Wednesday, December 31, 2008

Unsustainable Lending (part II)

News has certainly slowed down at the end of the year (and the Bush administration has checked out entirely), but the Fed just announced that it will buy $500 billion in mortgage backed securities (MBS) by the middle of next year. There are a few obvious questions that I have: (a) isn't this what the TARP was supposed to do?; (b) are they just printing money to do this?; and (c) what is the risk we're taking on? Leaving these questions aside, I've been trying to look into what's in these. Is it simply that these distressed assets are severely undervalued, and it's purely an overcorrection in the (illiquid) MBS market? Or are we purchasing something more akin to Madoff "assets"? Again, as I reminded you in part I that I'm just a simple astrophysicist bumpkin...

The mortgage backed security (MBS) is the simplest of the fancy derivatives that have run rampant over the past few years, and the only one that I vaguely understand. (And I'm not sure that anybody really understood the credit default swap (CDS), let alone AIG). In an MBS, individual mortgages are bundled up and sold to investors. In theory, mortgages of borrowers of similar creditworthiness are bundled together, and although some small fraction of these might default, this will be built into the credit rating. In practice, I believe people played fast and loose with bundling these mortgages, especially non-traditional subprime and alt-a mortgages such as the option ARM. The MBS itself has value based on (a) the underlying assets, that is, the houses that were mortgaged, and (b) the interest paid by the borrowers. These MBSs may then sliced up some more, traded around, etc. None of this trading is done on an exchange, however, and thus these are illiquid assets. If you can't find anybody to buy the security, it's hard to tell what it's worth.

As house prices have declined, the values of MBSs have tanked. First, the value of the underlying assets has gone down. Second, with such thinly traded assets, if you need to sell in a down market the buyer has a distinct advantage. But a bigger problem is that the MBSs built on option ARM type mortgages are pretty much a complete sham. As I described in part I, the only way for a borrower with one of these loans to possibly afford it after the introductory teaser rate is to refinance or sell the house. And with prepayment penalties and negative amortization, house prices need to go up by at least 4% annually--without interruption-- for this to be possible.

Meanwhile, there's a wave of foreclosures that still hasn't fully crested. And massive foreclosures are devistating for neighborhoods, driving up blight and driving down prices even further in a painful cycle. In a half-assed attempt to arrest this in November, the Bush administration put together a "plan" to renegotiate some mortgages to keep people in their homes. Some other banks have also signed on voluntarily. For the owner of a mortgage, this can be a good deal: foreclosures are expensive, and houses are sold at fire-sale prices. If you can renegotiate and keep people in their houses, then everybody wins. (Or at least everybody loses a little, rather than everybody losing a lot.)

However, this plan did not help the large numbers of homeowners whose mortgages had been bundled up into MBSs. Instead, the bondholders flatly refuse to allow the mortgages to be renegotiated. This is a many-headed problem. Most notably, when your mortgage has been split up and is owned by thousands of investors, who do you talk to about renegotiating terms? But I think there's the additional unwillingness to fess up that renegotiating the underlying mortgages would show that the current distressed values of MBSs are actually the true values.

Again, there are two ways to calculate the value of the MBSs. The first is the underlying assets -- the houses -- and these have gone down in value, and are probably worth even less if you assume all of them are foreclosed on (of course a worst-case scenario). The second is the cash flow coming from the borrowers. On paper, this looks great: after the initial teaser rate, these borrowers will be paying out like gangbusters! 6%! 8%! Sounds fantastic! But in reality, the borrowers can only really afford that teaser rate. So any renegotiation of terms that will be affordable will end up either (a) fixing the interest rate at the teaser rate of 2% or (b) with a reasonable fixed rate of ~6%, by reducing the value of the mortgage by ~40%. Either way, the MBSs no longer appear to be such a hot deal, barring a sudden and unlikely reinflation of the housing bubble. (But you can't unscramble an egg.)

Right now it looks like the bondholders stonewalling on any renegotiation will work: they'll get bought out by the Fed, without having to admit that the securities are worth much less than they claim they are on paper. We'll all be stuck with the bill, and regular people will be kicked out of their houses. Of course, many of these people took out loans that appeared too good to be true...and were! Others were fleeced. And we all pay the price.

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