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Monday, September 24, 2007

"Captain Tanta" Has a Nice Ring to It . . .

by Tanta on 9/24/2007 10:15:00 AM

Via Clyde, a fascinating (well, if you're mortgage- and rating agency-obsessed) discussion from Institutional Risk Analytics. I thought former regulator Thomas Day's remarks on the surreal nature of his own mortgage experience were quite interesting; imagine how surreal it was for those who never worked for the Federal Reserve.

But this is certainly Quote of the Day material:

The next speaker was Sylvain Raynes of RR Consulting, who also teaches at Baruch College in New York. Raynes began by reminding the audience that while it may seem easy to criticize the actions of the major ratings agencies, "most people are trying to find ways to look beyond the rating agencies. Most regulators have stopped believing in them a long time ago, at least five years ago, as far as I can see. But what you cannot do is throw the captain overboard in the middle of a storm because then you become the captain. This is the Caine mutiny strategy.

A New Bear Stearns Deal

by Tanta on 9/24/2007 09:22:00 AM

It used to be basically impossible to keep up with the terms of newly-issued mortgage deals, but you could at least stay up to date with downgrades. Now that the situation is completely reversed, I thought it might be interesting to look at the terms of one of the very few new issues out there.

This Bear Stearns deal (Asset Backed Securities I Trust, Series 2007-AC6) just got rated. With 7.90% credit enhancement to the AAA tranches for an Alt-A deal--that's more than you used to get in some subprime--I thought it might be interesting to look at the prospectus.

Remember the uproar earlier in the year about Bear buying delinquent loans out of securities in an attempt, it was alleged, to "manipulate" the market? This prospectus has a new bit I've never seen before that clarifies that:

[A]s described in this prospectus supplement, the sponsor has the option to repurchase mortgage loans that are 90 days or more delinquent or mortgage loans for which the initial scheduled payment becomes thirty days delinquent. The sponsor may exercise such option on its own behalf or may assign this right to a third party, including a holder of a class of certificates, that may benefit from the repurchase of such mortgage loans. These repurchases will have the same effect on the holders of the certificates as a prepayment of the mortgage loans. You should also note that the removal of any such delinquent mortgage loan from the issuing entity may affect the loss and delinquency tests that determine the distributions of principal prepayments to the certificates, which may adversely affect the market value of the certificates. A third party is not required to take your interests into account when deciding whether or not to direct the exercise of this option and may direct the exercise of this option when the sponsor would not otherwise exercise it. As a result, the performance of this transaction may differ from transactions in which this option was not granted to a third party.
You have been warned, I guess. There is also this:
The sponsor may from time to time implement programs designed to encourage refinancing. These programs may include, without limitation, modifications of existing loans, general or targeted solicitations, the offering of pre-approved applications, reduced origination fees or closing costs, or other financial incentives. Targeted solicitations may be based on a variety of factors, including the credit of the borrower or the location of the related mortgaged property. In addition, The sponsor may encourage assumptions of mortgage loans, including defaulted mortgage loans, under which creditworthy borrowers assume the outstanding indebtedness of the mortgage loans which may be removed from the mortgage pool. As a result of these programs, with respect to the mortgage pool underlying any issuing entity, the rate of principal prepayments of the mortgage loans in the mortgage pool may be higher than would otherwise be the case, and in some cases, the average credit or collateral quality of the mortgage loans remaining in the mortgage pool may decline. . . .

Modifications of mortgage loans implemented by the related servicer or the master servicer in order to maximize ultimate proceeds of such mortgage loans may have the effect of, among other things, reducing or otherwise changing the loan rate, forgiving payments of principal, interest or other amounts owed under the mortgage loan, such as taxes or insurance premiums, extending the final maturity date of the mortgage loan, capitalizing or deferring delinquent interest and other amounts owed under the mortgage loan, or any combination of these or other modifications. Any modified loan may remain in the issuing entity, and the reduction in collections resulting from a modification may result in reduced distributions of interest or principal on, may extend the final maturity of, or result in an allocation of a realized loss to, one or more classes of the certificates.
You have been even more warned. Furthermore,
The underwriter intends to make a secondary market in the offered certificates, but the underwriter has no obligation to do so. We cannot assure you that a secondary market will develop or, if it develops, that it will continue. Consequently, you may not be able to sell your certificates readily or at prices that will enable you to realize your desired yield. The market values of the certificates are likely to fluctuate, and such fluctuations may be significant and could result in significant losses to you.

The secondary markets for asset backed securities have experienced periods of illiquidity and can be expected to do so in the future. Illiquidity can have a severely adverse effect on the prices of certificates that are especially sensitive to prepayment, credit or interest rate risk, or that have been structured to meet the investment requirements of limited categories of investors.
In case you hadn't noticed, you're getting warned again.

As far as the mortgage pool? It's fixed-rate Bridge Mix: 18% full doc; WA FICO of 701 with range from less than 600 to more than 800; average balance just under $306,000 with a range from $33,000 to $2MM; 14% non-owner-occupied; 29% CA and 10% FL; 35% interest only. The sort of thing that would have skated by a year ago, in other words. The big difference here: only 28% of loans are purchase-money, and only 19% have subordinate financing.

The loans are also rather older than new production issues have been in the last few years--averaging 7-10 months--which suggests that it took a while to put this deal together. I'd say this is less an indicator of what kind of loans are being made today than it is what kind of loans have been parked in Bear Stearns' inventory since the first quarter, waiting for the RMBS market to revive. And with subordination levels of nearly 8.00% on fixed rate "Alt-A," it's quite clear that rates to consumers for "non-conforming" loans have nowhere to go but up.

Sunday, September 23, 2007

House Prices: "Get real"

by Calculated Risk on 9/23/2007 11:32:00 PM

Quote of the day:

"Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that."
Professor Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School
From the NY Times: A Reality Check for Home Sellers

This article discusses homeowners not want to sell for a loss. But even homeowners with some profit reluctantly reduce their prices, unrealistically hoping for a price close to recent sales in their neighborhood. As the article notes:
... the [housing] market went into a deep freeze as many people held out for market prices that no one would reasonably pay.
We will see how much of a "deep freeze" later this week when the new and existing home sales reports are released.

Want To Buy A Second Home?

by Tanta on 9/23/2007 10:50:00 AM

The Washington Post has some excellent advice for you, if you do. My favorite part was making sure you found a job thirty years ago that paid a lifetime pension with health coverage, and you stuck to it like glue. Otherwise, you'll want to look into the strategy of borrowing as much as possible (up to the conforming limit) at 6.50% because after taxes (retiree taxes, no less) you can surely end up ahead by investing your savings elsewhere. And if you're trying to maximize your mortgage interest deduction, why wait for RE prices to come down a bit more?

So a couple of folks with $600,000 in savings and a $20,000 balance on their HELOC (on the "paid off" home) allowed their names to appear in the newspaper. I'd guess by noon they'll have 47 mortgage brokers lined up in the driveway . . .

Saturday, September 22, 2007

Deposit Insurance: U.K. May Increase Coverage

by Calculated Risk on 9/22/2007 06:01:00 PM

From Bloomberg: U.K. May Insure 100,000 Pounds of Depositor Funds (hat tip FFDIC)

The U.K. government may guarantee as much as 100,000 pounds ($202,000) of people's bank deposits as it seeks to avoid a repeat of the run on Northern Rock Plc, Chancellor of the Exchequer Alistair Darling said.
Currently the official deposit insurance program covers 100% of the first £2,000, and 90% up to £35,000. This is a flawed insurance program, and didn't prevent the bank run at Northern Rock. To stop the bank run, the British government ended up guaranteeing all deposits - talk about encouraging moral hazard!

Although most people think deposit insurance is intended to protect depositors, perhaps a more important reason for insurance is to prevent bank runs and maintain the stability of the financial system.

The problem with the current British system isn't the size of the insured deposit £35,000 (about $70,000) but the coinsurance feature above £2,000. The coinsurance idea is flawed, both in concept and in practice (see Northern Rock). The idea of having relatively small depositors assess the risk of a bank is absurd. In practice, small depositors will just move their deposits to another bank at the slightest hint of trouble.

Many other coinsurance programs work very well. As an example, a co-pay for a doctor's visit lowers the overall cost of medical care. Without a co-pay, some patients overuse the services of doctors (this isn't a discussion of health care, rather an example of a positive aspect of coinsurance). But the purpose of coinsurance for deposit insurance is to encourage the depositor to assess the risk of the institution - something perhaps beyond the capability of most depositors. And even if the depositor has the skill to assess the institution, and the access to adequate information, it is still easier to just move their funds.

There are Moral Hazard and Principal/Agent issues with deposit insurance. For those interested in this topic, I suggest this paper, written in 1999 by George Hanc at the FDIC: Deposit Insurance Reform: State of the Debate. Here is an excerpt on Moral Hazard:
When applied to deposit insurance, the term moral hazard refers to the incentive for insured banks to engage in riskier behavior than would be feasible in the absence of insurance. Because insured depositors are fully protected, they have little incentive to monitor the risk behavior of banks or to demand interest rates that are in line with that behavior. Accordingly, banks are able to finance various projects at interest costs that are not commensurate with the risk of the projects, a situation that under certain circumstances may lead to excessive risk taking by banks, misallocation of economic resources, bank failures, and increased costs to the insurance fund, to solvent banks, and to taxpayers.

Moral hazard is present because (1) a stockholder's loss, in the event a bank fails, is limited to the amount of his or her investment; and (2) deposit insurance premiums have been unrelated to, or have not fully compensated the FDIC for, increases in the risk posed by a particular bank. Moral hazard is particularly acute for institutions that are insolvent or close to insolvency. Owners of insolvent or barely solvent banks have strong incentives to favor risky behavior because losses are passed on to the insurer, whereas profits accrue to the owners. Owners of nonbank companies with little capital also have reason to favor risky activities, but attempts to shift losses to creditors are restrained by demands for higher interest rates, refusal to roll over short-term debt, or, in the case of outstanding longterm bond indebtedness, restrictive covenants required when the bonds were issued.

Probably the most effective counterforce to moral hazard is a strong capital position. Because losses will be absorbed first by bank capital, the likelihood (other things being equal) that they will be shifted to the FDIC diminishes as the capital of the bank increases. In addition, increased capital serves to protect creditors and helps reduce distortions in bank funding costs caused by deposit insurance. Capital regulation, therefore, tends to curb moral hazard, as do other forms of supervisory intervention--specifically the examination, supervision, and enforcement process. Moreover, risk-based capital standards and risk-based insurance premiums attempt to impose costs on banks according to the institutions' risk characteristics.
In the U.S., the insurance premium is based on the FDIC's evaluation of the riskiness of the institution. The FDIC is in a much better position to judge the riskiness of institutions than depositors.

Placing the burden on the depositor defeats the purpose of deposit insurance:
Proposals for exposing depositors to greater risk seek to induce depositors to increase their monitoring of bank risk and, by means of their deposit and withdrawal activity, discipline and restrain risky banks. However, increasing depositors' risk could defeat the very purpose of deposit insurance.

...one should bear in mind the following considerations: (1) the relative cost of acquiring the information and analytical skills needed to monitor bank risk as compared with the cost and/or inconvenience of shifting funds to alternative investments entailing little risk; (2) the ability of depositors (and other market participants) to monitor bank risk effectively on the basis of publicly available data, given the 'opaque' quality of bank loan portfolios; and (3) the threat to the stability of the banking system resulting when potentially ill-informed depositors have greater risk exposure.
If the U.K. is going to offer deposit insurance, my suggestion would be to set the limit to cover the total deposits of say 98% of all depositors (£35,000 might be sufficient), and eliminate the coinsurance feature (insure 100% to £35,000).

Fannie, Freddie Portfolio Caps Could be Lifted Next Year

by Calculated Risk on 9/22/2007 02:41:00 PM

The WSJ reports: Limits on Fannie, Freddie Could Be Lifted

The top regulator for Fannie Mae and Freddie Mac said limits on both companies' investment portfolios could be entirely lifted in February if they begin filing timely and audited financial statements.
...
The Office of Federal Housing Enterprise Oversight imposed strict limits on the portfolio size at Fannie Mae and Freddie Mac last year after accounting scandals at both companies. ... Neither company has filed timely audited financial statements in several years, though both plan to do so by early 2008.

Ofheo Director James Lockhart said in an interview that much could change between now and February, but he indicated for the first time that the caps could be eased. "There's a reasonable chance that the caps will be lifted or changed significantly" by that time, Mr. Lockhart said.
This is a discussion of removing the portfolio cap limit, not the conforming limit for the size of a loan.

Saturday Rock Blogging

by Tanta on 9/22/2007 11:59:00 AM

Um . . . because.


CRE: Bought at the top?

by Calculated Risk on 9/22/2007 12:50:00 AM

From the WSJ: Macklowes On a Wire

Mr. Macklowe and his son Billy paid $6.8 billion to buy seven New York buildings from Equity Office Properties Trust. ... the sale was one the most expensive real-estate deals in U.S. history, symbolizing the skyrocketing prices paid for buildings at a time of cheap debt and demand for office buildings.

The transaction was emblematic of the lax underwriting standards of the real-estate boom. Macklowe Properties put in only $50 million of equity and borrowed $7.6 billion, according to the documents. (Mr. Macklowe borrowed more than the purchase price to cover closing costs and other fees.) The deal also had "negative debt service," meaning that the rents from the buildings weren't expected to cover the debt payments for five years ...
Talk about a leveraged transaction: borrowing $7.6 Billion for a $6.8 Billion purchase on properties that have probably declined in value. Approximately $5.0 Billion of the debt must be paid off in February.

Friday, September 21, 2007

Eurozone Slows

by Calculated Risk on 9/21/2007 07:35:00 PM

Wile E. Coyote UPDATE: Video of Paul Krugman interviewed by Georges de Menil on financial markets and global imbalances. (if this doesn't work, go to this page.)

From the Financial Times: Eurozone suffers ‘worst’ jolt since 9/11

The eurozone economy has this month suffered its biggest jolt ... with global financial turmoil hitting the services sector particularly hard, according to a closely watched survey.

The unexpectedly steep fall on Friday in the eurozone purchasing managers’ index – the third consecutive monthly drop ...

... financial markets have started speculating that the next ECB interest rate move will be downwards.
With the Euro at $1.41, and an ongoing credit crunch, it is no surprise that the Eurozone economy is slowing. Yesterday I argued that if the trade deficit has peaked - as seems likely - the dollar is probably much closer to the bottom than the top.

This would be the other side of the coin: with the weak dollar, trade from the Eurozone to the U.S. will slow, impacting the Eurozone economy (although the service sector took the biggest hit in this report). This will probably lead to rate cuts in Europe - and that would also support the dollar at the current level.

Harman Says Buyout Scuttled

by Calculated Risk on 9/21/2007 04:25:00 PM

WSJ: Harman Says Buyout Scuttled

Harman International Industries Inc. learned this afternoon that Kohlberg Kravis Roberts & Co. and Goldman Sachs Group's GS Capital Partners VI Fund LP don't intend to complete their $8 billion buyout of Harman.
...
Harman said the private-equity companies informed [Harman] that they believe there was a "material adverse change" in Harman's business and that Harman breached the merger agreement.

Harman disagrees ...
The breakup fee is $225 Million. Perhaps that is why KKR is arguing Harman breached the merger agreement - to avoid, or at least negotiate, the fee.