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The "Man" & his SubPrime Plan, Pt II

A few have emailed me to ask my opinion on how the new prime will affect the companies that I cover and invest in (against). Well, I believe that this is basically a non-event from an economic perspective with very little effect. This is primarialy a political move, wich is unfortunate because the policy guys actually had a chance to help someone.  Below is my annotated excerpt from the American Securitization Forum Outlines Procedures for Servicers to Follow in Streamlining Loan Modifications.

"American Securitization Forum, which represents companies that issue mortgage backed securities, as well as investors, loan servicers and rating agencies, issued a 34 page document outlining guidelines for servicers to follow in streamlining refinancing or loan modifications on adjustable rate mortgages that are scheduled to adjust in the next 2 1/2 years.

ASF Executive Director George Miller said the agreement provides a common framework to evaluate borrowers’ situations, and expedites processes for loan servicers to pursue refinancing and loan modification options on a more systematic basis.

Let’s go over some of these details which now seem to be set in stone;

• Applies to first mortgages only - It is the second lien mortgages that are most likely to default. It is also the second lien mortgages who should now be most aggressive in pressing for foreclosure, since not having first lien position maks them much more likely not to recapture any value in the case of foreclosure, especially with housing values depreciating as fast as they currently are. If they do press for foreclosure, they will be forced to take out the 1st lien in cash, which means that only the houses with substantial equity will be foreclosed on (it makes no sense to do it with a house that is underwater or close to it). This portends that any distressed housing stock in America that has any value will (should if the 2nd lien holder acts in the best interest of the investor) be pushed into a very quick foreclosure if/when this "Man's Subprime Plan" is implemented. It is a matter of self interest. It will also literally alienate 2nd lien MBS investors, foreign capital in particular. Again, I don't think the plan was very well thought out.
  
• Adjustable rate mortgages fixed for 3 years or less (ie: 2/28 & 3/27 ARM’s etc.) So, the more knowledeable buyers who locked in for longer fixed rates are left out of this. When these guys do start to default, we will be back in this situation, but with even less housing equity to negotiate with, albeit also with a different administration to deal with the problem as well.
• Only loans originated between January 1, 2005 and July 31, 2007 - The most toxic years in terms of default rates are January 1. 2005 to July 31, 2007, with a concentration in 2006 and 2007. But, the defaults of the previous years should pick up because initially they have more equity than the later buyers, but as housing prices go down, that equity will be elimitated as well. If housing prices revert to mean, (depending on geographic area - real estate is a local game) real prices should revert to about 2002 levels. That means a lot of foreclosures are going to happen and this play will purposely avoid helping them.
• Have initial reset rate between January 1, 2008 and July 31, 2010 - This would exclude the most toxic of the loans, the 1 month, negative amortization option ARM pushed by companies like Washington Mutual and Countrywide.
• The streamlined loan modification approach would be begin before the initial reset and typically should begin 120 days prior to the reset of the borrowers rate
• If loan to value (LTV) or cash loan to value (CLTV) is below 97%, servicer may obtain an updated value via desk top appraisal (AVM) or broker price opinion (BPO) Have we not learned our lesson yet? Desktop appraisals and broker price opinions will not cut it. You need an actual physical appraisal that is then audited in house for inconsistencies, conservative approach and conflicts. The phooey appraisals are the reasons why these banks have to even wonder if the LTV is under 97% in the first place!!!
• All servicers of 2nd liens “should” cooperate fully (should does not mean mandatory and can be a HUGE issue) " And why "Should" they cooperate. If anybody needs a foreclosure, it is the second lien holder on a 97 CLTV property in a rapidly declining market. At 97% CLTV, the 10% LTV 2nd lien holder gets nothing after expenses, even if foreclosure happens immediately. As a matter of fact, if the fiduciary mandate of the servicing agent is to protect the economic interests of the investor, they will be in breach of their fiduciary duty if they do not foreclose. The issue here is that the second lien holder will be forced to take out the 1st position loan in order to secure their interests. This probably would not happen with the 97% CLTV instances, but should be guaranteed in every instance when there is just enough equity to make sense, ex. 85 CLTV or lower. Anybody with brains will pull the trigger now, before housing values fall farther.

I have amended this post here based upon info highlighted (and missed by me) by harlynman in the comment section below (hat tip, and good job). Research like this is one of the two main reasons I have decided to keep providing my proprietary research for free. I would like to create the socio-economic wikiweb,where the intellect of the masses can be gathered in one place. Alas, again I digress. Let's address Harlynman's alarming points.

1. The framework allows servicers to modify loans without borrower signatures -Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 13, third paragraph from bottom of page Interesting, and it would seem, leaving open the potential for litigation since "If appropriate," has not been explicitly defined.
2. According to the American Securitization Forum's Framework for the rate freeze, borrowers will not have to document current income to be eligible for refinancing, even if they received initial loans with embellished incomes - Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 3, FICO test. The actual document reads: "If the current FICO score is less than 660 and is less than a score 10% higher than the FICO score at origination, the borrower is considered to have met the “FICO test.” If the borrower meets the FICO test, the servicer will generally not determine the borrower’s current income." This is economically significant to the investment positions in this blog. The overarching reason for this country being in this mess is the imprudent offering of excessive debt to individuals who could not repay it, primarily collateralized by assets that were at the apex of a price appreciation bubble. By including the primary driver of delinquencies as part of the solution, in order to achieve political gain by having insolvent homeowners remain in homes they could never afford. The problem is exponentially exacerbated. This is why. We are in the midst of an economic downturn, call it a hard landing, soft landing, recession, depression, whatever - things are worse off economically in the upcoming 8 quarters than they were during the last 8 quarters. This means less earning power, less asset wealth. Couple this with the fact that we are verifiably in the midst of a housing depression, where housing values are trending down sharply across the country, and you have a recipe for disaster x 2. The people who should not have qualified for a prudently underwritten loan received one anyway for an overinflated property they could not afford. The government coerces the private sector to make modifications that produces fees income for certain agents (I need to verify this) who are themselves in severe financial distress, thus incentivizing and allowing these agents to modify a loan that allows the insolvent participants to remain in the overvalued property longer, as the value of this property is rapidly decreasing. This will lead to an inevitable foreclosure since the solvency of the property owner will decrease due to worsening economic conditions and reduced earning power. The asset wealth of the property owner will decrease due to the housing slump progressing further. The collateral of the investor (mortgage investor, that is) is further impaired... And when the insolvent property owner does lose the property, it is thrown back to the market at a time when asset values will probably be at their lowest. This looks very, very ugly and exacerbates over time (maybe 6 to 18 months) the problems of all industry participants whose viability is linked to residential housing.
   

See the comments below for additional issues found in the proposed guidelines. 

The "Man" & his SubPrime Plan

A few posts ago, I linked to Nouriel Roubini's blog, commenting on how I vibe with his strategic thinking. Well, he just posted a piece on the subprime plan that I completely disagree with. I had planned to stay away from this topic, but since I already implicitly endorsed him, I might as well clear the air. I have a lot of respect for his prescience and foresight in calling the real estate bust (because he agreed with me:-), but...

I thoroughly disagree with the good Doctor on this subprime thing. Most of my points have been covered by others in the comments on his blog and others, but a major one seems to be continuously missed by all, including our current administration - This was never a subprime problem. It was a bad underwriting problem. These defaults that you see in subprime, are now manifesting in Alt-A, prime and everything in between. Not just housing either - consumer finance, auto, boats, credit cards, you name it. Consumer asset prices are trending down. The government, following its logic, will have to open this program up to borrowers of all credit ratings of all loan amounts. That's right. That doctor with the 1 million dollar house may be part of the plan as well. If one forecloses on a house now, they will get significantly more than if they foreclosed on a house two years from now or probably 5 years from now. "They" includes the homeowner and the mortgagor. So, yes, this will end up in less valuable securities for the investor and a worse outcome for the homeowner. If a workout is in the best interest of the servicer/investor, they will pursue it out of selfish interest (greed), and do not need government intervention to coerce them.

If the government really wishes to get involved, they should go after those who were victimized through being fraudulently induced into applying for mortgages and home sales that weren't in their best interest. Make the perpetrators of that fraud make the victim whole, which takes no government funding (many of the perpetrators themselves may need funding, though). Fraud was prevalent in the boom, but unilateral fraud on the part of the vendor is where the government should focus its resources. The market should be allowed to sort out the rest.

For more on the ill thought out consequences of this plan: "I hate to say it, but this thing is going to be ugly, and we are a good 2-3 years from even thinking about the bottom. We finally started reaching critical mass with 'subprime' foreclosures, but we haven't even begun to hit the alt-a and a-paper sham loans. They are starting to pop up, but they will take longer. Most alt-a and a-paper borrowers were doing 5, 7, and even 10 year ARM loans." See the overly optmistic post for the rest of this post.