Wednesday, December 13, 2006
How bad will it be, part 2
From the panel discussions sponsored by Treasury:
The regulators said little pn Panel 2 except that compliance with regulations is not exactly stellar. But Lew Ranieri had a good segment. He emphasized that there are big problems, but in a small portion of mortgages. Ranieri pointed out that the governmental housing agencies Freddie Mac and Fannie Mae used to act as gatekeepers. In the last two years, regulation has fallen apart. 80% of loans originate with mortgage brokers outside of the the regulated market. The SEC is the regulator of the capital market, but they ignore housing. Investors have no idea what the risk of the instruments are, and they are risky because of negative amortization, meaning that home buyers automatically become ineligible for the mortgage unless they hit the lottery or get a huge raise. These get sold to the public. Who is buying the risk? In many cases, no one knows, because the original securities get re-packaged, often times without the warning label.
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One can pretty well figure out what the game is. The option ARM is a negative amortization loan. That is, the bank sells you a house plus a line of credit. Because you don't earn enough, you use the line of credit to make payments that are below the interest accruing on the loan. So, your equity is actually falling. At some point, this triggers a huge increase in the monthly payment.
Meanwhile, the bank records as income the sum that the buyer should be paying, not the actual payment. This inflates the bank's earnings, making its stock attractive and, separately, allows it to lend out even more money. The money supply has increased, but through sleight of hand, not good business practices. The bank bundles the mortgage which it is almost certain will end in default with 9 good mortgages and re-sells them to Freddie Mac/Fannie Mae, federal agencies which in effect become responsible for the performance of the loan. Then, secondary securities are issued by Wall Street and sold to hedge funds. The hedge funds dictate terms that insulate it from default.
So, who ends up holding the bag? The taxpayer. Either through the failure of banks or through the underwriting of the mortgage or through homelessness. As Business Week says:
Banks that hold lots of option ARMs on their books will surely be hit by loan defaults in coming years. "It's certainly reasonable to expect to see some excesses wrung out," says Brad A. Morrice, president and CEO of New Century Financial Corp. But even here the damage will likely be limited. Banks use insurance and other financial instruments to protect their portfolios, and they hold real assets -- homes -- as collateral. Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions, a researcher and unit of title insurer First American, forecasts total defaults of $300 billion across all types of loans, not just option ARMs, over the next five years -- less than 1% of total homeowner equity. (In comparison, JPMorgan Chase & Co. alone has a mortgage portfolio of $182.8 billion.) Cagan estimates that banks will end up losing only $100 billion of it all told.
Most of the pain will be born by ordinary people. And it's already happening. More than a fifth of option ARM loans in 2004 and 2005 are upside down -- meaning borrowers' homes are worth less than their debt. If home prices fall 10%, that number would double. "The number of houses for sale is tripling in some markets, so people are not going to get out of their debt," says the Ford Foundation's McCarthy. "A lot are going to walk."
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