The Law of Unintended Consequences
March 6, 2009
By John Mauldin

Unintended Consequences
The I-Factor
Rating Agencies Gone Wild
Knights to the Rescue

~~~

Rules have consequences. And sometimes they have unintended consequences. If I told you that the US government was going to give multiple tens of billions of taxpayer dollars to hedge funds and private investors, you would justifiably not be happy. I think the word angry would come to mind. But that is exactly what is happening, as a result of rules that were written for a time and place seemingly long ago and far, far away. Further, we are looking at potentially much larger sums being lost in the bank bailout (can we say hundreds of billions?), a reduced lending capacity at banks and, in general, a worsening of the very problems at the core of the crisis.

The good news is that it can be fixed, but the authorities need to get a sense of urgency. As Steve Forbes writes today in the Wall Street Journal, Obama is continuing with the worst of Bush’s policies, making the crisis far worse than it should be. It is as if we are giving all 13-year-old kids a “F” in math because one kid failed.

Today’s letter will look at some rather obscure rules which are having major unintended (and negative!) consequences, and what can be done. Then, if we have enough time, we will look quickly at Japan, unemployment, and a few more statistical predictions of when the
recession will end that you should be very wary of. It’s a lot to cover, but it should make for an interesting letter.

But first, and quickly, I just wanted to take a moment and remind you to sign up for the Richard Russell Tribute Dinner, all set for Saturday, April 4 at the Manchester Grand Hyatt in San Diego — if you haven’t already. This is sure to be an extraordinary evening honoring a great friend and associate of mine, and yours as well. I do hope that you can join us for a night of memories, laughs, and good fun with fellow admirers and long-time readers of Richard’s Dow Theory Letter.

A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. If you are a fellow writer, you should make plans to attend or send me a note that I can put in a tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven’t, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don’t procrastinate. I wouldn’t want any of you to miss out on this tribute. I look forward to sharing the evening with all of you. I am looking for a few sponsors to help with the costs, to make sure we do this evening right. A number of friends, along with EverBank (www.everbank.com) and ProFunds (http://www.profunds.com/),have already committed. Drop me a note if you would like to be a sponsor as well. And now to a discussion of the rules.

Unintended Consequences

(Let me state at the outset that I am going to oversimplify this story to keep it from getting too long and technical, because I think it will make it far more readable and understandable to the majority of readers.) Let me note that while I am talking about rules that do not make sense, this in no way should be seen as a criticism of the regulators. It is their job to enforce the rules, not make them. The authorities at the top (including Congress and the administration) should be taking action.

In the beginning there were ratings agencies, and they rated corporate bonds from the very highest of credit quality (AAA) down to junk (CCC). Now AAA means that the chances of losing money are very, very low. With each level of increased incremental risk comes a lower rating. If a corporate bond was at risk for losing just one dollar, it was rated all the way down to junk. And that was fine. Everybody knew the rules of the game. But then investment banks asked the agencies to rate a large group of home mortgages in a pool known as a Residential Mortgage Backed Security (RMBS). The investment bank would divide the pool (the RMBS) into various tranches. The highest-rated tranche would be given a rating of AAA. Let’s say that the AAA tranche was 92% of the loan pool. The AAA tranche would get the first 92% of all monies coming into the pool before the other investors were paid (again, really oversimplified, but that is the net effect). That would mean that the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even one dollar.

We all know now, though, that some of those AAA-rated tranches are in fact going to lose money. And the rating agencies are now writing down the ratings on the former AAA tranches. I am not talking about the exotic CDOs and CDO squareds, or some of the truly toxic securitized assets which are going to zero. What I am writing about today are plain vanilla mortgages grouped together in securitized pools. I wrote three weeks ago, “The downgrades by Moody’s today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow. Moody’s warned in a report last week that loss assumptions would be increased for RMBS and that downgrades could be expected. Moody’s is projecting that alt-A deals originated in the second half of 2007 will experience 25.5% losses of original balance, compared to 23.9% of 1H07 deals, 22.1% for H206 deals, and 17.1% for 1H06 deals.

The rating agency in May expected average losses for 2006 and 2007 vintage deals to reach 11.2% and 14.7%, respectively.” (The Big Picture) Fitch and S&P are also piling on with downgrades. Most of them see RMBS’s go from AAA all the way down to junk. This has some very bad unintended consequences. Let’s say a bank has a loan portfolio of 1,000 individual mortgages valued at an average $200,000, for a total portfolio value of $200 million. The loan officers were not very good, and it turns out that 18% of the homes went into foreclosure and lost an average of 50%. That means 180 homes went into foreclosure and that the bank lost an average of $100,000 per home, or $18 million overall. The bank was charging 6% interest, so in a few years it would at least have its original investment back, although the losses would eat into capital. To make those loans of $200 million, the bank would need at least $20 million in capital, and so would need to go raise some money or reduce its loan portfolio by selling the performing loans. The reality is that for a bank to have such a large mortgage book, it would probably be a much larger and better-capitalized bank. If it were not, it would soon be taken over by the FDIC.
Note that the remaining 82% of loans are still performing and are carried on the books at full value (again,
oversimplified). There is real value in the remaining loan portfolio. But what if the bank invested in a RMBS that was rated AAA, and 18% of the loans in the security went bad? Remember, the AAA tranche gets the first 92% of income. The loss to the RMBS is 9% of capital. The losses to the AAA tranche are only 1%. Hardly a catastrophe. Annoying, but something you can deal with. Except for some very nasty rules. Remember, a bond is downgraded to junk if it loses even $1. Now, let’s take it to the real world. Say a bank buys a $1-million AAA portion of that large RMBS. It can use that AAA debt in its capital base, and can actually lever it up about five times, as the rules only make the bank take a 20% “haircut” on an AAA bond. But if the bond goes to CCC, the bank must now move the entire bond to its “risk-impaired” portfolio. And because most institutions cannot buy junk paper, there are very few buyers out there who will want to buy it — mostly hedge funds and private capital. The price on that paper might easily drop to $.50 on the dollar because of the potential for a 1% loss.


The accountants, being conservative and living with new mark-to-market rules, make the bank take a $500,000 loss. This directly reduces regulatory capital by $500,000. Banks are required to have a maximum of 8% of risk-impaired assets as compared to solid capital to be considered adequately capitalized. Keeping the asset on the books means they have $1 million of risk-weighted assets. If they have to sell to get the
capital required to follow the regulations, they will lose $500,000. And they lose this on an asset that the rating agencies say might lose $1 ten years from now.

Again, at the risk of oversimplification, if they keep the security that also means that the bank loses roughly $10 million in lending capacity. They have to reduce their loan book or raise more capital.

Rating Agencies Gone Wild

Here’s the truth. That bond should never have been rated AAA to begin with, and it shouldn’t be rated CCC today. The ratings agencies took a perfectly fine corporate bond rating system and tried to bootleg it onto a security that has an entirely different set of circumstances. A corporate bond is a bond from one company or one obligor. An RMBS might have several thousand obligors. (An obligor is a person or entity that is obligated to pay back debt.)

It was very convenient for investment banks to get the rating agencies to use the corporate bond analogies, because that meant they did not have to explain a new system. Everyone knew what AAA meant, or AA or BBB. A bond buyer in Europe or at a pension fund simply looked at the rating and hit the buy button. Easy. No need for a lot of research. Make your purchases and go to lunch. While I can’t go into specifics, I have looked into these bonds with some real interest. Let’s assume that you can actually buy an AAA tranche of an RMBS at $.60 on the dollar. That means that 80% of the mortgages would have to go into foreclosure and lose 50% before you would ever lose a penny.

There are AAA bonds selling at steep discounts that are composed of mortgages with 80% loan-to-value in 2005, a 7% interest rate, and 90+ percent performing loans. These loans are being called in as mortgagees take advantage of lower rates and refinance. And with Obama’s new proposed lower rates, even more of these loans will be refinanced. If you buy the loan at $.60 on the dollar, and it gets refinanced, you get an immediate capital gain of almost 50%! If it keeps on being paid, you get an effective rate of about 10%.

So, why wouldn’t there be a lot of institutions standing in line to buy such a dream investment? Because banks fear the danger that the security will get downgraded, just like the thousands of such instruments that have already been downgraded, and then their regulatory capital will be impaired. The technical banking term is that you would be screwed. So you don’t buy what would be a very good performing asset, because of the rules.

So, who can (and does!) buy? Hedge funds and private investors with liquidity. But these “vulture capitalists” (among whom are many of my friends) know that the sellers are operating from a position of weakness. And because there are not enough of them to buy the bonds on offer, the prices of these bonds are very low. Smart money managers
are raising money to exploit these distressed sellers.

So, in effect, we are giving banks taxpayer money while forcing them to sell assets that might be worth $.95 cents on the dollar in a less-stressed world. We are shoveling money in the front door while it is being pushed out the back door to my friends at the hedge funds.
How much are we talking about? US banks and thrifts have $315 billion in AAA non-agency (Fannie and Freddie) bonds, insurance companies have $190 billion, broker dealers have $75 billion. Overseas investors have $160 billion. Banks have written down about $700 billion in assets. The majority of those losses have been mark-to-market write-downs and not actual losses. Yet taxpayers are in essence paying them to sell, because the rules say they have to raise capital.

Some simple rules changes would solve a lot of this problem. First, let’s recognize that the root of this particular problem is the ratings system. If an RMBS is likely to get $.95 of its capital, then it should be valued at some number below that, but don’t make them assign it 100% to their risk capital. That is like making the bank with the 1,000 home loans in its portfolio write off all of them because 18% are bad. In principle, there should be no difference.

Then, the Federal Reserve should call in the rating agencies and have a “come to Jesus” meeting. They are at the heart of the problem, and they need to fix it. They need to change their ratings system for packaged securities like RMBS’s.

The I-Factor

Let me throw out one idea (there are likely to be a lot better ones, but let’s get some ideas on the table). Let’s move away from using standard bond ratings for multi-obligor securities. Why not rate a bond by the percentage of capital likely to be returned? Let’s call it the Impairment Factor, or I-Factor. If a bond is likely to lose 10% of its capital, then it would have an I-Factor of 10%. An I-Factor of 0% would mean the bond should see all its capital returned, and an I-Factor of 100% would mean that all the money will be lost.

Now, that tells investors something. That’s a useful statistic, as opposed to “CCC.” What does CCC mean? Am I going to lose $1 or $1,000 or all my money? CCC gives me no useful information if I want to buy or sell a bond. And without real transparency, you end up with a world in which a few very knowledgeable buyers can make a lot of money. That is because there are a lot of AAA bonds that are going to zero, as in 100% loss. If you are on an institutional desk and would like to participate in getting some of the better values, unless you have a very sophisticated team with good analysis software, you simply can’t take the risk.

Further, if the rating agencies do their homework to figure out what the I-Factor is, they will have all sorts of useful information that can be disclosed about the security, such as average loan balance, average loan-to-value, how many loans are at risk of default, where the loans are, and scores of other details. Armed with that information, buyers can make rational decisions. And if you modify the rules so that banks and other institutions can use those bonds (with an appropriate haircut) as part of their regulatory capital, then you immediately get a large number of buyers into the market, and that will make prices go up and mean that banks will need less taxpayer money.

The current rules were written for a time when banks actually bought corporate bonds. They made sense back then, and still do. But applying those ratings to asset-backed securities makes no sense. We need to change those rules now.

Marking assets to market when there are no markets is illogical. I have spent some time looking at these securities. Like kids, they are all different. And some are really different. Yet we make a bank mark an asset down because one that is in the same broad class is impaired. Like giving every 13-year-old in school an “F” in math because one kid failed. Further, we don’t make a bank mark down the value of a loan on its books if interest rates increase. The loan, if sold into a market, would indeed not be sold for book value. But the bank keeps it at book value on its books, and simply realizes less interest. If we madebanks mark down their assets because of interest-rate increases, we would lurch from one bank crisis to another with every interest-rate cycle.

Let me be clear. I am for full transparency. If an asset is only worth ten cents on the dollar, then mark it down. We do not need zombie banks. For whatever reason, the Obama administration seems to be afraid to use the “N” word (nationalization). If a bank is insolvent, yet deemed too big to fail, then take it over, repackage it, and sell it back to the private market with some options that will allow for
taxpayers to at least have the potential to get their money back. But do it quickly rather than dithering, as is happening now, because that will just cost more in the long run. But as a start, change the
accounting rules so that we stop shoveling taxpayer money in the front door to banks and out the back door to hedge funds. That can be done quickly if the administration simply says “do it.”

Let me quote this note from Gary Townsend, which I wholeheartedly agree with: “The problem, of course, is that the MTM (mark-to-market) results have little to do with the intrinsic value to a bank of a loan or a security that it plans to hold to maturity. In a bank, the decline in a loan’s value is offset with a forward-looking provision for loan losses. The decline in the loan prices net of loan loss allowances is not due to credit deterioration; it’s the result of the distortions and speculation in the world’s financial markets. Mark-to-market accounting isn’t improving the transparency of bank accounting. It has reduced it, with enormous and growing damage to our economy and prospects. “The Financial Accounting Standards Board has said that it will issue new guidance on the application of FAS 157. That’s encouraging, but can anyone recall when the FASB has been timely? The damage from this misguided rule is already huge, widespread, and growing daily. Mark-to-market accounting creates a powerful negative feedback loop. Actual or imputed FAS 157-related losses weaken capital
ratios and undermine confidence in the financial system generally, which weakens the economy and adds pressure on loan pricing, causing more FAS 157 losses, and around we go. “This cycle needs to be broken.
Mary Schapiro? Tim Geithner? Are you listening?”

And let’s add President Obama, Ben Bernanke, Barney Frank, Chris Dodd, and Larry Summers to the list of those who should be listening. I know that some of my readers will have access to these people. See if you can get them to focus on this problem, and let’s move on to the next problem — housing.

As a final note, I know that some regulatory bodies are in fact paying attention to this while others are not. Good on the ones who are listening. As for the others, the adults in charge need to make sure the kids are playing nicely in the sandbox. This is an argument for a significant review and reform of our regulatory system. But right now, we need some immediate action.

Knights to the Rescue

The world is in the throes of a global recession. But as usual, the very poorest are being hurt the most. I want to close by quickly asking you to consider helping one of my favorite causes, emergency relief for the poorest of the poor. My friends at Knightsbridge (Ed Artis, et al.) currently have three hundred thousand dollars of medical equipment and supplies (relief) sitting in two separate locations here in the United States. It’s worthless while stored here but “gold” in the developing world. We need $37,000 to ship these items to the Philippines, where we can stage them for delivery to clinics in Cambodia, Vietnam, Myanmar, and the Philippines. This medical relief, when delivered, will save the lives of thousands of people affected by disease and poverty. Knightsbridge works with many people around the world who volunteer their time to help us hand-deliver this relief, as you can see in Adrian Belic’s multi-award-winning documentary film Beyond The Call (http://www.beyondthecallthemovie.com/) and (http://www.pbs.org/independentlens/beyondthecall/).
For every additional $18,500 that is raised, we can obtain and ship 40 cargo containers of valuable medical supplies and equipment, worth between $150,000 and $500,000, to the staging area in the Philippines. We have almost unlimited resources here in America for the collection and staging of medical equipment and supplies to be shipped overseas. We will run out of shipping dollars long before we ever run out of medical relief goods in need of shipping.

Each dollar that you donate will ship many times that much in lifesaving medical relief. Your donations can be sent to Knightsbridge in two ways:

  • * Online donations are immediate and can be sent to us via the PayPal / DONATION icon located on our website at www.kbi.org
  • * Checks should be made out to our NEW partner NGO, A Prescription for Peace, in the US (http://www.APrescriptionForPeace.org).

These checks will be processed, appropriate receipts issued, and the proceeds deposited to our credit.

A Prescription For Peace (a California 501[c]3)

P.O. Box 67696

Century City, CA 90067
John Mauldin

John@frontlinethoughts.com

Copyright 2009 John Mauldin. All Rights Reserved

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John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Category: BP Cafe

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

12 Responses to “The Law of Unintended Consequences”

  1. Mike in Nola says:

    I get John’s newletters by email and he sounds like a knowledgeable guy, but after reading the beginning where he cite Steve Forbes, I almost deleted it without reading.

    Steve Forbes is only anyone because he was born rich to someone who did have talent. He learned as much about economics and finance from his parent as W learned about governing from his dad.

  2. Steve Barry says:

    As my dad would say…if it weren’t for Steve Forbes’ dad, he’d be a garbage man.

  3. AllStreets says:

    John, that is a brilliant article and excellent advice to the ratings agencies and government regulators. A new rating system for multi-obligor bonds wouldn’t totally solve the housing and mortgage crises, but it would certainly improve the prospects for normalization in the credit markets and reduce the chance of many more bank failures. If only those in charge of solving the credit crisis took the time to look hard at the nuts and bolts of the problem, and listen to the many workable suggestions from outside commentators, it could be solved much faster and with far less cost to taxpayers. It’s hard to grasp the fact that with all the finance MBA’s and PhD’s prowling Wall Street and government, the common sense you elucidate regarding the issue of rating MBSs and all other multi-obligor securities hasn’t been applied yet. Let’s hope some of those in authority or their aides will read and act on your sound advice. Considering how simple and obvious your recommendations are, those who are suspicious of government might wonder whether the regulators are deliberately deferring action until their hedge fund and investment bank buddies are loaded up on deeply discounted MBS’s and their call options.

    I’ll be adding a module containing your recommendation to the plan I’ve drafted to stop the mortgage, and economic crises. It’s called The AllStreets Bailout Plan found at http://www.themortgagenews.info. The heart of it is a direct loan program using 30-year 3% fixed rate federal loans not secured by properties to to pay down a significant portion of mortgage debt and for other purposes for those adult citizens who do not have a mortgage or don’t own a residential property. The paydown of each mortgage is replaced by loans equal to half the paydown to each of the homeowner and the lender.

    However, I do quibble with two non-critical premises in your article. First, in your sentence “The loan officers were not very good, and it turns out that 18% of the homes went into foreclosure and lost an average of 50%” there’s the maddening implication that BECAUSE the loan officers were not very good THEREFORE, the loans went into foreclosure. We find this the same general unjustifiable slam on loan officers everywhere in writing and speaking about the housing and mortgage crises. The truth is, loan officers had almost nothing to do with causing the foreclosure crisis. It’s like blaming the clerks at McDonald’s for serving hamburgers with infected meat that caused a massivefood poisoning crisis. Sure there were possibly more than just a few bad apples who lied about borrower’s income on stated income loans, but that’s probably not much different than historical rates of malfeasance. However, I seriously doubt that occurred in a significant portion of the cases of loan defaults in the last two years. The fact is, loan officers merely filed loan applications. Loan officers do not set loan guidelines, and they cannot APPROVE loan applications. Lenders set guidelines, and underwriters approve loans in accordance with the guidelines if they are doing their job right. Borrower’s sign loan applications attesting to the contents. Loan officers don’t have any power or ability to investigate the underlying facts beyond the documents required by underwriters. Even in the case of stated income loans, the underwriter must check the income against average salaries in the borrower’s region for their type of employent, which is verified. If underwriters approved implauible stated income loans, then they, or their quality control supervisors are to blame, not the loan officers.

    In the case of mortgage brokers, they merely send loan applications to wholesale lenders. The lendets’ underwiriters approve the loans. In the case of lenders’ loan officers, they send loan applications to their own company’s underwriters. If you’ve ever tried being a loan officer, you would know that getting a loan approved by an underwriter is often a very difficult task. The underwriters are the gate keepers, and they just evaluate loans against the guidelines, but they don’t set the guidelines. There are a myriad of causes of loans going bad other than the loan officer being “not very good,” including fraud by the borrower, the loan guidelines themselves, the underwiriters’ applications of those guidelines, economic circumstances of the borrowers that changed to “not very good” (50% of all bankruptcies are caused by medical bills, and most of the others by job losses), and the drop in home values that prevented so many from refinancing out of exploding ARMs. Of course, shame on loan officers who lied about income, appraisers who overstated values, and borrower’s who knowingly signed false mortgage applications. However, I propose that those cases are only a tiny minority of the loans going into default. I maintain that in the case of subprime ARMs, the main thing that was not very good was the terms of the loan themselves, which are such that the loans are guaranteed to blow up when the interest rates adjust, due to usurious margins over the adjustment index, typically 5% to 9% over the 6-month LIBOR. It’s just amazing that here we are over a year into global credit crisis that started with adjusting subprime ARMs, and, there still hasn’t been a single regulation, proposed or implemented, to prevent usurious terms of ARMs.

    In the case of loan guidelines, you can blame either the very existence of stated income loans, or the allowance of 95-100% financing. However, stated income loans have been around for a long time, and lenders set guidelines for them in a manner consistent to protect themselves in view of historical performance data. High LTV mortgages have been around for decades. FHA has always allowed 97.5% and VA allows up to 100%. Fannie and Freddie allowed 100% with good credit. Even 95% financing, subprime or not, would have resulted in pretty much the same foreclosure crisis, and loans like that had been around for decades. In fact, Fannie and Freddie, still allow at least 95% financing as a routine, 97% for some loaons, and, under Geithner’s new refinance plan, they will allow 105% refinancing (which, I guarantee will have relatively few takers due to the rate pricing, unless mortgage rates drop to the 4.5% area, but that’s another story).

    Another very important thing that turned out to be “not very good” was the issuance on September 28, 2006 of Interagency Guidance on Nontraditional Mortgage Product Risks” by the U.S. Treasury, the Federal Reserve and all the federal bank regulators. They solicited and received compliance with all state regulators of state-chartered mortgage lending institutions. I get a big laugh every time I hear that inadequate regulation was an important cause of the mortgage crisis, when, in fact, it was precisely ill-timed, aggressive, unprecedented, government regulation of mortgages that contributed mightily to ensuring that a significant problem would become a worlwide financial crisis. The analogue is the Federal Reserve drastically raising margin requirements during the stock market crash of 1929. Perhaps it’s no coincidence that home prices peaked almost the exact month the guidance was issued. The guidance required that all ARMs be underwritten using “the fully-indexed rate with the fully-amortizing payment” regardless of initial “teaser” rate or other terms of the loan (interest-only or negatively amortizing payments). The guidance had the practical effect of guaranteeing that no subprime ARM borrower, or many other ARM borrowers, would be able to refinance with another ARM. The Interagency Guidance almost immediatley put all subprime lenders out of business. By April, 2007 there were virtually no subprime lenders left. Interest rates for most subprime borrowers were adjusted in 2007 when the 6-month LIBOR index was over 5%. so they faced adjusted rates of 10-14% in most cases, and few had any way out of their loans. After index rates dropped it was too late, since their rates had already adjusted and would only come down by 1% per month. Even those who might have refinanced with FHA or GSE loans couldn’t, since by then they were upside down. Of course, that caused a subprime foreclosure crisis which Ben Bernanke warned Congress about in December, 2006 but neither did anything to stop it.

    The other premise I quibble with is “And with Obama’s new proposed lower rates, even more of these loans will be refinanced.” I regret to report that it’s unlikely there will be a significant proportion of loans refinaned at significantly lower rates under the part of the Geithner plan that is supposed to refinance 4 to 5 million loans, even if that many refinance. There are approximately 25% of homeowners with zero or negative equity, or about 27 million. Most of those can’t refinance due to LTV’s being over 105%, especially if it’s necessary to finance settlement costs. A huge portion of underwater mortgages are for investment properties, second homes and jumbo loans. Jumbo loans don’t qualify, second homes could be helped, but investment properties have pricing that sets rates too high to allowing significant rate relief for most owners. In additon for the plan to help many it’ll be necessary that mortgage rates stay near or under 5%, a dubious assumption. Rates near 5.16%, as suggested by the Treasury fact sheet, is unlikely for most with more than an 90% LTV loan, based on the pricing adjustments that were published Friday, 3/6/09. Even at today’s rates, near the lowest ever, most folks would get 5.50% or higher. That means that a borrower’s rate needs to be at least 6.25% for the refinance to save much. Most who qualify for a rate like that have already refinanced with agency or FAH loans allowing up to 97.5%. FHA would still be the best bet for most borrowers with LTV’s of 90-97.5% even with the 0.5% mortgage insurance. You can verify this by simply comparing the pricing for such a loan to the pricing for an FHA refinance loan up to 97.5% LTV to the rates on the new Fannie Mae Refi Plus program. FHA will win every time, especially for anybody with a credit score under 700.

    First, let’s look at the rate for an FHA refincne loan good to 97.5% LTV? The pricing excercise is simple for any FHA loan, since there are virtually no pricing adjustments. The par rate on 3/6/09 morning was 4.875%. However, there’s a rate add of 0.50% (0.55% for some borrowers) for government mortgage insurance, so the effective rate is 5.375%. That rate is good for all qualifying middle credit scores down to 620.

    Under the new Fannie Mae Refi Plus program under the Geithner Affordability program, there is only one pricing adjustment for a loan at 97.01-105% LTV with a credit score of 660-679, and that’s 1.25% fee, which has the effect of raising the par rate to 5.25%. The pricing adjustment is only 0.50% for qualifying credit scores of 680-719, so par is 5.125%. Importantly, however, there is no mortgage insurance required regardless of LTV, if the existing loan being refinanced does not have it. As you can see the rate difference between an FHA refinance loan and the GSE Refi Plus loan is very minor, if any, for most borrowers with credit scores of 679 or less. However, the FHA loan does require an up-front mortgage insurance premium of 1.75% that can be rolled into the loan principal without affecting the LTV. That might push a few into the GSE refi instead. One big difference between FHA and the GSE loans is that the GSE’s will include second homes, and for those there are no pricing adjustments. In addtion, the new GSE loans cover investment properties, however, the pricing adjustment for investment property type alone is 3.75% for LTV’s over 80%, so, in practice, that prices most investment properties out of any rate advantage (3.75% pricing adjustment woul put the rate at 6.125% costing 1.25% in points, with no par rate available on the rate sheets I looked at). On balance, it appears that the GSE Refi Plus program will have its greatest impact on refinancing second homes, and those primary residences that have 97.5%-105% LTV’s owned by folks with credit scores over 680. Remember, however, that in all these cases there needs to be enough equity in the property to pay about 3-4% of the loan in closing costs.

  4. Mannwich says:

    I stopped reading when you referred to Steve Forbes.

  5. pappy says:

    the forbes metaphor is weak IMO ..and it’s seems the basis to frame the story from a particular narrow perspective………..because the CDO , CDS, and other three letter soups besides RMBS are the reason more banks deserve a F in their other classes……….so you can argue that they all don’t deserve F’s in RMB’s. ….so they can have a C grade their….. and bunch of F’s in their other classes . Cdo’s , CDS…etc.ect ……but i will say we should re-institute the Uptick rule…..And Stop Pork laiden stimulus packages that go to campain contributors….as well as the revolving door from private to public back to private office again…

    THE TALF and the PPP plan are damn near giveaways to the private investors (hedge funds who are left standing) ……the gov’t provides up to 90 leverage (which doesn’t have to be paid back should the investment be a “loss”) considering the MKT price with gov’t gearing will be artificially high….most buyers seem destined for a loss…….imagine putting up .08$ capital plus (getting gov’t to loan .77$) and creating a “current mkt price” of .85 then when it’s time to sell you find you can only get .40$….(since the new buyer isn’t getting generous gov’t leverage) …..poor you …….you lose your .08$ and don’t have to pay the loan back since you took a “loss” but you wind up pocketing .40 (5 x what you risked!)….all in a nifty way to transfer the liability’s from the bank’s book’s to the govt’s and gaming the scam for private investors….

  6. pappy says:

    the key for the american economy is the dollar maintaining it’s world reserve currency status.

    They got Japan and China on their “jock” to keep buying treasury debt and getting american’s to buy their cars……..They (US again) has Gulf Cooperation Council country’s selling oil in Petro dollars……..now recently the americans seemed to side with China on oil prices (vs OPEC) and allowed oil futures mrkts to have a capital flight (they could have maintained a higher price via PPT infusions) should they have wanted to……Now the thing to watch will be the GCC stiffing america because they are not getting what they once were for a barrell of oil (yes …the dollar strengthened but NO WHERE In realtion to the amount OIL has fallen) ………Watch for america to wage war in the Mid east……should the GCC launch a new currency….. how would this war play out….? perhaps that depends on wether there is a better arangement of currency’s available that will grow the DEBT (banker food) for international bankers in a more sustainable future income stream

  7. cix says:

    I see a lot of comments on secondary stuff like Steve Forbes, but I’m actually quite shocked by the real content of the article.
    Can anybody confirm that it is correct?
    Is it true that securities worth 90c are currently trading at 60c? This would change completely the perspective on everything. And the “toxic” paper the government is buying is actually worth the money.
    Please confirm this.

  8. sourcethree says:

    cix –

    yes, it is true – and if the people here weren’t so pre-occupied with slamming Steve Forbes, they’d read through to what the real issue is, as you point out it is the tragedy of mark-to-market
    (as an aside, these people remind me of our Congressman who are so intent on getting back at those evil bankers that they are focusing on the wrong short-term issues (executive comp, marketing budgets, private planes) instead of figuring out solutions to fix the system, improve confidence and thus attract private capital!! (instead of only attractig taxpayer capital))

    anyway, I digress…

    yes cix, it is true – while some of these assets are toxic, bank after bank after bank are recording ‘unrealized losses’ in their securities books not because of actual credit deterioration but simply because of market illiquidity – THE PRICING THAT YOU POINT OUT FORCES COMPANIES TO TAKE THESE UNREALIZED LOSSES, WHICH HITS THEIR TANGIBLE CAPITAL RATIOS, AND THEN EFFECTIVELY FORCES THE GOVERNMENT TO GIVE THE BANKS TAXPAYER-FUNDED CAPITAL TO REPLACE THIS ‘LOST’ CAPITAL – THIS ACCOUNTING RULE IS UNNECESSARILY TAKING MONEY OUT OF EVERY TAXPAYER’S WALLET! – if you want to stop the bank bailouts (at least for long enough to figure some kind of game-plan), getting rid of this rule is an incredibly low-cost solution… its $free!

    think of it this way – the mark-to-market problem is a byproduct of the process of deleveraging that the system is going through – i.e., too many banks/investors/etc. borrowed too much money and now everyone is going through the process of deleveraging and cleaning up their balance sheets (hedge funds are getting hit two ways – they are seeing redemptions AND the banks aren’t lending them as much money as they used to) – plus, all the securitized vehicles that used to buy this stuff (CLOs, CDOs, etc.) are no longer being created – thus, simply put, there is no money to buy these securities – the fact that they are complex combined with the uncertain economic backdrop adds to the avoidance of these securities as investors will just prefer something perceived (actually or not) to be safer, or at least easier to analyze

    so, in many cases, these securities are suffering from a lack of demand because of deleveraging, not credit deterioration – and with the supply/demand dynamic out of whack, they prices are out of whack as well

    but BECAUSE OF FAS 157, which was JUST PUT IN PLACE IN 2007, we have to play this mark-down game and it is costing taxpayers billions and threatening the health of the U.S. banking system – the banks say they are willing to wait it out and hold the securities to maturity, when they expect to get paid back at par or close to it – but in the meantime, this accounting rule is putting the banks out of business so they might not even make it to that point

    it seems to be a simple choice – if you want ‘transparency’, keep the rule – but understand the only transparency that is being provided is the condition of (non-)buyers in the market, not the condition of the assets themselves AND realize it will knock out probably at least the top 5 or 6 banks in the U.S., with whatever ‘unintended consequences’ that means for the global financial system and our U.S. economy and your wallet

    but if you want a functioning U.S. banking system – get rid of this d*mn rule – its killing capitalism
    (i.e., by killing banks with this rule, its preventing lending, which sends the economy down, which results in more mark-to-market hits, which prevents more lending, which sends the economy down further… get the drift – its a negative feedback loop!!!! – therefore, its killing capitalism)

    note that because of the impact these write-downs have on tangible capital, this rule is a short-seller’s dream! – as long as deleveraging continues and a lack of buyers persist, the short-sellers know they can frighten investors by calling the banks insolvent and thus they can ‘safely’ systemically attack bank after bank (they’re even now going after the ‘stronger’ banks now like JPMorgan, Wells, PNC and U.S. Bancorp)
    – note that the metric du-jour isn’t Basel capital ratios, which aren’t impacted by unrealized losses, but the newfound discovery of tangible capital ratios – this ratio is the bullet the short-sellers can use to shoot the banks (other weapons of choice include puts, CDS, triple-leveraged ETFs, no uptick rule, and rumors – sure, the rules allow it (except for the rumors, but you can’t prove those), but I would think the soundness of our banking and economic systems would be more important than allowing investors free-reign to destroy the banks – banks are built on confidence – without confidence, you have what you see today – there are simply too many tools for these players to manipulate the sphere of confidence around these companies – but thats a different topic…)

    I haven’t been on this site too long, but I have a sneaking suspicion that Barry is pro-mark-to-market – would be nice to see his opinion on this important matter

    note that there is a panel hearing this Thursday in Washington on mark-to-market – but don’t expect anything big to come out of it – Mary ‘head-in-the-sand’ Shapiro already came out on Jan. 2 and said its a good rule – and the FASB apparently is too powerful to let this rule go – but suspending (permanently or temporarily) this rule sure does seem like a cheaper solution for taxpayers than having us pony up more capital for these guys

    ST

  9. sourcethree says:

    one quick follow-up to round out the answer to cix

    you say ‘And the “toxic” paper the government is buying is actually worth the money.’

    2 things:
    1 – the gov’t hasn’t been buying any of this paper – they’ve been trying to set something like this up since TARP was put in place, but…
    2 – the dilemma is two-pronged – lets say these things are priced at $0.60 on the dollar, but the banks think they are worth $0.90 – if the gov’t tries to split the difference and buys it at 75 cents, but it turns out in the end they really were worth only $0.60, taxpayers will fume
    further, the banks probably won’t want to sell at 75 cents – they’d have to lock in the loss and that would hurt their regulatory capital ratios

    hence, the stalemate, and why they haven’t been able to put this part of the program together

    Geithner is trying to get around the first dilemma posed above by replacing the government with private money (the ‘private-public’ partnership that he trotted out)

    but that still leaves the second dilemma – perhaps just give the banks a $1-for-$1 tax write-off equal to the dollar amount of the ‘loss’ on the sale to the pub/priv partnership (or the gov’t, whoever the buyer is) so that it is all even on the bank’s books (not sure if the accounting is that simple) – this would incentivize the banks to sell and get these things off their books – if that doesn’t fly by itself, make the banks pay back this tax write-off over x number of years so (not inflation-adjusted) the gov’t comes out even as well – maybe even tax the hedge/private equity funds (the private part of the public/private partnership) if the return is over and above some prescribed windfall profit amount

  10. sourcethree,

    that’s the most rational ‘pro-Bank’ rationalization I’ve seen ‘in public’..

    two things: 1.) some of those ‘Securities’ Are improperly structured/poorly perfected/incorrectly written
    2.) if the ‘Banks’ were Really worried about the ‘Market’ for their “Assets”, all they would have to do is pull back the Kimono–Show the ‘Goods’–explain what they’re holding..

    157, or no, serious Investors, if there were readily Identifiable Assets, would smoke Shorts, post-prandially..
    http://www.thefreedictionary.com/prandial

    the BS CF in D.C., and the lack of ‘show ‘n tell’ by the ‘Banks’, doesn’t, as was said, “Play well in Peoria”–for good Reason..

  11. dunnage says:

    Lot of truth in the article. I surmise, at this point in the free market, that the Money Centers would like to be free of Mark to Market for the reasons stated above; but want Mark to Market to apply to the rest of the commercial banks. Pressure Commercial Banks, take them over and give their deposits to the money center Zombies. Because the Money Centers are so screwed that nothing but massive, continuous injections of capital are needed for years.

  12. sourcethree says:

    dunnage –
    you almost lost me after that first sentence – from then on its pure speculation out of thin air… doesn’t add much to the discussion – your last sentence is true, but I have a feeling if we implement the tax plan as I lay out in my second post above, that issue will be largely alleviated

    also, the mark-to-market issue is more of a money center issue than a regular commercial bank issue given the sizes of the securities portfolios on their respective books – so the money centers could probably care less if m-t-m applies to the others

    lastly, in terms of competition – the drag on future earnings/dividends from having to re-pay the tax payment should put the commercial banks in slightly better competitive position, all other things being equal – but the key is, the tax plan stops the negative feedback loop we are currently stuck in

    and one other point I didn’t mention before – if the gov’t doesn’t want to be ‘out’ the tax payments, they could set up a trust and create a plain vanilla asset backed security that will collect the future tax repayments and distribute the cash flow payments to bondholders – if necessary, the gov’t can provide whatever credit enhancement is needed to spur investor demand

    p.s. – dunnage, I’m not picking on you – just trying to spur thinking that will generate ideas for a solution as opposed to more criticisms of what may (or may not) be – we all need to find a way to move forward