Sunday, February 17, 2008

What Your Congressman Won’t Tell You

What Your Congressman Won’t Tell You

Next time you visit Washington D.C. ask a politician why the government wants to get involved in “fixing” the mortgage market mess. Their response would be something along the lines of “to help the average American who is in danger of losing their home.” In reality the primary reason is to help the banks. Lenders are sitting on billions of dollars of loans, many in danger of going into default, which they would like to sell. If they can't sell these loans and get cash, their balance sheets and profit statements go in the tank. Well, so what if the government helps the banks if that also helps homeowners as well? The problem is the government solution doesn’t require the banks to pass along any of benefits of their liquidity to their borrowers. On the contrary, I believe that the situation for borrowers will get even worse.

Here’s How It Works Banking 101

People deposit savings into banks to earn interest. Banks can do two things with the money: they can put it into their vaults and invest a small percentage of it in a few select very safe, low interest rate investments giving their shareholders meager profits; or they can loan almost all of it out at a much higher interest rate generating more profit. Banks decided long ago that the lending business is much more lucrative than the investing business. But what happens when the banks use up all of their cash and can’t get enough people to come and deposit more? That’s where the government started to “help” us back in the 60’s by establishing quasi-governmental agencies to buy loans from banks. Fannie Mae, the largest of these agencies, buys loans from banks which, in turn gives them more cash to lend earning them more profits.

Wall Street Gets Jealous

Since the 1970’s, but especially during the past ten years, Wall Street perfected a way to horn in on the action as banks were making enormous profits lending seemingly endless amounts of money to willing homebuyers. They called it “mortgage-backed securities or MBS’s.” Now investment houses were running around town buying loans and selling them to your father’s pension fund and to your rich old aunt Sarah promising them riches beyond their dreams, or at least, beyond their paltry 2% certificates of deposits. They set the bait on the hook and just reeled in the fish.

Bank Loans Then and Now

With the help of armies of Merrill Lynch salespeople selling MBS’s money flooded into banks as they generated and sold loan after loan after loan. Bank VP’s were just finishing their PowerPoint presentation showing last quarter’s record profits, when bank Presidents were demanding even more loans be made and even more profits be generated. The results were simple—adjust the guidelines for approving loans to allow ever more people to qualify. Like the car dealers on Saturday morning TV say, “Come on down! Bad credit? No problem! No job? No problem? You can drive off with the car of your dreams.”

1970’s Loan Guidelines: 20% minimum down payment; 6 months of savings in the bank after you put the money down; full documentation showing borrower’s income and debts; home loan payments can’t be more than 33% of borrower’s income.

Current (well, at least until a year ago): 0% down payment; interest only loans; stated income/stated asset loans (also called “liar’s loans); home loan payments up to 50% of borrower’s income.

Disastrous Results

Add money, combine with greed, stir for 10 years and the result can’t be good. One of the most widely sold and bought home loans were interest only loans whereby the borrower only paid back to the bank the interest owed. Since the borrower wasn’t paying back any portion of the amount of money they had actually borrowed, the monthly payments were much lower than a regular loan. There were two fundamental flaws for the borrower for these loans: first, most were only 5-year loans and at the end of the loan the borrower owed the same amount they had borrowed; and second, at the end of the 5-year period the loan interest rate would adjust to the rate at that time.

5-year interest only loans took off about 5-years ago and guess what? People who took out these loans 5 years ago have watched their home values drop and interest rates go up. A typical borrower could now have a monthly loan payment that is easily 50% more than it was when they qualified and took out the loan. Fast forward 5 years and the delinquency rate and foreclosure rate have skyrocketed. Coincidence? I don’t think so. At this point what had only been a potential problem for borrowers now had snowballed into an enormous problem for banks, for Congress, and even for the world economy. So let’s recap.

1. Banks were willing to lend money to practically anyone to make more profits

2. Borrowers were encouraged to lie about their qualifications on their applications, put no money down, and get a loan where they can barely afford the monthly payments

3. Interest rates go up

4. Home values decrease and, because borrowers didn’t put any money down, the amount of the loan is greater than the value of the property

A perfect storm and during an election year to boot.

The White Knights

Our elected officials would like to be re-elected and they would like us to believe that they can act to solve the mortgage crises. The influential bank lobbyists would like our elected officials to think that they need donations from the banking industry in order to get re-elected. So the lobbyists offer up a win-win solution: the government should raise the limit on the loan amount that Fannie Mae can buy thereby allowing banks to sell billions of dollars of loans that they have gathering dust and that have borrowers who are in danger of going into default, and voters can see that the government cares. The only problem is that this is a win-win for the government and for the banks, but a win-win-lose where the losers are the very ones that they are trying to help—the borrowers.

The End Result If Congress Increases Loan Limits

There is no assurance that the banks will turn around and start making new loans; or that they will be willing to reduce the current interest rate spread between conforming and jumbo loans; or, most importantly, that they will ease up at all on loan requirements (down payment, income/debt qualifying ratios, FICO scores, etc...). If they don’t do all three, then all of the people that have loans that they can’t afford now will still be stuck with loans that they can’t afford.

Wall Street basically stopped purchasing MBS’s in July 2007. Prior to that the interest rate on jumbo loans were only about 0.25% higher than conforming loans. Now the difference is 1%+ since banks are not be able to sell jumbo loans and have to keep them increasing their risk and decreasing their profit. If the government increases the conforming loan limits (currently $417,000), lenders will be able to sell them again because Fannie Mae will insure the new loan holder against any loss.

Loan underwriting guidelines will continue to get tighter: loan to values ratios will continue to go down as lenders want to see more home buyer equity; increasing requirements for the amount of money the borrower needs in reserves; and higher credit scores to qualify. The biggest Whammy is on interest only loans where lenders are no longer willing to qualifying borrowers on the interest only payment which is what they are getting, but now require them to qualify as if they are getting a fully amortized loan. If a borrower could afford a fully amortized loan, why would they even consider an interest only loan in the first place?

The facts are that over the last 5+ years most people qualified for loans with a 50% income ratio based on the interest only payment. If they were at 50% before, most likely they are at 55%+ now and no lender will touch them. Further exacerbating the problem bank underwriters consider California a "soft market" (decreasing home values) which made banks require an additional 5% to the down payment.

So what will happen when the government increases the conforming loan limit?

1. Many financial analysts believe that conforming loan rates will go UP, not DOWN because of the increased risk (the larger the loan, the greater the risk to the lender).

2. Lenders will charge a higher interest rate for loans above $417,000 based on the loan amount. For example:

Loans up to $417,000 no add-on

Loans from $417,000 to $500,000 conforming rate plus 0.25%

Loans from $501,000 to $600,000 conforming rate plus 0.50%

And so on.

3. Lenders will require a higher % for a down payment. For example:

Loans up to $417,000 20% down payment

Loans from $417,000 to $500,000 25% down payment

Loans from %501,000 to$600,000 30% down payment

And In Conclusion

We are being screwed by a combination of our government and the banking industry lobby using the mortgage industry debacle as a smoke screen to get public support of the program. The banks will get rid of all of the crappy loans that they made and Mr. and Mrs. Joe Borrower will still have the same problem of deciding every month whether they will buy food or pay their mortgage. So instead of the banks getting stuck with the defaults on these loans, the taxpayers will.

Saturday, February 16, 2008

Who's to Blame for the Mortgage Mess

You know who the victims are. We name some of the villains in a credit crunch built on irresponsible subprime lending in the United States.

By Michael Brush

It’s not over, folks. There’s plenty of pain left to come for homeowners and investors already battered and bruised by the subprime-mortgage meltdown. Consider that analyst Mike Mayo of Deutsche Bank predicted Monday that worldwide losses from bad subprime-mortgage loans will reach as much as $400 billion. To date, reported losses are less than a quarter of that total. And market strategist Ed Yardeni on Monday doubled the odds of recession in 2008, to 30%.

But even if we don’t know when it will end, we’re getting a much better idea of whom to blame. It’s a collection of regulators, Wall Street titans and too-smart number crunchers who were supposed to be providing adult supervision. Instead, they chose either to enrich themselves or to look away as others did. Below is a rundown of the worst offenders.

No. 1: Alan Greenspan

In his best-selling book, Alan Greenspan describes how well he managed the economy during an “age of turbulence.” Unfortunately, he’s largely responsible for the current dose of it.

As chairman of the Fed, Greenspan took the federal funds rate down to 1% in 2003 and left it there for a year. Even as the Fed began raising rates, Greenspan’s exceptionally low interest rates “planted the seeds for the housing bubble,” says Robert Rodriguez, a money manager at First Pacific Advisors who saw the emerging subprime mess early on and has managed to dodge most of it so far.

Greenspan’s role in the current mess doesn’t stop there. He encouraged the use of adjustable-rate mortgages in a 2004 speech, which was “an insane, idiotic recommendation,” says Rodriguez. The following year he endorsed subprime loans to help marginal borrowers get into houses. And true to his somewhat naive brand of Ayn Rand libertarianism, Greenspan dismissed calls for more oversight of the mortgage business. This gave free rein to our next culprits: greedy mortgage brokers who had no problem pushing inappropriate loans on borrowers so that they could reap lucrative fees.

No. 2: Countrywide CEO Angelo Mozilo

None of this would have been possible without the help of mortgage lenders willing to go along with the charade. There are many of them, but I’d cite Countrywide Financial (CFC, news, msgs) CEO Angelo Mozilo as one of the most egregious.

Mozilo acknowledged potential risks in the subprime market early on, but he continued to compete to maintain market share, even though the only way to do this was to water down loan underwriting standards like everyone else. “If the market was offering something, they wanted to offer it too,” says Erin Swanson, a Morningstar (MORN, news, msgs) analyst who covers the stock.

Even though Mozilo made more than $20 million a year in salary and bonuses in 2004 and 2005, he wanted to book more profits, mainly by selling stock options, as Countrywide was riding high on the bubble. We know this because he took advantage of a special rule to set up an automatic selling program in his company’s stock. Company documents show he realized $310 million in the three fiscal years ending in June 2007. If his agenda was to cash out personally, he had a good motive to play along with the subprime charade.

Countrywide declined to comment, but a company spokesman has told other media outlets that no one, including Mozilo, could have foreseen the events that led to the current problems with subprime-mortgage debt and that all of Mozilo stock sales complied with regulatory rules.

No. 3: Christopher Ricciardi

Mozilo and the rest of the subprime lenders couldn’t have underwritten all those dodgy home mortgages without having a way to sell them and get them off their books. In this effort, they got a hand from our next culprits: the crafty bankers who created a Wall Street debt machine that repackaged subprime loans so they could be sold to investors.

An investment banker named Christopher Ricciardi helped turn Merrill Lynch (MER, news, msgs) into the “Wal-Mart of the CDO industry” between 2003 and 2006, according to The Wall Street Journal. Ricciardi “lobbied both credit-rating firms and investors, talking up the safety and juicy returns of CDOs,” the Journal says. Ricciardi has since left Merrill, which on Oct. 24 reported a $7.9 billion write-down related to its collateralized debt obligations.

Even if then-Merrill Chief Executive Stan O’Neal missed the subprime losses because they were too far down in the chain of command, he obviously knew about the First Franklin acquisition last January. First Franklin specialized in offering subprime mortgages to borrowers with poor credit histories. Merrill purchased the operation to get more exposure to subprime lending — just before the business was about to turn sour. So he shares the blame for Merrill’s role in the subprime debacle. He admitted this in a 20-minute video message to employees before leaving the bank.

No. 4: Ralph Cioffi and Jim Kelsoe

The masters of the CDO universe on Wall Street couldn’t have gotten very far without willing investors who stood ready to buy the repackaged subprime debt. There was no shortage of buyers because these instruments offered a tempting higher yield.

So who was bingeing on subprime-backed debt and contributing to the creation of a thriving end market for these instruments? Some of the biggest casualties so far happened at Bear Stearns (BSC, news, msgs), where two hedge funds run by Ralph Cioffi blew up earlier this year, costing investors in those funds an estimated $1.6 billion. Bear Stearns declined to comment.

The biggest subprime-related disaster in the mutual fund world has played out at Regions Morgan Keegan Select High Income (MKHIX), according to Morningstar analyst Scott Berry. The fund, run by Jim Kelsoe, is down nearly 50% this year. Morgan Keegan declined to comment. But in a Nov. 7 note to shareholders, Kelsoe said that 14% of the Select High Income fund portfolio was linked to subprime mortgages. He said many debt instruments in his portfolio no longer trade. So their values are based on models projecting future cash flows, and “there are no optimistic projections at this time.”

The big tip-off that these CDOs might be trouble — according to money managers who avoided them — was their sheer complexity, which made them virtually impossible to understand. This is because the CDOs were made up of hundreds of individual mortgage-backed bonds. Each of them was backed by a thousand or more subprime loans. So it’s tough to get a handle on key factors like the average credit scores of the borrowers or the real-estate markets the loans were made in.

“We realized we couldn’t dig in and understand what was in those things,” says Connie Bavely, who runs the T. Rowe Price Summit GNMA Fund (PRSUX). “You don’t buy something if you don’t understand it.”

No. 5: The ratings agencies

Money managers may have been blinded to problems with debt instruments backed by subprime mortgages because of their hunger for higher yields. But in missing the cues, they also got a hand from the credit-ratings agencies, which get paid to evaluate debt products and make a call on the likelihood of default. The three big ones are Standard & Poor’s, Moody’s Investors Service and Fitch Ratings.

“The rating agencies missed something, to be gracious about it,” says Don Quigley, the co-portfolio manager of the Julius Baer Total Return Bond Fund (JBGIX). Part of the problem, says First Pacific Advisors’ Rodriguez, is that rating these debt instruments was big business, and the ratings agencies were often getting paid for the ratings by the same people who were creating the debt instruments. So they might have been tempted to let their guard down when it came to weighing the likelihood of negative scenarios.

“As far back as 2004-2005 we were aware of questionable underwriting, potential fraud and limited documentation” in the home-mortgage industry, says Rodriguez. “These did not appear to be appropriately considered in the rating process.” What’s more, risk models used by the ratings agencies assumed continued home price appreciation that would allow marginal home buyers to refinance their loans when their monthly mortgage payments went up.

“We suspect that with so much money to be earned by originating, securitizing and rating, there were too many conflicts to take a very critical view of the process,” says Rodriguez. The ratings agencies declined to comment.

No. 6: Mortgage brokers

Home buyers should have known better than to get into adjustable-rate loans they couldn’t afford when interest rates reset higher. But I’d single out another party in the industry for the most blame: the mortgage brokers.

For mortgage brokers — many of whom were independent operators in mom-and-pop shops — the real-estate bubble was a real bonanza, and their greed got the better of them.

“Quite frankly, there was a race to lower standards to generate more loans,” says a former mortgage broker with a major bank in the Chicago area. And for good reason: A merely “good” mortgage broker could easily take home $250,000 a year. But most of them were bringing in $500,000 to $750,000 as long as they cranked out enough loans — and damn the consequences, says the former mortgage broker. “It was like kids in a candy store. You had to be a complete screw-up not to make money. There were basically no guidelines, no restrictions and no oversight.”

Ultimately, to keep the money machine moving, the mortgage brokers stooped to offering so-called “ninja” loans, or loans that required no verification of income, job or assets. “It got to the point where the only thing you had to do was be able to breathe and have a credit score above their threshold,” says the former broker. Mortgage brokers couldn’t care less if the loans ultimately went bad — because they knew by that time the loans would be far away in the hands of unwitting investors.

The lawyers drawing up the mortgage-loan contracts deserve honorable mention as culprits. They could have done a far better job of telling home buyers what would happen when mortgage rates reset, believes Joe Stegmayer, the chief of Cavco Industries (CVCO, news, msgs), which sells manufactured homes.

“The lawyers were drafting contracts that were so complicated, they knew home buyers were not going to read them,” he says. “So why not have a summary sheet that says ‘You are signing an adjustable-rate mortgage, and the rate probably will go up by this amount.’”