by Calculated Risk on 1/31/2007 08:33:00 PM

Note from CR: A friend sent me an excerpt from Fleckenstein's newsletter yesterday and I forwarded it to Tanta. First, from Fleck:

Turning to the subprime industry, once again I heard from my friend who has been staggeringly accurate. He continues to feel that things are about to really get worse. In an email to me, he wrote: "Scratch and dent loans are killing everybody. Bids that were 92 or 93 are now low to mid-80s. It is a bloodbath, and is pressuring even strong companies to buckle. NO ONE is making any money in the market right now. We are at a point of no return for many. The next two weeks will be wild."

I've been in the investment business over 25 years, and again, I have rarely seen someone so accurately call a turn in the market as he has done. Remember, we are just now witnessing a change in lending standards, and these will ripple all through the lending food chain, though thus far only small changes have occurred.

And the following are Tanta's comments:

Thanks for the tidbits--a former colleague of mine used to get Fleck’s newsletter and you could frequently hear some serious snickers from that cubicle—we’d all have to go over and hear what Fleck said this time. Mortgage punks—the Secondary Marketing ones, at least--aren’t, in my experience, mostly permabears, but they’re cynical as the day is long. It comes from constant exposure to the underbelly of the credit monster.

“Scratch and Dent” is a real industry term. The approximate meaning is “loan with incurable defect.” “Curable” is a real industry term and indicates something like a loan that closed with too little MI coverage (a kind of “bad stuff that happens”): you can “cure” that by buying more coverage. If you can’t get the customer to pay for it, though (usually because you didn’t disclose the correct MI on the regulatory docs, and so if you start charging the borrower more MI, you then provide yourself lawsuit or pissy regulator material), the loan has a serious long-term yield problem and qualifies for a “scratch & dent” pool. A loan that once had a 30-day late but then made the last six payments is just “seasoned,” unless the late was EPD (Early Payment Default), in which case the loan, assuming it’s performing again, is S&D. (You can’t “cure” an EPD. It’s the mortgage equivalent of the unforgivable sin.) The stuff the rating agencies call “reperforming” is S&D. 99% of performing loans that are repurchased from an investor are sold by the repurchaser as “S&D.”

The actual industry term for seriously nonperforming loans (in BK, 90 days, nonaccrual, in FC, etc.) is “nuclear waste.”

I suppose you could get someone to take a loan with certain kinds of “misrepresentation” evidenced as S&D or NW—the ones, say, where income has been proven to be “exaggerated” but there is no other evidence of fraud that could mean a payable claim for the property seller or some other party. The ones with incurable title problems? No exit. If nobody can convey title, you can’t foreclose. Your only possible recovery comes from criminal prosecution, if you’re lucky enough not to be an unindicted co-conspirator yourself and therefore have standing in the courts. That will, of course, take longer than a lot of these folks can stay solvent.

Fleck’s informant is saying that scratch & dent is getting nuclear waste bids. This implies that nuclear waste is probably heading for “no bid.” In any case, one is generally made to repurchase a loan at par (you might have to give back any actual premium paid if it’s an EPD, depends on the contract). So passing it off to a junk dealer, in turn, at a bid in the 80s is a painful thing. Hanging on to it, if you’re as thinly capitalized as your average subprime mortgage banker, is out of the question. Hence the “bloodbath.”

If it hits an outfit like Fremont—which is an FDIC-insured thrift and can therefore hang onto this stuff a lot longer than a mortgage banker can—we’ll be out of “thinning the herd” and into “decimation.” One reason it’s so hard to tell at the moment how bad this might get is that it’s hard to tell how many more “pending” repurchases we have out there. The EPD garbage is just the first wave. Every NOD in that big pile you see reported has been most thoroughly examined for other potential rep and warranty “issues” if the investor is any kind of awake, and they seem to be waking up. There used to be this idea that you didn’t push so hard on your correspondents and brokers that you broke their backs—you need a counterparty to keep having a business model. That’s a “normal” downturn idea. The current one seems to be more like “close the gates of mercy, shoot the wounded, and sink the lifeboats.” That does imply—as JPMorgan also implies—that the Big Dogs have more cooties on the balance sheet than they’re prepared to tolerate. Looks like total war to me.