by Calculated Risk on 12/28/2007 07:00:00 PM

From Adam Ashcraft and Til Schuermann: Understanding the Securitization of Subprime Mortgage Credit

See page 13:

Several point raised in this section were first raised in a 20 February 2007 post on the blog http://calculatedrisk.blogspot.com/ entitled “Mortgage Servicing for Ubernerds.”

Note: there is link in the menu bar for Tanta's UberNerd series: The Compleat UberNerd.

Here is the introduction:

How does one securitize a pool of mortgages, especially subprime mortgages? What is the process from origination of the loan or mortgage to the selling of debt instruments backed by a pool of those mortgages? What problems creep up in this process, and what are the mechanisms in place to mitigate those problems? This paper seeks to answer all of these questions. Along the way we provide an overview of the market and some of the key players, and provide an extensive discussion of the important role played by the credit rating agencies.

In Section 2, we provide a broad description of the securitization process and pay special attention to seven key frictions that need to be resolved. Several of these frictions involve moral hazard, adverse selection and principal-agent problems. We show how each of these frictions is worked out, though as evidenced by the recent problems in the subprime mortgage market, some of those solutions are imperfect. In Section 3, we provide an overview of subprime mortgage credit; our focus here is on the subprime borrower and the subprime loan. We offer, as an example a pool of subprime mortgages New Century securitized in June 2006. We discuss how predatory lending and predatory borrowing (i.e. mortgage fraud) fit into the picture. Moreover, we examine subprime loan performance within this pool and the industry, speculate on the impact of payment reset, and explore the ABX and the role it plays. In Section 4, we examine subprime mortgage-backed securities, discuss the key structural features of a typical securitization, and, once again illustrate how this works with reference to the New Century securitization. We finish with an examination of the credit rating and rating monitoring process in Section 5. Along the way we reflect on differences between corporate and structured credit ratings, the potential for pro-cyclical credit enhancement to amplify the housing cycle, and document the performance of subprime ratings. Finally, in Section 6, we review the extent to which investors rely upon on credit rating agencies views, and take as a typical example of an investor: the Ohio Police & Fire Pension Fund.

We reiterate that the views presented here are our own and not those of the Federal Reserve Bank of New York or the Federal Reserve System. And, while the paper focuses on subprime mortgage credit, note that there is little qualitative difference between the securitization and ratings process for Alt-A and home equity loans. Clearly, recent problems in mortgage markets are not confined to the subprime sector.

This report is recommended reading to understand the entire securitization process. Congratulations to Tanta, and hopefully she will comment on the report.

Also note the last two sentences of the introduction: "... while the paper focuses on subprime mortgage credit, note that there is little qualitative difference between the securitization and ratings process for Alt-A and home equity loans ... recent problems in mortgage markets are not confined to the subprime sector."

by Calculated Risk on 12/28/2007 06:57:00 PM

From Bloomberg: Legg Mason Shores Up Cash Funds With $1.12 Billion

Legg Mason Inc. pumped $1.12 billion into two non-U.S. cash funds to prevent losses, the biggest bailout by a money manager tied to asset-backed debt sold by structured investment vehicles.

The move, along with an earlier cash infusion, will reduce earnings per share by 15 cents in the quarter ending Dec. 31, the Baltimore-based company said today in a statement.

The Confessional is still open.

by Calculated Risk on 12/28/2007 03:40:00 PM

Update: added comments from Tanta at bottom.

Several recent articles have referenced my post on the possibility of a change in attitude towards foreclosure. I wrote:

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

Although the purpose of the post was to discuss changing social norms, the primary reason the post was mentioned was because of some pretty big numbers, like the possibility of $1 trillion in mortgage losses based on a few rough assumptions. A couple of quotes:

Australia theage.com: Americans 'walk' from loans

Late last week ... Calculated Risk figured that housing losses might reach $US1 trillion and even $US2 trillion.

WSJ: How High Will Subprime Losses Go?

Back in the U.S., the Calculated Risk blog sidestepped the colorful language and went straight for the big number: “The losses for the lenders and investors might well be over $1 trillion.”

The $1 trillion number is a simple calculation: If prices fall 30%, then approximately 20 million U.S. homeowners will be upside down on their mortgages. If half of these homeowners walk away from their homes, with an average 50% loss to lenders and investors, that is $1 trillion in losses (the average mortgage is just over $200K).

This wasn't a forecast, just a simple exercise to show why changing social norms is very scary for the lenders.

And this isn't just a subprime problem, and these aren't just potential "subprime losses". In the original post I referred to the potential of foreclosures becoming "socially acceptable" for the middle class.

But even though the problems have spread far beyond suprime, some reporters are stuck on the subprime meme. As an example, Bloomberg columnist John M. Berry wrote: Subprime Losses Are Big, Exaggerated by Some

As the U.S. savings and loan crisis worsened in the 1980s, analysts tried to top each other's estimates of the debacle's cost to the federal government.

Much the same thing is happening now with losses linked to subprime mortgages, with figures of $300 billion to $400 billion being bandied about.

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy.

A loss of $150 billion would be less than 12 percent of the approximately $1.3 trillion in subprime mortgages outstanding. About $800 billion of those are adjustable-rate mortgages, the remainder fixed rate.

This is subprime reporting. It's absurd to think that mortgage losses will only come from subprime loans; in fact most of the upside down homeowners will be Alt-A and prime borrowers. By focusing solely on subprime, Berry misses the larger mortgage problem.

And the credit problems extend well beyond mortgages. As an example, from Bloomberg this morning: Citigroup, Goldman Cut LBO Backlog With 10% Discounts

Citigroup Inc., Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co. are offering discounts of as much as 10 cents on the dollar to clear a $231 billion backlog of high-yield bonds and loans.

We don't know the exact haircut on each LBO deal, but an average 5% haircut would be over $10 billion in losses. And there are losses coming from corporate debt, CRE loans, and other consumer debt too. As Floyd Norris asked at the NY Times this morning: Credit Crisis? Just Wait for a Replay

"... just how different was subprime lending from other lending in the days of easy money that prevailed until this summer?"

Short answer: not very.

Back to mortgage losses, both Felix Salmon: Are Subprime Losses Being Exaggerated? and Paul Krugman, Jingle mail, jingle mail, jingle mail — eek! bring up a key issue: recourse vs. non-recourse loans. Felix writes:

... no one is going to have a real handle on mortgage losses unless and until someone manages to get a handle on the percentage of mortgage loans which are non-recourse. If your house falls in value and you have a non-recourse mortgage, then it makes perfect economic sense for someone in a negative-equity situation to simply walk away – something known as "jingle mail". But given the amount of refinancing going on during the last few years of the mortgage boom, I suspect that the vast majority of mortgages are not non-recourse. (Refis are never non-recourse.)

This is an important issue. In California, purchase money is non-recourse. If the borrower walks away and mails in the keys (Fleckenstein's "jingle mail"), the lender is stuck with the collateral. However, if the California borrower refinanced, then the lender has recourse, and can pursue a judicial foreclosure (as opposed to a trustee's sale), and seek a deficiency judgment.

The lender can enforce that deficiency judgment by attaching other assets, or by garnishing the borrower's wages. Historically lenders rarely pursued (or enforced) deficiency judgments, but that could change if many middle class borrowers, with solid jobs and assets, resort to jingle mail.

For purchase money, state law determines the recourse vs. non-recourse issue. As Felix noted, refis are always recourse, and there was significant refi activity in recent years.

But before we think most loans are recourse, we have to remember that about 22.3 million homes were purchased during the last 3 years (2005 through 2007), and in a period of rising rates, many of these homeowners probably did not refi. It's difficult to estimate the exact losses - since we don't know the percent of recourse loans, we don't know how far prices will fall, and we don't know how homeowners will react to being upside down - but we know the losses will be significant.

Note: I'm trying to find a state by state list of recourse vs. non-recourse for purchase money.

On recourse loans, Tanta adds (via email):

I suspect that you will have some very aggressive lenders and some not very aggressive lenders in that respect.

Which will tell you who thinks it doesn't have a fraud problem and who does.

Back in my day working for a servicer, we never went after a borrower unless we thought the borrower defrauded us, willfully junked the property, or something like that. If it was just a nasty RE downturn, it rarely even made economic sense to do judicial FCs just to get a judgment the borrower was unlikely to able to pay. You could save so much time and money doing a non-judicial FC (if the state allowed it) that it was worth skipping the deficiency. Plus we had a soft spot, I guess.

At any rate, the absolute all time last possible thing you could get me to do is send an attorney barging into court demanding a deficiency judgment if I had any reason whatsoever to fear that my own effing loan officer was implicated in fraud on the original loan application. Any borrower with half a brain will raise that as a defense, and any judge even slightly awake will not only deny the deficiency but probably make the lender pay all costs, or worse. And I'd call that justice.

This goes double if the loan was made as a "stated asset" deal. I can just hear a judge asking me why I deserve to get other assets now when I never bothered to make sure the borrower had any in the beginning.

So yes, some people will get hit with a deficiency. But I'm not sure it will be as many as you might think. T

by Calculated Risk on 12/28/2007 01:57:00 PM

Dr. Christopher Thornberg writes in the LA Times: Realty reality: Housing prices are headed way down

In 2002, the median price of a single-family home in Los Angeles was $270,000 and the median homeowner's income was $65,000. With a $50,000 down payment, the annual cost of that house (taxes, insurance and payment on a 30-year fixed-rate conventional mortgage) would add up to about 33% of the median household's income -- just under the 35% mark that the Federal Housing Administration calls the upper limit of "affordable."

By 2006, the cost of that same house doubled, to $540,000 -- pushed by unbridled speculation fueled by unparalleled access to mortgage capital. But median income rose a paltry 15%. So today that same set of costs come to 60% of gross income.

... Prices must and will fall. Everywhere. Probably 25% to 30% from their peak.

I believe Thornberg's price forecast is for Los Angeles. It appears his "everywhere" comment is referring to all the neighborhoods in LA.

by Calculated Risk on 12/28/2007 11:01:00 AM

First, a couple of key points to consider on housing.

Note: For more graphs, please see my earlier post: November New Home Sales

Let's start with revisions. This month (November) is one of the few months were the initial report wasn't higher than the previous month. Usually the small reported gain in sales is then revised away in subsequent releases.

Look at the report today (for November), the Census Bureau revised down sales for August, September and October. This has been the pattern for most of the housing bust; almost all the revisions have been down. I believe the Census Bureau is doing a good job, but the users of the data need to understand what is happening (during down trends, the Census Bureau initially overestimates sales).

For an analysis on Census Bureau revisions, see the bottom of this post.

Next up, inventory. The Census Bureau reported that inventory was 505 thousand units. But this excludes the impact of cancellations. Currently the inventory of new homes is understated by about 100K (See this post for an analysis of the impact of cancellations on inventory).

This also means that the months of supply is understated. The Census Bureau reported the months of supply as 9.3 months. After adjusting for the impact of cancellations, the actual months of supply is probably closer to 11.3 months.

Click on graph for larger image.

This graph shows New Home Sales vs. Recession for the last 35 years. New Home sales were falling prior to every recession, with the exception of the business investment led recession of 2001.

This is what we call Cliff Diving!

And this shows why so many economists are concerned about a possible consumer led recession - possibly starting right now.

The second graph compares annual New Home Sales vs. Not Seasonally Adjusted (NSA) New Home Sales through November.


Typically, for an average year, about 93% of all new home sales happen before the end of November. Therefore the scale on the right is set to 93% of the left scale.

Through November, there have been 732 thousand New Home sales, and, with one month to go (and a few revisions) it looks like New Home sales for 2007 will be around 775 thousand - the lowest level since 1996 (758K in '96).