The foreclosure crisis is going from bad to worse. More foreclosures are stopping. Buyers are stepping back from bank owned properties. The U.S. Department of Justice has started looking into the mess.
The crisis is a tabloid's dream: Robo-signers gone wild, lawyers and courts operating foreclosure mills, homeowners booted through fraud, politicians pontificating, and subpoenas flying. But there's a Frankenstein that lurks within this house of horrors: the question of who owns mortgages. This is the worst aspect of the crisis, and if the problem is widespread, it could have extremely damaging consequences.
News coverage has reported that, sometimes, banks attempting to foreclose couldn't prove they owned the mortgage in question (or that they represented the true owner, if the bank was servicing the mortgage). When proof of ownership was lacking, the bank evidently provided courts with documentation that may not entirely be on the up and up. This practice, which could amount to a fraud on the court and be subject to criminal punishment, is now under review as banks, judges, plaintiffs lawyers, prosecutors, and all kinds of other folks try to sort things out.
If the ownership problem is widespread--and it might be, since it seems to have arisen from the hyper-pace of creation and securitization of trillions of dollars of mortgages in past years--the implications could be enormously bad. Banks would have to write off mortgages they can't prove they own, and reverse any past recognition of revenue and earnings from those mortgages. After all, banks can't claim as an asset a mortgage they don't own, nor can they recognize revenue from a non-owned mortgage. The sheer scale of mortgage lending and securitization is such that even if only 1% of mortgages are affected by ownership problems, the amounts involved could reach $100 billion or more of mystery mortgages. (There are about $14 trillion of mortgages outstanding, $7.5 trillion of which are securitized.) The U.S. banking industry would have a tough time swallowing another $100 billion of losses, especially now that banks already need to bulk up their capital to meet heightened capital requirements. Taxpayers, put your hands on your wallets.
Another implication of the mortgage ownership problem is that the downturn in the real estate market could be dragged out for years longer than otherwise. Foreclosures aren't legit unless the true creditor is seeking to collect the loan. It will now take months and even years to plow through legal records to establish true ownership of the many, many thousands of mortgages that might be in question. Buyers will step back from bidding for foreclosed properties. No matter, since some title companies aren't insuring title to such properties, so the banks probably couldn't sell them anyway. The foreclosures now in suspension won't be held off forever. Eventually, some resolution of the current mess will be achieved, those foreclosures will proceed, and the recovered properties resold. So these properties overhang the market, and buyers will be cautious about bidding even for non-foreclosure listings.
Then, there are the foreclosures in states where court approval isn't required. About 23 or so states that require court approvals for foreclosures. The rest allow foreclosures to proceed without court orders. But that doesn't mean that inability to prove ownership of the mortgage is okay in those states. To the contrary, booting a homeowner without being the true creditor on the mortgage probably violates the law in more than one way. Doing so may well be a fraud on the owner. If a sheriff's deputies were used to evict the owner, the lender might be deemed to have lied to sheriff. Lying to a peace officer is never a good idea. A subsequent buyer would not obtain clear title, so the lender might well be deemed to have perpetrated a second fraud. If such clouds over title are widespread, real estate markets in nonjudicial foreclosure states could be crippled for years, as title insurance companies try to sort out their risks and buyers stay away.
Another aspect of the mortgage ownership problem emerges in the securitization market. Large quantities of foreclosure mortgages are or were securitized. The mortgage ownership question implies that investors in the securitizations of those mortgages might or might not have invested in actual mortgages. To the extent, they did not, the banks that underwrote the securitizations can look forward to receiving investors' fraud claims. To make things worse, in the case of past foreclosures, investors who received the proceeds of foreclosures on mortgages they didn't actually have an interest in might be liable to repay the money. Needless to say, they would look to the banks servicing the mortgages for recompense. Given the apparently lousy state of the recordkeeping, the morass on the securitization end of the things could take years to clear up. The revival of the securitization market might be pushed back for a similarly long period. If things turn out to be really bad, securitization as a large-scale method of financing may be gone forever.
The foreclosure mess bears watching. It seems to be about where the financial crisis was in 2007: a year before we see the worst of things. If the foreclosure mess turns out to be a real monster, expect Wall Street and the real estate industry to try to dump it where the financial crisis ended up--in the laps of taxpayers. Whether that will be politically feasible is open to question. We are now witnessing the largest taxpayers' revolt since the Whiskey Rebellion in the 1790s. Maybe this time the banks will have to bear the losses they created.
Showing posts with label securitization. Show all posts
Showing posts with label securitization. Show all posts
Wednesday, October 6, 2010
Tuesday, March 2, 2010
The Donkey-Backwards Housing Finance Debate
One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.
That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.
Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.
The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.
First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.
Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.
Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.
Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.
The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.
That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.
Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.
The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.
First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.
Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.
Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.
Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.
The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.
Tuesday, February 24, 2009
Can We Have Economic Recovery Without Securitization?
Today, Fed Chairman Ben Bernanke said in Congressional testimony that the recession could end some time in 2009 if the financial system were stabilized. Although Bernanke cautioned that a full recovery could take two or three years, this statement helped to spark a stock market rally, with the Dow Jones Industrial Average rising 236 points, or 3.32%.
This is nice to know, but there's a rather big "if" in the statement. Chairman Bernanke prefaced his prediction of recovery on stabilization of the financial system. By now, we all understand that the financial system won't be easily stabilized. The front end of the problem involves trillions of dollars of bad debt from the real estate mess and American economic downturn, along with a growing crisis in Europe and Asia--Russia and the nations on its perimeter are, in particular, becoming increasingly problematic. Just stabilizing the formal banking system (i.e., those institutions legally chartered as banks) by removing toxic assets and recapitalizing will take trillions from the government.
Then there's the back end of the problem of stabilizing the financial system: securitization. In the last 30 years, a shadow banking system evolved through the securitization market. A wide variety of loans, ranging from mortgages to consumer loans to corporate debt. were bundled into investment vehicles that were financed by investors who, for the most part, took the risk of loss on the bundled loans. This was a wonderful financial innovation for banks, since they could earn fees making, selling and administering loans, while not bearing the risk of losses from those loans. Securitization seemingly came to be viewed by bankers as one good thing there couldn't be too much of.
Well, just as there is no such thing as a free lunch, there's no good thing that you can't have too much of. Since securitization appeared to generate vast earnings for banks with minimal risks, they securitized early, often, over lunch breaks, after office hours, on weekends and even while in the shower. They defied contemporary social trends by setting aside multitasking in order to concentrate on securitizing. Generating the profits that would allow CEOs and other executives to earn tens of millions in bonuses required that the banks make more and more loans. There are, however, only a finite number of borrowers with good credit ratings. After that, in order to get more loans to securitize, you have to make loans to increasingly poor credit risks. Thinking that they could continue foisting the risk of loss onto investors, bankers kept the profit making party going by exercising increasingly poor credit judgment.
Today, we know how the story ended: today's economic mess. A rather under-publicized aspect of today's mess is that the securitization market is dead. Good riddance, one might say. It was a monster that Wall Street created but couldn't control. But the cash used to make trillions of dollars of loans came from the securitization process. Without it, banks have to use their capital and deposit base to make loans, and they are now stuck holding the loans they make. From one perspective, this is a good thing. If banks have to eat what they kill, they will be careful about what they aim at. However, today's bankers aren't like the bankers of yore. There's nary a J.P. Morgan among them. They don't really want to be responsible for the loans they make. We can analyze this as a Baby Boomer, Gen X, Gen Y, Millenial, all of the foregoing, or whatever problem. It remains a problem and, as a result, banks have cut back on lending.
The conventional discussion about fixing securitization revolves around requiring the banks that make the loans to "keep some skin in the game" by retaining some of the risk of loss on the loans they sell. This is the way securitization is sometimes down in Europe. But such a concept assumes two things: (a) banks are willing to retain risk; and (b) investors remain willing to invest in securitized assets. Both assumptions are questionable. Retaining risk takes away much of the advantage to banks of securitizing. Sure, the banks get to spread some of the risks around. But increased loan loss reserves, expanded risk management systems and other drags on earnings will get in the way of $50 million executive bonuses. Moreover, investors now profoundly mistrust the banks that underwrote the securitizations. Lawyers could draft elegant Indentures of Trust for securitization transactions that would make abundantly clear that underwriting banks bear some risk of loan losses. Yet, investors wouldn't fork over their money. A cat that walks on a hot stove top doesn't care who's legally liable for its veterinary care. It simply won't walk on that stove top again.
Thus, to get the banks lending again, they and the government need to deal with the loss of the securitization market. More precisely, the securitization market was the very large, unregulated segment of the banking system that collapsed last year. This loss must be replaced somehow, and eliminating toxic assets, recapitalizing banks, and tweaking the securitization concept probably won't take us the whole distance.
At the moment, the federal government has substituted itself for the securitization market. Mortgage loans are still being securitized by Fannie Mae, Freddie Mac and Ginnie Mae. All of these investments are guaranteed by the U.S. government, so investors will buy them. The Federal Reserve is buying or will buy bundles of consumer loans and corporate loans, in order to free up bank capital for more loans. In essence, the Fed is providing the funds for more consumer and corporate loans. The Fed guaranteed money market funds and bailed out auction rate securities (a money market fund equivalent). If you deposit your cash the right way into a bank, you can have unlimited federal deposit insurance, at least until the end of 2009 (hint: amounts over $250,000 should be placed in a non-interest bearing acccount). Our financial system has been de facto nationalized, although no senior federal civil servant will admit to it.
But we can't have financial markets that are all government, all the time. No one wants that, not the President, nor Congress, nor Democrats, nor Republicans. The federal government has only blunt instruments to combat the economic crisis. The Fed, in a variety of different and innovative ways, has flooded the banking system with printed money, which has kept the hounds at bay but with serious potential for inflation. The Obama administration has secured the passage of a $787 billion stimulus package, an impressive accomplishment for a rookie President, but it doesn't replace the loan funding formerly provided by the securitization market.
As we know from the mortgage crisis and credit crunch, a lot of the financial system's problems involve the fine details of the plumbing system. Just as the substance pipes are made of (copper, not polybutylene), and the washers and gaskets used, can be important to a home's plumbing, the structures of mortgage backed securities, CDOs, special purpose entities, credit default swaps and myriad other financial esoterica can make a great deal of the difference in the viability of the financial system. The federal government can't solve this problem. Federal civil servants can be far more creative and effective than popular culture would hold. But they can't develop new funding mechanisms for Wall Street, not if Wall Street wants to be privately owned. This is one for the private sector. Wall Street is fortunate to exist in a nation that believes in free enterprise and which will provide the funding to recapitalize banks after they have effectively collapsed through many faults of their own. If the major banks do not want to remain wards of the state, they must develop new funding mechanisms. Most likely, this will require sharing with investors some of the profits from securitization banks used to keep for themselves. That wouldn't be a bad thing. Investor confidence isn't going to come back by itself, or because the President tonight made one of his typically eloquent speeches. It's going to come back when investors get a better deal.
This is nice to know, but there's a rather big "if" in the statement. Chairman Bernanke prefaced his prediction of recovery on stabilization of the financial system. By now, we all understand that the financial system won't be easily stabilized. The front end of the problem involves trillions of dollars of bad debt from the real estate mess and American economic downturn, along with a growing crisis in Europe and Asia--Russia and the nations on its perimeter are, in particular, becoming increasingly problematic. Just stabilizing the formal banking system (i.e., those institutions legally chartered as banks) by removing toxic assets and recapitalizing will take trillions from the government.
Then there's the back end of the problem of stabilizing the financial system: securitization. In the last 30 years, a shadow banking system evolved through the securitization market. A wide variety of loans, ranging from mortgages to consumer loans to corporate debt. were bundled into investment vehicles that were financed by investors who, for the most part, took the risk of loss on the bundled loans. This was a wonderful financial innovation for banks, since they could earn fees making, selling and administering loans, while not bearing the risk of losses from those loans. Securitization seemingly came to be viewed by bankers as one good thing there couldn't be too much of.
Well, just as there is no such thing as a free lunch, there's no good thing that you can't have too much of. Since securitization appeared to generate vast earnings for banks with minimal risks, they securitized early, often, over lunch breaks, after office hours, on weekends and even while in the shower. They defied contemporary social trends by setting aside multitasking in order to concentrate on securitizing. Generating the profits that would allow CEOs and other executives to earn tens of millions in bonuses required that the banks make more and more loans. There are, however, only a finite number of borrowers with good credit ratings. After that, in order to get more loans to securitize, you have to make loans to increasingly poor credit risks. Thinking that they could continue foisting the risk of loss onto investors, bankers kept the profit making party going by exercising increasingly poor credit judgment.
Today, we know how the story ended: today's economic mess. A rather under-publicized aspect of today's mess is that the securitization market is dead. Good riddance, one might say. It was a monster that Wall Street created but couldn't control. But the cash used to make trillions of dollars of loans came from the securitization process. Without it, banks have to use their capital and deposit base to make loans, and they are now stuck holding the loans they make. From one perspective, this is a good thing. If banks have to eat what they kill, they will be careful about what they aim at. However, today's bankers aren't like the bankers of yore. There's nary a J.P. Morgan among them. They don't really want to be responsible for the loans they make. We can analyze this as a Baby Boomer, Gen X, Gen Y, Millenial, all of the foregoing, or whatever problem. It remains a problem and, as a result, banks have cut back on lending.
The conventional discussion about fixing securitization revolves around requiring the banks that make the loans to "keep some skin in the game" by retaining some of the risk of loss on the loans they sell. This is the way securitization is sometimes down in Europe. But such a concept assumes two things: (a) banks are willing to retain risk; and (b) investors remain willing to invest in securitized assets. Both assumptions are questionable. Retaining risk takes away much of the advantage to banks of securitizing. Sure, the banks get to spread some of the risks around. But increased loan loss reserves, expanded risk management systems and other drags on earnings will get in the way of $50 million executive bonuses. Moreover, investors now profoundly mistrust the banks that underwrote the securitizations. Lawyers could draft elegant Indentures of Trust for securitization transactions that would make abundantly clear that underwriting banks bear some risk of loan losses. Yet, investors wouldn't fork over their money. A cat that walks on a hot stove top doesn't care who's legally liable for its veterinary care. It simply won't walk on that stove top again.
Thus, to get the banks lending again, they and the government need to deal with the loss of the securitization market. More precisely, the securitization market was the very large, unregulated segment of the banking system that collapsed last year. This loss must be replaced somehow, and eliminating toxic assets, recapitalizing banks, and tweaking the securitization concept probably won't take us the whole distance.
At the moment, the federal government has substituted itself for the securitization market. Mortgage loans are still being securitized by Fannie Mae, Freddie Mac and Ginnie Mae. All of these investments are guaranteed by the U.S. government, so investors will buy them. The Federal Reserve is buying or will buy bundles of consumer loans and corporate loans, in order to free up bank capital for more loans. In essence, the Fed is providing the funds for more consumer and corporate loans. The Fed guaranteed money market funds and bailed out auction rate securities (a money market fund equivalent). If you deposit your cash the right way into a bank, you can have unlimited federal deposit insurance, at least until the end of 2009 (hint: amounts over $250,000 should be placed in a non-interest bearing acccount). Our financial system has been de facto nationalized, although no senior federal civil servant will admit to it.
But we can't have financial markets that are all government, all the time. No one wants that, not the President, nor Congress, nor Democrats, nor Republicans. The federal government has only blunt instruments to combat the economic crisis. The Fed, in a variety of different and innovative ways, has flooded the banking system with printed money, which has kept the hounds at bay but with serious potential for inflation. The Obama administration has secured the passage of a $787 billion stimulus package, an impressive accomplishment for a rookie President, but it doesn't replace the loan funding formerly provided by the securitization market.
As we know from the mortgage crisis and credit crunch, a lot of the financial system's problems involve the fine details of the plumbing system. Just as the substance pipes are made of (copper, not polybutylene), and the washers and gaskets used, can be important to a home's plumbing, the structures of mortgage backed securities, CDOs, special purpose entities, credit default swaps and myriad other financial esoterica can make a great deal of the difference in the viability of the financial system. The federal government can't solve this problem. Federal civil servants can be far more creative and effective than popular culture would hold. But they can't develop new funding mechanisms for Wall Street, not if Wall Street wants to be privately owned. This is one for the private sector. Wall Street is fortunate to exist in a nation that believes in free enterprise and which will provide the funding to recapitalize banks after they have effectively collapsed through many faults of their own. If the major banks do not want to remain wards of the state, they must develop new funding mechanisms. Most likely, this will require sharing with investors some of the profits from securitization banks used to keep for themselves. That wouldn't be a bad thing. Investor confidence isn't going to come back by itself, or because the President tonight made one of his typically eloquent speeches. It's going to come back when investors get a better deal.
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