by Calculated Risk on 3/02/2010 02:49:00 PM

From Zach Fox at SNL Financial: Credit Suisse: $1 trillion worth of ARMs still face resets

Most of the resets are expected to occur through 2012. Between 2010 and 2012, the chart indicates that $253.25 billion of option ARMs will adjust, while Alt-A loans totaling $163.71 billion will reset over that time. Altogether, $1.010 trillion worth of ARMs will reset or recast during the three-year period.
...
"Option ARM resets are still pending. … Nothing much has happened yet because rates were so low that resets were pushed back," Chandrajit Bhattacharya, head of non-agency RMBS and ABS strategy at Credit Suisse, told SNL.
...
[Greg McBride, senior financial analyst at Bankrate.com] was cool to the idea that option ARMs could flood the foreclosure rolls. Option ARMs are less concerning, he said, because so many have defaulted already. Indeed, the September 2009 Fitch Ratings report showed that 30-day delinquencies on option ARMs sat at 46% even though just 12% had recast. Further, option ARM foreclosure rates already match the sky-high subprime foreclosure rates.

Instead, McBride is worried about the prime ARMs posted in the Credit Suisse chart [if interest rates rise - see article for discussion].
excerpts with permission

Click on graph for larger image in new window.

Source: SNL Financial.

This graph shows the amount of ARMs resetting and recasting over the next few year. Resets are not a huge worry right now - because interest rates are so low - but if interest rates rise, this could lead to more defaults in the future.

Recasts - when the loans reamortize - are a concern, although it is unclear how large the payment shock will be. For borrowers with negative equity, any payment shock might be lead to default. As I wrote last year in A comment on Option ARMs

It is a little confusing. You can't just look at a chart of coming recasts and know when borrowers will default. The real problem for Option ARMs is negative equity, and the surge in defaults is happening before the loans recast.

But the recasts will matter too, since many of these borrowers used these mortgages as "affordability products", and bought the most expensive homes they could "afford" (based on monthly payments only). When the recasts arrive, these borrowers will have few options.

by Tanta on 8/13/2008 07:52:00 AM

My post yesterday featuring some rate reset charts from Clayton prompted a good deal of concern in the comments regarding the issue of Option ARMs and the differences between the Clayton chart and some others that have been published lately. Reader Greg kindly emailed me copies of two charts on Option ARMs that have been published in the WSJ and Business Week recently, with a request that I comment on the apparent differences between and among these charts in terms of the timing of "reset" problems.

As far as I'm concerned, a large part of the confusion here is that our friends in the media are not very careful about using the terms "reset" and "recast" consistently, like us UberNerds do. Take this chart from Business Week:



The chart title says "Reset Schedule," but the legends make it clear that what you have here is actually a "Recast Schedule." No wonder people are encouraged to use these terms interchangeably.

This chart from the Wall Street Journal doesn't use the term "reset" at all, which is good since it clearly explains that it is talking about "recast":



Do note, though, that the WSJ chart uses only "scheduled recast dates." The Business Week chart above contrasts "scheduled" recast with projected actual recast based on the rate of growth in actual negative amortization balances as of the chart date.

And, finally, we have our Clayton chart I posted yesterday that avoids the whole lingo problem by opting for the title "Loans With Rate Changes." Maybe the Clayton analysts got tired of the "reset vs. recast" confusion and just decided to go long-form. In any case, the Clayton chart, unlike the two above, includes but is not limited to Option ARMs; it is looking at the whole "Alt-A" pile which includes amortizing hybrid ARMs and lots of interest-only ARMs as well as OAs.

There obviously isn't perfect consensus here on terminology. All I can really do is make clear how I am using these two terms. I think my usage conforms to the way industry wonks talk, but I can't promise you that anyone outside the wonkosphere will be as careful with these distinctions. Caveat lector.

"Reset" refers to a rate change. "Recast" refers to a payment change.

On a normal fully-amortizing ARM, the interest rate resets on what is called the "Change Date" (five years out for a 5/1 ARM, three years out for a 3/27 ARM, each year thereafter for the 5/1 and every six months thereafter for the 3/27, etc.). The payment recasts exactly one month after the rate resets. Mortgage interest is paid in arrears, so first you reset the rate, then the following month you recast the payment. "Recast" is really just a shorter word for "reamortize": you take the new interest rate, the current balance, and the remaining term of the loan, and recalculate a new payment that will fully amortize the loan over the remaining term.

On an interest-only ARM with a rate change that happens during the interest-only period, the rate resets on the Change Date and then the interest payment is recalculated on the next payment date. I wouldn't tend to use the term "recast" here since with an IO, you aren't actually amortizing or "casting" a new payment, just adjusting the interest due given current balance and new rate. The big issue with IOs is the end of the IO period, when the payment has to be amortized over the remaining term. This date is what I would call the "recast" date of an IO. It may or may not coincide with the first interest rate reset date. Some 5/1 IOs, for example, reset and recast both at the end of five years. Some have a 10-year IO period, meaning they reset annually between years 5-10 but do not recast until year 10. If the rate resets to a higher rate in that period, the required IO payment increases, but not as much as it will when the recast hits and principal must also be repaid on a 20-year schedule.

On a typical Option ARM, the rate resets monthly beginning as early as the first month of the loan. The payment is adjusted, but not recast, annually; usually the payment increases by no more than 7.5% each year. It is that mismatch between rate reset and payment change that actually creates the potential for negative amortization; the "minimum payment" gets outstripped by the actual interest due because it increases much more slowly than the rate does.

Option ARMs do not "recast" until the sooner of 1) the loan reaching its balance cap or 2) the first "scheduled" recast date, which is usually 60 months from origination. What you see in the Business Week chart is the difference between the two: the recast projections come a lot earlier if you look at how close loans are actually getting to their balance caps, rather than just assuming they'll all recast on their five-year anniversary.

By and large, the biggest danger for Option ARMs and IO ARMs is the recast date, not the first or subsequent rate reset dates. However, for any ARM borrower who qualified at the highest possible debt-to-income ratio they could manage, any payment change, even one not quite as shocking as the recast on an OA or an IO, can tip the balance. As we are talking in this specific context about Alt-A, I for one believe that most of these loans did stretch too far in the beginning, and so even first rate resets on IOs or fully-amortizing ARMs will cause a marked increase in delinquencies in the absence of the borrower's ability to refinance at reset into a new discounted ARM, which will be the case for some time.

I hope that clears it up a bit, at least for the next week or two.

by Calculated Risk on 8/05/2008 10:32:00 PM

From the WSJ: FirstFed Grapples With Fallout From Payment Option Mortgages

Like many mortgage lenders, FirstFed Financial Corp. is struggling with rising losses. ... Forty percent of its borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast. The number of foreclosed homes held by the bank doubled in the second quarter from the first quarter.

But FirstFed isn't another bank grappling with the fallout from subprime mortgages that went to less-creditworthy borrowers. ... [T]he Los Angeles bank is on the front lines of what could be the next big mortgage debacle: payment option mortgages.

It seems like Tanta and I have been writing about the coming wave of Option ARM defaults forever, but it's only been since 2005!

Barclays Capital estimates that as many as 45% of option ARMs, as they are often called, originated in 2006 and 2007 could wind up in default. Another analysis, by UBS AG, suggests that defaults on option ARMs originated in 2006 could be as high as 48%, slightly higher than its estimate for defaults on subprime loans.

The key here, for the housing market, is that the next wave of defaults will be hitting middle to upper middle class neighborhoods.

We're all subprime now! (a classic Tanta phrase)

by Tanta on 5/13/2008 08:08:00 AM

Bloomberg reports:

May 13 (Bloomberg) -- The benchmark interest rate for $62 trillion of credit derivatives and mortgages for 6 million U.S. homeowners faces its biggest shakeup in a decade as lawmakers question if banks are understating borrowing costs.

For the first time since 1998, the British Bankers' Association is considering changing the way it sets the London interbank offered rate, according to Chief Executive Officer Angela Knight, who appeared before a parliamentary committee in London today. ``We've put Libor under review,'' Knight said in an interview yesterday. While she declined to discuss specifics, the BBA will announce changes May 30, she said. . . .

While the BBA set the one-month dollar Libor rate at 2.72 percent on April 7, the Federal Reserve said banks paid 2.82 percent for secured loans later that day. Secured loans typically yield less than unsecured debt.

``The Libor numbers that banks reported to the BBA were a lie,'' said Tim Bond, head of global asset allocation at Barclays Capital in London. ``They had been all the way along. The BBA has been trying to investigate them and that's why banks have started to report the right numbers.'' . . .

Libor rates jumped after the BBA said April 16 that any member banks found to be misquoting rates will be banned. The cost of borrowing in dollars for three months rose 18 basis points to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze last August. The one-month rate climbed 14 basis points, its biggest gain since November.

For your information, the vast majority of subprime and Alt-A hybrid ARMs--plus a significant number of prime hybrid ARMs--are indexed to the 6-month LIBOR. Option ARMs are frequently indexed to one-month money, and as far as I know are roughly split between the one-month LIBOR and the MTA index (Moving Treasury Average or Monthly Treasury Average, depending on whom you ask. You will also see it called the MAT index. I just work here.) In any event, spikes in short LIBOR rates will most immediately be felt by Option ARM borrowers.

Style sheet question, for those of you in the reportorial class: when did LIBOR get to be "Libor" in the USA?

by Tanta on 12/09/2007 10:18:00 AM

CR did a wonderful post yesterday clearing up some of the myths and misunderstanding about the Hope Now/"Paulson Plan." I just want to follow up on one of them, the issue of whether this is a "bailout."

We will never establish consensus on that point as long as anyone uses the term "bailout" to mean just any post-hoc action that could benefit someone. CR is using the term somewhat more specifically, in the sense of providing actual taxpayer funds to subsidize mortgagors or make whole mortgagees. In that latter specific sense, the Paulson Plan does not represent a "government bailout."

Several people have noted that it does seem to rely on the availability of government-insured refinance loans (FHA and FHASecure), and it proposes, certainly, the development of government-sponsored bond programs (the "government" in the latter case would be states and counties and cities, not the federal government, as far as I can tell).

I therefore thought it would be helpful to remind everyone what the difference is between a "government-insured" loan and a bond program. FHA does not buy loans. It does not provide capital to make loans with. It is not entitled to any interest income from performing loans. It does not service loans. Ginnie Mae securitizes FHA loans, but Ginne Mae doesn't buy loans either. It "wraps" pools of loans with its guaranty.

So FHA gets nothing out of performing loans except the required insurance premium that the borrower pays. Premiums are held in the MMIF (Mutual Mortgage Insurance Fund) and used to pay out for claims on defaulted loans. We don't need to get into all the technical parts of that today. The point is that the general goal of the FHA MMIF is to be revenue-neutral. Whether it is or not at any given point in time depends on how well the premiums were priced and how well the loans perform. For a long time the MMIF has been a "negative subsidy" on the federal balance sheet, meaning that it actually is in the black. It may well not continue to be in the black, but my point is that what's in the black isn't "profit" from interest payments made by mortgage borrowers. FHA doesn't own any loans. What's in the black is insurance premiums collected in excess of claims paid.

Bond programs are different. There are a jillion flavors of them, but in essence they are public versions of securities: they actually do buy loans, pool them, and issue bonds to investors who receive the principal and interest payments from the loans. Typically, they are set up to buy low-interest (below market) rate loans, because they are issued by governments and everything gets favorable tax treatment. It is possible that the loans in a bond program pool also have some other kind of credit enhancement like FHA insurance, private mortgage insurance, or second liens.

But the bottom line issue here is that insofar as the loans do perform, the bond program's investors do receive the interest income. The bond issuer is ultimately at risk if the loans default and there is not enough principal recovered to make the investors whole.

But in both cases--government-insured loan programs and bond programs--private investors are providing the capital. Of course cities and states and counties can themselves invest in mortgage securities, and we see that they have. But that's hardly the traditional way of doing a mortgage-backed bond issue: the idea there is to get someone else to provide the capital, since the issuer is providing the credit enhancement.

The federal government does not have any program in which it directly buys mortgage loans, or directly invests in mortgage loan pools. The lending capital in this context is always coming from the private sector.

So to get back to the "bailout" question: at the simplest level, what's going on here is that loans that were "insured" (or credit-enhanced) by the private sector are being refinanced into loans that are insured or credit-enhanced by the public sector. Therefore the risk is moving off the private balance sheet and onto the public one. The rewards--such as they are these days--are still firmly in the private sector. In that sense, you could call this a bailout: it's moving the risk of default.

On the other hand, it only works if investors are still willing to buy Ginnie Mae securities or municipal bonds. There has to be some capital supplied. The idea here is that nobody's stupid enough to buy high-risk mortgages right now without government guarantees. So far--and I do stress so far--not even FHA has been willing to go down the road of upside down loans to borrowers who can't qualify with income docs. That's why the whole Paulson Plan is about, in essence, what to do with those loans. So FHA is "taking out" some pretty weak loans, but it isn't taking the weakest ones. The weakest ones get "the freeze" or the foreclosure. That is why this Plan is usefully described as not a government bailout. If FHA or municipalities would take all the toxic waste, we wouldn't need this Plan; servicers would just be busy refinancing. The Plan exists because there is a big pile of loans that do not qualify for any of those refinancing opportunities.

Some people are getting confused by the extent to which The Plan talks about refinances. We already had FHASecure and plain old FHA before this Plan; the Plan did not invent those options. The Plan is about designing rules of thumb for quickly sorting out the loans that don't qualify for refinances, and doing something about them. In that sense it's no more of a "bailout" than what we had before The Plan.

Now, as I noted last week, Paulson's "total package" includes lobbying for "FHA Modernization," which would certainly increase the number of loans FHA could "take out" and decrease the number of loans the private investors have to live with somehow. There are many reasons not to like that; even if you do like the idea of FHA taking on more of the problems, though, the answer here would be to expand FHASecure, which is a new program specifically designed to refinance troubled loans. Changes to the regular old FHA warhorse program would allow more "take outs," but it would also apply to new loans, and we'd have it forever (because there's never the political will to tighten FHA requirements during the next boom), and so FHA would be in the front of the mess next time, with no "dry powder."

"FHA Modernization" might be a kind of bailout, but it's not, in my view, really much of a bailout of existing, defaulting mortgage securities. It's a "reflation" of the mortgage origination industry and the RE market (existing and new). That's the only rationale for pressing for FHA Modernization rather than pressing for easing restrictions on FHASecure. As I said, there are precious few investors who will put money in mortgages right now without a government (or quasi-government) guarantee. Ignore the spin: FHA Modernization is about making new purchase money loans, not about refinancing old problems. That is not an "investor bailout"; it's life-support for loan originators and builders and sellers of existing homes.

We should, I guess, pause over "sellers of existing homes," because we have a vocal subset of the commenting community who keeps arguing that borrowers in trouble should just be counseled to mail in the keys and be done with it. I take it the idea is not to have the banks and REMICs own that REO forever; the idea is that the REO would be sold at a much lower price to new borrowers. Who quite possibly can't get financing right now because the mortgage market is stalled and all appraisals are now in question. So even at a lower price, you need financing for these new borrowers. Enter "FHA Modernization."

There are many kinds of "bailouts," and they don't all depend on not foreclosing on current owners. I frankly am more worried about FHA Modernization becoming a "bailin" than I am FHASecure being a "bailout."

by Calculated Risk on 12/08/2007 05:05:00 PM

Update: OK, eleven!

10) This is not a bailout. There is no federal money involved.

9) The Paulson mortgage plan does not violate any contracts. Tanta nailed this immediately: The Plan: My Initial Reaction

A lot of people are very worked up over the idea that the New Hope Plan is, in essence, the government mandating a kind of reneging on private contracts (the PSAs or Pooling and Servicing Agreements that govern how securitized loans are handled). I personally think you can all stand down on that one.... it is clear to me that it is in fact structured with the overarching goal of making sure that it stays on the allowable side of the existing contracts.

James Hymas of Prefblog (via Econbrowser) dug up this contract language. I've highlighted section Y, what Tanta pointed out immediately!

EMC, as master servicer, will make reasonable efforts to ensure that all payments required under the terms and provisions of the mortgage loans are collected, and shall follow collection procedures comparable to the collection procedures of prudent mortgage servicers servicing mortgage loans for their own account, to the extent such procedures shall be consistent with the pooling and servicing agreement and any insurance policy required to be maintained pursuant to the pooling and servicing agreement. Consistent with the foregoing, the master servicer may in its discretion (i) waive any late payment charge or penalty interest in connection with the prepayment of a mortgage loan and (ii) extend the due dates for payments due on a mortgage note for a period not greater than 125 days. In addition, if (x) a mortgage loan is in default or default is imminent or (y) the master servicer delivers to the trustee a certification that a modification of such mortgage loan will not result in the imposition of taxes on or disqualify any trust REMIC, the master servicer may (A) amend the related mortgage note to reduce the mortgage rate applicable thereto, provided that such reduced mortgage rate shall in no event be lower than 7.5% and (B) amend any mortgage note to extend the maturity thereof, but not beyond the Distribution Date occurring in March 2035.

8) There will be no lawsuits from investors (other than lawsuits that would have happened anyway).

There have always been different interests of the various investors - what Tanta referred to as "Class Warfare". These different interests may lead to lawsuits, but this isn't the result of the Paulson plan. Earlier this year Tanta wrote a series MBS for Ubernerds, and in the April edition she pointed out:

... the notion of a multi-class security is generally premised on the happy assumption of a bunch of different investors with different investment needs—fixed income, hedges, what have you—all of whom can come together, take the piece they want, and play “support bond” for each other, while the REMIC issuing trust happily takes the leftovers in the residual out of the kindness and generosity of its heart. What lurks beneath this premise—and will get crucial when we start talking about credit risk again—is that multi-class can introduce “class warfare.”

One thing you can say about the various part-owners of a big single-class pass-through is that they’re all in the same boat, since they’re all getting a pro-rata share of whatever is going on—fast prepayments, slow prepayments, high-coupon, low-coupon—in the underlying pool. In a multi-class REMIC, fast prepayments could be great for me and tough luck for you. Changes in the underlying interest rates on the loans could be tough for me and great for you.
emphasis added

The proposed changes in the interest rates (the freeze) may be tough for a particular investor, but they are permitted under the PSA (Pooling and Servicing Agreements).

7). These are not teaser rates.

The freeze rate is usually in the 7% to 8% range. Some people hear "teaser rate" and think 1% or 3%. Nah. These loans started at a much higher rate. In the above EMC agreement, the minimum rate was 7.5%.

6) The plan is voluntary - not a mandate - and this is not government regulation.

5) The plan targets homeowners with weak credit who owe more than their house is worth.

All this talk about LTV greater than 97% makes it sound like this plan is for homeowners with LTVs from 97% to 100%. Nah. This is plan is for homeowners with weak credit (maybe 1.2 to 1.8 million) that are underwater - or about to be underwater - on their homes. They can't sell. They can't refinance. And they probably can't make the new payment.

Imagine the headlines if they had set the level to 105% LTV or greater. The actual number of eligible homeowners wouldn't decrease much - most of these people are probably more than 5% underwater already and will be further underwater soon - but the headlines would blare: the government wants people to pay on mortgages that are for more than their collateral is worth!

And that is the goal.

Of course the level was set at 97% or greater LTV because the industry recognizes that anyone with less than 3% equity cannot refinance. For those with a 96% LTV mortgage - no worries - just wait a few months and the value will probably decline enough to put you in the plan.

4) This is an industry / investor plan. Don't be confused about the happy talk about helping homeowners stay in their homes. This is about helping the investors, and trying to slow the impact of the housing Depression on the economy.

Some homeowners will be helped, but as Tanta wrote:

In my reading of this, giving a deal to a borrower almost seems incidental.

3) The savings for the investors will be small. Professor Krugman took a stab at the numbers:

Only a small fraction of borrowers will be covered. According to one estimate, we’re talking about maybe 145,000 mortgages. And because of the nature of the borrowers, these aren’t big mortgages — average value almost surely under $200,000.

Now, the idea of the deal is that it will avoid foreclosures, which are very costly — losing 40 to 50 percent of the value of the mortgage, according to some estimates.

Suppose that’s right — and that virtually all the benefits of the deal go to investors, not homeowners. Then we’d be talking about $100,000 per mortgage, over say 150,000 mortgages. All told, $15 billion.

In reality, it would be substantially less than this, both because borrowers will get something, and because some of the rescues will fail. So we’re almost surely looking at less than $10 billion in losses avoided.

Meanwhile, estimates of subprime losses to investors are currently running in the $300 -$400 billion range.

So the back of my envelope suggests that this plan is a drop in the bucket.

2) Recidivism will be high. Again from Tanta:

I want to comment on this little statistic, that is getting thrown around a lot:

Modified loans frequently re-default. Joshua Rosner at Graham-Fisher & Co. says 40% to 60% of subprime and Alt-A borrowers who have their loans modified end up defaulting anyway within the next two years. Fitch Ratings puts the recidivism rate at a slightly lower 35% to 40% for good modification programs.

Let us bear in mind that such statistics have to be based on loans that were modified no more recently than 2005 (newer mods would not have a 24-month post-modification history). It is quite possible, indeed it is likely, that modifications done in 2005 and earlier (when there were many more refi opportunities and most borrowers could sell their homes for at least the loan amount) were done for borrowers with problems like job loss or illness that either simply recurred or that created other (non-mortgage) debt problems down the road.

This is not to argue that modifications done now for loans originated in 2005 and after would perform better. Or worse. Or the same. It is to say that we are probably in uncharted territory and that "past history" was a lousy guide when we made the loans and might be a lousy guide when we have to work them out.

I suspect the percentage defaults (recidivism rate) after a rate freeze will be in "uncharted territory". And this means the losses for investors aren't being avoided, just postponed.

1) For the Home Builders: Nothing.

There is an investment myth that this freeze will help the homebuilders because there will be fewer distressed homes on the market next year. This seems silly. The homebuilders are getting crushed because of the current inventory levels. Sure, the freeze will probably keep a hundred thousand - maybe a few hundred thousand - distressed homes off the market. That is a drop in the bucket.

And most of this distressed inventory is coming - it's just being postponed - and that will prolong the slump.

AND FINALLY: The purpose of the plan is to publicize that lenders will modify loans.

All of these modifications could have been made anyway without the freeze. But the problem was very few homeowners called their servicer before defaulting on their mortgages - and most homeowners didn't answer their servicer's calls once they were delinquent.

By having a standard, the guideline can be publicized. The goal of this plan is get homeowners to pick up the phone.

by Calculated Risk on 12/07/2007 01:44:00 PM

Secretary of the Treasury Henry Paulson hosts a Q&A.

Randall, from Kearney, Ne writes:
Why are we responsible for bailing out the ARM lenders, or if you insist, the borrowers that were fully informed of the consequences of an Adjustable Rate Mortgage? This is for the benefit of lenders, isn't it?

Henry Paulson
Let me say first, this is not a bail-out – there is no federal money involved in what was announced yesterday. It’s a private-sector led initiative that is to the benefit of everyone – the families who face losing their homes, the neighborhoods and communities they live in, as well as mortgage servicers and mortgage investors. Foreclosure is to no one’s benefit. I’ve heard estimates that mortgage investors lose 40-50 percent on their investment if it goes into foreclosure.

Because everyone loses in foreclosure, the industry – lenders and investors – already has a process for working with struggling borrowers to avoid foreclosure whenever there is a better option for everyone. What we announced yesterday is simply a streamlining of this process.

There are 1.8 million owner-occupied subprime ARMs expected to reset in 2008 and 2009. The combination of lax underwriting standards when these loans were originated followed by stagnant or declining home values in the last two years means we expect a dramatic increase in the number of borrowers who are likely to find these mortgage resets unaffordable. The standard loan-by-loan process for working with struggling borrowers would not be able to handle the volume of work that will require. The industry needs a systematic approach, in order to cope with increased volume over the next few years, and we applauded them yesterday for putting forward just such a streamlined approach.

And let me be clear – we will not avoid all foreclosures. Borrowers who are struggling even with the lower initial ARM rate are unlikely to be eligible for assistance, and likely will become renters again. We worked with the industry to create a streamlined process so that those for whom there is a better solution don’t end up in foreclosure simply because the system was too overwhelmed to assist them in time.



--------------------------------------------------------------------------------

Alan, from Arizona writes:
Mr. Paulson Do you anticipate bank failures like England saw with Northern Rock?

Henry Paulson
Alan – I’m glad you asked this. The U.S. banking system is thoroughly regulated and well capitalized. We have a strong deposit insurance system that provides good coverage for the savings of hard-working Americans. Another thing to remember as we work through this mortgage market turmoil is that we’re confronting these challenges against the backdrop of a strong global economy and a fundamentally healthy U.S. economy. Business investment has expanded in recent months, our exports are being boosted by the strong economic growth of our trading partners and the healthy job market has helped consumer spending continue to grow. But I have also been very clear that the housing decline is still unfolding, and I view it as the most significant current risk to our economy.

More Q&A at the link.

by Tanta on 12/07/2007 09:53:00 AM

There were a number of comments yesterday about the nitty gritty mechanics of subprime ARMs (the ones likely subject to the Freeze Now Plan). I have therefore prepared one of my badly-formatted childish-looking charts (you want nice visuals, you read my co-blogger's posts).

This data is a bit aged--it was based on subprime ARM outstandings that had not yet reset at the end of Q2. Given the generally wretched levels of new originations and (voluntary) payoffs in Q3, the averages probably aren't that far off from what updated numbers would tell you.

Note that interest only (IO) is not nearly as ubiquitous in subprime as in Alt-A and prime; only a quarter of these loans have an IO feature. I don't have a breakdown (on unreset outstandings) for the term of the IO feature. It does vary; the IO period can be the same as the initial fixed rate period, or it can be longer than that. The loans that have the IO period expiring at the first rate adjustment are the real "exploding ARMs," since that means there's a double-whammy: the rate goes up, and the payment is amortized over the remaining term all at the same time. There are at least some of these loans that have IO terms of ten years (meaning that during the first ten years of the loan the rate can change, but the borrower is still paying interest only.)

I assume that in most cases, a servicer who is "freezing" the start rate for some period of time is also extending the IO period, if necessary, for the same period of time. If the idea is that the borrower just can't take any payment increase, it wouldn't help much to forgo the rate adjustment but hit the borrower with amortization. There might, of course, be borrowers who could afford to begin amortization, but only at the start rate. Don't ask me what will happen for "fast track modifications," because frankly I can't tell. If I figure it out, I'll let you know.

At any rate, the vast majority of subprime ARMs are amortizing from the start, and the vast majority are also 2/28s, meaning that the initial rate is fixed for two years, followed by adjustments every 6 months for the next 28 years (unless and until the loan hits its maximum lifetime interest rate). There is a substantial minority of 3/27s and a handful of 5/25s.

The term "teaser rate" is very relative, and as I've noted before, in the context of subprime "teaser" doesn't mean "low" relative to prime or Alt-A product. As you can see, these loans have very large margins--the average for the 2/28 is 6.00%. On the assumption that the index value (the index is the 6-month LIBOR for all of these loans) at the time of origination was in the vicinity of 5.00%, that means that the "fully-indexed" rate at origination was around 11.00%. Therefore a start rate of 8.00% is "discounted" or, in popular terminology, a "teaser." That doesn't make it a fabulous deal; it means that the fully-indexed rate is ugly. (Compare to prime ARMs of the same vintage: they probably had a margin of 2.50%, or a fully-indexed value of 7.50%, and a discounted initial rate of 5.50-6.50%.)

The way ARM adjustments work, at the change date the current value of the index is determined and is added to the margin. That gives you "fully indexed." That raw number is compared to the sum of the start (initial) rate plus the cap that is specified in the note for the first adjustment. The lower of the two numbers (possibly rounded) gives you the actual adjusted rate.

I used the December 1, 2007 6-month LIBOR value of 4.8265 here to arrive at average adjusted rates for these loans. If you want to know how low LIBOR would have to go for these loans to stay at their start rate at the first adjustment, just subtract the margin from the start rate. For instance, for the plain 2/28s, the biggest bucket, the average start rate is 8.00% and the average margin is 6.05%. Therefore, the loan rate will increase at the first adjustment as long as LIBOR is greater than 1.95%.

It is not likely that the rates on any of these loans would go down, even if LIBOR dropped under 1.95%. That is because subprime ARMs (unlike prime ARMs) usually have a rate floor: they just never get lower than the start rate, regardless of what the index does. (Fannie and Freddie, by the way, will not under any circumstances buy an ARM with a rate floor. It is truly a subprime thing.)

All a "rate freeze" as such does is keep the loan at the current (initial) rate for some period of time. A servicer could make the "freeze" permanent; that would simply turn an ARM into a fixed-rate loan. It appears that the Hope Now Plan involves something less than a permanent freeze; the ASF document indicates that the "fast track" mod involves extending the intial rate out up to another five years from the original first adjustment date. That would mean a loan originally made as a 2/28 ARM becomes a 7/23 ARM. It is possible that the servicer can also extend the maturity on these loans--making them, say, a 7/33 ARM by pushing the maturity date out ten years, but I see no mention of this in the "fast track" part. So that would have to be one of those "case by case" things. I doubt this maturity extension would be very common; the deal documents for a lot of these securities depend on having all the loans paid in full by the original 30-year maturity date (or sooner), and as far as I can tell this whole plan is about not messing with the deal documents.

To sum up, then, a borrower who gets a five-year extension of the intital rate simply continues to pay under the other (unmodified) contractual terms. If the loan was amortizing from the beginning, the borrower simply continues to make an amortizing payment at the start rate. If the loan had an IO period that ended at the original first change date, then the borrower will start making amortizing payments at the initial rate, unless the servicer extends the IO term to match the new extended first rate change date. If the loan had an IO period of 10 years, then the borrower will continue to make IO payments at the start rate until the extended first change date.

Some folks seem to think that this means that the "forgone" interest is somehow carried over or tacked onto the loan. It isn't. This "freeze" thing is simply a matter of postponing the first contractual adjustment date on these loans. I'm guessing that the Option ARMs (which are a whole nuther subject) are confusing everyone. There is nothing in the Hope Later Plan that involves capitalizing the "forgone" interest. I am putting "forgone" interest in quotation marks because some people seem to think that there is "additional" interest that these borrowers would still owe under the freeze. There isn't. If you do not raise the borrower's contractual interest rate, the borrower doesn't owe you more interest than he is currently paying. The freeze plan is not creating negative amortization ARMs here. The rate at which interest accrues is the rate at which interest is paid for these loans (whether only interest is paid, or principal and interest is paid).

I hope that clears it up. If not, I'll be hiding under my desk if you need me . . .

by Tanta on 12/06/2007 04:20:00 PM

A lot of people are very worked up over the idea that the New Hope Plan is, in essence, the government mandating a kind of reneging on private contracts (the PSAs or Pooling and Servicing Agreements that govern how securitized loans are handled). I personally think you can all stand down on that one. From what I have seen about the plan to date, it is clear to me that it is in fact structured with the overarching goal of making sure that it stays on the allowable side of the existing contracts. I proceed from the assumption that nobody could write such a convoluted and counter-intuitive plan if that wasn’t the goal. So everyone who is thinking, “Gee, we’re violating contracts and we still don’t get much out of it!” is thinking the wrong thing, in my view. It’s more like “Gee, we don’t get much out of it when we don’t violate contracts.”

American Banker has a summary of The Plan details up here (it’s free this week if you register, and the registration process is painless). The basic outline is that loans are put into three segments:

1. Borrower appears (from fairly superficial analysis of the data, not any deep digging) to be eligible for a refinance. These borrowers are to be encouraged to refinance.
2. Borrower appears able to make payment at current rate, but appears (again, from fairly superficial analysis) to be unlikely to be able to refinance (generally because LTV is too high with FICO too low). These borrowers are eligible for the “fast-tracked” mod (the rate freeze) if they meet some FICO and payment increase tests.
3. Borrower appears unable to make payment even at current rate; these borrowers are presumed to be unable to refinance. They are not eligible for the “fast track” rate freeze mod; they may be eligible for some kind of work out, but it would have to be handled the old-fashioned fully-analyzed case-by-case way.

There’s some detail about the FICO and payment tests used in segment 2.

I’m guessing that structuring of things will strike folks as weird. To me, it says that a rule of thumb is being created that puts borrowers in three categories:

1. Not in default and default not imminent
2. Not in default and default reasonably foreseeable
3. In default or default imminent

As it happens, the PSAs for these deals will nearly universally contain language that says loans can only be modified if they are in default, or default is imminent, or default is reasonably foreseeable. Therefore, what The Plan does is simply provide a kind of standard definition of those categories for the vintages of loans in question. That’s why the Group 1 borrowers—those who could be eligible for a refinance—are never eligible for these “fast track” mods. It is hard to say that default (in the current pool) is reasonably foreseeable for a loan that has a refinance opportunity. No, it doesn’t make any difference that the refinanced loan might be highly likely to default at some fairly soon point in some new pool. This isn’t about solving the borrower’s problems permanently in the best possible way (a mod might be a better permanent solution than a refi for the borrower). It’s about solving the problem while staying inside the security rules.

And the rules in question are really important ones, not just idiosyncratic servicing rules that could probably be waived in a crisis by the trustee with the consent of the rating agencies.

First, REMICs (go here if you have no idea what a REMIC is). REMIC election involves the tax treatment of principal and interest payments and is much too complex to summarize here. The basic issue is that it creates a trust that owns the underlying pool of loans. The trust issues two classes of securities, regular interests and a residual interest. Interest income is taxable (as ordinary income) to the holders of regular interests. Gain/loss for tax purposes is also taken by the residual holder. The trust itself is not taxed; it’s just a pass-through entity. That prevents a “double taxation” from arising, in which the trust would have to pay taxes on interest income and then the regular class holders would also pay taxes.

One of the qualifying requirements of REMIC status is that the underlying pool of loans is “fixed.” REMICs do not acquire new loans after their pools are established; they do not account for any loans on a “held for sale” basis and they do not sell any loans. (Putbacks for breach are an exception, and always transact at par, not at market value.) If at any time the trust starts taking actions that can be interpreted as “actively managing” the underlying pool, the REMIC status is in jeopardy (the trust might have to start paying taxes, which would make the whole deal uneconomical).

So while the legislation and IRS rules authorizing and dealing with REMICs are not really about defining default servicing practices, they have affected default servicing practices (loss mitigation) because they have defined a kind of transaction that might look like active management of the pool but really isn’t: modifications (or other workouts) for defaulted or about-to-default loans. In essence, the REMIC law creates an exception for these loss-mit practices, so that servicers can use them without endangering the REMIC status of the trust. This is how what might seem like unrelated issues—how to best service a mortgage loan, how trust entities are or are not taxed by the IRS—get related.

The issue is further complicated by the off-balance-sheet nature of these trusts. (They don’t have to be off-balance sheet, but most of them are.) To be accounted for off the issuer’s balance sheet, the trust must be “qualifying” under the SFAS 140 rules. The “Q status” is similar to the REMIC status: the pool must be “static” or fixed or not actively managed or, in the charming industry parlance, “brain dead.” If it is determined that a pool is being actively managed, it “loses its Q” and gets forced onto the issuer’s balance sheet. SFAS 140, like the tax code, isn’t designed to be about good mortgage servicing practices, but it, like the tax code, has to include some definitions of acceptable “managing” of individual loans that are exceptions to the “brain dead pool” rule.

There was a bit of a dust-up earlier this year over the SFAS 140 issue. In a nutshell, while the REMIC law says that modifications are OK when the loan is in default or default is reasonably foreseeable, there was some concern that SFAS 140 only allows modifications if the loan is in default. That would mean that if you modified a loan that was current today, but that you had reason to believe would default next month (say, at reset) if you didn’t do anything about it, you’d be OK with your REMIC status but not OK with your Q status. The waters were calmed when the SEC published an official opinion that “reasonably foreseeable default” was an acceptable basis for modifying a loan under SFAS 140 as well as IRS 860D.

The takeaway point: a great deal of more-or-less informed commentary and blather you will find on whether securitizations “allow” modifications is based not on a question of what verbiage is or is not in the PSA, but rather on an interpretation of what is or is not required for REMIC tax treatment or off-balance sheet accounting. All the PSAs say, somewhere, that servicers will not do things that would jeopardize REMIC status or Q election. The whole point of the letter opinion released by the SEC this summer was to create a kind of regulatory “safe harbor” here: it said that if servicers use the “reasonably foreseeable default” standard that they are already allowed to use for REMIC-status purposes, they are OK with Q-status.

This “safe harbor” for Q-status did not and does not “override” any explicit contractual limitations on modifications that might be in any given PSA. In other words, if the PSA says explicitly that mods are allowed only for loans in default, but not for loans that are current (but likely to default), then that’s the standard. If a servicer went ahead and modified a current loan (under the “reasonably foreseeable” standard), then the servicer could be in breach of the PSA contract, even though the servicer is OK on the REMIC status and Q status. This raises the interesting question of whether there are actually any PSAs that so explicitly forbid this kind of modification, and if so, how many; that’s our next subject. But I know of no informed, sane observer who is claiming that the SEC letter, for instance, was a form of government abrogating of existing contracts. It was simply a case of a regulator ruling that if the PSA allows a certain class of modifications (implicitly or explicitly), the servicer’s exercise of the option to pursue those mods would not create an accounting nightmare. You may, if you like, interpret that as a regulator removing an obstacle to the enforcement of contracts as written.

So what do the PSAs say?

This is a hard question to answer definitively, because the PSAs for mortgage-related securitizations have not been forced to be uniform on this (or about 100 other) subjects. It is possible that some verbiage related to loss mit and modifications differs between contracts because someone somewhere really thought it was important; it is possible that some of it differs just because different law firms with different styles were used to draft the PSAs; it is possible that some of this is a matter of a lapse of attention somewhere. I think it never pays to underestimate the extent to which the industry does certain things because they did it that way back when they did their first securitization, and at no time since then has it ever become an issue, and nobody makes bonuses by making issues out of things that aren’t issues. Certain people have reacted to proposals for “safe harbor” legislation involving mortgage modifications by assuming, not necessarily wisely, that the contractual provisions in question are always and everywhere something that the parties to the contract have a real interest in defending or enforcing. The possibility that both servicers and investors are going back, reading these things, slapping themselves on the heads and saying, “Damn, why’d we put that in there?” is very real. Unfortunately, “investors” are so diverse and numerous and diffused that you just don’t get two parties sitting down and amicably agreeing to amend these PSAs to clear up a little problem.

So we get back to the apparently empirical question of what these PSAs actually do say. I have read many of them, but I sure haven’t read all of them. I am therefore willing to take the American Securitization Forum’s word for it here:

These agreements typically employ a general servicing practice standard. Typical provisions require the related servicer to follow accepted servicing practices and procedures as it would employ “in its good faith business judgment” and which are “normal and usual in its general mortgage servicing activities” and/or certain procedures that such servicer would employ for loans held for its own account.

Most subprime transactions authorize the servicer to modify loans that are either in default, or for which default is either imminent or reasonably foreseeable. Generally, permitted modifications include changing the interest rate on a prospective basis, forgiving principal, capitalizing arrearages, and extending the maturity date. The “reasonably foreseeable” default standard derives from and is permitted by the restrictions imposed by the REMIC sections of the Internal Revenue Code of 1986 (the “REMIC Code”) on modifying loans included in a securitization for which a REMIC election is made. Most market participants interpret the two standards of future default – imminent and reasonably foreseeable – to be substantially the same.

The modification provisions that govern loans that are in default or reasonably foreseeable default typically also require that the modifications be in the best interests of the securityholders or not materially adverse to the interests of the securityholders, and that the modifications not result in a violation of the REMIC status of the securitization trust.

In addition to the authority to modify the loan terms, most subprime pooling and servicing agreements and servicing agreements permit other loss mitigation techniques, including forbearance, repayment plans for arrearages and other deferments which do not reduce the total amount owing but extend the time for payment. In addition, these agreements typically permit loss mitigation through non-foreclosure alternatives to terminating a loan, such as short sales and short payoffs.

Beyond the general provisions described above, numerous variations exist with respect to loan modification provisions. Some agreement provisions are very broad and do not have any limitations or specific types of modifications mentioned. Other provisions specify certain types of permitted modifications and/or impose certain limitations or qualifications on the ability to modify loans. For example, some agreement provisions limit the frequency with which any given loan may be modified. In some cases, there is a minimum interest rate below which a loan's rate cannot be modified. Other agreement provisions may limit the total number of loans that may be modified to a specified percentage (typically, 5% where this provision is used) of the initial pool aggregate balance. For agreements that have this provision: i) in most cases the 5% cap can be waived if consent of the NIM insurer (or other credit enhancer) is obtained, ii) in a few cases the 5% cap can be waived with the consent of the rating agencies, and iii) in all other cases, in order to waive the 5% cap, consent of the rating agencies and/or investors would be required. It appears that these types of restrictions appear only in a minority of transactions. It does not appear that any securitization requires investor consent to a loan modification that is otherwise authorized under the operative documents.

The ASF goes on to propose model contract language that it encourages the industry to adopt. This would go a long way to preventing this kind of chaos in the future. But even with existing documents, you will note that it appears that very few have explicit restrictions on modifications (aside from the “golden rule” standard of generally accepted servicing practices, with the expectation that the servicer will treat the pooled loans in the same way it would treat its own portfolio of loans). Those that do have explicit restrictions have mechanisms for those restrictions to be amended, in most cases by less than 100% concurrence of all investors.

So is all this uproar over contractual provisions just a tempest in a teapot? Well, some of it is. The issue around “safe harbor” and enforcement of contracts heated up once we moved from the proposition of doing mods the old-fashioned “case by case” way, and into this new idea of the “freeze” or a kind of across-the-board approach to modifications. It is that, specifically, that appears to some people to be a violation of contract provisions; therefore, to give servicers “safe harbor” for using the “freeze” approach would, it seems to many people, be a case of the government invalidating contracts.

Whether this is really a serious issue or not depends on how the “freeze” thing works out in detail. It seems likely to me that Sheila Bair’s original proposal for the “across the board” freeze of all ARM rates would, in fact, have run into this very serious problem. It’s not that in that case the number of modifications would exceed the set caps in the contracts; it would clearly do so for those contracts with caps, but as we’ve seen those caps can be waived or amended in most cases. The problem with the Bair proposal is that it doesn’t measure each modification against the standard of benefit to or neutral effect on the trust, and that loans that are probably not in any reasonably foreseeable danger of default would get included. That would cause the REMIC and Q status problems to come back into play.

The Hope Now proposal is intended to be an improvement on the Bair proposal by limiting the “freeze” precisely to the “in reasonably foreseeable danger of default” category. That solves the REMIC and Q-related problems. The difficulty that remains is whether, in any given case, the default that is in foreseeable danger of happening would cost more to the security than the modification. That is where the rubber meets the road.

That’s the rationale for excluding loans that could qualify for a refinance. The presumption is always that the trust would lose less by a refinance (since it would get paid off at par) than a mod, and so you can’t say that modifying one of these loans shows a net benefit to the trust. The rationale for defining the modification-eligible group, number 2, as “not refinanceable” is that that creates a presumption that a mod would be a net benefit or neutral to the trust (since the only other option, given that we believe default is reasonably foreseeable, is foreclosure).

So it’s not that we’re necessarily replacing the old-fashioned case-by-case mods with the fast-track “freeze” mods. We’re creating a way of segmenting the borrower class so that one class of borrowers can be presumed to meet all the requirements in the PSAs for modifications. If the borrower isn’t in that group (2), then a modification could still be done, but it doesn’t have the presumption of meeting the rules, you still have to determine whether a mod is less loss to the trust than not modifying (and therefore letting the loan default and foreclosing), you have to examine the borrower’s circumstances (to make sure that they are no longer in reasonably foreseeable danger of default after the mod), get a new appraisal or AVM or broker price opinion on the property (to estimate losses in event of foreclosure), and run the comparative numbers.

At the end of it, then, it gets a lot easier to figure out the rationale of some of the details of the Group 2 process (FICOs here or there, income verified or not, etc.). None of that is about figuring out whether the borrower "needs" or "deserves" to be helped. It is about figuring out whether the borrower has any realistic option of refinancing, given current contraints in the mortgage market and the HPA outlook. That, in turn, is crucial because to modify a loan that could have refinanced opens up the servicer to liability for contract violations (and potentially loss of REMIC tax status and Q-status, too).

There isn't, as far as I can see, any "safe harbor" provision in all of this. That tells me, at this point, that the authors of this plan believe it is liability-proof (that it basically meets the requirements of the existing PSAs, with the caveat that it isn't a legally binding mandate on all servicers and securities, so a deal with a very restrictive PSA that this isn't compatible with can just opt out).

Is it all kind of anemic after all the build-up? Yep. Does it mean contracts are now invalidated in the U.S.? Not as far as I can see; in fact, I'd say the contracts were the part of this that got the most thorough protection. In my reading of this, giving a deal to a borrower almost seems incidental.

by Calculated Risk on 12/06/2007 12:11:00 PM

Mr. Bush speaks at 1:40PM ET. Mr. Paulson at 1:45PM. Tanta at 2:00PM.

OK, I'm just kidding about Tanta, but I'm looking forward to her comments.

by Tanta on 12/05/2007 07:30:00 PM

I am, in fact, working on detailed post about The Plan. Since it appears there will be details released tomorrow, I expect to have more worthwhile to say after that.

But, to speak to what just got released (as presented in Bloomberg): this thing with the FICO score buckets seems to have taken a lot of people aback. Certainly we hadn't heard explicit mentions of FICO bucketing in the earlier hints about The Plan.

I think what this is about is a way to keep this focused on subprime loans. As regular readers of this blog (at least) know, there really aren't hard-and-fast definitions of subprime. Saying that efforts will be "prioritized" by FICOs under 660 is a way to try to target this effort to what we would consider "subprime," regardless of how the loans might be described by a servicer or in a prospectus.

And that, really, is a way to target the "freeze" to start rates that are already pretty high. I think some people are getting a bit misled by the idea of "teaser" rates here. As Bloomberg reports quite correctly, the loans being targeted have a start rate in the 7.00% to 8.00% range. (My back-of-the-envelope calculation is a weighted average of about 7.70%, with a weighted average first adjustment rate of just over 10.00%.) Nobody wants to come out and say that "Hope Now" is all about freezing just the highest initial ARM rates that there are, but that's in fact what it's about.

So asking, in essence, why we are "rewarding" people with the worst credit profiles is, really, missing the point. The point is that the cost of this goes directly to investors in asset-backed securities, and those investors are being asked to forgo 10% (the reset rate) and take 7.70% (the current or start rate). They are not being asked, say, to forgo 7.70% and take 5.70%, which is roughly what it would be if this "freeze" were extended to the significantly-over-660 crowd (Alt-A and prime ARMs).

So far, I'm prepared to believe assurances that this will not involve taxpayer subsidies: the cost of this is, actually, going to be absorbed by investors in mortgage-backed securities. This is why "good credit" borrowers are not going to be "rewarded"--because investors cannot be brought to forgo that much interest. Somebody did the math, and somebody concluded that freezing a rate that is still about 200-250 bps over the 6-month LIBOR isn't going to be a disaster (at least not compared to having to foreclose these things).

More tomorrow.

by Calculated Risk on 12/05/2007 05:08:00 PM

I believe Tanta is working on an analysis for tomorrow or later this week. Meanwhile here are some details via Bloomberg: Subprime Rate Five-Year Fix Agreed by U.S. Regulators

The freeze may apply to mortgages issued between January 2005 and July 2007 that are currently scheduled to reset between January 2008 and July 2010, said a person who has seen a draft proposal. Borrowers whose credit scores are below 660 out of a possible 850 and haven't risen by 10 percent since the loan was issued will be given priority.

by Tanta on 12/03/2007 09:19:00 AM

From the San Diego Union-Tribune, a fabulous distillation of bubble-think in the story of Michael and Suzanne, who got Countrywide to modify their ARM.

Details: In around mid-September 2004, Michael and Suzanne borrowed $437,750 to buy a $440,000 condo. The $352,000 first mortgage was an interest-only 3/27 ARM with a start rate of 4.97%, a 3.00% first adjustment cap and 2.00% annual (1.00% every six months) periodic cap after that, with a maximum lifetime rate of 11.97%. It is presumably indexed to the 6-month LIBOR. The $85,750 second mortgage was a fixed rate (of unspecified term) at 8.00%.

The first scheduled adjustment on the first mortgage would have taken the monthly interest payment up by $880. Michael and Suzanne cannot, apparently, afford another $880. Nor is sale or refi a great option, since the value of the condo is apparently now $400,000. Michael and Suzanne did not have $40,000 for a down payment in 2004 and they still don't have $40,000 for a down payment.

They feel a touch let down by the world:

“We understood the situation with loan adjustments to be that after our first three years, our low rate would increase to the rate that everyone else is buying at right now,” said Suzanne, 38. “We didn't realize that we would see an increase of our monthly mortgage payments by several hundred dollars or that we'd now be facing this uphill interest rate climb that we're not going to be able to afford.”

That's an interesting way of thinking of an ARM: it won't hurt you because the rate will only go up to the rate buyers will buy at. This will make that rate adjustment affordable to you because nobody will ever buy in the future at a rate you cannot afford, even though your plan is that everyone will buy in the future at a higher price than you did.

A note to Countrywide: You get the borrowers you deserve in this business.

by Calculated Risk on 11/24/2007 01:44:00 PM

The WSJ features a front page story this morning from Ruth Simon: Rising Rates to Worsen Subprime Mess

The subprime mortgage crisis is poised to get much worse.

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

It is accurate to say the "subprime crisis is poised to get much worse". As is the mortgage crisis in general, including prime loans. As is the housing market crisis. As is the overall credit crisis.

But the WSJ sticks to subprime, as David Einhorn noted:

"Subprime is not about us, for we are not subprime."

This morning I drove through Laguna Beach, a very nice area of southern California. I saw house after house with "For Sale" signs, many with added teasers like "price reduced" or "seller motivated". I guarantee these desperate sellers didn't buy these multi-million dollar homes with subprime loans!

But the WSJ sticks to subprime reporting. Oh well ...

Ms. Simon does catch a glimpse of the real problem when she notes that resets weren't the primary driver for defaults this year:

Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Forget flippers and fraud, the real driver for defaults over the next couple of years will be a combination of borrowers who "stretched too far" and falling home prices. Yes, subprime matters, and the coming resets will make the problem worse. But, the problem will be much more widespread than subprime.

Also, the WSJ article mentions a recent Bear Stearns research report:

The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home prices will drop further as lenders "mark to market" repossessed homes.

As I noted on Oct 1st, in some neighborhoods of San Diego, a large percentage of homes on the market are already distressed (REOs, or offered as short sales):

I spoke with one of the top agents in San Diego this weekend, and she was analyzing one neighborhood for a client in the $375K to $450K price range. There were 70 listings (very high for that neighborhood and price range), but she was shocked to find that approximately 75% of the listings were short sales, and a similar percentage were vacant.

So I'm not surprised that Bear expects a fairly large percentage of the existing home inventory to be distressed next year, but I'm not sure this will add four months to the overall inventory (as Bear Stearns suggests). As the number of REOs surge, I'd expect some of the less desperate homeowners to take their homes off the market.

Currently the months of supply for existing home inventory is at 10 months. As sales continue to fall, I wouldn't be surprised to see 12 months of inventory next year. Right now I don't expect to see another 4 months of inventory on top of that - but it is possible.

by Calculated Risk on 11/20/2007 09:02:00 PM

From the Sacramento Bee: California lenders agree to freeze rates (hat tip Sacramento Land(ing) blog)

... Gov. Arnold Schwarzenegger announced a deal Tuesday with four mortgage lenders to freeze adjustable interest rates for some of the state's highest-risk borrowers.

The state's agreement with Countrywide Financial Corp., GMAC Mortgage, Litton Loan Servicing and HomeEq Servicing covers more than 25 percent of California's subprime mortgage loans ...

The article does not mention the duration of the "freeze".

UPDATE: Here is the Press Release with a video.

by Calculated Risk on 11/16/2007 03:22:00 PM

Note: Danielle DiMartino was warning about a housing bubble a couple of years ago when she worked for the Dallas Morning News. She now works for the Federal Reserve Bank of Dallas.

Here is DiMartino's current Economic Letter (with John V. Duca): The Rise and Fall of Subprime Mortgages (hat tip Kett82)

Here is the Dallas Fed reset chart. This shows most of the reset problems for subprime are still ahead of us.

Note that this chart doesn't include the second wave of resets for Option Arms coming around 2010. See here for a longer term chart.

Here is their conclusion:

The rise and fall of nonprime mortgages has taken us into largely uncharted territory. Past behavior, however, suggests that housing markets' adjustment to more realistic lending standards is likely to be prolonged.

One manifestation of the slow downward adjustment of home prices and construction activity is the mounting level of unsold homes. The muted outlook for home-price appreciation, coupled with the resetting of many nonprime interest rates, suggests foreclosures will increase for some time.

The sharp reversal of trends in home-price appreciation will also dampen consumer spending growth, an effect that may worsen if the pullback in mortgage availability limits people's ability to borrow against their homes.

Although recent financial market turmoil will likely add to the housing slowdown, there are mitigating factors.

First, the effect of slower home-price gains on consumer spending is likely to be drawn out, giving monetary policy time to adjust if necessary.

Second, the Federal Reserve has been successful in slowing core inflation while maintaining economic growth. This gives policymakers inflation-fighting credibility, which enables them to coax down market interest rates should the economy need stimulus.

Third, even if the tightening of mortgage credit standards undesirably slows aggregate demand, monetary policy could still, if need be, help offset the overall effect by stimulating the economy via lower interest rates. This would bolster net exports and business investment and help cushion the impact of higher risk premiums on the costs of financing for firms and households.

by Calculated Risk on 10/23/2007 10:52:00 PM

From the WSJ: 'Option ARM' Delinquencies Bleed Into Profitable Prime Mortgages

Subprime mortgages aren't the only challenge facing Countrywide Financial Corp. ... Some loans classified as prime when they were originated are now going bad at a rapid pace.

These ... option ARMs ... typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow -- a phenomenon known as "negative amortization."

Click on graph for larger image. This chart from Credit Suisse via the IMF shows the heavy subprime resets in 2008, plus it shows the reset problems with Alt-A and Option ARM loans in later years.

... An analysis prepared for The Wall Street Journal by UBS AG shows that 3.55% of option ARMs originated by Countrywide in 2006 and packaged into securities sold to investors are at least 60 days past due. That compares with an average option-ARM delinquency rate of 2.56% for the industry as a whole and is the highest of six companies analyzed by UBS.
...
The deteriorating performance of option ARMs is evidence that lax underwriting that led to problems in subprime loans is showing up in the prime market, where defaults typically are minimal. Challenges could grow, as from 2009 to 2011, monthly payments on some $229 billion of option ARMs will be adjusted to include market-rate interest and principal, according to Moody's Economy.com.
...
It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS. emphasis added

These Option ARMs, especially the low doc, minimal downpayment Option ARMs, are ticking time bombs.

by Tanta on 10/23/2007 09:19:00 AM

Thanks to Anonymous, our attention is directed to BankUnited's visit to the confessional. Somehow loan loss reserves went from $8-10MM in pre-release to $19.1MM in the official release. It's the sort of thing that can happen to anyone, you know.

Because we were talking about Option ARMs yesterday, I thought I'd share this bit:

As of Sept. 30, 2007, BankUnited’s option-ARM balances totaled $7.6 billion, which represented 70% of the residential loan portfolio and 60% of the total loan portfolio. For the quarter ended Sept. 30, 2007, the growth in negative amortization was $48 million, compared to $46.4 million for the quarter ended June 30, 2007. Of the $7.6 billion in option-ARM balances, $6.5 billion had negative amortization of $270 million, or 3.55%, of the option-ARM portfolio.

If I'm reading that correctly, it means that 87% of the OA portfolio, by balance, is negatively amortizing, and the total amount of negative amortization is 4.1%. Without the weighted average age of the loans, there is no way to calculate an annual rate of negative amortization. I would be surprised if the average age is more than 24 months, which would produce a rate of around 2.00% annual average balance growth.

by Calculated Risk on 10/22/2007 11:05:00 AM

From the IMF: Assessing Risks to Global Financial Stability

Click on graph for larger image. This chart from Credit Suisse via the IMF shows the heavy subprime resets in 2008, plus it shows the reset problems with Alt-A and Option ARM loans in later years. Although many of the homeowners in the 2009 to 2011 reset periods will refinance (if they can), this shows that the problems in housing will linger for several years. What is especially concerning is all these Option ARM resets in 2010 and 2011. Most of these homeowners are selecting the minimum payments (negatively amortizing) and many homeowners will be upside down when the ARM resets.

by Calculated Risk on 10/04/2007 04:34:00 PM

From Bloomberg: Subprime Borrowers' Payments Should Be Fixed, FDIC's Bair Says (hat tip Brian)

Federal Deposit Insurance Corp. Chairman Sheila Bair called for payments on most subprime mortgages to be fixed at current levels.

Lenders should extend "teaser" rates on all subprime adjustable-rate mortgages if the borrowers haven't missed any payments and they live in the homes, Bair said today in New York. Modifying loans on a case-by-case basis and fixing rates for limited periods won't avert enough foreclosures, she said.

And from Congress: (hat tip NYT junkie)

House: "Miller and Rep. Linda Sánchez Introduce Legislation to Protect Consumers in Financial Distress from Losing Their Homes"

Senate: Durbin Introduces Bill to Help Hundreds of Thousands of Homeowners Avoid Foreclosure

To help families save their homes, the Durbin bill would:

* Eliminate a provision of the bankruptcy law that prohibits modifications to mortgage loans on the debtor’s primary residence, so that primary mortgages are treated the same as vacation homes and family farms.

* Extend the time frame debtors are allowed for repayment, to support long-term mortgage restructuring.

* Waive the bankruptcy counseling requirement for families whose houses are already scheduled for foreclosure sale, so that precious time is not lost as families fight to save their homes.

To further help families get back on their feet financially as they go through bankruptcy, the bill would also:

* Combat excessive fees that are sometimes charged to debtors in bankruptcy.

* Maintain debtors’ legal claims against predatory lenders while in bankruptcy.

* Reinforce that bankruptcy judges can rule on core issues rather than deferring to arbitration.

* Enact a higher homestead floor for homeowners over the age of 55, to help older homeowners who are fighting to keep their homes as they go through bankruptcy but live in states with low homestead floors.

* Reinforce that consumer protection claims are still available in bankruptcy.

And from Sentor Specter: Specter Introduces Bill To Combat Home Mortgage Crisis

And there is a growing backlash against the bailout proposals, from CNNMoney Subprime: Bailout backlash

But judging from the hundreds of reader responses CNNMoney.com has received in recent weeks, "foreclosure prevention" sounds a lot like "bailout" to many Americans, and they don't like it one bit.
...
Joseph Mason, an associate professor of finance at Drexel University and a senior fellow at Wharton, argues in a research paper released Wednesday that proposed remedies could actually make things worse and even that troubled borrowers have gotten some benefit from their loans.
...
One proposal seems to be garnering support from everyone: exempting homeowners who foreclose or otherwise have some of their mortgage debt forgiven from having to pay income tax on the forgiven amount.

Who is this "everyone"? I support no income taxes on debt forgiveness on the purchase debt (or equal amount if the homeowner refi'd), but for homeowners that borrowed money on their home - tax free using their home as an ATM - shouldn't they be liable for the taxes on that forgiven debt? What a mess.

Note: Say someone bought a house with a $200K first, and then loses the house in foreclosure. I don't think there should be any tax consequences. But if they borrowed an additional $50K tax free (now owe $250K) and then lose their home in foreclosure, I think they should be liable for taxes on the additional $50K.