Thursday, December 6, 2007

Taking two sides of the same coin...

Ben Stein pointed the other day to the fact that Goldman had been shorting mortgage securities at the same time that it was underwriting them (and selling them to institutional investors). I pointed out that there is a clear conflict of interest in this and that it would create waves.

The NYT came out today with an article on how bad the situation for the securitizations from the street in 2006 are currently and points to the fact that many of them were actually hedging agaist a downfall (or being short) at the same time that they were underwriting them.

One big bank that saw the trouble coming, Goldman Sachs, began reducing its inventory of mortgages and mortgage securities late last year. Even so, Goldman went on to package and sell more than $6 billion of new securities backed by subprime mortgages during the first nine months of this year.
Of the loans backing the Goldman deals for which data is available, nearly 15 percent are already delinquent by more than 60 days, are in foreclosure or have resulted in the repossession of a home, according to data compiled by Bloomberg. The average default rate for subprime loans packaged in 2007 is 11 percent.
In any case, the bankers argue, buyers of such securities — institutional investors like pension funds, banks and hedge funds — are sophisticated and understand the risks.
Wall Street officials maintain that the system worked as it was supposed to. Underwriters, they say, did not pressure colleagues on trading desks or in research departments to promote securities blindly
.

Goldman Sachs also moved early to insulate itself from potential losses. Almost a year ago, on Dec. 14, 2006, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting. The investment bank’s mortgage desk was losing money, and Mr. Viniar, with various officials, reviewed every position in the bank’s portfolio.
The bank decided to reduce its stockpile of mortgages and mortgage-related securities and to buy expensive insurance as protection against further losses, said a person briefed on the meeting who was not authorized to speak about the situation publicly.
Goldman, however, did not stop selling subprime mortgage securities. The bank, like other firms, retains a piece of the securities it sells. A Goldman spokesman said the firm was not betting against the mortgage securities it underwrote in 2007.
Like Goldman,
Lehman Brothers also started to hedge its huge inventory of home loans in the second quarter of this year, concerned about poor underwriting standards. But Lehman also continued to sell mortgage securities packed with shaky loans, underwriting $16.5 billion of new securities in the first nine months of 2007. About 15 percent of the loans backing these securities have defaulted.

As has been pointed out in the past - there was a clear link between Wall Street and sub-prime originators. Wall Street found (smart and/or dumb) liquidity for exotic instruments that were backed by mortgages and the originators had no problems finding ever higher yielding mortgages.

I am guessing this will have interesting tails...

Monday, December 3, 2007

The Government hand in "helping borrowers": what will the result be?

So the Government is laying out a plan to help the mortgage industry: they will coordinate with lenders and servicers to allow for more loan modifications to happen.
Here is Secretary Paulson:
Paulson has said rate freezes would not be offered to people who can afford the adjusted payment or those who, despite having made mortgage payments so far, have too little income and assets to do so in the future. Another issue was whether to exclude heavy borrowers who owe more than their homes are now worth.

Hope Now alliance members are close to agreeing on a systematic approach for dealing with resets on adjustable-rate mortgages, but they are still developing criteria for determining which borrowers will be eligible for streamlined refinancings and loan modifications

This reminds me of the kinds of market trampling that for which Emerging Markets get penalized every 10 years. Whenever the Government tries to have a direct effect on the market, fuel is added to the fire and ends up being counterproductive. The Government needs to make rules through which the economy plays; if rules are made and then changed, players don't play and the economy doesn't work.

Let's see what they are after here: They want to decide what kinds of loans should be modified in the market, because the market has only been able to modify 1%. Let's see, rational investors and borrowers (knowing that there is a 40% loss event if things go into foreclosure), have only been able to modify 1% of the loans. Is it because they are not cooperating and they need an intermediary or is it that there is simply no opportunity to rationally modify these loans?

I have no idea how they will be able to decide which borrowers are eligible to remain at their current rates and which ones not (without offering the option to everyone), not to say the drastic problems they would create to future incentives. Let's see, the responsible borrower that took out a fixed rate loan, or took out an ARM but has been making significant sacrifices to consumption patterns to afford the future payment, or somebody who refinanced just recently into a fixed rate loan, or somebody who took out the risky loan, but, simply can afford it... those don't get help. But, an irresponsible (or the victim of an irresponsible broker) borrower who took out an adjusting loan that upfront couldn't be repaid at the higher rate or those in the camp above but that are able to that fool the system into believing they can't pay, AND (to do justice to what they are trying to do) can pay at the unadjusted current rate, then, those are getting relief (or in market terms - significant returns on their (conscious or unconscious) gambles).

Market distortion: the government will always be there to the rescue...or investors beware if you are making very risky investments - it could be the case that the government will step in and decide exactly how many cents on the dollar you are getting back.

here is a frustrated borrower:
I’m no doubt opening myself up to charges of heartlessness. I don’t have a an ultralow teaser-rate ARM. My loan isn’t subprime. In fact, I knew exactly what I was doing when I bought an adjustable-rate product. I understood the risks and benefits. I’ll be able to afford the consequences of a rate increase.

Still, why should I be the sap who pays just because the above is true? The Journal’s primer suggests that only borrowers for whom a freeze would make the difference between staying in their home and defaulting would be eligible for a freeze. Those who either can afford their mortgages without a freeze or can’t afford their mortgage under any circumstances wouldn’t qualify. Good luck deciding who doesn’t need the help. I’ve just told you I don’t need it because I’m being honest and I’m not sharing any numbers. Would I like to continue paying the same interest rate for the next five years? Hell yes.


The decision to freeze an interest rate or otherwise modify a mortgage is appropriately handled by the borrowers and the lenders, and, in our current reality, the investors who bought the loans from the lenders. They’re the lenders now. They’ll act in their economic interests, whether that be freezing a rate or forcing a default. Anything else makes a total sham of the system of lending money so a borrower can purchase an asset which, in turn, is pledged as collateral against the loan.

I am simply very skeptical that this effort will succeed without creating huge distorsions in the credit incentives that will simply end up making matters worse.

Sunday, December 2, 2007

NYT: The answer to the mortgage mess: North of the Arctic Circle...

It is usually heard that brokers at origination point that misled borrowers into very risky loans, or that lenders funded these loans (knowing that they weren't putting the capital)... and we've heard about realtors, and rating agencies, and investment banks...and in summary, there was such a complex system to originate and sell mortgages that the simple eye would simply recognize early on that this would not have a happy ending...

but, as I have established in the past - the golden rule regulates markets and if there had been no "takers" for these loans, there would have been no borrowers either. For example, volume in these loans dried up significantly this year and it is not because borrowers suddently decided they had enough of brokers or unscrupulous lenders, it is simply because there weren't any more buyers for this paper. The market signals I get point lead me to believe that if there were liquidity for these loans right now, there would still be borrowers.

Because of this, we need to ask ourselves how that liquidity entered the system and if there were schemes that were created to amplify the liquidity.

Here is one example from Narvik, Norway (city of 18,000 people north of the Arctic Circle):

"Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters." "Above all, the residents want to know how their close-knit community of 18,000 could have mortgaged its future — built on the revenue from a hydroelectric plant on a nearby fjord — by dabbling in what many view as the black arts of investment bankers in distant places." "They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level." "The chief investigator of Norway’s financial regulator, Eystein Kleven, said Terra Securities’ Norwegian-language prospectus did not mention such payments, or other risk factors. Citigroup’s term sheet did provide information on risks, but Narvik got a copy only after it had signed the agreement."
The financial alchemy that started it all - the concept that risky collateral could be transformed into safe investments by packaging it creatively - went around the world looking for every single pocket of liquidity that existed - first it was smart liquidity (that probably pretty quickly figured the game) and then it used intermediaries to sell on dumb liquidity. Of course, the more complex the structuring got, and the more parties that were involved in a security (security enhancements, et al), the easier it was to sell (even to smart liquidity) - who could've know what was going on in the first place? it was almost impossible.

I come back over and over to the same point - market intermediares (smart), paid on a commission basis (no skin in the game), line up the necessary elements to connect the dots to generate those commissions... and there are usually (not so smart) dots in the map (although not necessarily in direct contact with those intermediaries).