by Anonymous on 8/11/2007 08:51:00 AM

I just got around yesterday afternoon to reading the full announcement that went with S&P's recent negative rating actions on Alt-A deals. I know it's not as exciting as Fed repos, but periodically we are allowed a little "No, really?" at the expense of a rating agency:

In late 2005 and 2006, mortgage origination underwriting guidelines expanded rapidly, which allowed the proliferation of layered risks within the Alt-A market. This combination of multiple risk factors for a single loan is the principal driving force behind the deteriorating performance of the 2006 vintage. Historically, the presence of high FICO scores within a loan has proved an effective mitigant to increased risk factors elsewhere, such as higher CLTVs. However, the increase in recent delinquencies across all FICO bands indicates that a borrower's previous credit performance is less
predictive of stronger performance for loans with increased risk layering. This emerging delinquency performance has prompted us to reduce our emphasis on FICO score as an offset to layered risk.

Insofar as FICOs are accurate measures of past performance, high scores indicate borrowers who have managed credit wisely in the past. Put those borrowers in unwise credit terms, and they perform just like people who have managed credit unwisely in the past. Glad we got some real-time empirical data to prove that. Sorry about your global financial crisis.

There's more:

Recent delinquency data also indicates a need to adjust default expectations for certain purchase loans. These loans are underperforming our initial assumptions, particularly when combined with high CLTVs. The performance related to purchase loans is unprecedented in historical data. We will increase our default expectations for the increased risk at high CLTVs, particularly those with CLTVs that exceed 90%.

It is, of course, perfectly true that all "historical data" I am aware of has shown lower risk for purchase transactions than for refinances; somewhat lower than no-cash-out and significantly lower than cash-outs. Of course there has always been a bit of a problem around the "well, controlling for CLTV, that is" part. As with the FICO thing, we only just got ourselves a big database of loans with nutsy CLTVs for all loan purpose types.

The thing is, S&P isn't the only one with a model that has been giving extra credit in the risk-weighting to "purchase" transaction types; just about everyone has. Credit models, pricing models, due diligence selection protocols--they've all included the "purchase benefit." The point is to ask why it is no longer a "benefit," and the CLTV issue is only a part of that. Or, at least, there's more to the CLTV issue than its value relative to historical lending patterns.

The fact is, historically appraisals for purchase-money transactions were the most reliable. Time and again you could test them and see this. We have always believed that it had something to do with the fact that in a purchase transaction, you have a sales price to work with. There was a vague sense among us that with a buyer and a seller out there behaving like Econ 101 says they behave, the sales price--and the comparable sales prices--would ground a purchase appraisal in some kind of "reality." It's not that all refi appraisals are bad, but that they are, as I've said before, inevitably a kind of "mark to model." Purchase appraisals are supposed to be "mark to market."

Funny how some people's models have worked out better than a lot of people's markets, isn't it? Value, of course, is not simply equal to price, and prudent lenders wouldn't be messing around with the time and expense of appraisals if it were. Everything you read about appraisers being pressured to "hit the number" boils down to an industry trying to force "value" to equal "whatever dumb offer someone can be crazy enough to make today." S&P wants to see this as a CLTV issue, and surely it is wise to stop making sunny assumptions about 100% financing, but the fact is that 100% financing works as long as the numbers keep going up.

We were talking yesterday about jumbos and conforming loans and their relative risks. Traditionally, lenders always required two separate independent appraisals for higher-end properties. For years, the cutoff was $650,000 or thereabouts; it sneaked up to $1,000,000 during the boom. I can remember reading a major Alt-A conduit's guidelines in 2004 or so and discovering that their appraisal standards depended--get this--on LTV: for loans over $650,000, a second appraisal would be required if the LTV were over 70%. It said that in the published guidelines. It made sense to a bunch of credit analysts that you could use "V" to decide how you were going to determine "V." Certainly, using a dollar-amount rule can sometimes seem arbitrary. But count me in the arbitrary group.

We are learning here that what are called the "soft guidelines"--all the rules and procedures of a lender that are not easily quantifiable in numbers that can be plugged into a computer model--are making a difference. OK, well, some of us have been insisting for years that this is the case, but the world that wants cheap, fast credit analysis of huge pools of loans without loan-level due diligence or highly-complex analytical models (say, ones that have more than Fitch's famous three doc types), is apparently in wounded-innocence stage. No wonder we'd rather be stunned and surprised by a weekend's worth of Fed repos.

by Calculated Risk on 8/10/2007 06:44:00 PM

Note: there is no mention in the OFHEO statement about changing the conforming limit.

From OFHEO:

The portfolio caps were put in place last year because of their serious safety and soundness issues in response to Fannie Mae’s request to increase the portfolio caps, we issued a letter today to Fannie Mae. We also issued a response to Senator Schumer’s recent letter on this topic, which is attached. The letters indicate that we will keep under active consideration requests for an increase in the portfolio caps, but we are not authorizing any significant changes at this time.

Click on graph for larger image.

This is an excerpt from the OFHEO letter to Senator Schumer (link above) describing OFHEO's views of the subprime, Alt-A and Jumbo prime segments.

by Calculated Risk on 8/10/2007 05:39:00 PM

From MSNBC: Fed takes action, but was it soon enough? (hat tip ac)

On Friday, as Bernanke faced the first big crisis of his 18-month tenure, the central bank was forced into action, buying up billions of dollars worth of crumbling bonds in an effort to stabilize financial markets that appeared to be coming unglued.

Nope.

Update: Technically the legal ownership of the collateral apparently does change hands, so saying the Fed is "buying" is not completely inaccurate - just misleading. It's been some time since I've looked at how a Repo works, so this has been an interesting exercise for me.

The Fed engaged in fairly ordinary 3-day repo activity (calender days) as detailed at the NY Fed: Temporary Open Market Operations

These Repos were all for MBS; usually they accept more Treasury and Agency collateral. And the size was a little larger then recent Repo activity.

What was unusual today was the Fed statement: The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

But the Fed didn't buy "billions of dollars worth of crumbling bonds". The MBS is just put up as collateral, and unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal.

by Calculated Risk on 8/10/2007 04:21:00 PM

From Bloomberg: Goldman's Global Alpha Hedge Fund Falls 26% in 2007, People Say (hat tip REBear)

Goldman Sachs Group Inc.'s $8 billion Global Alpha hedge fund has fallen 26 percent so far this year, according to people familiar with the fund.

According to earlier reports, the fund was off 16% at the end of July:

Global Alpha, Goldman's widely known internal hedge fund, is now down about 16% for the year after a choppy July, when its performance fell about 8%, according to people briefed on the matter. The fund, based in New York, manages about $9 billion.

If these reports are accurate, the fund has lost about 10% so far in August.

by Anonymous on 8/10/2007 03:08:00 PM

From Marketwatch, "How effective would Fed rate cut be?":

"It is unwise bordering on imprudent to assume that terrible will not follow bad," Catalano said.

by Anonymous on 8/10/2007 12:04:00 PM

From the New York Times:

Banks that are worried about their own liquidity decided this week to increase their reserves, which they can do by borrowing from other banks. Loans on such rates rose as a result of the added demand. Both the federal funds rate — the rate on loans of reserves between American banks — and the London Interbank Offered Rate leaped sharply yesterday.

The Fed — which conducts monetary policy by focusing on the fed funds rate — was forced to inject money into the system to bring the rate back down to its targeted level. And the E.C.B. lent almost 100 billion euros ($130 billion), to European banks.

If the current panic is just that — unreasoning fear — then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.

On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.

by Calculated Risk on 8/10/2007 09:48:00 AM

UPDATE: From Bloomberg: Fed Adds $19 Billion in Funds by Buying Mortgage Debt (Hat tip Napolean)

The Federal Reserve added $19 billion in temporary funds to the banking system through the purchase of mortgage-backed securities to help meet demand for cash amid a rout in bonds backed by home loans to riskier borrowers.

The Fed accepted only mortgage-backed debt as collateral for this morning's weekend repurchase agreement. ...

Fed funds traded above the central bank's target for a second straight day. The Fed's benchmark was 6 percent the last time fed funds opened at today's level.

After the Fed addition today, Treasuries pared their gains. Stocks dropped worldwide on speculation the losses in mortgage debt will hurt economic growth and earnings.

Click on graph for larger image. (hat tip Brian)

From the Federal Reserve:

The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

See Professor Thoma at Economist's View for an explanation of how this works. Also see Dr. Krugman's comments:

And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.

by Anonymous on 8/10/2007 07:48:00 AM

The Washington Post reports this morning on the heart-rending situation of upper-middle-class borrowers who are facing the dire situation of being offered a jumbo mortgage interest rate of "more than 7 percent":

Nicholas Schor and Liza Losada-Schor were ready and willing to spend up to $850,000 on a house in Maryland. That was a month ago, when the rate on their mortgage would have been as low as 6.25 percent.

But a sudden shift in the mortgage market means that the couple -- he's a psychiatrist, she's a clinical nurse psychotherapist -- now face a rate of more than 7 percent, reducing their buying power even though they have solid credit. That's because in the past few days, rates on loans for more than $417,000, known as jumbo loans, have shot up.

"I'm sort of surprised that even though we have excellent credit and excellent income and are putting down a 20 percent contribution that the banks aren't able to offer better rates for folks who seem to be a more reliable investment," Schor said.

This is "price rationing," the evil twin of "nonprice rationing," the two components of a thorough-going credit crunch. The Schors may be surprised to discover that the same mechanisms that allowed ample credit to high-risk borrowers also kept the cost of credit to low-risk borrowers artificially low, but those of us in the financial industry do not speak of credit crunches in tones of horror because they are simple predicable, controllable "corrections" that merely tidy up a few regrettable underwriting guidelines and leave the traditionally-creditworthy unscathed.

Of course, it could have something to do with that $850,000 house:

"With a rate increase from 6.75 percent to 7.5 percent, the buyer's buying power just dropped by 10 percent," said Frank Borges LLosa, a broker at FranklyRealty.com. "That $600,000 buyer will now have to look at buying a $550,000 place or paying 10 percent more per month for the same house versus last week."

That's what happened with the Schors. They recently bid $675,000 for a six-bedroom house in Olney, instead of the higher amount they originally thought they would spend. They are still hoping they can find a mortgage lender that will offer a better rate.

It is possible, however, that the lender will be just as spooked by the appraisal of the $675,000 house as the $850,000 house. There's a lot of price froth yet to evaporate in Olney, Maryland.

I don't particularly want to pick on the Schors--I'm sure they're nice people and decent credit risks--but theirs is the story I think of frequently when I hear clamoring to raise the conforming loan limit. I don't hear too many folks asking how Fannie and Freddie can afford to shave 100 bps off the Schors' interest rate when the private jumbo market cannot.

by Anonymous on 8/10/2007 07:04:00 AM

Via Clyde, from Financial Times:

Borrowers of alt-A mortgages may be of higher caliber than their subprime counterparts, but that hierarchy doesn’t necessarily hold for the bonds backed by the two types of loans. In fact, some alt-A securities are trading in line with comparable subprime-backed bonds, according to several market participants.

“We’ve historically been very wary of alt-A because of the decreased levels of subordination in the transactions,” said a buyside source. “We are much bigger believers in subprime.” . . .

Despite what may be higher credit fundamentals of alt-A mortgages, securitizations of the loans are more vulnerable to losses in underlying collateral. That’s because rating agencies have not required as much credit enhancement on the transactions as they have for subprime deals, according to a research report by JPMorgan Chase.

For now, alt-A borrowers are defaulting more slowly than subprime mortgage borrowers, as evidenced by their lower delinquency rates. JPMorgan found that 60+ day delinquencies averaged 7% for a sample of alt-A loans originated in 2H06 versus just under 13% for the ABX deals of the same vintage.

But some investors are opting for subprime securities because of their higher yields and credit protection relative to alt-A. Increasingly valued as interest only investments, subprime-backed bonds purchased at low enough dollar prices may generate superior returns, the investors say.

While subrime delinquencies outnumber those on alt-A mortgages, a fair number of alt-A bonds rated A2 and lower and originated in the second half of 2006 have loss coverage ratios of less than 1 assuming a 30% severity, according to JPMorgan. That compares with an average 1.31 loss coverage ratio for BBB rated subprime bonds underlying the ABX 07-1 index and 1.15 for BBB- bonds, assuming 40% severity. . . .

Key predictors of alt-A securities’ performance are borrower FICO scores, percent of limited or absent documentation loans, exposure to risky geographies – mainly California and Florida – and the loan-to-value ratios of the underlying collateral.

Subordination levels relative to expected losses suggest that most AA and A-rated alt-A bonds are behaving like single-Bs, according to JPMorgan, which tested roughly 30 deals late last month.

by Calculated Risk on 8/10/2007 02:19:00 AM

Paul Krugman writes in the NYTimes: Very Scary Things

Note: the NY Post is reporting that these columns will be free in the near future. Excerpts are from Economist's View.

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in ... financial instruments backed by home mortgages ... have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.
...
When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C ...

And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.

See Economist's View for more excerpts.