-backed REMIC issue I was looking at the other day. (I’m not here to encourage or discourage investing in anyone’s new issue, so whose issue this is isn’t the issue.) The credit enhancement percent on each tranche is the amount of lower-ranked principal that would have to be lost before the tranche in question took a loss; it’s the total of the lower-ranked tranches plus the OC divided by the pool balance.

The way this particular deal is set up, the monthly gross remittance (pool interest less servicing fee, master servicer fee, and lender-paid MI plus scheduled and unscheduled payments of principal) is applied first to the senior notes, on a pro-rata basis; then to the subordinate notes on a sequential basis (the highest-ranked subordinate note gets principal and interest payments until it is retired, then the next one down gets payments, and so on); and third to “excess cash.”

Each month, the “excess cash” is applied first to the OC, as principal, if the OC amount is under target; then to any realized losses of the senior notes; then to any realized losses of the subordinate notes, in order; then to the holder of the residual interest (the unrated interest of the security issuer). If in any period realized losses on the pool exceed the excess cash, then they are applied as a principal write-down first to the OC, then to the lowest subordinate tranche, then to the next-highest tranche, and so on.

In this deal, the “excess cash” is coming both from the interest on the OC portion and from excess spread on the collateralized portion—the rate paid on the underlying loans is greater than the coupon rate to the bondholders plus the fees. The actual payment structure on this deal is more complex than my summary would lead you to believe, and that is largely due to the fact that it’s backed by neg am loans. There are all kinds of “interest deferrals” and “carryovers” and a “final maturity reserve” and further weirdness that is necessary to deal with the underlying problem that the loans generate accrual but not cash-flow sometimes. I tend to wonder how many investors looking at this prospectus have any idea whatsoever about what it all means, but I have been called cynical. I do, however, have some experience with misunderstanding of the underlying loans, so there.

This deal also has a “step-down date,” which they all do. That is a date on which, if certain “trigger events” have not happened, the “excess cash” stops being applied to OC and can be released as distributions to the bondholders. In this deal, the triggers are 1) a serious delinquency rate in the pool of 40% or more of the total balance of subordinate bonds plus OC, or 2) realized losses of a certain percent or more as of a set of future dates. The step-down date calculation on my example pool is really complicated—they’re neg am loans—but generally it will be when the senior notes are completely paid down to zero principal. Remember that the senior notes get principal prepayments first, before the subordinate notes do, so they will mature faster. How fast will that be? Good question. Anybody issuing a new Option ARM Alt-A pool (this one is more than 75% stated income and most loans have a balance cap of 115%) in 2007 had better have a “Plan B” for dealing with very slow prepays. Don’t ask me what Plan B is.

So you can see how a tranche of this deal can get a credit rating that is much better or much worse than the rating of the underlying loans. You can also see how a downgrade of a tranche can happen. The credit rating of each tranche is not just a matter of the percent of credit enhancement under it, but it is strongly dependent on that, and if, say, sudden early losses on this pool wiped out the OC and ate into one or two of those subordinate tranches in a big way, you would see the senior notes and the top tier of subs downgraded, even though they may not have realized losses. They get the downgrade because they have less “support” than they were intended to have.

This one being a neg-am-backed deal, it wouldn’t surprise me any to see some subsequent downgrade if the loans negatively amortized a lot faster than initially predicted. That could create some evil cash-flow problems at the same time that any thinking person would conclude that the underlying loans were at greater risk of default, even if they hadn’t managed to default in abnormal numbers yet.

That’s important to keep in mind, because it implies that forcing a troubled loan to refinance (making it a prepayment, possibly with a prepayment penalty to goose the interest payment) will improve the cash-flow of this security (deferred interest will be replaced with cash interest), pay down the senior note balances (which will bring that step-down date, when the others finally get paid, closer), or supply some “excess cash” that can be used to cover current period losses. If you lowered the accrual rate on too many of these loans, you wouldn’t have that nice juicy “excess spread” to cover losses with.

On the other hand, if too many performing or even just under-performing but not yet loss-generating loans pay off too soon, you’re more likely to hit that “trigger,” because the percentage of seriously delinquent loans you’re left with gets up there. And, of course, if you refuse to modify but the borrower can’t get a refi from some other lender, you’re going to realize some losses. “You” are probably not a senior note holder in that case, but you could see your nice AAA drop down to AA if your CE gets whittled away too far. At the same time all this is going on, you have a servicer whose monthly servicing fee goes away when loans prepay, but who also has to keep advancing interest on delinquent loans until they are declared “uncollectable.” Your security can get a rating downgrade because your servicer’s got a cash-flow or capitalization problem, too.

The point here is that it is dangerous in the extreme to think that the interests involved here are either simple or uni-directional. We’ve seen Lewis Ranieri sounding the alarm over a security servicer’s inability to modify loans if it wanted to. It is not at all clear to me that all bondholders would want to, or that all classes would want to in the same degree or at a period in time that is mutually convenient. Conundrums are nasty things, as a certain Fed Chairman might have said once.

For those of you keeping score at home, notice that we haven’t yet gotten to the question of how a tranche of a REMIC becomes part of an asset pool backing a CDO. We’ll get there eventually. At the moment, just imagine the lowest-rated tranches of REMICs backed by some pretty scary loans becoming collateral for subsequent debt-funded securitization instruments that have even weirder and more complex structures than any known REMIC does. But don’t be frightened at the thought that we are getting to dangerous levels of derivation and dispersion and complexity, or some braver soul will call you a simple-minded cave bear and you’ll have to pretend that your feelings were hurt by that. I’ve got Kleenex if the tear-jerking gets out of hand, but I doubt the Calculated Riskers will need it.

by Calculated Risk on 5/04/2007 12:27:00 PM

From the WSJ: As Market Cools, Home Buyers Seek a Way Out

In the latest fallout from the housing market's decline, disputes are breaking out between builders and buyers who signed contracts for new homes and condos when the market was hot -- and now want to get out of them.

... "People will go to great lengths to get out of a legally binding transaction," said Larry Sorsby, chief financial officer of Hovnanian Enterprises Inc. "They were willing to ride the real-estate boom on the way up, but some are not willing to ride it on the way down."