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Mortgage Lenders on the Precipice   (September 1, 2006)


Astute correspondent Paul M. alerted me to a looming risk buried in the easy-money, bubblicious go-go mortgage lending of the past few years--stated-income loans: (emphasis added)

As a self-employed professional and homeowner, I understand the usefulness of "stated-income" mortgage lending. But I agree that taking the borrower's word for something as fundamental as his ability to repay is a completely inappropriate basis upon which to make a rational lending decision. The secondary mortgage market could be characterized, therefore, as irrational. The question begged, then, is: to what extent?

I don't sense a lot of transparency in the mortgage-backed securities market. Maybe your other readers can shed some light on the extent to which these loan portfolios contain what we used to call in banking "classified" loans; i.e. loans posing actual or potential loss exposure.
For those of you not familiar with stated-income mortgages, here's how it works. let's say I am an independent contractor or self-employed person without pay stubs from an employer. My actual income is $40,000 a year, but alas, that doesn't qualify me to buy an outhouse in today's market. But fortunately, there are mortgage lenders who don't require any pesky documentation of income, such as tax returns. All I have to do is "state" my income, which I do--as $75,000 a year. Presto, I now qualify for my very own McMansion in exurbia. Isn't modern lending wonderful?

But oops, my income has dropped recently, and it's now either make the car payment, pay the fire insurance and cover the minimum on my five credit card payments, or pay the mortgage. Guess I'll "defer" the mortgage because, hey, I think I'll do better next year and then I'll catch up.

You see where this is going, don't you? Stated-income loans have been sold and packaged as low-risk mortgages, and promptly tranched into mortgage-backed securities which have been sold off in the hundreds of billions. They are gone, Baby--there is no way investors who bought these securities can pick through hundreds or thousands of mortgages and "return to sender" the ones which are going bad. These securities are in the hands of Swiss re-insurance firms, Thai banks, hedge funds--you name it. They're all over the globe.

The risks of many of these mortgages--the stated-income ones, the adjustable-rate (ARM) ones, the interest-only ones, even the obviously subprime ones (see below) have neen grossly misrepresented.

The net result: as the defaults start kicking in, the value of these mortgage-backed securities, which are basically bonds, plummets as over-stretched borrowers stop paying their mortgage. As the income stream dries up, so does the value of the security. Now as I have explained before, many of these securities have been sliced and diced (tranched) into various levels of risk: some collect only interest, which is considered higher risk than those which collect only the principle payments. And of course the securities have supposedly been tranched by the risks posed by the borrower as well.

The point is: have the risks been accurately priced in? Given the low returns, the absurdly low reserves and the obvious risks of the housing bubble deflating, the answer is clearly a resounding "no."

So what happens when option ARM mortgage holders stop paying their monthly tab? Both tranches lose out. The "low risk" tranch is just as vulnerable to defaults as the "higher risk" tranch. Which means what? Risk has been completely and totally mismanaged on a vast scale. The entire lending and investment banking industries have been acting as if the housing and mortgage markets are rock-solid, with default rates of under 1%, even as the reality has been a Wild West orgy of risky lending to people with no capital and shaky or over-stated incomes.

Correspondent Wayne D. recently alerted me to the importance of the losses announced by H&R Block's mortgage lending subsidiary, and voila, here is an excellent account of the sobering risks facing the mortgage and mortgage-backed securities industries in the Wall Street Journal: Mortgage Market Begins to See Cracks As Subprime-Loan Problems Emerge:
Last week, H&R Block, the big tax preparer, alerted Wall Street that its Option One Mortgage unit, which focuses on the subprime market, would have to set aside about $60 million, or 19 cents a share, because borrowers were falling behind on their payments.

Here's what's been happening: Mortgage originators make loans and then sell them to investment banks, which mash them together with other loans and slice them up like sopressata for sale to institutional investors.

Now, with the mortgage market slowing and the secondary market for mortgage-related securities faring modestly worse than in the past, investment banks are scrutinizing the loans that come into their sausage factories more carefully.

The investment banks have been sending mortgages back to the lenders if they find slip-ups, such as inaccurate paperwork or poor performance. The most common trigger is a so-called early payment default, where the mortgage holder has missed the deadline for the first payment.

Lenders complain that the investment banks are taking advantage of a contractual loophole to push the mortgages back. Customers often miss first payments, they say, for reasons that have nothing to do with credit worthiness. Sometimes it's just an indication of an administrative delay.

But that's probably wishful thinking.

If the problems spread beyond customers with poor credit, they'll infect the world of exotic mortgages for supposedly credit-worthy customers first. Along with the companies that offered mortgages to customers who didn't produce much documentation of their income and assets, the more vulnerable will be banks that sold huge numbers of option adjustable-rate mortgages.

Option ARMs give borrowers choices to minimize their mortgage payments, including the ability to make a minimum payment that is lower than the interest due that month. When a customer chooses that option, the mortgage balance goes up. After a certain period, often just a year, the rate can move up sharply.

Skeptics have wondered whether customers understood the full costs of these loans and whether lenders correctly estimated how likely it was they'd be paid back.

In an indication that there was reason to worry, Washington Mutual, one of the country's biggest mortgage lenders and a big option ARM player, slipped in a rather stunning confession in its annual filing with the Securities and Exchange Commission.

In the filing, WaMu confessed it had bungled the underwriting for option ARMs, improperly measuring some of its customer's debt-to-income ratios for 2004 and most of 2005.

Of $43 billion of such loans, WaMu discloses, the unpaid balance for borrowers who were qualified at below the market rates totaled $30 billion.

Option ARMs have been among the most scrutinized exotic mortgage products over the past year. That such an error could creep into WaMu's lending should worry investors not only about the bank's balance sheet but the industry's lending standards as a whole.

Option ARMs didn't go to subprime customers. That's precisely why the coming mortgage problems may not be isolated to customers with poor credit. (emphasis added)
Correspondent Albert T. had alerted us to something rotten in the state of WAMU's financial reports some weeks ago (Basel II, Risk and Leverage) and here we have confirmation in the Wall Street Journal. Albert had observed that WAMU's loan loss reserves were insanely low--that the lender expected something like 1/10 of one percent of its loans to go bad. Now we discover that fully 70% of its option ARM loan portfolio is at risk. Do you reckon WAMU has set aside enough cash to cover those losses? Not even close, according to their financial statement notes.

So what's that mean? Massive defaults in subprime and option ARM loans, creating equally massive (and obviously unexpected) losses to lenders and holders of mortgage-backed securities. In other words, the unraveling of stupendously risky mortgage portfolios which have been supported by unprececentedly feeble reserves for bad debt.

Is this endemic mismanagement of risk evidence of a "healthy" mortgage industry and economy? I think not.

Thank you, correspondents Paul M, Wayne D. and Albert T. for your insightful alerts on this subject.


For more on this subject and a wide array of other topics, please visit my weblog.

                                                           


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