Subprime: everybody start whinging: Part 3, pity the poor investor?
[Continued from Part 1 and Part 2.]
Yesterday’s continuation of our examination of the subprime rate-reset amnesty program used the Wall Street Journal’s coverage to look at all the people complaining about the free handout, mainly from the borrower side.
That’s my position
I finished by observing that some on the lender side were likewise grumbling, such as:
Doug Dachille, chief executive of First Principles Capital Management in New York, which invests in some mortgage-backed securities [says], “There ought to be costs to both the borrowers and lenders, but right now you’re just giving a freebie to homeowners. They still get to live in their house and benefit from any appreciation in the value of the house over the next few years.”
I don’t get any appreciation
Mr. Dachille is right that homeowners who recover will gain equity they will not share with their lenders. That’s their incentive for hanging in now. Economist Nouriel Roubini with admirable clarity makes the investors’ case for relief:
In the specific, the benchmark of losses against which this Treasury/banks proposal should be judged is what would happen if this proposal is not implemented: and that benchmark is one where in the absence of loan modifications millions of households will default, end up in foreclosures and the losses to holders of mortgages, RMBS and mortgage related CDOs would be massive. So, the benchmark for investors is not one of being paid in full and in time but rather one of massive bankruptcies and severe financial losses.
Translation: Lenders and investors, you are going to lose something. The question is how to minimize it.
Trying to slow the rate
Against that benchmark we can ask the question: do loan modifications of the sort proposed in the Treasury plan make the losses bigger or smaller for these investors? And the answer to that question is simple: losses will be lower and the reduced value of these ABS claims will be greater than under the alternative of massive defaults (cum case-by-case slow restructuring of the claims). The reason why the losses will be lower and the value of the ABS assets larger than otherwise is simple: you avoid liquidation costs of avoidable defaults and foreclosure and you allow illiquid but solvent borrowers not to default.
This is classic — and utterly correct — risk mitigation thinking.
Saying that investors will lose money because you prevent teaser rates – averaging 7% now – from being reset to an average 10% is nonsense; the alternative is for investors is not getting a higher 10%; the alternative is rather that at 10% hundreds of thousands of homeowners will pay 0%, i.e. they will stop paying both interest and principal on mortgages that often have a value above the one of the underlying asset. On in expected terms, investors are worse off in a world where most of these borrowers default compared to a world where the teaser rate is maintained for another five years. So investors should be cheering this proposal rather than opposing it.
On the other hand, it is clearly in the capital markets’ interest — and if Mr. Dachille doesn’t like this round, he will surely not like the next round or rounds likely to arise. Mr. Roubini again:
Most likely much more relief should be given to more borrowers than this plan provides, as only a small subset of subprime borrowers will qualify for such debt relief compared to those who need it and deserve it. So the problem with this plan is that it does too little, not too much, in terms of extent and coverage and size of the debt relief; not enough deserving borrowers will qualify for the relief under this plan. But the alternative of doing nothing would be much worse than a positive step in the right direction, i.e. providing relief to those borrowers – not all borrowers but only those - that were victims of reckless and predatory lending practices.
I agree with Mr. Roubini — this doesn’t solve everybody. But that is all right. In all of my experience, when you have a big complicated messy portfolio, there is no Grand Unified Theory of mortgage restructuring.
I have a Special Theory of Repayment, and a General Theory of Repayment,
But I have no Grand Unified Theory of Repayment
Rather, you solve a subset, then you solve another subset, then you solve another subset, and some properties or loans you put in the ‘too hard’ bucket.
Milton Ezrati, market strategist with money-management firm Lord Abbett & Co., says the plan could undermine the market for mortgage-backed securities. Investors may say, “if you can interrupt my cash flow today, you can do it tomorrow,” says Mr. Ezrati.
Our market is being undermined
Yes, it could. It ain’t perfect. But if there is such a disruption, it’s a purely private-market affair. The government has done nothing here to intrude upon contractual agreements between responsible entities, all of which are well capitalized and generally able to take care of themselves.
Another question concerns mortgage servicers, the companies that collect payments on behalf of the eventual debt holder: Can they change the terms of mortgages without being sued by the investors who purchased them?
That’s why they banded together, 84% of the marketplace, so as to create a united front against the litigation threat.
Jordan Schwartz, a structured-finance partner at law firm Cadwalader, Wickersham & Taft LLP, says agreements that govern mortgage securities generally give servicers discretion to modify loans if they consider it to be in the best interest of investors who hold the securities. But any plan that emerges from
No, it doesn’t have the force of law. Servicers could get sued. Almost certainly some will. Among the tricks in workout triage is reducing the upside of suing and the number of plaintiffs, to change the cost-benefit of embarking on litigation.
George P. Miller, executive director of the American Securitization Forum, a trade association of investors, servicers and other securitization players, said servicers won’t receive a guarantee against being sued.
Nor should they.
But because the plan was created by major industry players, including his group, and was endorsed by the Treasury Department, it offers a substantial shield against lawsuits.
As Treasury Secretary Paulson put it in his Wall Street Journal Op-Ed, “because these industry standards are the product of investor and servicer discussions, the risk of litigation should be manageable.”
That’s litigators, Miss Litella, not alligators
Alan Gulick, a spokesman for Washington Mutual Inc., Seattle, the sixth-largest subprime servicer, according to Inside Mortgage Finance, said the bank is “supportive of the proposal.”
Mike Heid, co-president of home mortgages at Wells Fargo & Co., the eighth-largest servicer, said his bank played a key role in developing the plan to help consumers who have managed their mortgages well but are “caught in the current whirlwind of market forces.”
I’ll let Mr. Roubini sum it up:
Thus only folks who are so blinded by their free markets fundamentalism and opposition to any government intervention in market failures would be so obfuscated by their ideological blinders that they would [fail to] realize that this plan – however modest and partially faulty and incomplete – implies a better market-oriented resolution and much lower losses to private investors than a disorderly and “mission impossible” case-by-case workout of millions of actual or threatened mortgage defaults.
The plan isn’t perfect, for the simple reason that a perfect plan is impossible.
Systemic market failures and crises require systemic response where government resolves the collective action problems of individual creditors rushing to the exits and causing a disorderly workout of severe debt problems.
A very nice way of expressing government’s value in convening distrustful competitors into collaborative action.
This mortgage disaster is a case where sound public intervention is necessary and desirable.
Implies Mr. Roubini — and I agree with him — there is more to come.
What group of borrowers will be up next?
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