CONVERSATIONS WITH A FORMER MORTGAGE BROKER

John

There is another aspect of mortgages and their value as investments that will become more well known as President Obama implements methods to build bank balances. As a former mortgage broker, you probably know that the lender may have earned more from loan origination than from the loan itself. Moreover, the origination fees came up front, while the interest return is realized over the life of the loan. As the Feds buy up mortgage based assets, they will not see the income stream coming from these that made them the hot ticket item over the last decade. But even without the origination fees, mortgages and mortgage based assets earn better than most other bonds.

I personally favor insuring the so-called "toxic" assets rather than buying them. I believe as people come to understand that they have been devalued beyond any reasonable amount, they will see their intrinsic value and the market will grow rapidly.

I still believe that suspending the "mark-to-market" rules is the cheapest and most accurate way to correct the savage damage done to bank balances by rushing to devalue mortgage based assets to notional markets. But if Federal guarantees are needed to make the market slaves come on board, do it.

Meanwhile, the stimulus part of the President's rescue plan must also be implemented. The financial sector has done too much damage to the "real" economy and correcting the financial sector will not resurrect the economic body fast enough. We still need to put the "paddles" to the body to get it beating again.

Leo Cecchini


John

Negative equity means non-payment, that is the premise on which all mortgage based assets were sharply devalued. However, one has to remember that a home is also a shelter. The person who leaves that mortgage leaves the home and must find another place to live. He measures the payment for the mortgaged home against the cost of renting another place. Thus, in this case, he does not act like a normal investor who would drop paying too high a price for a devaluing asset. As long as the home owner pays, the mortgage maintains its value, in your case, $800,000 at whatever the interest rate. The return on the mortgage remains constant and is not affected by changes in the value of the underlying property.

More interesting, "investors" who bought properties at subprime rates, and these were the main users of subprime mortgages, continue to hold their "negative equity" homes because they rent them out and continue to earn money on the property. They too continue to pay with a small default or foreclosure rate. Again, the rental income is not affected by the value of the underlying property.

My point is that mortgages, and their associated properties, are not like other assets with a market that reacts to the usual rules. Moreover, the value of the mortgage is not the value of the property, since the property is only collateral. I insist, that as long as the foreclosure rate remains relatively low, we should continue to value the mortgages at their maturity value, i.e. the balance of the loan times the interest rate over the full term of the loan.

All of this is said in the context of the "financial crisis" scenario. Now that the panic has spread to the "real" economy we will see a different situation. As the unemployment rate goes up you can be sure that foreclosures will rise in tandem. The foreclosure rate during the "Great Depression" stood at something like 25%. The immediate problem is to get people back to work and the Obama plan may help here. For the long term, however, we must revalue the mortgages and the mortgage based assets to a more realistic level which is not the "market."

By the way, I have recently bought shares in Fannie Mae and Freddie Mac, so to anwer your question, I continue to invest in mortgages. Others continue to buy less risky mortgages. The point is that they still maintain their intrinsic value, i.e. they pay better than other debt instruments and that is why they were bundled and served up in large portions to investors as "securitized debt."

Leo

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I believe the reason that foreclosure rate only going from 1% to 2 or 3% is causing problem now is that in 2004 and 2005 prices were still going up or holding strong as the top did not come until late 2005. Therefore when the banks went to foreclosure they either sold it at the courthouse for a profit or took the property back and made money on the REO. Let me ask you if you look at one mortgage say in California that was originated in late 04 and the purchase price was $800,000 and was of course a neg am no down payment loan, now properties in this town are selling for 500,000 a 37% decline. Now this homeowner’s loan is going to adjust and the payments are going to double, they can’t refi because the houses next door are only selling for $500,000. There are billion, $ wise, of these type of loans. All the banks have these on their balance sheets, and this is why there is no market for the securities. What would you pay for a $800,000 note backed by a property worth $500,000?

John

John

Yes, the real problem is no one knows the full extent of what I call debt becomes asset becomes debt becomes asset structure we built. My point is that if a 1% foreclosure rate in 2004 and 2005 caused no problem, then a 2% rate should not bring down the house. I use the foreclosure rate in Lee County, where I sold homes, as my base number and it is the highest foreclosure rate in the nation. Do not confuse depressed value of homes with foreclosures. Loss of equity may induce many to stop paying their mortgages but that is a assumption. As I have laid out before, if you have a $1 million portfolio of mortgages backed by $100,000 in deposits or other reserves and there is a 2% foreclosure rate you stand to lose $20,000 in a year and reduce your reserves by that amount. You are still very solvent and earning on the $980,000 in other mortgages.

The problem is that those doing the valuations were panicked by the rising foreclosure rate and had no idea of the actual size of mortgage based securities. They simply devalued all mortgage based assets to the depressed value of the real estate market and they did not use a uniform valuation of the real estate market. I heard the CEO of BlackRock say they used the depressed value of the real estate market in Southern California as their bench mark.

My point remains that the underlying asset, mortgages, are still basically sound, so the assets built on them should not be devalued beyond the actual foreclosure rate. That is not what has happened. The result is an economy in the tank that has led to higher unemployment rates. And I will be the first to say that higher unemployment will lead to higher foreclosure rates. In essence we have built a self-fulfilling prophecy.

Leo C
----- Leo,

I understand that a very low percentage of loans are in default, but when you look at the market’s overall decline in value and add to that the leverage that some of the investment banks used it only takes a modest 5-10 percent decline in home values to wipe out all the capital. That is the real problem. There is not a liquidity problem it is a solvency problem. I agree that all the assets do not need to be marked to market because there really is not a market for some of the debt instruments and the majority are performing and can be valued at a discounted cash flow model. But with the securitization of the debt into different levels of risk it is nearly impossible to separate the good loans from the bad. From my experience here in Florida seeing first hand the amount of debt that lenders have on properties purchased between ‘04 and ’08 they are under water anywhere from 25% to 60% in certain areas. This amount of debt really gives no incentive for homeowners to continue paying their mortgage the best option for the lenders is to do an aggressive loan modification which includes principle reductions, which they have not been willing to do it will likely take tax payer money. There is a lot of moral hazard that could be created and could encourage a wave of new problems if not implemented correctly. I am attaching a report that really delves into how everything went wrong and what is happening now, it is a long read but lays it out pretty straightforward. If you are looking for the next shoe to drop I would take a look at what is going on in the credit card business. There models are not prepared for unemployment above 8%. Here is a little excerpt about leverage from the report:

…with Leverage?
How could $1.2 trillion in subprime mortgages outstanding cause such a large global financial disaster? Leverage
is certainly a part of the problem. If banks maintain a leverage ratio of 10:1, only $120 billion of capital can
support $1.2 trillion. With such a small amount supporting such risky loans, a 10 percent decline in the $1.2
trillion of assets could wipe out all of the banks’ capital. Of course, some institutions were more highly leveraged
than 10:1, and in some areas, home prices have fallen much more than 10 percent; so too has the value of the
subprime mortgages. (If the ratio were 30:1, which was the case with some firms, then the supporting capital
for $1.2 trillion would be only $40 billion.) These situations can force some institutions into insolvency if capital
cannot be raised to offset the decline in the value of assets.