GLG News by Joseph Smith, II

Implications: Models only cover certain variables and the crisis involved much more than mortgage pricing and a few macroeconomic issues. Risked based pricing as used in the mortgage industry had an underlying flaw that caused the models to fail. Greed played the other part.

Analysis: The models perdicting mortgage investments based on Risked Based pricing were flawed in that only half the equation was used. Yes the cost for a $100K mortgage to the borrower with bad credit was priced with a higher interest rate. That does not address the risk, only the yield. Some of the risk was planned for in the reserves, an increase from a 1% loss rate to a 3% loss rate. What was not addressed was the asset and its risk.
If borrower A has good credit then he deserves market rate. If borrower B has bad credit you do raise the interest but you either do not lend him the same amount, in other words you increase the LTV to say 75% in order to protect the asset, you do not give him a no money down loan. If you do want to give him a no money down loan, then you reduce the exposure to say $75K even though his data supports a $100k loan.
That was the first failure. The other failures in the models is the ability to plan for macroeconomic trends including such issues as a negative savings rate, an over building of product, etc. It amazes me that the models could not get right what several of us in the industry knew and warned against. Why, because common sense does not play a role in models.
Greed was the final factor, the product offerings got ridiculous because the industry was feeding the beast (Securities) with the need to grow volume for each quarters new securities. That combined with ultimate failure of the models to understand the "not on my balalnce sheet mentality" of the originators caused the toxic pool of loans because they became the investor's problems.
To borrow a line from the movie "National Treasure" someone needs to go to jail.

Implications: 1. Shows how truly bad the mortgage industry has gotten and how scared the feds are of where we are going. 2. If the major source of liquidity can not survive, who will? 3. What should be the outcome.

Analysis: The fear of the ongoing mortgage issues as well as macro economic issues pushed the Fed to act. What is not being said is that there was no way for Fannie and Freddie to stay capitalized in the face of ongoing defaults and risks. This is a huge statement that certianly questions the increase in the markets on Monday. So bond holders are a little more secure. The rest of the economic message was hold on to your hats. The values are driving to the lowest possible outcome through lack of intervention and excess volume of homes for sale.

If the two largest holders and ongoing makers of mortgage loans can not weather the storm then we have a far more serious issue than is being discussed. Who will make mortgage loans going forward, portfolio lenders, or possibly "covered bonds". The issue raises the question of how much will the Fed put into to bolster originations and workouts. Without the mass ability to refinance or provide financing the result will be that FHA, FHLB and FAFHA will be the majority funders of new loans. So much for jumbos and subprime loans.

Speaking of subprime and risk based pricing. Since when did pricing up for risk mean dropping economic reason. The issue in our defaults are that we priced high, well beyond the ability to actually pay on the loans, without looking at the ability to pay. Lending has to bring back common sense which is based on the front and back ratios and if you have a higher risk, then price higher but give them less so they continue to afford the property. Common sense died, is still dead and will not come back until both sides of the equation are met.

Finally, the outcome should be a discussion held, mandatory attendance for any planning a foreclosure action, by the securitized trustees, wall street banks, major lenders, investors, government agencies, bankruptcy trustees (DOJ and US Trustees),Hope Alliance and all other parties to agree upon workout resolutions, standard formulas for using them and applying them and turnaround time based on completed packages. That way a uniform message can be provided, borrowers will respond and a standard can be used to recreate a value to mortgages. If not the end result will be the continued foreclosure increases followed by a maximization of home volume to liquidate and a threshold home value that will be reached sometime in 2010 or begining of 2011. That is a long time for a serious depression.

Implications: The news is not good for UBS. The amount of mortgage holdings in US and Non-US declining markets will lead to further losses. 1. $45 B of additional US Mortgage Holdings. 2. An undisclosed amount of non-US mortgage holdings. 3. A UK and Eurpoean mortgage market that is going down as well. 4. The slump in home prices is not over and is impacting performing mortgages. 

Analysis: UBS has not taken all of its mortgage losses yet, not by a long shot. With the holdings in US and non-US markets, the exposure is multi-fold. They have dropping values erroding the worth of currently performing loans and causing further losses. They have early delinquencies going further in default. The loss rate on defaults is going up and will go higher with the new Senate refinance plan. 

All of the news would indicate that the losses will continue. A conservative estimate on the US holding alone would be another $2 to $8 B just from a roll rate analysis leading to loss.   That does not include the losses on non-US mortgages.

Implications: The article is right on target in pointing out the various issues around bank reporting their losses todate. 1. Allowable accounting standards. 2. Permanent versus Temporary Losses 3. Capital Requirments The article goes on to highlight the various issues around soveriegn wealth funds, capital levels and loan leverage. The article ends with a list of "hidden losses" by various financial institutions. The interesting part of the article is the acknowledgement of an additional $35 B to be taken by the banks. The bigger issue is the losses to be taken by the investors.

Analysis: The loss of an additional $35 B by these financial institutions raises issues of which you report and the hidden reasons to report certain ways.
1. Would the loss if taken put the company over the edge based on other results?
2. The hope for some kind of bailout to reduce the losses?
3. As some analysts put it, "transparency is important" and "smart institutions are getting the losses on the table".

The concern I have is if the financials have taken $300 B plus and have $35 B to go, who is reporting the other losses? The current plans of Fannie, Freddie and FHA saving 1,000,000 homes with an 85% ltv to new appraised price raises the issue of a 40% loss severity on a million homes. Given the averages that is another $80 B in direct charge off in addition to the other 1,000,000 loans in default that will also take hits. That potential $160 B has to belong to someone!

That brings us to reality. The investor community owns a lot of these loans. We know from loss mitigation efforts that many short sales (same as what was proposed in the house and senate) are not being done because investors are deferring charge-offs to REO liguidation and meanwhile keeping the monthly scheduled interest payments going. The real question is then how big is the exposure to these investors, and how severe will the actual write downs be to them? There are many retirement/pension funds tied into these mortgage investments. What will their write downs do to current and future retirees? 

Implications: 1. While the article does a good job of pointing out that the losses will be greater under the House FHA Plan than expected and that the tax payers will carry the cost, it along with the plan by the House  misses the mark by thinking banks will take advantage of the plan. 2. The real owners of these loans are the investors, not the banks. 3. The investors are already not doing short sales, why would they take 40 and 50% losses under this plan.

Analysis:  Lets get something straight, Bank of America, Wells Fargo and Countyrwide (for the most part), do not hold very big mortgage portfolios. Those they do hold are mainly prime loans with a Private Wealth Unit backing. The bad loans they do hold are those that they could not originally sell. In the case of Countrywide that is a bigger percentage but in the national picture these protfolios are small. But please stop referring to the "Banks, Lender, and Servicers" taking these hits, the loans are not on their balance sheets!

The group that owns these loans and is subject to the large write down without recourse as proposed by Mr. Franks and the House are the investors who bought stake in traunches of securities.  These are hedge funds and direct investors like TIAA-CREFF and state retirement and pension funds along with insurers and foriegn investors. I do not think that is the group that congress want to force to take significant charge -offs and the foriegn investors will just laugh at the idea. 

I can just see Mr. Franks explaining to his own state Attorney General and the state citizens that the reasons the teachers pension and state employee pensions are down and payouts are reduced is becuase he did not realize they owned loans.  That will make for good drama, unfortunately a number of retirees may then lose their homes, I wonder if Barney can come up with another plan for them.

Currently B of A, Wells, Countywide and others are taking over three months to approve short sales. They need to get the investor apporval first and why would the investor do it. Currently, they can defer the charge off until liquidation and under most securities they get a monthly advance of interest (interest is paid on a scheduled basis and principal on an actual basis). So Mr. Frank wants them to accelerate their charge off, give up cash flow and have no recourse. I do not believe the tax payer is going to get hit that hard becuase vey few investors will approve a short of the 40 or 50% magnitude this proposal promotes. The "Law of Unintnded Consequences" is in full swing with this proposal, it shouldbe entertaining.

Implications: Through mid 2008 these will continue to be the drivers of home loan financing. Coming up quickly will be HUD/FHA. The unkown related player will be community banks, credit unions and small regionals. There is a problem that is already surfacing, add on fees by the banks using these groups for funding.

Analysis: From mid 2007 to present day and through mid 2008, Fannie, Freddie and FHLB's will continue to be the main players. Coming up behind them will be FHA, particularly if they can get a refinance program that will work (reguiring existing loan holders to write down first will only have minimal to moderate success).
FHA will be what it was before sub-prime, the home of first time buyers and others without the credit file to get a Fannie or Freddie loan.
The savings & loans and credit unions are already getting involved in their local markets and gaining share in jumbos and local loans.
The problem will develop over the additional fees and requirements being layered in. Fannie and Freddie are requiring more equity and downpayments. Banks are charging additional fees on loans to increase margins.
The drive to get a higher return is to offset infrastructure expenses that can not get by on the low returns provided by these funding sources. It is hard to support a retail environment on the spread on a Fannie loan. Just ask Countrywide, particulalrly when they were designed for sub-prime spreads. It is only a matter of time before someone is denied credit based on these additional fees and the subsequent litigation will prohibit the exercise going forward. The industry is still not a fast learner.

Implications: It looks like the legislative solution is not getting off the ground again as far as working out loans. The proposals that have come out are mainly directed at going forward purchasers, builders and cities. So much for the defualted borrower. The ideas that were being floated carried their own risk.

Analysis:  There have been several different proposals sent up the pole to see how they will go, they are 1. Federal Intervention by an RTC like institution 2. A FED / HUD FHA bailout involving defaulted borrowers if the lender will reduce the balance to market. 3. A Partial Insuring on the reduced value to protect further decreases. 4. Funding refinancing in full 5. Moratoriums on Foreclosure 6. Covering all Loans 7. Not covering speculative loans. Dodd, Clinton, Ombama and McCain all have indicated some level of intervention but none of them understand some basics that will prevent their plans from working and will actually make them look very stupid as each attempt to date has done. Consequence 1. 1. The lenders can not make these concessions. They do not own the loans. The small town in Norway owns a portion of the loans from a traunche they bought into. They do not even own specific loans for them to give permission on. The Trust manages the loans in the traunche, they have assigned the loans to a servicer, the servicer must perform as outlined in the pooling and servicing agreement as established by the investment bank and the securitizing originator in the Purchase Agreement. This ownership issue is why suggestions and programs in the last year have failed. The rate freeze and the FHA Secure all require the concession of the owner/ investors, not the servicers who agreed to them. I have actually had servicers tell me that they would us my company or the Hope Alliance if they could determine how to pass the fee to the Investor. This is quite a "Catch 22" when you realize most investors would like to workout as many loans as possible to avoid losses. To make matters worse, if the servicer, Chase, Bank of America, Wells Fargo, etc agree to do these deals without the approval of the Owners the resulting consequences could be devastating and I for one will set up some investors to make hay on it. 1. If the lenders/ servicers agree to do these actions and reduce principal to allow a short refinance, then the owners can go back to the trustee and require a repurchase or that the Trustee make them whole. The Trustee and the owner/ Investor can go to the Investment Bank and claim a Securities violation of Reps and Warranties. 2. The Investment Bank is going to go back to the originators and hold them responsible. 3. The Insurers will also have their out against paying claims for violations of contracts and reps and warranties. 4. You can not have an RTC organization when they can not take over the loans, they are not taking them from the servicer/ lenders, they do not own them and the loans are not on their balance sheet. So the RTC will be taking away assets that belong to TIAA-CREF, the City of Cinncinati, The state of New York Retirement fund, etc. These are not actions that are going to make any candidate look good. End Result: The very same institutions that the FED is trying to prop up, Investment Banks and Lending Institutions, will be the victim of the change and have to absorb the losses with the resulting international financial system failure. Do you see state Attorney Generals letting this opportunity slip by to recover state losses on their investments? Consequence 2. Performing loans that are underwater will also try and qualify. What borrower who has seen his home's equity disappear and guestions why he is continuing to pay on it, will not do what he can to qualify for a lower payment. This will completely invalidate the agreements above and will also expand the amount of loss being incurred. Is the Government ready to cover $2 trillion in lost equity. Consequence 3. The reason that security owners are not jumping on the bailouts is that they are getting paid their interest by the servicers until the loan is liquidated or it is determined that there is no equity left. When the loan is liquidated they receive the outstanding principal less expenses. Given the longer and longer periods to liquidate that will continue to grow, the owners can avoid/defer losses because they are still getting paid. In addition, even 75% of the sub prime are paying still and they do not want to see the number get smaller or have to realize losses sooner, both of which they would have to do if they take the short payoffs to allow government refinancing. Consequence 4. Adverse selection of pools will occur. Good paying borrowers are going to jump at the chance to go to lower rates than they contracted to pay. Thereby leaving those loans that can not perform on the servicers books and the investors' pools. All level of securities will be wiped out and losses will be realized immediately. The end result could be driving the market to take all $2.4 Trillion of lost equity as a loss instead of just the delinquent losses. There is a way around this, but it involves a different audience than the ones the FED is talking to now. It also involves a different strategy that segments the types of borrowers in to those with primary residence issues and works out their loans based on their situation. The correct audience 1. Trustee organizations 2. Investment securitizing institutions 3. Insurers 4. Investor owners (Fannie, Freddie) plus large players like TIAA-CREF and others who hold substantial securities positions. These groups need to meet, determine and agree upon the solutions to be offered and the mechanisms to be used to reach the borrowers and resolve the loans. There are other alternatives that allow borrowers who can afford something to keep the home, make payments and catch up. For those that can not afford to keep the homes, then there are ways to liquidate those homes that reduces cost and credit impact to the borrower. To put it simply, the country can not afford a $2.4 Trillion refinance plan of all defaulted borrowers and lost equity. The country should support plans and actions that manage the situation and resolve loans in the best manner. These solutions exist and there are several groups, including ours, working to make them happen, but they can not be a Band-Aid that will fail in the near term or reward irresponsible behavior either on the part of the borrower, the lender, or the investor.

Implications: The article raises valid concerns on security of these insured transactions. Expect: 1. More suits as the insurers try legal tactics to invalidate coverage. 2. That the contracts and premiums have been paid and the courts will likely take a dim view of legal ploys to invalidate coverage based on semantics. 3. That the additional capital that has been raised by the monolines is still not sufficient to cover all of their risk.

Analysis: The article did a great job of high lighting the issues and concerns that will continue to play out as the mortgage mess continues to go south. If you believe that the bottom has not been reached and that there will be more defaults then the validity of the insurance coverage is the next area to review.

In this case the legal play to invalidate coverage by claiming that another insurer is covering higher rated traunche's ( who isinsurer in control) is just that, a ploy to avoid a claim. It was known when the coverage was taken out that XL Capital was not the sole insurance provider and which traunches it was covering. The acceptance of the fees and premiums on an ongoing basis is an acceptance of that contract.

The courts will take a dim view of an insurer trying to weasel out and leave the ultimate investors (small towns in Norway and the Midwest) with larger losses because of semantics. If XL is successfull in the suits then plan on merrill being the next to fall when the rest of the investors who bought insured loan traunches sue for misrepresentation.

There has been talk in the last few weeks that Companies like MGIC and MBIA have raised extra capital to the tune of $15B each. As the article points out, Merrill with a $26B exposure is just one of many investment groups that insured loans. The math does not indicate that the additional capital is enough.  There are still several hundred billion in CDO's and direct investment losses to be taken.

Implications: The Fed does not know what to do after they reduce interest tomorrow. This follows on the tail of the bailout of Bear Sterns in a sweet heart deal with JP Morgan/ Chase, and the opening of the FED window to non-depositories. The next issue and crisis is going to be the dollar value and its impact on the economy. Gas is going to continue up as will most other costs that are fuel dependent. What will be the impact as a G-7 goes off the dollar and say to the EURO?

Analysis: So our financial system is in a crisis and everyone will admit it now. The Fed has pulled out its last gun (maybe) in the effort to stop the potential for a failed financial system. We are now hearing rumblings of a new RTC. I wonder if that will work in all of the credit markets?

Of course other credit markets are in trouble along with the exposure to mortgages there is the risk in autos, cards, commercial and especially Home Equities. The amazing thing being there are only a few that have big exposure to all five areas including 1st mortgages. The bad news is that they are the same investment banks reeling from 1st mortgages. Even worse is the companies that are risk adverse, B o A and Chase, that have exposure to several of these areas. Any one of which in a bad year could significantly hurt the institutions earnings. The end result is a pretty strong prediction of ongoing poor performance across the financial markets.

When we layer in the economy for average "Joe" consumer, the picture even gets worse. As the Fed lowers interest the trend has been for an increase in fuel prices. So Joe consumer will pay more at the pump and for every item purchased. The borrower will retrench further having tapped all equity or been denied access to remaining equity. The result, "The just do it" and the "Live Richly"era is at an end.

The scariest outcome of all will be if one of the G-7 decides to go off the dollar. I read in a news service this morning of a Washington DC hot dog vendor that is now accepting Euro's. How is your German these days?

Implications: 1. Market reacts to Bear liquidity and FED temporary bailout plan by dropping over 200 points. 2. Will market continue to yo-yo as these events happen. 3. Will FED change plan if Bear fails?

Analysis: This morning the news of an overnight liquidity problem (confirmation of weeks of specualtion) for Bear Sterns raised the issue of  the new FED 28 day loan process. Bear will be able to pledge assets and receive a 28 day loan while Chase tries to find permanent financing. As the article points out, there is no quarantee they will be able to find that fianancing.
This morning the market dropped well over 250 and then bounced back minutes later with a 100 point recovery. Then it has been an additional 50 point loss and an 50 point gain all in the last 10 minutes. Quite a bit of yo-yo action. Volatility will rule the day.  
So here we go with the FED giving money for discounted mortgages at PAR for 28 days. Bears stock dropped over $20 a share this morning in just an hours time. So what happens in 28 days if the stock is junk and the loans are less than the collateral value they support? Will the FED bailout the Bear or will it force them into Bankruptcy. More likely is that they will let them pledge more loans and create another 28 day note. 
The liquidity issues that are going to hit these mortgage holding investors is going to continue. In addition their capital levels will continue to be under pressure as the stocks take their additional hits.

So the real question becomes will a 28 day reprieve be enough to save one of the top investment houses and will the FED be left holding the bag.

Implications: How afraid is the FED of where the economy is going that has caused them to promote such a drastic step as opening up funds to non depository banks? 1. The Fed lending at Par for devalued assets to Non Banks. 2. Will more money be made available when the markets continues down? 3. How will write offs upon liquidation of the underlying asset be addressed, during the 28 days or before it is repledged to the next 28 day period? 

Analysis: We have now seen the results of forgetting history, a huge bump in the stock market yesterday, as the Fed agreed to open treasuries to the Investment Banks. The really fun part is that they get to secure these 28 day loans with collateral that has diminished in value to the point that there is not a trading market, and they get to do it at PAR!
So the government is now a participant in the same lending that took place with the individual mortgages, making loans to someone who can not afford them (or find financing elsewhere) and for more than the underlying collateral is worth. I wonder if the FED will have the same shock that the secondary mortgage market had when they realized the collateral was bad?
When the next set of data comes out and states the economy is continuing to stagnate, drop or actually is in a recession, will the FED put more funds in play to prop up the market? If they decide to put more in, at what point will they stop? The old adage is a I lend you a little and you owe me. I lend you a lot and you own me. Do they become to indebted to allow to fail?
At what point will one of these borrowers actually write down the asset after liquidation? Will they write it down and pay back that portion during the 28 days or will they write it down after the 28 days before they re-pledge assets for another 28 day period?
I wonder how many multiples the Street can get on these funds in 28 days? Will profits that the street firms make on lending this additional liquidity be shared with the investors who bought the securities to begin with? Will they share the profits with the monolines who insure the asset?
Will the focus on fixing loans diminish? Now that the Investment Banks can roll with funds while the assets diminish, will they care about the resolution.
The real issue here is the underlying FED and Treasury position on where the economy is going. While the government has said it is bad but we will grow, other economists have been saying recession and stagnation. What this move tells me is pure fear of a recession if not worse. The real issue is the underlying equity lost already in the market ($1.4 to 1.9 Trillion) and the realization of that loss on collateral with liquidations and mark to market rules.  The piper will be paid at some point and there is only one way to minimize the impact and that is to handle each mortgage and either fix it if you can or foreclose it and liquidate and take your full losses. In the end the losses will be realized one way or the other the only real questions are how much and for how long!

Implications: While many companies and investors are planning on what to do with cheaper money due to the rate cuts, one of the implications has been that a rate cut will help re-start the mortgage industry engine. Yes, originators will get some new refi's completed and earn some fee income, and there will be a few borrowers who were not in the market before that get in to it now. There will even be some purchases of some of the mortgage inventory. Due to tightening credit standards and qualification criteria, the number of new loans will be minimal and the refi's will be to the best credit worthy borrowers. Truthfully, the rate cuts of last week and this week will actually hurt the mortgage industry due to adverse selection in exisitng mortgage pools with subsequent accelerated write-downs.

Analysis: The exisitng mortgage pools are made up of performing and non-performing loans. The performing loans run the gamut of pristine borrowers (conforming loan pools) and paying as agreed borrowers (sub-prime) to defaulted and foreclosed borrowers who do not pay. The loans stay in the pools until they are liquidated and then the loss or gain is realized.
By taking the best credits out of both the conforming and non-conforming pools, the credit worthiness of the existing pools is comprimised. Also comprimised is the value of the Mortgage Servicing Rights (MSR's) which the servicer/lender must recognize. The MSR's have been one of the few bright spots with increased value as the pre-payment speeds have declined. Now pre-payments will increase with each refi and the exisitng pools will have fewer paying loans.
With fewer performing loans, the pools results will be lower causing an impact to the bond holder, the servicer and the insurer on the pools. Hardly a helping hand at this time.
Just imagine how Fannie and Freddie will feel having a loan currently at 7% that will refi to 5%. They get to watch their exisiting pool drop in value and get to give up 2% in the process of backing a new loan. Not what I would call winning math.

Implications: The reduction in interest rates is going to have a negative impact on the existing mortgage portfolios due to adverse selection. The decrease in those seeking unemployment benefits is very misleading. The stimulus package is not going to help those in real trouble and will pay some bills for most.

Analysis: The news the last few days could not be worse for the existing mortgage investors. The pools of loans they hold are going to be adversely selected by good quality borrowers leaving for lower interest rates leaving only those that are currently in default and those that can not refi behind. This is true whether it is subprime or conforming.

Fannie Mae will take a hit as their exisiting pools at 7% prepay so the performing borrowers can get 5.5%. The accounting is simple to see, incur a prepayment out of one pool and a new loan for another at a reduced rate. Result is a 1.5% margin reduction. Plus a lower rating on the existing pool if enough payoff and hit a prepay trigger. 

For non-conforming loans that are already causing write downs it is even more severe. The percentage that were performing keeping the top traunches performing will now be decreased as well resulting in further MBS, CDO and SIV losses.

The unemployment benefits news is very misleading. Everyone knows that the numbers are not true numbers. Many have used up their benefits and fall off the rolls. Others do not file. If the numebr was inclusive of all unemployed then it would mean something. The only thing it means is that the governments expense for unemployment benefits is down. Certainly not that unemployment itself is down.

As to the stimulus package, $400, $500, $800, whatever the number is not going to make a big difference. The money will be used to pay bills. Whether it is paying your utilities or paying down the credit card. Some will be used for groceries and gas so that will help stimulate the economy but I do not believe that was the stimulation the market was looking for. It certainly will not buy the new washer or dryer or car. It also will not create jobs. In our economy jobs are based on capapcity and sales. With no sales we do not need excess capapcity so exisitng jobs are held in check and new jobs are not created.

The off shoring of jobs is great for an immediate bottom line impact for a corporation, however it does take away from the tax base and employment base. For our new high school graduates the question is at which MacDonalds are they going to find a job. The manufacturing, service industry, automotive, etc are all not hiring.

If there is no one left working from the lower middle and lower economic strata, who is going to buy anything to keep the economy going. The upper 20 % of the workforce can only own so many cars, houses, dishwashers, etc.

The scary part is that the same issue will apply to the commercial loan pools as well.

Implications: Over valued versus the risk of litigation, talent flight, legislative constraints, portfolio loss and about every other imaginable variable. Overvalued servicing rights with disappointed servicing investors. Average industry systems, nothing great. Short staffed already. More leaving. Mozillio defineltly a liability and not an asset.

Analysis: At a real value of 75 bp not 150 bp the servicing is valued at about $ 9B, versus the $6 B invested. The question is how much of that will be relaized and what other losses and expenses will go against it. The risk of litigation and legislation is high. Suits have already been filed and will continue to be filed. When you are the biggest, you are also the biggest target.

The servicing rights are heavily dependent on the investors continuing to keep loans with Countrywide. There is a very high sentiment in the industry that countrywide is doing a poor job of servicing others loans. I know from several investors that they are not happy and talking about pulling their loans.

The systems are not that great, they have been blended from acquisitions and are the industry norm. The CIO just announced that he was leaving and going to FIS. I know their phone system for loss mit does not allow the extensions of the loss mit personnel to be put in to reach back to the person handling the borrowers case. You first have to go through someone who screens the calls and verifies info then they send an internal message to reach the person who then tries to call you back at some point. A nice game of tag.  No wonder this huge company did so few modifications in the first 9 months of the year.

There is an estimate from the open position rec.s that Countrywide is over 1,000 employees short staffed right now at its various centers.

Finally, Angelo Mozillio is not a benefit. He will be the source of many suits and his actions and lending standards were definetly a major contributor to the mess we are in now. I know many industry servicing professionals that have no use for him and his products and would not mind seeing him prosecuted for predatory loans and servicing. His greed ( and if not greed incompetance) is a major sponsor for the mess the industry is in now.

Implications: While on paper the acquisition versus the valuation of loan servicing looks good, the reality is a whole mess of operational and regulatory risk. The Countrywide CIO was just announced leaving for FIS (Fidelity) and the state of the art systems was one of the selling points in the acquisition. An asset sale will probably be the answer.

Analysis: 1. Potential increase in defaults against portfolio loans.
2. Potential rising for class action suits based on lending and securities issues.
3. Potential for talent flight at countrywide.
4. lack of in depth expertise on sub-prime at BOA, they dropped sub prime a while ago.
5. Existing staffing issues at Countrywide servicing
6. Legislative initiatives.
7. The lack of profitable channles to originate loans. The whole sale channel is not viable right now and closed, that leaves the retail originating a narrow margin fannie and freddie product. The big margins supporting the retail expansion was the sub-prime.

I know that the systems there are not that great, when a loss mitigation specialist gives an extention number to call back and when you do there is no place in the call sequence to input the extention and you therefore go through the usual phone tree. Something defaulted borrowers will not be inclined to do more than once. The other question is the valuation at 150 basis points.  Most of this paper is conforming at 25 basis points and I do not believe the average life is going to be 6 years even with the decrease in pre-payment speeds. The non0conforming portfolio is at 50 bps of servicing fee but also has accelerated advances and now a large portfolio of unsold loans to take on balance sheet.

Implications: While it is true that investors risk money on potential returns and soundness of the underlying assets, it is also true that both the packager and the investor have analytical staff whose job it is to understand the investment. The underlying collateral of mortgages does have the value of the stream of mortgagors' payments; the key is that the stream be maximized to create the fullest return. Once the value of the stream is established then the pool will have worth and a basis for a market value. Instead of sitting back and bemoaning the investment banks who merely provided an investment option with very clear indications of the types of loans in the prospectus. Belittle the society that endorses short cuts to sound business.

Analysis: When we invest money we are making a bet, a gamble, that we understand the asset and the market in such a way that will reward our investment. In the case of mortgage back securities and underlying derivatives, the same holds true. There were analysts from the originators and the investment banks determining the best way to package interest only, negative am, variable rate, and teaser loans made on stated income with no documentation and non-owner occupied. These loans came with pre-payment penalties and yield spread premiums. All of these characteristics were fully disclosed in the prospectus provided. The investing analysts saw these loan characteristics and reviewed the assumptions behind the securities and made the decision to buy. As with most exploding markets you could count on the returns and the allure of the high yields sucked them in.

As with all exploding markets they must stop at some point.That brings us to the underlying value of the mortgages and thereby the value of the investments. The truth of the matter is that the payment streams on the loans have been the underlying value from the beginning. They support the coupon that the investor in the security bought and are the basis for the derivative as well. According to the latest numbers, 20 to 25% of the loans are delinquent in the sub-prime pools. Many of those can be fixed with proper attention and the wise use of actual loan by loan modifications. These re-performing loans and the original 75% that were always performing will create an 80% plus size pool generating investment flows. If with time, the pool shows a consistent 80% value based on the flow of the payments then the pool should be able to be traded at the 80% level. That is a far cry from being wiped out. Instead, traders not understanding the assets and the risks are dumping assets with no understanding of the value or the potential to fix the value. That is why the distressed buyers are looking for buys right now, knowing they will make a fortune on the rehabilitated loans. The only real risk being how much further home values will drop.

That brings us to the real issue, instead of blaming the securitizers and looking for them for restitution, investors need to take a stand through their trustees and push the servicers to work out as many loans as possible. The investor needs to be active enough to endorse a transfer of servicing if the servicer does not comply. I am starting to see this on behalf of some of the major investors and it will drive the process of recreating a value to the pools and re-establishing a secondary market.

Implications: Potential Lawsuits, repurchase demands and flawed collateral documentation will cause many more problems than the intended solution will solve. The limited nature of the eligible loans will be far less than the 1,000,000 loans identified by the administration. The parties making the agreement do not have the right to do so.

Analysis:

With the best of intentions many groups have latched on to the "teaser Freeze" as a way to reduce the additional loans going to foreclosure and to allow those same borrowers a chance to refinance out of those loans in the future when there is a stable real estate market. Unfortunately, the Law of Unintended Consequences is at work with such intentions and as always the devil is in the details.

1. Lender/Servicers ability to make such a deal. These lenders can not speak for the investors. They can only speak to the loans that they hold in portfolio. Many of the investors are foreign and will not take kindly to government intervention. Because the loans are not individually owned in a securities pool every investor in a pool will need to agree or they will be able to sue based on a securities violation. They will sue the securitizing firm who will inturn demand repurchase of the orignator of the loan. The very same banks that are committing to the plan may have to buy the loan back and then they can agree with the plan all they want.

2. What is so special about the cut off dates selected. It will be a class action/ tort attorneys dream to have a borrower whose loan was originated right before or right after the cut offs. Can you imagine a jury saying it was okay for one individual to get assistance and not another. The same will hold true for those borrowers whose rates have already reset and they were forced into delinquency and foreclosure/bankruptcy. Why should they be excluded. How about those whose loans had longer than two years in the teaser period, originated in 2004 with a three year reset or five year reset. I quess they do not count.

3. The funny part of the plan is the logic that the same servicers who can not get to their defaulted borrowers and work them out (long wait times, delays, etc) are going to review each of these loans and make the reamortizations happen. I did not know that there were that many folks standing by with nothing to do at the loan servicers. I will be curious how many FTE are assigned to address these "Teaser Freezer" loans instead of working on the defaulted loans at hand and trying to stop the bleeding.

4. Speaking of which, does the plan require each loan to be modified by and individual? Who is going to pull the title work to make sure that no second lien (second mortgage, home equity loan) has been established since the loan was originated. If they do not pull preliminary tiltle then there is the strong likelihood that the modified first mortgage will now be a modified second mortgage. The former second will be able to foreclosure out the first. Talk about lawsuits.

5. If the plan is to just grant modifications without a borrower signed legal addendum to note and addendum to mortgage, then there will be no legal binding agreement to ever present if the loan goes delinquent again. This is not a small problem, afterall these are sub prime loans.

6. Fitch has already raised the issue of loan accounting being an issue and these accounts will reflect delinquent for some time before they are fixed. If they ever go delinquent again, what amount will be brought before a judge for foreclosure? We have judges that are dismissing with predjuice foreclosures (basically making it impossible to foreclose and giving the borrower the home) now for unrecorded assignements, imagine what they will do with a disputed loan amounts.

The issue is not the intentions of the plan designers but the execution. Why this group and not all borrowers in default (exception to the investment properties). Why not make the servicers use the likes of the Hope Alliance and the Foreclosure Attorneys to make contact and present them with solutions and then make the solutions happen for all loans. The 100,000 to 200,000 loans impacted by this plan will not stop the fall for the mortgage industry and the economy. By the time the lawsuits are done, repurchases made, and homes lost and back on the market, a recession will be the least of our worries.

Implications: HSBC's indications do not necessarily indicate the extent of change in the market. Since HSBC is very forthcoming with their news, they do not capture some lenders who have not been in the past. These other lenders, some of whom are significantly larger than HSBC, have been deferring some wirte offs and will take larger positions of loss going forward. HSBC does indicate the trend but not the severity.

Analysis: The analysis of HSBC as an indicator of coming trends in the worsening mortgage crisis is correct but does not include the impact of some larger lenders who have not recognized their losses and exposure as readily as HSBC. An example would be Citigroup and its continued announcements of loss each month. Citigroup took $4B then announced potential losses of another $11 B. Yet Citi still has an exposure of over $50 B in CDO's alone. Given the loss rates and downgrades on CDO's this should translate to loss exposures in the $25 B to $30 B range.
 
So, while HSBC has done a good job of reporting and staying on top of its losses, others have not. There will come a time when HSBC will bottom out on their exposure and losses and some significantly larger players will still be increasing their losses and continuing to swing the market to a greater extent than HSBC's impact.

Implications: The problem with programs of this type is flight from debt. For many of the lenders for which we work, we can not find a high number of these foriegn buyers. if they have any problem with their financial situation they leave the country. Numerous principal residences are vacant and we have tracked them to housing scams where the refinance or purchase was related and inflated.

Analysis: These borrowers have a tendancy to move around and become difficult to find. When the payments stop and delinquency does occur, then the default go straight through to foreclosure.

many of the eastern european customers have been related to mortgage fraud as straw buyers. Many of the South American buyers we find leave the country and either do not pay while they are gone, or never return.

Implications: Stress is yet to be seen, early indicators are bad, the future is going to be worse. The actions to date have failed the test for working out of the mortgage crisis. What is yet to come on the mortgage market can be changed if acted on, current trends are leading to disaster.

Analysis: Interest rate cuts, liquidity, FHA help plans, Fannie and Freddie caps and FHA limits are all good perception builders for the market place. The bad news is that it is only perception and as to the stress test, we are failing to make changes that could bring the market to the road to recovery.

The interest rate cuts only help those individuals that already have had a rate reset. The 2 million to come are not going to benefit from those cuts, the resets are less than market rate on the first pass (initial caps) for most of them. Even if they did reset to market, most can not afford the new payment anyway.

Liquidity is also just a perception. Unless you are an institution that faces a run, it will not help. Most of the larger banks involved in the US mortgage market are limited by their asset ratios and capitalization as to the amount of new mortgage loans they can put on balance sheet.

The FHA help plan is a joke with only 80,000 (FHA estimate) being able to qualify. As just stated, most can not afford to go to the market rate and you also can not have had a mortgage delinquency.

Fannie and Freddie caps are a real issue and prevent the resurrgence of conforming loans into a secondary market. The amount of room left on these caps is less than a months originations. They are relying on run-off to give them some room to take new loans each month. However, run-off is slowing down (prepay speeds). I am mixed on expanding the caps given the agencies ability to manage their finances, but believe if proper oversight is provided it can work.

FHA increasing its loan size does help provide a new market but does nothing for the investment properties.

How bad is the problem? Well Yale professor Robert Shiller is estimating Trillions will be lost in equity on home values. That is in addtion to the hundreds of billions that will be lost in direct investment as these loans fail and go to foreclosure and ultimately liquidation.

Lets recap: millions of loans in default, excess inventory in most markets, increases in inventory expected as foreclosures are completed putting further downward pressure on prices, no new avenue to refinance, no secondary market to trade the loans, lenders not really stepping up to workout the borrowers. End result total failure of the housing market, subsequent mark to market on all performing loans as to secured nature of collateral and asset value, horrendous operating losses as the second mortgage market is wiped out as unsecured and many first mortgages are written down to only partially secured. Other industries are also brought down and those not ruined are limited in their revenues (housing goods, appliances, lumber, railroads, trucking, home improvement, etc.).  We will not even get into how the housing market has carried the US market economy for four years and the loss of the equity will impact consumer spending.

What can be done to fix the mess? First, investors and insurers need to insist that servicers start working out loans on a permanent basis. I recently learned of one international investment bank that was very upset that their servicer was averaging three workouts per year on defaulted borrowers, they were all repay plans that all failed. What is needed is modifications of interest and borrower counseling on budgets to create some value in these loans and investments. The losses are currently trending above the historic 35 % rate and are going up as length of time to liquidate goes up. A 25% defualt rate with a 50 % loss severity is going to be a 12.5 % overall loss to a pool. That is the strip traunche as well as part of the next traunche. That is just the losses and does not include the mark downs on asset values.

It takes a long time before it makes more sense to foreclose on a loan than to re-write the loan and reduce the interest rate. As a matter of fact it is at least 17 years. ($100,000 loan at 35 % loss is $65,000 which takes 18 months to get back and reinvest. Meanwhile the $100,000 at 1% continues to earn at the rate $1,000 per year.) 

If we work these loans out and create re-performing loans they will have value, if they have value, they will be traded, if they are traded we will have a marketplace for them and confidence in the performance. If we do not do this, we are going back to the days of S & L's, Credit Unions, Community and Small regional banks along with FHA as lending sources.  They will make loans and money. Wonder what the big street firms that have vertically integrated will do with their investments in orignations, securitizations and serivicng?

So the stress is seeing a recession with possible ramifications to a depression if actual remedies are not created. The test will be in the actual workouts, not the feel good actions that bolster the market until the next company fails.