GARP Risk Review (Global Association of Risk Professionals) Risk Review, March/April 2007 Issue 35. Tavakoli Structured Finance retains the copyright for this article.
Whether you are a borrower, an investor or a risk manager, writes Janet Tavakoli, the current subprime mortgage market is rife with danger. Tavakoli discusses the impact that predatory lending practices have had on borrowers and investors, explores the role investment banks have played in the rise and fall of subprime lenders and explains the dilemma that subprime relationships pose for risk managers working at banks.
Fannie Mae (FNMA) and Freddie Mac (FHLMC), the privately chartered United States mortgage giants which are overseen by the department of Housing and Urban Development (HUD), deserve credit for their stance on the $1.3 trillion subprime mortgage market. The “subprime” market developed for borrowers that have lower credit scores and traditionally have had more difficulty meeting the requirements for a home mortgage. FNMA and FHLMC have general lending standards for “conforming” loans which both meet their lending size requirements and their origination guidelines. Both entities prefer loans where the income of the borrow has been verified, the total housing cost including insurance and fees is no more than 28% of gross income, the borrower’s total debt burden is less than 36% of gross income, the borrower does not have an excessive history of late payments, the borrower has its own funds for the down payments and closing costs, the borrower has two years of job stability, and the borrower has a cash cushion of at least two months of payments after all living expenses have been met. Even with all of these belts and braces, FNMA and FHLMC are concerned about this class of loans because of potential softening of the United States economy and a slowing and at times negative growth rate of housing prices.
Mortgage-backed securities rely on two factors: (1) the quality of the origination [i.e., the soundness of the original loan, the quality of the underlying collateral and the equity in the home] and (2) the ongoing servicing of the loan [i.e., the procedures for the collection of payments from homeowners].
Both FNMA and FHLMC recognized that the biggest risk associated with “subprime” mortgages has nothing to do with the sophistication of one’s model and has everything to do with common sense, specifically the type of common sense that helps us decide whether a borrower is a good credit risk or whether we are enabling the borrower into overleveraging his position. Both entities refuse to purchase loans that do not meet their standards, and they reject loans originated by mortgage brokers known for predatory lending practices.
Purchasers of mortgage backed securities that have not been issued by FNMA or FHLMC need to pay careful attention to what they are getting, because many mortgage lenders have engaged in a race to the bottom when it comes to creating worst practices in mortgage lending. Mortgage brokers originate 70% of subprime loans. Some adhere to prudent self-imposed underwriting guidelines, but most do not. According to the Mortgage Lender, since the end of 2006 of the top 25 subprime lenders, five of the top have been shut down, three no longer operated independently, seven announced large write-downs, and one is up for sale. In total 47 have gone “kaput” in this short time period. This class of mortgages is being hit by a quadruple whammy: poor loan underwriting standards, creation of mortgage loan products unsuitable for lower credit score borrowers, the decline – in some areas, the reversal – in home price appreciation (HPA), and slower economic growth.
These failing mortgages have found their way into collateralized debt obligations (CDOs), and the normal benefits of securitization are failing to provide protection. Part of that is due to the upfront lending practices, and part of it is due to voluntary due diligence failures particularly in securitizations sold as private placements, 144A deals. Investors include insurance companies, foreign central banks, mutual funds, hedge funds, and pension funds.
Subprime borrowers tend to be less sophisticated and include a higher percentage of minorities. Unscrupulous lenders prey on the relative naiveté of these borrowers. This isn’t a new problem, but like the overheated lending to hedge funds, the subprime market overheated around the second half of 2005, and we are seeing the effects.
In the early days of this century, First Alliance Mortgage Company, FAMCO, was taken to task for fraud on borrowers, most of which were subprime borrowers. Origination fees of 10% to 25% of the loan value were misrepresented as being part of the interest rate and monthly payments. Low initial “teaser” rates were said to be constant unless market interest rates increased, but in reality rates could climb up to one percentage point every six months irrespective of market rates. The “amount financed” should have disclosed the full amount, but did not include the high origination fees, and borrowers were not given a booklet which would explain the adjustable rate mortgages (ARMs) as required by the Truth in Lending Act (TILA).
Even if borrowers remained unscathed during origination, servicing and collection abuses abounded. Borrowers had been promised better terms in future that never materialized. Unjustified servicing fees were added to collection amounts. ARM payments calculations were inflated, and difficult to interpret on statements.
To preclude class action lawsuits, the subprime mortgage documentation included language that required mandatory arbitration.
Today, purchasers of subprime mortgages complain about fraud on lenders, instead of fraud on borrowers. Some “borrowers,” often in collusion with unscrupulous brokers, supply phony documentation or engage in identity theft. Lenders have a right to complain about this type of fraud, even if their own due diligence standards could be tightened. Yet, fraud on borrowers still riddles the subprime market.
Predatory lending practices currently pose the biggest problem in the subprime market. While many of these practices are not technically illegal, they employ “truthiness” in lending. Comedy Central’s Stephen Colbert defines truthiness as “what you want the facts to be, as opposed to what the facts are, what feels like the right answer as opposed to what reality will support.” Very few states currently have predatory lending laws, but the handful include Georgia, Massachusetts, New Jersey, New Mexico, and New York. Other states have a variety of lending laws, and California, Illinois, Florida, Michigan, and Ohio are tightening standards with many other states saying they will follow suit. Congress is considering federal legislation, and the SEC is investigating asset backed sales practices.
In contrast to the standards required by Fannie Mae and Freddie Mac, many mortgage brokers offered no-income-verification or “stated income” loans making loans with very little documentation. Borrowers were often allowed to take out “piggyback” loans, i.e., second liens on their homes in order to fund down payments so that 100% of the home value was financed. Existing homeowners were targeted for refinancing so that brokers could earn more fees and to generate prepayment charges in a practice known as “rent seeking.”
Some of the loan products seemed to set up low credit score borrowers for failure. Mortgage brokers offered 45-year ARMs in which homeowners built up virtually no equity in their homes in the early years of the mortgages. Teaser rates were unclear, so that homeowners were unaware how much and how quickly the coupons would increase. Option ARMs offered the worst case scenario. Homeowners could choose initial payments that were so low, the payments did not cover the interest costs on the loan. The uncovered interest was added to the loan balance. As the song goes, these homeowners got “another day older and deeper in debt.” But that wasn’t the worst of it. In some areas, home prices declined. Homeowners now had homes that were worth less while their mortgage balances were higher and climbing.
Given that Fannie Mae and Freddie Mac refused to buy subprime mortgages and given that many banks will not extend credit without sufficient documentation, predatory lending practices thrived outside the channels of mainstream mortgage financing. Lax standards were enabled by investors’ voluntary due diligence failures in the asset backed securitization market, particularly the 144A market for securitizations and REITS.
Mortgage lenders turned to investment banks for financing. Investment banks extended credit lines, so that mortgage lenders could originate subprime mortgages outside of traditional banking channels. Some investment banks even purchased subprime lending businesses, either in full or in part. For example, in 2006, Morgan Stanley bought subprime lender and servicer Saxon Capital for $706 million and Merrill Lynch bought National City Corp’s First Franklin subprime unit for $1.3 billion in 2006. (Merrill also had a part interest in now bankrupt Ownit Mortgage Solutions and is a creditor [along with UBS, Bank of America and Bear Stearns, among others] of New Century, a subprime lender that filed for Chapter 11 bankruptcy protection on April 2.).
What’s more, Barclays announced on April 2 it closed its purchase of subprime lender Equifirst Corporation and, according to the Wall Street Journal, it paid only $76 million — one third of the $225 million Barclays had agreed to pay in January.”
After mortgage lenders originated mortgage loans with the help of money borrowed from investment banks, investment banks warehoused the mortgages, repacked them into mortgage backed securitizations, and sold the repackaged and tranched risk to investors. These investors included insurance companies, foreign central banks, REITs, mutual funds, pension funds, bank portfolios, hedge funds and others. It shouldn’t be a surprise to learn that hedge funds were net buyers of the higher yielding riskier tranches in 2005, but by the latter part of 2006, hedge funds had become net sellers.
Securitizations tout protections for investors. Documentation usually includes “reps and warranties” and recourse and collateral substitution rights. For example, if housing appraisals are found to be inflated or if the borrower quickly defaults, the investment bank has the right to put the loans back to the mortgage broker from which it bought the mortgages. Credit enhancements include subordination, excess spread, overcollateralization and credit wraps. So what could possibly go wrong with mortgage-backed securitizations?
Well, for one thing, circular credit logic began to fall apart in recent months. Investment banks that securitized deals asked mortgage lenders to buy back loans. But investment banks themselves had provided credit lines to these mortgage lenders, and now the investment banks have slowed the gushing flow of credit to a trickle. The mortgage lenders are having a hard time coming up with the money to buy back mortgages, and often they simply cannot resulting in the wave of mortgage implosions revealed by The Mortgage Lender.. The founders of the mortgage brokers paid themselves well, and investment banking securitization groups earned high fees. Meanwhile, subprime mortgage borrowers are losing their homes, and investment banking financing arms cannot get back their funds; the extent of their losses has yet to be tallied. Investors in mortgage backed securities backed by subprime mortgages are finding their portfolio values are falling.
If an investor is required to mark its portfolio to market, a lot can go wrong, and it can go wrong rapidly. Losses in the underlying mortgage portfolio do not have to cause a principal loss to cause a mark-to-market loss. As subordination and other credit protections are challenged, tranches are perceived to be higher credit risks long before the rating agencies have a chance to revise their ratings. Second market liquidity dries up, spreads widen, and prices of even highly rated tranches drop dramatically.
Investors who bought lower rated tranches may experience outright losses. UBS’s recent research estimates that investors in BBB- rated tranches can sustain cumulative losses of 9-11% before losing principal. Subprime foreclosures are estimated to peak at 20-30%, and recoveries will fall to unprecedented lows, perhaps as low as 30-50% in distressed zip codes. It is highly probable that principal losses will touch the BBB- rated tranches, and higher rated mezzanine tranches of deals with high proportions of subprime mortgages will also probably lose principal.
A few mortgage brokers employ best practices when it comes to subprime mortgages. If you are an investor and you have the 144A documentation for your mortgage backed securities and CDOs, check the disclosure. These documents must disclose material information. If some of the mortgage loans have minimal documentation, are stated income “liar” loans, are “option ARMS, have low teaser rates, or have high loan to value ratios, those facts must be disclosed in the documents. Private placements, 144A deals, are marketed to sophisticated investors who are responsible for doing their own due diligence. Since many investors competed for product, they often did not scrutinize these deals very carefully, but jumped into the market to purchase these products without demanding better documentation on the underlying loans. Investors that engaged in voluntary due diligence failures will find little sympathy (If material information was not disclosed, that is a separate issue with potential remedies). Such investors may have thought the initially slightly higher coupons compensated them for the additional risk, even if it hasn’t worked out that way.
For example, if the documents state that underwriting criteria is not available for a large percentage of the mortgage loans (one deal showed documentation was unavailable for 79% of the loans), it is too late to wonder why the deal was purchased in the first place. It is too late to question how the rating agencies are evaluating these deals. You very likely already own a problem, and you had the means of knowing you were at risk. Any collateral acquired through mortgage brokers and non-originators – with no information about the underwriting guidelines of the originator – is risky collateral.
A risk manager’s ability to address the issues presented by subprime mortgages doesn’t hinge on one’s mathematical ability, the size of one’s data base or the elegance of one’s models. The problem is power. Risk managers usually do not have very much of it.
Even Ben Bernanke has problems. Ben Bernanke has appeared on national television admonishing lenders to apply tighter standards. The problem is that the Fed regulates the investment banking arms of commercial banks like JPMorgan Chase and Bank of America, but it does not regulate investment banking/brokerage firms such as Merrill Lynch, Lehman Brothers, Morgan Stanley, et al., and it does not regulate independent mortgage lenders.
If Ben Bernanke has problems getting the market to exercise common sense, risk managers may have an even bigger problem. According to the New York Times, Mike Blum, Merrill Lynch’s head of global asset backed finance, sat on the board of Ownit Mortgage Solutions. He faxed in his resignation when it imploded. Ownit made second lien mortgages, issued 45-year ARMs and originated no-income-verification loans. In the words of William D. Dallas its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”
It would have been a career cratering move for a risk manager to limit the credit line that the investment bank extended to the mortgage broker, because the bank’s asset securitization group was earning high fees for securitizing the broker’s subprime mortgages. Questioning the wisdom of the investment banking/mortgage broker relationship would have been career suicide. This is my opinion based on my own past experience as a risk manager and based on my ongoing discussions with current risk managers (GRR readers may have different experiences and opinions, and if so, please feel free to direct them to the editor of this publication).
Risk managers feeling thwarted by the intractable internal politics presented by the subprime and hedge fund risk management dilemmas are simply trying to manage the wrong side of the trade.
It is much more fun to make money off of the fact that the subprime lending process is mismanaged than it is to wage futile battles with more powerful and better compensated securitization managers. Risk managers in particular were in a great position to exploit this situation, because they are familiar with skew. I have been very public about pointing out an opportunity in the credit derivatives market that provided an antidote to softening in the subprime market.
Of course, risk managers would first have to join a hedge fund or the trading side of the bank to exploit these opportunities, but if one is unable to properly manage the risk due to political handcuffs, one might as well exploit the risk by trading one’s job position and then trading the market opportunity.
Last November, one could have bought credit protection on the asset backed index ABX-HE 06-2 BBB- (referencing BBB- rated tranches of 20 various home equity loan asset backed deals). This index began trading its first series in January of 2006, and the HE 06-2 is the second in the series. This is a price based index and traded at 98.2 at the end of November 2006. By January 26, 2007 it had fallen to 90.34 (I continued to publicly recommend it) and by February 13, 2007 it had fallen to 80.35 when I recommended covering this short making for a very happy Valentine’s Day. Hedge funds that bought protection by shorting the index made a leveraged bet skewed in their favor and rapidly multiplied the value of their hedges.
This is a classic example of using your intelligence to resolve your frustration and get properly skewed. Given the fundamentals of the subprime lending market, the probability of the price of the index increasing in price was very low and even if the price rose, the likelihood the rise would be very minimal and very temporary. On the other hand, the probability of a drop in price was very high and the price drop was likely to be substantial. As the predators began falling, so did the prices of mezzanine tranches of the ABX indexes.
If you’re a risk manager at an investment bank and you oversee your firm’s relationships with subprime mortgage brokers, you may believe that switching jobs seems too drastic a step. However, it’s still important to realize that few sensations in this post Sarbanes-Oxley world are more painful than bearing risk management responsibility without the power of effective action.
If risk managers have the power to effect change, the time is past due to exercise this power. But with respect to arrangements with subprime brokers, many investment banks simply do not want to listen to the counsel of their risk managers, and managers who work for such firms cannot and should not be held responsible for the consequences of investment bank/subprime broker relationships.
Epilogue from Janet Tavakoli (2014): There were (and are) widespread manipulation, fraud, and abuse in the credit derivatives and collateralized debt obligations markets. Many of these abuses are detailed in my 2003 book, Collateralized Debt Obligations and Structured Finance, and the fully updated 2008 second edition, Structured Finance & Collateralized Debt Obligations.
Read more finance articles by Janet Tavakoli