Bailout not a done deal

[clifp]

I think he was talking about Credit Default Swaps (CDS) like AIG held, and other insurance-type assetts. It's quite possible that if things go bad the writer (insurer) of the CDS could be on the hook for up to the whole amount of the loan, which could be many times the "value" of the CDS.

AFAIK there is no proposal for the Feds to purchase CDS only Mortgage backed securities. So screaming about toxic waste in a thread about the debt restructuring is fear mongering.

The only taxpayers liability with respect to CDS is a AIG. This is limited to $85 billion in loans being repaid at an interest rate of 11%+, backed by 100% of the assets of the company and 80% of the equity. I suppose in theory we taxpayers could lose the 80 billion. However, I'd personally be glad to give AIG $100K with those terms, it is way better than anybody who purchased an annuity from the company ever got!

 

[free4now]

Clifp, I looked at the TARP proposal and you're right that it doesn't provide for purchasing CDS. It says:

The purchases are intended to be residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans

AFAIK, Mortgage Backed Securities have the same toxic waste characteristics as CDS: Their "value" is much less than the loan amount, but whoever ends up holding them is responsible for the losses up to the loan amount if they can't collect. Please correct me if I'm wrong.

 

[OAG]

This BAILOUT is an Nuclear Bomb were a crew of real, single shot, snipers are what is needed. Of course if we did that no one would notice, since the carnage would be, for the most part, invisible. Today we have to have lots of video, lots of CNBC screaming all day long, and of course this week will be the congressional, "show and tell", heroics. Have no fear by Friday the problem will be solved, but, by next Friday we will still see more banks dropping. How can they "save the banks" if they (us in the form of the Treasury) purchase mortgages in such a way to help the Bank, and still "make a profit" for the taxpayers "down the road". I, personally, do not want to walk down that road as I do not own enough pairs of shoes to make the LONG walk. But, who cares what the "public" wants "they" are going to RAM it down out throats regardless of what we want.

 

[Gone4Good]

AFAIK, Mortgage Backed Securities have the same toxic waste characteristics as CDS: Their "value" is much less than the loan amount, but whoever ends up holding them is responsible for the losses up to the loan amount if they can't collect. Please correct me if I'm wrong.

Nope. The "toxic waste" characteristic of CDS is only a function of leverage. That is to insure $10MM in bonds, you don't have to put up $10MM initially but you are still on the hook for buying the $10MM bonds at par in the event of default. Mortgage backed securities don't carry any such obligation.

 

[clifp]

Clifp, I looked at the TARP proposal and you're right that it doesn't provide for purchasing CDS. It says:



AFAIK, Mortgage Backed Securities have the same toxic waste characteristics as CDS: Their "value" is much less than the loan amount, but whoever ends up holding them is responsible for the losses up to the loan amount if they can't collect. Please correct me if I'm wrong.

I'm afraid you are confused, but listening to what I thought were at least smart reporters (old folks like Donaldson, George Will)) on This Week you are in good company.

Lets step back 3 years or so. Joe wants to buy a home. He has lousy credit not much money for down payment, and his income doesn't really support the house he want to buy. He goes to Washington Mutual and they loan him $500,000 to buy house that is appraised at $525,000.

The terms of the loan are 5 Year ARM interest only at 8%, on year 6 it reset to rate probably a lot higher. WaMu gets 2% (points) as fee for making the loan. WaMu makes a 100 loans virtually identical. Now these loans are too risky for even the loosened credit standards of Fannie Mae and Freddie Mac. So WaMu puts 100 of these loans together into their own 50 million (500K * 100) Mortgage Backed Security offer. Each $1,000 bond pays 8% interest on the principal, the potential for higher interest payment in year 6, plus as people refi, or sell their house you also get some principal returned. The math wizards say that expected maturity is 7 years. The collateral behind these bonds is 100 house valued at least $525,000 each. At 8% interest for a "7 year" loan, WaMu finds buyers for 1/2 of the bonds and keeps the remain 1/2 on their books.

In year 1 everybody pays and 10 people actually refi or pay back the mortgage
In year 2 of the remaining 90, 5 have stopped paying and only 5 refinanced.
In year 3 of the remaiining 80 loans 10 have stopped paying. What is worse when the 5 house we foreclosed on last year only fetched $400,000 each not the $500,000 we loaned against them. None of the remaining mortgage holders have enough equity to refinance.

Lets imagine that you own 25 of these bonds. You are unhappy that instead of getting $80 interest you are now getting only $56 (70 loans still paying). 20 loans were paid back but instead of collecting $200 in principal you only got $190 back. How much are these bonds worth? If you are answer is I don't know congratulations you are as smart as anybody on Wall St. You scream at your broker get rid of these pieces of garbage interest rates have dropped and instead of going up in value my bonds are worth less. But because these are thinly traded and concerns about dropping real estate prices, the best you can do is get $500 a piece.

So you lost $300 x25, but look what happened to WaMu. They may have been valuing these bonds reasonably at $700 (remember $200 in principal was repaid) but because of Mark to Market rules suddenly your trade caused them to plunge to $500 each and WaMu assets dropped from 17.5 million to $12.5. The $5 million loss in capital in turn, means that they have approximately $60 million in less loans they can make. What us taxpayers are actually doing is buying the remain securities from WaMu. WaMu gets cash which they can in turn lend out to other borrowers.

Lets step back and look at the big picture. If a person owned all of these bonds they would own 80 mortgage (70 of which are still paying) at the absolute worse case lets say everyone stopped paying. One perfectly viable option would be to simply say in lieu of foreclosing I am going to allow you to live in this house but you own me fair market rent. Than at a latter time sell the properties.

So far from owning Toxic Waste what the American public is purchasing for hundreds of billions of dollars is several million rental properties in prime locations like California and Florida.

 

[free4now]

Great explanation, exactly what I was looking for. I actually had googled for "MBS example" and couldn't find one. I wonder if you could submit this post to google... there must be lots of people trying to figure this stuff out right now.

The more I understand this stuff, the more comfortable I get with the bailout proposal. I still think MBSs are toxic waste, but I think most any real estate is toxic waste right now. At least it's not radioactive waste like the CDSs!

As the original post says, this bailout proposal is just getting started now, like when the Iraq was was starting and Bush was saying it would cost less than 100 billion (rather than the trillion or so the war is now projected to cost). By the time we're done I suspect it's going to look more like a cash infusion and less like an investment, but I hope I'm wrong.

 

[donheff]

Clifp: Good, simple explanation. How about expanding a couple of parts a bit. 1) If Paulson buys the WaMu portion then WaMu is off the hook and can go back to making lousy loans - so far so good. What happens to the the bond holders of the other 50%? Does that depend on what Paulson does with his 50% or are the two parts completely separated? 2) How does Paulson handle the rents? If I understand the current setup banks are not really prepared for that, they know how to forclose but not reclaim and rent. Won't this take an RTC2 type organization ala McCain's proposal? And, if so, what happens to the properties of the 50% that were sold to people Paulson doesn't bail out? I guess, the underlying question is, who is administering the mortgages for those "other" 50%? Is it still WaMu?

 

[ChrisC]

Clifp: Good, simple explanation. How about expanding a couple of parts a bit. 1) If Paulson buys the WaMu portion then WaMu is off the hook and can go back to making lousy loans - so far so good. What happens to the the bond holders of the other 50%? Does that depend on what Paulson does with his 50% or are the two parts completely separated? 2) How does Paulson handle the rents? If I understand the current setup banks are not really prepared for that, they know how to forclose but not reclaim and rent. Won't this take an RTC2 type organization ala McCain's proposal? And, if so, what happens to the properties of the 50% that were sold to people Paulson doesn't bail out? I guess, the underlying question is, who is administering the mortgages for those "other" 50%? Is it still WaMu?

(1) Technically, WaMu (and it would generally be a mortgage subsidiary of WaMu) transfers the loans to another entity, which would issue the bonds or securities backed by the loans (the so-called issuer of securities, a trust in many cases). The investment banks underwrite the issuance and purchase of the securities. WaMu or its subsidiary, as soon as the bonds are purchased (by the initial underwriters), is essentially out of the picture completely -if the math wizard and credit rating agencies have actually predicted the default rates of the underlining loans (ha ha), unless the issuer of the securities has the right to go back to WaMu and have a "bad" loan (i.e. a defaulted loan) replaced by a performing loan that WaMu has made to another borrower. So, when the underlining loans have problems, it causes the mortgage-backed securities, which are now in the secondary market (purchased by pension funds, hedge funds, Fannie and Freddie from the initial underwriters), to become tainted with a steep decline in value. For one thing, the "put" (i.e. the ability of the issuer to replace a bad loan with a performing loan) feature of the deal doesn't have any real meaning, as one could argue that you're merely replacing a bad loan with another bad loan. The people holding the securities, if they're financial institutions like Fannie, Freddie, or Lehman) have to mark-to-market the securities under FAS 157 (an accounting rule), and the securities have become "illiquid" because no one wants to touch them.

(2) With every securitization, there's a master servicer that handles collection and servicing of the loans transferred to the issuer of the securities. The holder of the securities does not have to concern itself with servicing of the loans/receivables that have been securitized. (The master servicer might be the same servicer for all the individual loans that make up the portfolio of loans that are securitized.)

(3) The draft legislation does not call for an RTC2 type agency -- just the ability of the Secretary of Treasury to purchase the mortgage-backed securities and add liquidity to the system that has been clogged up with these illiquid assets.

 

[FinanceDude]

I'm afraid you are confused, but listening to what I thought were at least smart reporters (old folks like Donaldson, George Will)) on This Week you are in good company.

Lets step back 3 years or so. Joe wants to buy a home. He has lousy credit not much money for down payment, and his income doesn't really support the house he want to buy. He goes to Washington Mutual and they loan him $500,000 to buy house that is appraised at $525,000.

The terms of the loan are 5 Year ARM interest only at 8%, on year 6 it reset to rate probably a lot higher. WaMu gets 2% (points) as fee for making the loan. WaMu makes a 100 loans virtually identical. Now these loans are too risky for even the loosened credit standards of Fannie Mae and Freddie Mac. So WaMu puts 100 of these loans together into their own 50 million (500K * 100) Mortgage Backed Security offer. Each $1,000 bond pays 8% interest on the principal, the potential for higher interest payment in year 6, plus as people refi, or sell their house you also get some principal returned. The math wizards say that expected maturity is 7 years. The collateral behind these bonds is 100 house valued at least $525,000 each. At 8% interest for a "7 year" loan, WaMu finds buyers for 1/2 of the bonds and keeps the remain 1/2 on their books.

In year 1 everybody pays and 10 people actually refi or pay back the mortgage
In year 2 of the remaining 90, 5 have stopped paying and only 5 refinanced.
In year 3 of the remaiining 80 loans 10 have stopped paying. What is worse when the 5 house we foreclosed on last year only fetched $400,000 each not the $500,000 we loaned against them. None of the remaining mortgage holders have enough equity to refinance.

Lets imagine that you own 25 of these bonds. You are unhappy that instead of getting $80 interest you are now getting only $56 (70 loans still paying). 20 loans were paid back but instead of collecting $200 in principal you only got $190 back. How much are these bonds worth? If you are answer is I don't know congratulations you are as smart as anybody on Wall St. You scream at your broker get rid of these pieces of garbage interest rates have dropped and instead of going up in value my bonds are worth less. But because these are thinly traded and concerns about dropping real estate prices, the best you can do is get $500 a piece.

So you lost $300 x25, but look what happened to WaMu. They may have been valuing these bonds reasonably at $700 (remember $200 in principal was repaid) but because of Mark to Market rules suddenly your trade caused them to plunge to $500 each and WaMu assets dropped from 17.5 million to $12.5. The $5 million loss in capital in turn, means that they have approximately $60 million in less loans they can make. What us taxpayers are actually doing is buying the remain securities from WaMu. WaMu gets cash which they can in turn lend out to other borrowers.

Lets step back and look at the big picture. If a person owned all of these bonds they would own 80 mortgage (70 of which are still paying) at the absolute worse case lets say everyone stopped paying. One perfectly viable option would be to simply say in lieu of foreclosing I am going to allow you to live in this house but you own me fair market rent. Than at a latter time sell the properties.

So far from owning Toxic Waste what the American public is purchasing for hundreds of billions of dollars is several million rental properties in prime locations like California and Florida.

Excellent post. Like I said last week, maybe the Fed is a shrewder financier than folks realize. Who else but the US govt can "sit" on "bad" real estate and wait until a great time to sell it

 

[donheff]

(2) With every securitization, there's a master servicer that handles collection and servicing of the loans transferred to the issuer of the securities. The holder of the securities does not have to concern itself with servicing of the loans/receivables that have been securitized. (The master servicer might be the same servicer for all the individual loans that make up the portfolio of loans that are securitized.)

(3) The draft legislation does not call for an RTC2 type agency -- just the ability of the Secretary of Treasury to purchase the mortgage-backed securities and add liquidity to the system that has been clogged up with these illiquid assets.

So basically the Treasury becomes just like the "other 50%" but holds a lot more paper? The master servicer keeps collecting the money and eventually pays off the paper? So who calls the shot on foreclosure, letting people stay in their homes (i.e. rent) until value comes back up etc? The master servicers don't have that as a function/priority do they?

 

[ChrisC]

So basically the Treasury becomes just like the "other 50%" but holds a lot more paper? The master servicer keeps collecting the money and eventually pays off the paper? So who calls the shot on foreclosure, letting people stay in their homes (i.e. rent) until value comes back up etc? The master servicers don't have that as a function/priority do they?

I'm not quite sure I understand what you mean by the "other 50 percent." (If you mean the entity that originated the loans, it doesn't keep 50 percent of the loans on its books; it transfers all of the loans that serve as the payment streams for the bonds to the issuer; the underwriters might purchase and hold 50 percent of an issue if they think they have an extraordinary good issue with great interest rates.)

The issuer makes payments on the bonds/paper, which might be in a series of tranches or classes. The issuer is sweeping the loan payments that are being collected by the servicer for ultimate payment to bond holders (after payment of servicer expenses). The loans are being serviced by the same servicer set up for the loan with a master servicer overlaid on the stream of payments. The servicer for the loan calls the shots on delinquencies. But I suspect that the holder of the loan can override those calls. Who owns the paper in the question? The issuer or trust owns the paper right.

I'd imagine that there's something in the Indenture or Trust Instrument that gives the bond holders the right to direct the Master Servicer to do certain things, if a majority of the bond holders want something to be done with the security/collateral that backs the bonds, i.e. the loans or foreclosed real estate. So, it wouldn't surprise me if Treasury holds 100 percent of the bonds for any given issue that it could demand the Master Servicer to engage in forebearances or moratoria on collections. (Pay attention to how the Government handles IndyMac where to a certain extent this might already be occurring.)

Sorry about the convoluted answer to your question but your original premise is faulty.

 

[FIRE'd@51]

So, it wouldn't surprise me if Treasury holds 100 percent of the bonds for any given issue that it could demand the Master Servicer to engage in forebearances or moratoria on collections.

This could be a place where the taxpayer is particularly exposed. Suppose Congress, for political reasons, decides that Treasury should restructure the debt in a way that favors borrowers over lenders. This will be easier to do if Treasury holds a majority of the paper.

 

[ChrisC]

This could be a place where the taxpayer is particularly exposed. Suppose Congress, for political reasons, decides that Treasury should restructure the debt in a way that favors borrowers over lenders. This will be easier to do if Treasury holds a majority of the paper.

Yeah, it could be a balancing act, but if you own the paper you call the shots. And there are some who might legitimately say that the "taxpayer" also includes those people who are delinquent in their debt, that you can't get water from a rock and that enlightened forebearance and moratoria is something that a lender would do anyway, if it still held the paper. Also, if the taint of the paper is really causing the low mark-to-market, then the Government might be in an incredible position to strike great purchases -- it could be the only game in town to purchase the paper and the underlining credits might be reasonably good.

 

[Zoocat]

From GRETCHEN MORGENSON writing in the NY Times today:

"Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.

A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.

So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.

Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?
And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?

We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.

A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.

Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.
Got that? "

There's more
http://www.nytimes.com/2008/09/21/business/21gret.html?em

 

[Retire Soon]

There is just one part in all of this that somehow doesn't make much sense. If I were to rob a Washington Mutual branch at gunpoint and get caught, I would most certainly go to prison. If Washington Mutual robs the taxpayers through a conflict of interest (using credit rating agencies to over rate bonds) and gets caught, it gets rewarded with some of the proceeds from a $700,000,000,000 government bailout. Where is the justice in all of this?

 

[ChrisC]

There is just one part in all of this that somehow doesn't make much sense. If I were to rob a Washington Mutual branch at gunpoint and get caught, I would most certainly go to prison. If Washington Mutual robs the taxpayers through a conflict of interest (using credit rating agencies to over rate bonds) and gets caught, it gets rewarded with some of the proceeds from a $700,000,000,000 government bailout. Where is the justice in all of this?

Ah, the process doesn't work that way. I'm afraid it's a bit more complicated than WaMu doing something bad. (In describing securitization of mortgage loans in this thread, WaMu was a very poor example to use, as lenders don't purchase bonds that have securitized their loans; Doesn't make any financial sense for lenders to do that -- why not just hold the loans to maturity?)

Equally false is the notion that lenders are hi-jacking the credit rating agencies rating of the bonds that securitize mortgage loans. Maybe the underwriters (like Bear Stearns, Merill, Morgan Stanley, or Goldman) do that -- they have the biggest incentive for these securities to be rated very high.

I suggest that people who are really interested in learning how the process works should invest some time learning more about this. A good start might entail reading about the guy who pioneered widespread use of mortgage-backed securities in the 1980's. Lewis S. Ranieri: Your Mortgage Was His Bond

 

[clifp]

Ah, the process doesn't work that way. I'm afraid it's a bit more complicated than WaMu doing something bad. (In describing securitization of mortgage loans in this thread, WaMu was a very poor example to use, as lenders don't purchase bonds that have securitized their loans; Doesn't make any financial sense for lenders to do that -- why not just hold the loans to maturity?)



I suggest that people who are really interesting in learning how the process works should invest some time learning more about this. A good start might entail reading about the guy who pioneered widespread use of mortgage-backed securities in the 1980's. Lewis S. Ranieri: Your Mortgage Was His Bond

Chris thanks for adding additional details and cleaning up my mistakes. I think Chris knows about this stuff, I am just an investor. I realized that my example of having WaMu holding the loans they securitization was a bad example, but it helped illustrate some of the problems of mark to market pricing. It is also important to note that almost all of the securities out there are quite a bit more complex than 100 virtually identical mortgages I proposed, which makes pricing them much more even tougher. It is a function of the current interest rate, expected future interest rate, expected maturity, expected default rate, and value of the underlying properties, with only the current interest rate known for sure and models all breaking down

I do have one question for you. The companies that service the securitization, aren't they typically banks or credit card companies? More importantly what incentives do they have for getting a good price at foreclosure?

 

[ChrisC]

Chris thanks for adding additional details and cleaning up my mistakes. I think Chris knows about this stuff, I am just an investor. I realized that my example of having WaMu holding the loans they securitization was a bad example, but it helped illustrate some of the problems of mark to market pricing. It is also important to note that almost all of the securities out there are quite a bit more complex than 100 virtually identical mortgages I proposed, which makes pricing them much more even tougher. It is a function of the current interest rate, expected future interest rate, expected maturity, expected default rate, and value of the underlying properties, with only the current interest rate known for sure and models all breaking down

I do have one question for you. The companies that service the securitization, aren't they typically banks or credit card companies? More importantly what incentives do they have for getting a good price at foreclosure?

I have a very basic understanding from a few deals a long time ago, when some of us would hammer out the final details of a securities registration statement in a New York City financial printer's office frequently late in the evenings or the early mornings. I suppose desk-top publishing and financial software has made things very easy since then. It was funny back then as you would actually have a Phd in math from Cornell or MIT do these mathematical compliliations to establish collateral/loan levels, default risks, interest rates for the securities, etc.

Mortgage servicing rights is a very lucrative part of the business. At one time, back in the day, there were only a few big players, but banks and other entities created their own mortgage servicing subsidiaries to obtain the business, especially during the height of the S&L crisis when lots and lots of distressed assets and mortgage loan portfolios were being serviced as whole loans or securitized assets from the RTC. JE Roberts might have started out in this business. I'm clueless about today's incentives for servicers. Software has made things very easy for servicers; but you can bet that if a loan goes into foreclosure, servicers would get paid more because there's more work to be done and more professionals involved with handling that loan.

 

[Retire Soon]

Ah, the process doesn't work that way. I'm afraid it's a bit more complicated than WaMu doing something bad. (In describing securitization of mortgage loans in this thread, WaMu was a very poor example to use, as lenders don't purchase bonds that have securitized their loans; Doesn't make any financial sense for lenders to do that -- why not just hold the loans to maturity?)

Equally false is the notion that lenders are hi-jacking the credit rating agencies rating of the bonds that securitize mortgage loans. Maybe the underwriters (like Bear Stearns, Merill, Morgan Stanley, or Goldman) do that -- they have the biggest incentive for these securities to be rated very high.

I suggest that people who are really interested in learning how the process works should invest some time learning more about this. A good start might entail reading about the guy who pioneered widespread use of mortgage-backed securities in the 1980's. Lewis S. Ranieri: Your Mortgage Was His Bond

ChrisC, thanks for the clarification and the book recommendation. I am a former mortgage banker loan officer from the early 80's and am very interested in the subject. Since I've been in the business before, it's a real shocker to see what is happening these days. It used to be that only people that could afford homes, were approved for mortgage loans. My how times have changed!

 

[USK Coastie]

Read an article on Fox yesterday aftrenoon that preported that as of Thursday morning if the Fed had not interveined we were only 500 trades from completely freezing market liquidity and collapse of the economy.

Do know how much weight to give this report but it did get my attention.