A couple of weeks ago, I wrote a two part analysis post on Structured Finance and the CDO market. There was one item of import that needed clarification, so I thought I would take this weekends open thread to do it.
I hope you are all enjoying the free preview of my rough draft for The Great Housing Bubble (or whatever the publisher may want to call it.) Vetting this rough draft in the open forum of this blog has been invaluable to me. The thousands of fact-checkers who read the blog each day have forged its message. I can’t thank you all enough. The daily inundation of analysis posts will end soon as I am getting close to completion of the draft manuscript, so we will be getting back to our daily dosage of schadenfreude soon enough.
Mortgage Default Losses
There is risk of loss in any investment, and losses in collateralized debt obligations arise from the difference in the book value of the underlying mortgage note and the actual resale value of the collateral on the open market, if this collateral is subject to foreclosure. There is an important distinction that must be made between the default rate on a mortgage loan and the resultant loss incurred when a default occurs. High mortgage default rates do not necessarily translate into high mortgage default losses and vice-versa.
Subprime loans have had high default rates since their introduction. When subprime mortgages began to capture broader market share starting in 1994, the rate of home ownership in the United States began to rise. The increasing use of subprime loans and the subsequent increase in home ownership rates put upward pressures on house prices. As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses. As time went on and prices continued to rise, subprime lending established a track record of investor safety which drew more capital into the industry; however, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising.
Take this phenomenon to its extreme and its instability becomes readily apparent. Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.
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There are no lyrics, but I am a long-time fan of Native American flute Music. Carlos Nakai is awesome.
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What came before these losses? Obscene profits.
Timely article after the historic bailout of Bear Stearns. The question keeps popping up in my mind. If people like us could see the bubble and the high risks associated with it why couldn’t they (Bear Stearns et al.)?
“They” surely had some sort of assurance that the coast was clear to do this craziness.
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If you work for somebody else (which by definition is everybody at a public company), then it is very dangerous to go against the tide. If you go against the tide and lose, you lose your job. If you go with the tide and lose, well…everybody else was doing it, so no big deal. Probably why Warren Buffet can avoid getting caught up in the latest financial fad. There’s also been some papers on how bubbles form when everybody has imperfect information. So when you see the behavior of others, it tends to make it more likely that you will follow the same behaviors.
What bank or investment firm do you think is the safest to hold cash reserves in currently and for the forseeable future?
I wonder how many mortgage brokers living in Irvine are waiting for the subprime industry to recover? I wonder if they realize it is not going to?
Hi IR, congrats on the book!
To your comment “Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.”
It’s been my experience (worked for a thrift until early 2004, and still closely follow many banks for consulting work) that when the market was strong (through late ’06), subprime borrowers would sell the homes they could not afford before the bank got its hands on it. In situations where there was equity in the houses at the time of foreclosure, the borrowers filed BK and the courts typically would not grant the bank relief from stay, and would instead allow time for the borrower to liquidate the property. If you look at the extremely low levels of foreclosure through about 4 quarters ago, I just can’t see where banks made $ in real estate through foreclosing on the subprime borrowers and then selling those houses for profit. Just food for thought.
Related to your post today, credit managers (at least those in regulated institutions, like commercial banks/thrifts) are very plugged into the concepts of ‘LD’ – likely of default and ‘LGD’ – loss given default. The multiple of the two is one of the primary drivers of how much banks reserve for loan losses. So while the LD has been high for years on the subprime junk, the LGD was low for the reason described above.
One thing I don’t have a feel for either is how much of the aggregate writedowns in the book value of subprime securities is due to deterioration in collateral values securing underlying loans, and how much is due to the investment banks being required to ‘mark to market’ the bonds that are held in their trading and available for sale portfolios. Ex. let’s say that the average value of collateral securing a pool of loans deteriorates 30%. But let’s say the lack of investor demand results in a bondpayer being willing to buy a bond for 40 cents on the dollar. The 60% writedown does not reflect the collateral deterioration, it reflects market deterioration. I only bring this up because of lyour comment that “losses in collateralized debt obligations arise from the difference in the book value of the underlying mortgage note and the actual resale value of the collateral on the open market, if this collateral is subject to foreclosure”. It’s not quite that simple.
Thanks for continuing to put forth such a great blog.
Though I don’t work in the mortgage part of our bank, I got to hear their casual conversations frequently. In 2005 and 2006, the frontline people didn’t think the problem would be housing prices dropping. They thought the problem was fraud and really crappy underwriting standards. Our firm’s mortgage standards didn’t decrease nearly as much as most competitors. The “fog a mirror, get a loan” concern kept popping up. Our mortgage people wondered how some of the nuttier offers elsewhere could possibly work for any period of time. They thought that certain competitors would get buried by their own stupidity, but that our firm would pick up market share once things were more responsible.
Thus, they had part of it right. The competitors they pointed to as having the worst standards were indeed the first to go. The slightly more sophisticated frontline people realized that banks who only originated mortgages were at risk. because they were diversified. Still, despite being in SoCal, most of them thought the chances of the prices of homes going down was pretty slim.
Great post. When explained this way, it makes the lending industry sound like a Ponzi scheme of incredible cleverness and sophistication.
As for: “If you look at the extremely low levels of foreclosure through about 4 quarters ago, I just can’t see where banks made $ in real estate through foreclosing on the subprime borrowers and then selling those houses for profit. Just food for thought.”
I worked and New Century in IT. Trust me, they made lots of money writing the loans. As long as they were able to walk away from the loans that went bad with out any major losses, the money flowed like water.
Did they trouble to reason, that the high percentage of fraudulent and/or badly written loans provided a very poor support for these prices?
Lenders were alert to the deterioration in underwriting standards and the growing prevalence of fraud as early as 2003.
These people have the tools availabe to them that enable them to get a better future view of the situation then most of the general public. For example, they could see, at a glance, just exactly how many loans were made for 4, 5, 6X or even greater multiples of borrowers’ incomes. They could, for example, see that if, say, 20% of their portfolios were for loans of $400K made to borrowers with incomes of less than $125K, that they had a problem in the making even if the current default rate was very low. They could see that 50% of all loans were adjustables for 7X the borrowers’ incomes, on which the minimum payment was being made, and that even if house prices stayed level, the borrowers could not afford them.
They could also get a handle on how much supply was coming on line, and do some quick calculations that could have told them that the local incomes and rents did not support these prices.
That is what credit analyst are for. They are supposed to be able to project future and “what if” situations based on informtion readily available.
The more a particular market is supported by leverege, the more intrinsically fragile it is.
A housing market supported by properly written loans has a stable base. However, most of the loans written everywhere in the country, especially in major metro areas, were either too large for the borrowers or were outright fruad. CA has more adjustable loans than anyone, and half the home mortgages written in the Chicago area in the past 5 years are adjustables.
That means there has been really no support for these housing prices since 2003, when many people were predicting that if house inflation continued on the path it was on, we would be in exactly the situation we are now.
Mav –
Just look for the most distressed bank with FDIC insurance. Take the highest rate of interest being offered but don’t exceed the FDIC limit. Got to http://www.bankrate.com.
There was a pervasive belief that rising prices would bail out just about any loan where the borrower was able to stay in the house for a few years. Thus, our guys were worried about first payment defaults and fraud. If you had told them in 2005 there would be a 20% drop in prices and a number of people walking away from house they actually could afford the payments on, they would have thought you were kidding.
Many of them could be convinced that prices would not rise nearly as fast in the future, but the regular people making the loans didn’t think a nationwide crash was likely. Many would have asserted it wasn’t even possible without some other horrible economic problem as the cause.
Level prices are more interesting. They thought some borrowers would refi out, especially those with ARMs. For a long time, you could do serial teaser rate refis.
People doing loan processing aren’t economists. They see someone willing to provide credit under particular terms on one side and someone who wants credit and might qualify on the other side. In between, they see their rules and potential for commissions. If you’re lucky, the loan agents comply with the rules, don’t add to the fraud, and catch some of the more obvious cases.
Thanks buster, that is what I have done…….. I have seperated my cash reserves in chunks less than $100K in several banks giving higher rates. I am not concerned about losing the money if (when) it hits the fan. However I am concerned about the liquidity of these banks, and access to the cash when it hits the fan.
Walter- Yes, no disagreement that they made lots of money making the loans. This point IR made was that they made $$ taking back REO and selling it at a profit – to which I was saying, no, not the case.
Clever ? Sophisticated ? On the contrary, I was amazed at the flat out stupid behavior that was rewarded vs. the prudent behavior that was not. As i’ve send in prior posts, greed first, credit at the end of the line for priorities…and because the non-banks (i.e. and therefore barely regulated!) like the New Century companies led the way in lack of underwriting, most smaller banks (under $20 billion total assets) that originated residential loans as a primary business line had no hope in surviving if they didn’t follow suit and offer more lenient standards- because losing all business to competition = no business = no buyers of stock = takeover target within a year. It used to be the smaller banks were more lenient, customized in their lending – but when you have the behemoths with the absolutely loosest underwritings standards, you’re done.
One of the reasons I got out of credit in late 2003 is because the company I worked for was going to 40 year mortgages and asking the brokers (who brought us all the loans) what else we could do generate more business. Puh-lease. I couldn’t stomach it so I got out. It definitely took much longer for the crash to come than I would have imagined…which means we just have further to fall now.
Cleverness and sophistication??? Pure poppycock. How about blatant lack of professional/business integrity in the greedy pursuit of profit!!!
I would ask you to wholly reject the notion the leaders in lending worked on the assumption that prices would continue upward for infinity. They knew it was a house of cards that was going to collapse. They just figured they would not get caught holding the bag.
What created this mess is the ease in which CDO’s and other instruments enabled lenders to profit from loanmaking while passing on the risk to others, thus removing any disincentive for making a bad loan. It is a classic “moral hazard” tale of perverse incentives encouraging lending as long as the borrower was not so fraudulent that a 1st-to-6th month default would force a loan buy back.
These folks were irresponsible and greedy–they did real damage to communities. Terms like clever and sophisticated should be reserved to people who build their success and their communities in honorable ways.
Mike S.
“…and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment.”
IR, do you mean 100% of subprime borrowers “in the tranche”? Otherwise, I don’t unerstand the significance of 100%. This paragraph without the context of the CDO and structured finance topics makes me think you are considering a situation where all the subprimers are defaulting – like the situation we have now. Then one reads about the lenders selling REO’s for profit – and we know that aint happening!
You are exactly right. This is a big problem with publicly traded companies. The right thing to do was to not issue these incredibly stupid mortgages. But, if you didn’t do it then you wouldn’t have made the huge profits in the early years. Shareholders would have been demanding new management if a company acted responsibly, because other companies – like Countrywide – would have been pulling in perhaps triple the profits of a sane company. Hence the need for regulation that is actually enforced. I think this whole thing could have been at least blunted if our executive branch did their job and enforced laws already on the books. But then investors would have whined their asses off about government interference in business.
You got three types of investors:
1) Idiots – biggest group
2) Short term investors – second biggest group: “Yeah, this is a Ponzi scheme, but I’ll be out before #1 gets it. Screw society.”
3) Long term investors – on the endangered species list.
For the record, I’m against a bailout (too late) until at least one big bank fails. It’s like a group of idiots that get high on PCP and start stabbing each other. If you patch them all up right away they will just do it again. If you let a few of them die then maybe their buddies will think twice before doing it again. I tried to explain this to the hospital, but they just gave me a horrified look and fired me anyway. I still stand by my decision.
Now announcing!!!
The Grand Opening of the First Mortgage Bank of Tony
Our mirrors have been treated to always fog. Fully supported by the Might of the Mexican Peso and the Canadian Loonie.
Come on down. our offices in Tijuana are opened 5 hours a day.
Only 7% on loans generated in pesos and loonies. 70% in US dollars.
We got Wall Street fully behind us.
Not only did our executive branch not enforce laws already on the books, they prevented states from trying to do so. The current government was an active participant in the housing bubble.
Here’s a great idea. Let’s make it more worthwhile from a tax standpoint to make money in real estate and finance. Let’s not fund basic research, but let’s give tax breaks to the oil companies. How can I tell my kids that science is a good career when the average pay of a VP/director in a technology company is less than the average pay of a Bear Stearns employee. That the chances of getting independent research funding before you are 40 at a university is almost non-existent. Yep, let’s just keep on giving money to those that already have it or don’t provide a productive service. Almost makes wish I was living in Rome.
Wait a minute, wait a minute.
The broker who fed me business followed the rules. We knew that the loans were sold afterwards, and put into a pool, but until I started blogging here and reading Calculated Risk, I had heard the word tranche but didn’t know what it meant. I’m not stupid, but I am not a finance expert either. The mtg broker certainly didn’t understand that the loans were sliced and diced and sold off to Norwegian towns. Neither of us had heard of a monline insurer. Or what RMBS was or CDOs or SIVs. Our expertise lay elsewhere.
I would look at the buyers and wonder how they were going to buy a tunafish sandwich and toothpaste after taking on that much debt, but I’m not a loan underwriter.
I thought my duty was to do the closing properly, stop the closing if I dectected outright fraud, make sure the buyer got good title, and the lender a good first or second lien of record.
I didn’t think, and actually still don’t think that my job is to re-underwrite loans, and tell buyers they shouldn’t take on so much debt. Unless they are specifically my client first. As it was, I would say occasionally that this was really a lot of money. . .
Nobody has ever declined to buy a house on my counsel that they were getting in over their heads.
The broker didn’t believe in neg am mtges and only did one in the time I was doing his closings. He put people in fixed rates whenever he could, despite being urged to make higher fees by not doing so by Countrywide. He used ARMs when the buyers had credit that was not so good, and told them to refinance after faithfully making their payments for the loan and their other debts. He really believed this. I did too. Some people actually did succeed in this plan, if they were lucky on the timing.
As far as house prices never going up, when people asked I said that in the short run they might go down, but I didn’t have a crystal ball. In fact, since I moved to Miami in 1972, they had only gone down once, slightly, in the middle 70s and promptly recovered, and then with the great interest rate hikes of the early and mid 80s. Again, a reasonably quick revival. I thought prices were going up awfully fast, but I had seen it before and reasonably thought that the most we could expect was a quick dip and a resumption of upward prices. Not the Great Depression II in housing (and elsewhere?).
I think that most people knew their part of the mkt, but hardly anybody really understood the whole picture.
Maybe not even the big guys with the big bonuses who are (hopefully) going down now.
I do now; boy do I know know.
Obviously I am leaving out the fraud part of it because I didn’t participate it it. The broker would occasionally tell people that even using the fog the mirror standards the lenders were using, he couldn’t qualify them, and why not buy a cheaper house that they could afford.
What they did was, they went somewhere else. To a fraudster, who proceeded to rape them. Then, they would come crying back to the broker. Sometimes he could help them, mostly he couldn’t.
You are not alone. I know a lot of people that see the same problems with this country’s priorities. Let’s hope we’re the new majority rather than stuck being the “unpatriotic” minority.
“Cleverness and sophistication??? Pure poppycock. How about blatant lack of professional/business integrity in the greedy pursuit of profit!!!”
I am amazed people attach moral value to the words cleverness and sophistication. I agree with everyone that what was done was greedy and lacked professional/business integrity. However, I saw first hand the complex methods used swindle what were to be very smart investors. This required a lot of cleverness and sophistication, because if you were up front and told the investors the house of cards they were buying into, they would have told you to get lost.
So, do realize that cleverness and sophistication can be used for good upright causes, to ruin lives, and anything in between. They carry no moral meaning.
“I am amazed people attach moral value to the words cleverness and sophistication. I agree with everyone that what was done was greedy and lacked professional/business integrity. However, I saw first hand the complex methods used swindle what were to be very smart investors. This required a lot of cleverness and sophistication, because if you were up front and told the investors the house of cards they were buying into, they would have told you to get lost.
So, do realize that cleverness and sophistication can be used for good upright causes, to ruin lives, and anything in between. They carry no moral meaning
”
REMEMBER: The road to HELL is always paved with good INTENTIONS.
And in this case: The love of money is the root of all evil.
While not everyone involved was evil, all the brokers, AEs, CDO/SIV packagers, etc. that I worked with loved money, and would do anything not specifically against the law to make more of it. There is always someone out there that will just about anything to make $30,000 – $40,000 a MONTH.
Hello Irvine renter,
This reply is not related to the post, but since I could not post on the other thread, I am dropping a note to you here.
Congratulations on deciding to publish your book! I will be one of your buyers since I have benefited a lot from this blog.
Two months ago when we started looking for a townhouse in Irvine, our realtor tried push us into buying an overpriced property and while googling on the net about the same, I stumbled on your website. Since then I have been checking daily, and has told our realtor to hold off.
Our realtor kept saying “I don’t know where you get your information from and who really posts such things that would never happen”, but I can see them coming true already:-)
Case in point: 256 Monroe 50, Irvine. Started at 525k which according our realtor was the best deal out there and after a little research at your website, we offered 474k. Our realtor told us there is no chance of getting the house and didn’t bother to submit the offer saying that the other realtor wouldn’t accept anything 500k since he already had two other offers at that range. We gave up.
The house went down to 500k two days ago, and today it is 480k. Guess there weren’t any offers at 500k as we were told.
Thank you for providing all the information at one place! Looking forward to your book, and knowing your real identity.
Cubic
I think you should post the name of your REALTARD(r). Consider it an act of kindness on your part…you know..to help him see the error of his ways.
$480K doesn’t even sound that good Cubic. This one is bank-owned and 15 years news than the units on Monroe:
http://www.redfin.com/stingray/do/printable-listing?listing-id=1554342
Here’s another that is much newer and below $480K:
http://www.redfin.com/stingray/do/printable-listing?listing-id=1427926
“The Great Housing Bubble”..I like the way this term has been coined. It seems that this recession is not going to end in the near future and homeowners will have to shell out more and more just for meeting their monthly mortgage payments.