Bad Things Happen When You Kick the Game Board Over.

Not long ago I was watching two of my sons playing a game of chess.  One son (I won't disclose which one did what so I won't get yelled at) was losing and he knew it.  I'm not sure if the "other son" realized how close he was to winning but he sure got pissed off when his brother "accidentally" knocked the board off the bed.  They got into a big fight and the son who knocked the board over finally convinced his brother to play again.  I was nearly incredulous when about twenty-five minutes into the game, the same son knocked the board over AGAIN!  Needless to say they don't play chess anymore.  The kid who invested nearly an hour of his time and got cheated twice won't invest another second playing chess with his brother.

I think about this simple story when I think about what is going on in the mortgage securitization market.  Let's forget about the non-Freddie and Fannie world that sprang up in this decade and at its height, probably financed sixty percent of American home financings.  Let's just deal with Freddie Mac and Fannie Mae mortgage backed securities ("MBS").  The market for these securities was the most liquid in the world.  The reason our trading partners who have tremendous trade surpluses with us (like China and Japan) hold vast quantities of these MBS is because the MBS market was the deepest market in the world.  The Chinese could come in and buy $2-$3 billion in a night and make the mortgage market move, all else equal a quarter of one percent at most?  Now that really sucked if you were short MBS versus Treasuries, but in the grand scheme of things, it was a tiny ripple.  If they tried to do that buying German Bunds or Japanese JGBs.....they would have moved those markets POINTS.  Even the U.S. Treasury market would have moved at least double what the MBS market would move.

Anyway, the market for American mortgages, prime credit mortgages was incredibly efficient.  It had been that way since at least the early 1990's.  Because of this efficiency, banks in the United States did not have to hold all these mortgages that they made on their balance sheet.  They could sell them in the form of MBS to all kinds of investors, foreign and domestic.  In return, American's had fantastic access to "cheap" home financing.  When I say cheap, I'm not talking about the insanity of the last four or five years, I'm talking about the first few years of this decade as well as the 1990's.  If the ten-year U.S. Treasury was at 5%, a thirty-year fixed rate mortgage was between 6% and 7%. This access to home finance was the envy of the world.

The basic premise that allowed for this great deal was that the rule of law would be followed.  One rule was that the collateral backing each loan was the borrower's home.  If the borrower defaulted on his mortgage, the home would serve as the primary vehicle to repay the loan.  The home was not allowed to be included under bankruptcy protection.  This was important because under bankruptcy, a judge could determine that if the loan on the home was higher than the value of the home, the difference could be used to reduce the principal of the loan, exposing the lender or investor to unsecured risk.  This is called "cramdown risk".  Now, due to our severe housing crisis, The White House is a strong proponent of covering borrower's primary residences under bankruptcy protection.  This is what we call in the business a "Game Changer".  Others might call it a "Jam Job"!

The other rule that is currently being messed with in the White House's new housing legislation is Freddie Mac and Fannie Mae's Government Sponsored Enterprise (GSE) charter.  As we reported, Tuesday I believe, the plan to allows the GSEs to buy or guarantee loans that have loan to value's of greater than 100% (105% is the current, new limit).  The problem with that is the GSE charter specifically prohibits the GSEs from buying or guaranteeing loans with LTVs greater than 80% without the borrower buying private mortgage insurance.  The new housing plan, in the interest of letting borrowers take advantage of historically low mortgage rates (manipulated by the government's buying of MBS) certainly isn't going to force them to buy expensive private mortgage insurance.  To get around this charter violation, Freddie and Fannie are calling these refinancings....loan modifications.  The only problem with that is, each existing MBS that the old mortgages are in specifically limit the amount of loan modifications that can be done in any one MBS pool.  Why do they do that?  It's there to protect a buyer of a MBS that has a premium.  For instance, par is 100-00.  Most MBS right now trade at prices greater than 100-00.  For example, if you bought a Fannie Mae 5.5% at 103-00, you paid a 3 point premium.  The bad thing that can happen to you when you buy at a 3 point premium is if many of the loans in the MBS prepay.  That's because you paid $103, but you get back $100.  This is a risk that MBS investors take with regard to prepayments, which are driven primarily by refinancing.  Therefore, while investors know they take prepayment risk and adjust accordingly, they are NOT supposed to be taking large loan modification risk.  They know this because it is in the documents of every MBS you buy.  So, if the GSE's are calling their actions under the new housing plan modifications how can they do this?  Simple!  For security purposes they are calling these refinancings!  Sorry investor...you lose!

This gets me back to the thrilling chess games at my house.  The kid who invests time and energy into two games of chess and then essentially gets the rules changed on him arbitrarily by his brother kicking the board over, isn't going to play anymore.  Similarly, the investor who has had the rule of law changed on him, to his disadvantage, arbitrarily, isn't going to play anymore either.  The result will be the end of housing finance in the country as we knew it.  Nobody is talking much about it but they will when the ten-year U.S. Treasury is at 5% and a 30-year fixed rate prime mortgage is at 8.5% or higher and required money down is 40% or more like the rest of the world.  What is that going to do to the housing recovery?  I don't think Treasury or the Office of Management and Budget are putting this little factor into their bank stress tests and economic growth models. 

Comments

[RPB]

Eric,

I do not even want to check my BP, it'll just make me angrier. Perhaps if they legalize pot we could all just mellow out and forgot about DC. I mean, anyone coming out of a top law school these days who wants to work in government has one goal in mind: to become a lobbyist. Its utterly disgusting how much money they make to influence our elected officials to make decisions. Campaign finance reform: public financing will pull the cash plug on all these dips**** lobbyists quickly. Government service should be the ending note of a long, successful career; not the career itself. Term limits will make sure we get people who succeed in the private sector, then move onto government.

Just a young (relatively) pup here, but is this the way its always been? Ha, because if it continues I am looking at an early grave from all this frustration.

RPB said, "lobbyists in the administration..."

Whose bread I eat, his song I sing.

The more things change...

[Eric Salzman]

Well RP, it's only Feb. but that may be the comment of the year. I find myself getting very angry. I just had my physical and my blood pressure and cholesterol were both bad for the first time in my life. I told that to a like minded buddy and he said, "Hey, I was off the charts too for the first time...they must have changed the test!"

[RPB]

I did not know the expanse of executive powers included the ability to renegotiate legal, binding contracts. All the while we still have domestic wiretappings, lobbyists in the administration, out of control campaign financing, the Patriot Act, the Black Holes named Fannie, Freddie and AIG, and domestic surveillance/tracking in DC and NYC. Make sure to hide your guns and your gold, Obama will be taking those next.

But at least we can now buy cheap prescription drugs abroad; the only price being innovation for those yet to be cured diseases. There aren't too many of those, right? Meanwhile we are taking steps to dump 47 million uninsured into a health care system already at its capacity. I am sure doctors and nurses will be lining up in droves to help expand the system when the cost of their medical school will no longer be subsidized and their expected pay will diminish under government mandate. Its ok though, at least with all these unqualified health workers to enter the industry you will be able to sue the system because the tort lobby has donated far too much money to the party in power for that party to question its practice.

No worries, we are going to stimulate the economy by making energy more expensive while simultaneously destroying the jobs in the energy sectors that produce power cheaply. Not to mention those that buy, sell and trade those cheap energy products. And never mind the railroads, which derive much of their revenue from the movement of coal and oil; they'll get bailed out too! Nuclear power? That is idiotic, who wants cheap, clean, renewable energy when we can reward the natural gas interests to supply electricity during peak power demand for the 100 billion dollar wind/solar farms or when the wind is not blowing/the sun is not shining. Never mind that this will lead to the rapid expansion of LNG which will give us the distinct pleasure of buying shiploads of gas from friendly countries such as: Russia, Iran, Algeria and Nigeria.

Cronism is not dead, its just been shifted to the new hands shaking the puppet strings. But hey, I like dancing.

Is there any way not to be angry?

[RPB]

Under the new administration you now receive more constitutional rights if you are a prisoner being held at Guantanamo Bay than if you invested in MBS.

Now that is Constitutional "Change" we can believe in!

Yippee, Obama in 2012!

[fletch]

this should be required reading for the beltway buffoons