I have made the decision to spend the time and energy and put together a blog, hopefully worthy of your time. I thought what better and appropriate way to start by entering as my First Offical Blog, an email I sent out last summer as the Capital Markets' melt down was beginning to take shape. I believe you'll find some of these items currently taking pace now.
I will look to update MBAFROG blogspot on a fairly regular basis. For those of you in the residential or commerical mortgage industries, I hope you will find this helpful as we collectivly navigate the waters in which we swim.
Since March, I have received a plethora of questions ranging from: Did poor credit borrowers who took out SubPrime mortgage loans really cause all this? How did this happen? What's happening to my stocks?!?!? How serious are these issues? How might this affect me? And what's going to happen going forward? I would like to offer an opinion (warning it’s lengthy) to those questions and if nothing else help you understand that "risks" associated with the current "liquidity" crisis is very real to not only the US housing market but the US and Global economies as well.
Fact Number 1 - Equity Markets Hate Uncertainty
First off, it's critically important to understand that the mortgage market "originates" from global capital sources. While the majority of home mortgages are generated from offices close to where we all reside, the backers (front money) tends to be National Banks (BofA, Chase, Citibank Wells Fargo), Regional Banks with a national mortgage presence (National City, Sun Trust, BB&T) and Investment Banks (UBS, Bear Stearns, Lehman Brothers, Credit Suisse). Credit Unions and others get into the act but the percentage is very small. The above mentioned firms have two options when originating or buying mortgages. They can resell them or place them on their balance sheet. As you read later, even the largest - most well capitalized companies find it difficult to execute the latter strategy for an extended period of time. That’s just how large the mortgage market is. As such the vast majority of loans are repackaged and sold. This process brings "liquidity" in to the mortgage market.
Fact Number 2 – Without Liquidity There is No Mortgage Market
Read what I am writing here. Without Liquidity, companies who originate or buy mortgages would only be able to carry as many loans as their balance sheet would permit. Hence one of the reasons and benefits for the creation of our government sponsored entities (FNMA and FDLMC). GSE’s were designed to add liquidity into the mortgage market. Here’s a little FYI, Fannie Mae was created way back in 1938 as part of FDR’s “New Deal”.
Fact Number 3 – No Private Intuition Can Provide Mortgage Capital More Cheaply than the GSE’s
If you can’t compete with Wal-Mart on price and you’re in the same business, you’d better find another way to compete if you are going to survive. In the 1980’s Mortgage Backed Securities (through a bevy of circumstances) were generated to pick off higher yielding products that the GSE’s could not buy (charter issues). Those now involved in creating Mortgage Backed Securities (MBS) could create mortgages as investor demand warranted. This may include all of the earlier companies (excluding Mortgage Bankers/Brokers) with the MBS investors ranging from Investment Banks, Hedge Funds, Pension Funds, Investment Funds, Mutual Funds, the US Treasury, Foreign Governments, and really, really Wealthy Individuals. Starting to hit home?
Comment Number 1 - A mortgage-backed security was never purchased or sold out of the goodness of the Sellers/Investors’ collective hearts or out of a desire to help provide housing for America.
Fact Number 4 – Capitalism is the Greatest Story the World will Ever Know
Keep in mind the sole purpose in buying mortgage-backed securities is to generate the biggest bang for the biggest buck… at the least amount of risk. Those capital sources mentioned above will invest in lawn gnomes if lawn gnomes could provide as much or more return with a similar risk profile as mortgage-backed securities (that's for you Robert).
In general the capital sources (from here forward called Investors) have a couple of performance benchmarks they are committed to. Like you and I, they are first and foremost interested in the return of their capital. Secondly they are keenly interested in the return on their capital. This may vary but MBS and CDO (for another discussion) Investors tend to be intently focused on generating a total rate of return of 150 basis points or more above a targeted rate of inflation. The higher the inflation adjusted rate of return with the least amount of risk the better. The safest but most limited returns are generated from investments in obligations underwritten by the full faith and credit of the United States government and are comprised of US bills, notes and bonds. These debt obligations carry credit quality ratings of AAA – signifying to the investor that there is little chance the creditor (in this case the US government) will fail to make remittances of both the principal and interest to the investor. Treasury obligations are considered the benchmark for a risk less rate of return primarily because Uncle Sam has the power to either tax or to print money to insure timely payments to his creditors. Wish I had that power!!!
How this comes together. Conforming mortgage-backed securities (FMNA, FDLMC, GNMA) don’t carry any credit risk to speak. Why? Because the borrower of each individual loan contained in a pool of conforming loans pays a guarantee fee as part of each month’s remittance. Don’t confuse guaranty fee with private mortgage insurance. Private mortgage insurance protects the lender against loss of a portion of the principal amount of the loan in case of foreclosure. The guarantee fee assures the investor holding a mortgage-backed security (an instrument collateralized by a number of individual mortgage loans) that all principal and interest remittances will be made. This guarantee fee is imbedded in the note rate of the each individual loan and may be as small as 6 basis points for a 30-year FHA or VA loan. The guaranty fee on conforming loans will vary from lender to lender and product to product but will seldom exceed 25 basis points. Thus, you and I pay this fee and it’s not something we can negotiate. This guaranty fee is collected by the loan servicer and transferred to a designated trustee to hold as a credit enhancement for the Investor. For an Investor, it’s a sweet deal. Add the guaranty fee and these conforming mortgage-backed securities carry the same credit quality as an obligation of the United States Government – AAA but with a higher yield! As you may/may not know only the highest quality debt obligations are rated AAA.
Question Number 1 - Ok Tory, enough commentary… how does this affect me?
In three ways:
· · The Mortgage Lender has very quickly received a disbursement from the bond dealer from the sale of the mortgage-backed security which enables the mortgage lender to immediately use this money to originate more loans.
· · Home buyers benefit from lower mortgage rates created by global demand for these mortgage-backed securities which in-turn provides an steady supply of money to meet loan demand.
· · The Investor, those whose money makes all this work in the first place, benefits from a higher rate of return than available from government debt instruments while being fully protected from losses even if massive defaults on the underlying mortgages were to occur.
Again, it’s a sweet deal all the way around.
Question Number 2 – How did SubPrime Cause This?
To answer this question, we need to travel back, way back. As mortgage interest rates tumbled to their generational lows first in the last 90’s and again during the first few years of this century, the total returns to investors in the mortgage market obviously fell. As Investors banged on Wall Street looking for more returns, Wall Street started to look at MBS. Hence the concept of making loans to people with poor credit histories as a way to increase loan demand and ultimately to increase the flow of higher yielding mortgage-backed securities was born.
To compensate for the elevated credit risk the borrower presented, it was decided that note rates on these loans would be at least 200 basis points higher than the note rates offered to grade A borrowers. The thinking (primitive back then) was even though a number of these borrowers would default on their mortgage – the higher fees paid at closing and the higher note rates would more than compensate for the loss. Goggle “Loss Reserves”. Add to the short term thinking, the argument was that even if the loan went into foreclosure the Investors had nothing to fear because the property would sell quickly at a price equal to or greater than the original sales price because of the positive HPA environment. HPA = Home Price Appreciation.
Comment Number 2 – When Everyone’s Talking About IT… It’s Now Time to Sell!
During the housing boom of late 2002 through mid-year 2005, Investors profited handsomely from returns far superior than they could generate in the conforming mortgage market. Initially these SubPrime loans performed so well that credit rating agencies (S&P, Moody, Fitch) rated some SubPrime and niche (Alt-A) securities as high as AA. This is a notch below a perfect score of AAA. Hey, few people are perfect. These high credit ratings allowed even Blue Chip conservative investors to join the mortgage feeding frenzy. As demand for these securities soared, credit standards continued to erode as the pool of prospective credit worthy borrowers shrank. Eventually all it took was a desire and a heartbeat (as we frequently joked in many of my meetings) to own a home. Hey it’s America and the mortgage market continuously fueled by Wall Street and their Over sea’s Investor connections to help everyone fund our “No need to worry about verifying Income, Assets, Employment all the while not requiring a down payment or money for closing cost financing.
Comment Number 3 – When it’s Raining Mud, Everyone is going to get Dirty
Things began to go significantly awry toward the end of 2006 as borrowers began to default on loans at a rate far in excess of what was anticipated. In certain geographic areas of the country HPA began to plummet as foreclosure rates skyrocketed. The fabric of the SubPrime and Niche MBS began to fray and then gave way entirely. In short order Investors began to experience delayed remittances of interest followed in short order by notices that their principal was lost as well. The alarms bells was sounded when Chief MBS player Bear Stearns warned in mid-June that two of it’s larger Hedge Funds (worth approx. $20Billion) were having significant performance issues. As chief investor Merrill Lynch pulled close to $800million of the highest quality loans out of the fund, the other shoe dropped. To add to the complexity, the credit ratings agencies had an epiphany and reversed themselves by dropping the credit ratings of hundred’s SubPrime securities to junk bond status. This is well below the minimum credit standard authorized by any portfolio quality for many mutual funds, insurance companies, money-center banks, Treasury departments of foreign government, ect, ect, ect. “And the Beat goes On”… Think if somebody had just yelled “Fire!” in a crowded club (some may say theatre but this is my analogy). The panicked rush for the exits was on and there was no doubt some people where going to be severely injured or killed in the stampede.
Question Number 3 – How Real is the Risk?
As day after day of sensationalistic journalism in every mass media outlet throughout the world bombarded the Capital Market and Investment community. Thus approximately three weeks ago, every emotion of fear completely over-ran the mortgage markets. Second Mortgages, ALT-A (Alternative Documents - Stated Income, No Income, ect) Non-Conforming mortgage programs all found little interest. So the American Homes, Greenpoint Mortgages and many, many others who make a these loan programs a primary source of income for their respective firms fell victim. See www.ml-implode.com See Fact Number 1. Investors now realized this miscalculated the risk and had no idea how much toxic waste they had on their books. Mutual Funds around the world stopped issuing imbursements as governments demanded a recalculation of “risk”. Risk - A word used more frequently in the past 6 months of this year than perhaps the first 6 years of this millennium.
This current period of all encompassing fear leaves no room at this juncture for rational “cause-and-effect” discussion. Liquidity for the above mentioned mortgages has ceased to exist. Many companies do not offer what were thought to be base line products anymore (Second Mortgages, Stated Income Loans). Some do and are having to balance sheet those transactions for resale at a time to be determined in the future.
Fact Number 5 - Markets are very efficient in correcting imbalances.
While this process is brutal and financially fatal for some, the markets are correct....you and I are not. So while the paradigm has moved to a historic level in terms of pricing of risk, it is my deepest hopes that with in 90 to 180 days that things will change. With that comment, I’ll answer the last question. “Where do we go from here?”
Unlike most economists’ who follows the capital markets, I’ll try not to speak in generality but will look to add some clarity on where I believe we are today..
Best Case Scenario
Mr. Bernanke’s unexpected decision to lower the discount rate cut last Friday adds some reassurance to Investors around the world that the Fed won’t allow for a Equity meltdown. Given that numberous governments added almost $1trillion in capital to the global economy over the past 10 days puts into action a “settling of the tide”. The scores of home owners who have SubPrime and short-term adjustable rate mortgages who are delinquent find a “willing partner” with their loan servicer and restructure their mortgage payments to an “acceptable level”. The Fed shrugs off their concerns for inflation and seeks to easy Investor demand for another cut of the important fed funds rate by at least 25 basis-points on or before September 18th (Next Federal Open Market Committee FMOC). By my accounts, traders have fully priced in this occurrence. The strong US Employment levels save the day and all is well in the new paradigm in early 2008.
My Expected Scenario
The Mortgage market is still experiencing a dramatic “flight-to-quality” as seen in the monetary flow to short term Treasury bills and notes. This is not what the Fed wanted to see following their surprise discount rate cut decision. The current buying spree, directed predominately toward the short end of the yield curve, is an indication that Investors are still refusing to take any additional risk with their cash holdings. Instead, they appear to be more than willing to accept sharply lower returns on their money in exchange for the safety of government bonds and conforming level returns. As an example; last week the four-week Treasury bills are currently trading below 2.0% after being auctioned off above 5.0% just three weeks ago. Three-month bills are currently trading at 2.85%, sharply below the 4.65% yield they offered just three weeks. The longer Investors sit on the sideline, the more various mortgage companies will fail, and especially those heavily tied to mortgage products with little or no liquidity and are not properly tied to a bank. Those firms which do survive the new mortgage paradigm will have the entire US mortgage market spoils at their feet. Many new players will emerge and the mortgage process will become even more efficient, even if the interest rates are not. All in all, the cost of mortgages will rise, many mortgage products which were the prize holdings for companies such as Countrywide and Street Firms will ease to exist. Foreclosures will continue to rise through 08’ prompting Congress (at the behest of the Mortgage Industry) to get involved and muddy up the water. All of the Best Case Scenario’s play out at a slower place.
Worse Case Scenario
All of the above does not occur with in the next 18 months. Tens of thousands of homeowners who took out Interest Only, Negative Amortization, Hybrid Arms (long and short), and either SubPrime or Hard Money Mortgages who are needing to reset their mortgage cannot as those mortgage products no longer exist and those homeowners either did not put any additional money to pay down their mortgage during their “introductory period” or should have never been in the home they purchased to begin with. Banks which have been “booking” those loan programs that no longer exist; do not have the capacity to assist the influx of stretched homeowners. FNMA and FDLMC are too slow to reacting to the issues and do not create mortgage products fast enough for those which delinquent home owners. Liquidly in the MBS market continues to sit idly by as no one in their right might is interested in picking up overly stressed mortgage asset for the entire US. HPA falls 25-30% in some of the top 8 metropolitan area’s (LA & Long Beach, San Francisco & San Jose, San Diego, Las Vegas, All of Arizona, Key Cities in Florida, Metro DC, Boston, NY & Suburbs, the rust belt (MI, OH, KY, IN, PA). Investors stay away because if people are given more time to repay their mortgages in order to avoid foreclosure, someone will have to pay for that. Keep in mind my first comment. Keeping people in their homes is very, very valuable. One foreclosure in an economically fragile neighborhood will cause the value of every other home in that square block to decline by as much as three to five-thousand dollars and consider the percentages I am illustrating above. The US economy endures a 3 year recession followed by a new awakening where we’ll have a smarter economic system…. until someone else looks for an opportunity to “capitalize”.
I hope you find the following informative and insightful. Please note: this commentary does not in any way represent National City Bank. If you have questions or comments, please feel free to email me directly.
Data collected from CNBC, ML-Implode and Larry Baer was used for this commentary.