by Anonymous on 8/19/2007 08:58:00 AM

I did a post yesterday that was ostensibly about loan modifications, but that was trying to make that an excuse to reflect on risk/behavior modeling. It didn't work, but life is like that in the risk business.

One of my points is that while all modeling of borrower behavior can be fraught with conceptual, mathematical, and data problems, modeling of what I call the "residual" borrower and the less polite call the "woodhead" borrower is more fraught than any other part of this. In any sufficiently large group of mortgage loans, you will get a "tail" of borrowers whose behavior you cannot predict or "solve for" (as the case may be) with intelligible results.

Some people simply will not behave the way theory says they will. As a risk manager in a financial instutition, I have always had some trouble dealing with this group. As a person, of course, I have always sought them out first in bars and parties. Theory predicts that I would be making you guys pay $100 an hour to listen to my insights about the world. In the real world, I'm bloggin'. Solve for that.

I suspect some of the friction that arises from time to time in our comment section involves the fact that I don't always like best the people I prefer to lend money to. I don't even always morally approve of them. But my job has always been to lend money safely and soundly at a reasonable profit, not to dole out rewards for good behavior or use loan commitment letters as a kind of Good Housekeeping Seal of Approval, a weird sort of Calvinist-banker thing that involves identification of The Elect. It's possible that uptight cheese-paring pompous authoritarian self-satisfied literal-minded parochial nosey-parkers are overrepresented in my approved borrower pool. That doesn't mean I'm willing to live in your neighborhood, listen to your homilies, or even drink your beer.

Some of the people I love best want to buy homes because if they own it, instead of renting it, they can paint it purple if they want to. Then they do, DIY, too, because they're frugal. Often the neighbors have a big meltdown over this, because it "brings down property values."

So many people want to be not just their own landlord, but everyone else's, too. I have a very vivid memory of the first time I saw the covenants and restrictions on a new PUD somebody actually wanted to buy a (bland, featureless, identical, not purple) home in. It prohibited hanging laundry in the backyard on a clothesline. I have been an apartment-dweller for a long time, and one of the two or three idle thoughts that would occasionally get me thinking about buying a home was wanting a place to hang my sheets out in the sun. I concluded that if we were going to make homeownership the equivalent of taking a shower with a raincoat on, I'd save myself the time and money.

At some level, the argument that a mortgage servicer should try reasonable alternatives to foreclosure because to flood the neighborhood with vacant REO punishes all the innocent bystanders makes some sense. At another level, it makes me uneasy. This is probably because I am a former lit major with an active imagination instead of a real high-class math wiz who understands only standard deviations. But I keep wondering whether some of these folks would be in such dire financial straits if they hung their laundry out to dry: the sun's free, but a gas dryer isn't. Lawns that look like lawns, not putting greens, cost less to maintain. Front doors that are an out-of-fashion color are in the sale bin at HomeDepot. Do you really want your neighbors to act prudently? Do you?

When I was in grad school I lived a few doors down from some folks who drove a '63 Plymouth Fury, gold-and-primer, with "Neighbors From Hell" painted on the side with Rustoleum. They'd get their shovels out and come help me dig my innocent white Volkswagen out of a snow drift when the need arose. It was a curious kind of hell they were from.

Yves over at naked capitalism has an interesting post up this morning on "cognitive bias" and risk assessment. This paper has some interesting comments on the subject for those of you who are more analytically rigorous than I'm in the mood to be this morning. I was, I admit, taken by the discussion of hindsight bias. It may be relevant to our preoccupations. I may either take it out on the patio to read over a cup of coffee, or get out a can of spray paint and go after my car. Some days it's a knife-edge.

by Calculated Risk on 8/19/2007 02:49:00 AM

From the NY Times: Loan by Loan, the Making of a Credit Squeeze. Here is an excerpt on the bankruptcy laws:

Congress is looking hard at changing the bankruptcy law so courts can restructure home loans as they do other personal loans like credit card debt. The goal, proponents say, would be to update the bankruptcy code in line with realities of the modern mortgage market.

In Chapter 13, a borrower’s mortgage obligation remains intact. The most that a person gets is extra time to catch up on payments in arrears, but every nickel on the mortgage must be paid.

The bankruptcy code went through a major revision two years ago, in what was seen as a triumph for banks and other lenders. The revision made it harder for people to declare bankruptcy, especially a Chapter 7, or “straight bankruptcy,” in which everything is liquidated, by setting tighter income and means tests to qualify. The 2005 amendments also set more stringent rules for writing down unsecured debt, notably credit card debt.

PROTECTION for the mortgage lender has been unchanged since the Bankruptcy Reform Act of 1978. At the time, first-time home buyers paid about 20 percent of the value of the houses upfront, got fixed-rate mortgages, and the lenders were local bankers — serious, skeptical types who scrutinized borrowers. Homeowners agreed to mortgages they could afford. When they ran into financial troubles, it was typically because of some unforeseen event in their lives like the loss of a job, an illness or a divorce. The mortgage was rarely the problem.

Yet the mortgage often is the financial culprit these days. That is particularly true of lending in the subprime market of zero-down loans with terms fixed for two years and then floating rates, arranged by aggressive national mortgage brokers and bankers who earn lucrative fees.

“The bankruptcy law was written for a different world, and we want to give the bankruptcy courts, and creditors, more flexible tools to work with borrowers to save their homes,” said Senator Richard J. Durbin of Illinois.

In September, Mr. Durbin, the Democratic whip, plans to propose amendments to the bankruptcy code, in a bill called the Helping Families Avoid Foreclosure Act. It would, among other things, permit writing down loans and stretching out payment terms.

Some bankruptcy experts agree that it is time to change the law. “Our bankruptcy laws are not well designed to deal with a massive wave of mortgage foreclosures,” said Elizabeth Warren, a professor at the Harvard Law School. In particular, Ms. Warren said, bankruptcy courts should be able to rewrite mortgages in line with market conditions.

The banking industry, which pushed hard for the tougher bankruptcy law in 2005, wants no easing up now.

by Calculated Risk on 8/18/2007 06:38:00 PM

From the NYTimes: How Missed Signs Contributed to a Mortgage Meltdown. Here is the quote of the day:

“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo.

by Anonymous on 8/18/2007 01:00:00 PM

This is basically just the result of a "random play" move I made the other day. For some reason the tune's been sticking with me. Apologies for the video, but maybe it'll calm everyone's nerves.

Enjoy.

by Anonymous on 8/18/2007 12:56:00 PM

I got my hands on another investment bank analysis of loan modifications—this one is Lehman’s (thanks, Clyde!). Like every other analysis from the IBs and the rating agencies that I have seen in the last two or three months, it concludes that modifications are usually allowable by the securitization trusts, and done correctly they are either loss-neutral (to the top tranches) or actual loss-mitigation (to the bottom tranches), and therefore advisable under careful terms and practices of the servicer.

What was interesting about the Lehman analysis is that it looked quite squarely at the possibility of what it calls the “moral hazard borrower,” or some set of borrowers ending up getting a mod when they wouldn’t have defaulted (or could have gotten a market-rate refi) because the servicer’s “targeting” was too wide. They conclude, actually, that with careful enough cost-to-trust analysis of the terms offered on all mods, and limiting mods to borrowers who have already become delinquent, the “moral hazard borrower” problem isn’t likely to cause noticeable losses.

If I get permission from Lehman I’ll post some more of the analysis. Until then I think I can get away with this snippet regarding the methodology of their analysis, which I bring up for discussion purposes:

In our scenario, we assumed that the proportion of the borrower pool in each of these groups [current borrowers, those who can be cured with a mod, those who cannot be cured, the “moral hazard borrower”] depends on the amount of rate or payment reduction. Because we did not have data on borrower responsiveness to loan modifications, we extrapolated the sensitivity of defaults from observed response of subprime ARMs to payment shocks. A 9% payment shock on subprime ARMs has historically caused about a 20% increase in the credit default rate (CDR). The experience from payment shocks is not entirely applicable to the loan modification scenario as subprime ARM borrowers who choose to stay on with their mortgage post-reset are adversely self-selected. The higher default rates from this self-selection cannot be directly distinguished from the economic impact of the payment shock. However, given the lack of data on the likely impact of loan modification, we are using the response to payment shocks as a proxy for the impact of loan modifications.

What might it mean to say that “borrowers who choose to stay on with their mortgage post-reset are adversely self-selected”?

First, we must assume that a choice is a choice. We therefore assume that there are alternatives, such as a refinance at a rate/payment lower than the reset rate/payment that these borrowers could qualify for but choose not to, or that the property could be sold without financial hardship to the borrower, or the borrower could simply mail in the keys.

Any borrower who “chooses” to keep a loan with a 6.50% margin that resets every six months instead of refinancing or selling at break-even or walking away is, therefore, presumed to be:

1. Uninformed
2. Irrational
3. Masochistic
4. Making plans to scarper
5. Running a tax dodge
6. So traumatized by the original experience with a loan broker that he or she is unable to contemplate going through that again even if it means starving
7. A couple of tranches short of a full six-pack, if you know what we mean.

The inescapable conclusion (you might want to sit down for this, it’s stunning) is that it is very difficult to model the behavior of this group with the usual variables like “in the money rate incentives” or “moral hazard” or “damage to credit rating” or “pupil dilation in presence of bright lights.”

At this point, we merely pause to recognize the nature of what this is saying about the subprime 2/28 and 3/27 ARM: it was never intended to be a 30-year loan. It was always a bridge loan pretending to be a 30-year loan. It cannot be modeled as a 30-year loan. But hey! It’s a great product for achieving stable homeownership goals!

In any event, as of today we’re well past that point where “choice” and “self-selection” are the operative mechanisms. In the current environment, we have:

1. Little available refinance money (lenders are not lending)
2. Little available refinance incentive (refi rates are high when they are available)
3. Little available refinance flexibility on high LTVs (the “add-on” cost for a high-LTV loan is no longer artificially lowered by “nontraditional loan products” manipulating the payment)
4. Little opportunity to sell for at least the loan amount plus transaction costs

This means, as far as I’m concerned, that it is quite likely that the universe of “post-reset borrowers” is no longer adversely self-selected. It may well be adversely selected: “little opportunity” to sell or refi does not mean “no opportunity,” and so the very highest-quality borrowers and the properties in the healthiest RE markets will opt out of the pool. But your remaining pool is not the “classic” self-selected group any longer.

This is why workout options like mods start to make sense: the pool of defaulting borrowers is no longer exclusively the group of people for whom little can be done; the pool includes people for whom the credit crunch removed what could have been a viable option. In a credit crunch, the model that assumed “adverse self-selection” no longer works reliably.

Beyond The Great Modification Controversy, I think it’s worthwhile to return to this question of how much “historical” data we ever had to justify all the risk we put into the system during the great lending bubble. A lot of people cheerfully made these 2/28s because they based their “stress test scenarios” on past episodes of economic or housing market distress in which different products were offered to borrowers (either fixed rate loans or straight “bullet” ARMs that don’t have this initial teaser/IO fixed period/prepayment penalty combo). The only excuse for this, which is now becoming explicit, is that we just counted on easy refi money and endless HPA to take care of the problem. I know that’s not news to the Calculated Risk crowd, but it still seems to be news to these CEOs (ahem) who stand up and say “no one saw this coming” and “we didn’t lend on appraised values.”

by Calculated Risk on 8/18/2007 01:15:00 AM

From Reuters: Sentinel files for Chapter 11 bankruptcy

Sentinel Management Group Inc., a U.S. futures commission merchant whose decision to freeze client accounts on Tuesday helped roil global financial markets, filed for Chapter 11 bankruptcy protection late on Friday.

The cash management company, which managed about $1.6 billion of assets, said its board decided it was in "the best interests of the corporation, its creditors and other interested parties that a voluntary petition be filed ... in an effort to restructure the indebtedness of the corporation," according to a filing in the bankruptcy court for the Northern District of Illinois.

Here is the Bloomberg article with more details.

by Calculated Risk on 8/18/2007 12:50:00 AM

WaPo: Fannie Mae Predicts Price Decline Will Accelerate in '08

Fannie Mae, the mortgage finance giant, yesterday predicted that housing prices will decline by 2 percent on average this year and by 4 percent next year as mortgage delinquencies rise, lenders tighten borrowing standards and the volume of unsold homes approaches record levels.

"This is clearly a market poised for more severe overall credit losses," Enrico Dallavecchia, Fannie Mae's chief risk officer, said in a conference call with investment analysts.

Adding to the trouble, Dallavecchia said, is that many borrowers with adjustable-rate mortgages are facing rising monthly payments, which could drive them into foreclosure. "This could have a cascading effect in the market," he said.

A 2% price decline nationwide - as measured by OFHEO - sounds about right for 2007. I also expect the pace of price declines to increase next year.

by Calculated Risk on 8/17/2007 08:09:00 PM

From the WSJ: Using Discount Window Is Sign of Strength, Fed Says

... the Federal Reserve held a conference call with major banks to encourage them to consider borrowing from the central bank’s discount window.

... Fed officials know the discount window action will only be effective if banks either use it, or the knowledge of its availability, to expand their own lending to high-quality counterparties such as high quality mortgage borrowers.

The participants from the banking world included ABN AMRO; Bank of America; The Bank of New York Mellon; The Bank of Tokyo-Mitsubishi UFJ, Ltd.; The Bear Stearns Companies Inc.; Citigroup; Deutsche Bank Group; Goldman Sachs; JPMorgan Chase & Co.; Lehman Brothers; Merrill Lynch; Morgan Stanley; UBS; U.S. Bank; Wachovia; and Wells Fargo.

by Calculated Risk on 8/17/2007 04:08:00 PM

From Paul Krugman: Workouts, Not Bailouts. Excerpts are from Economist's View.

... if historical relationships are any guide, home prices are still way too high. The housing slump will probably be with us for years, not months.

Meanwhile, it’s becoming clear that the mortgage problem is anything but contained. ... Many on Wall Street are clamoring for a bailout — for Fannie Mae or the Federal Reserve or someone to step in and buy mortgage-backed securities from troubled hedge funds. But that would be like having the taxpayers bail out Enron or WorldCom when they went bust — it would be saving bad actors from the consequences of their misdeeds.

And Krugman argues for workouts, not bailouts:

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, ... the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the ... mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets ... And the result is that there’s nobody to deal with.
...
The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts. ... Say no to bailouts — but let’s help borrowers work things out.

Tanta has written about the servicer issues. For an overview of how servicing works, see: Mortgage Servicing.

Tanta also wrote about some of the servicer vs. investor conflicts in SFAS 140: Like A Bridge Over Troubled Bong Water. Tanta concluded:

The time to have gotten fired up about the real issues around off balance sheet securitization--the great "de-linking" of risk that was openly advertised as the benefit to the investor of all of this--was back when those 2/28s were being originated. We here at Calculated Risk were on it back then, and being dismissed as "bubbleheads." Absolutely nobody, as far as I know, is happy with any of the bad choices we now have since we've gone into cleanup mode. But this desperate attempt to keep the moral hazard in place, whether it's Cramer begging for a rate cut or bond investors demanding that FASB shoot the wounded, sink the lifeboats, and close the gates of mercy to protect the interests of the AAA crowd, is a little hard to take.

Sit down, boys and girls. There has always been an "information asymmetry" issue with mortgage-backeds. The originator has always known more than you know. The servicer has always known more than you know. The auditors have always known more about the balance sheet ingredients than you have. This problem did not arise a couple of months ago when the ABX tanked.

It has also always been the case that the party on the other side of that cash-flow is Joe and Jane Homeowner. Taxpayer, voter, citizen, parent, child, grannie and gramps, your neighbor. This is a group of folks it's a bit hard to demonize. We've been trying, with this "it's all subprime and all subprime borrowers are deadbeats" meme, but except for a few dead-ender holdouts, that dog is no longer barking. No one will be less surprised than I to find many politicians doing the wrong thing here, out of a misguided sense that something must be done, and seen to be done. Possibly someone will do something sane and useful.

Perhaps Krugman is proposing something 'sane and useful'.

UPDATE: Here is an example of bad ideas from Senator Schumer yesterday.

Senator Charles E. Schumer today renewed his call on the Bush administration to immediately lift the portfolio cap on Fannie Mae and Freddie Mac to help ease the liquidity concerns in the mortgage markets. Schumer added that if Fannie and Freddie’s regulator doesn’t act soon to temporarily allow the companies to provide more liquidity, he will introduce legislation to do so as soon as Congress reconvenes in early September.

by Anonymous on 8/17/2007 01:23:00 PM

Or mortgage brokers will get like totally bummed out.

CHICAGO (MarketWatch) -- There's more at stake in Countrywide's health than the future of the company -- if it isn't able to keep making loans, the psychological impact of the loss would be felt directly by consumers, participants in a California Association of Mortgage Brokers news conference said on Thursday.

"The consumer will feel that there is no loan availability if companies like Countrywide can't keep their doors open. This isn't some small company that decided to start up yesterday that had a risky business plan. This is America's leading lender," said Ed Craine, the public relations chairman of the group.

"The credit crunch is working its way through the whole market, taking companies we've seen as solid companies that nobody would ever expect to have problems and putting them on the brink of disaster."

As it is, certain mortgage products have been drying up and lending guidelines have been tightened -- "changing almost hourly," as the California group said in a news release. Lenders who have shut their doors this year have also reduced consumer options.

The problems Countrywide is having are proof of the depth of the market's current troubles, said John Marcell, who served as the group's president from 2005 to 2006.

"It just goes to show you the state that the market is in right now when you have the largest mortgage lender in the United States having these kind of difficulties," Marcell said. "We're going to have to get some relief some place to keep companies like this still in business."