AAA RATING FOR SUBPRIME MORTGAGE BONDS!!!
ARE YOU SERIOUS???
I have great news for pension funds, investment banks, and municipalities
around the world! Another pool of subprime mortgage backed securities have earned
a AAA rating from Moody’s Investors Service. The New Residential Mortgage Loan
Trust 2016-1 mortgage bond is a securitization of over $261 million of
first-lien prime, subprime, and Alt-A mortgages that were originated from
2001-2005. Over 75% of the 1,789 loans within the portfolio consists of
subprime and Alt-A originated mortgages. These are same type of mortgage-backed
securities, from the same timeline, originated from the same pool of lenders,
and rated by the same rating services that helped cause the American subprime mortgage
crisis of 2007-2008 - leading into the Great Recession of 2008-2009. The only difference
is that now these mortgages are 11-15 years seasoned.
Moody’s Investor Service gives several reasons why they have
rated the bond AAA. They claim that based upon the age of the loans in the
pool, the originators of the loans are less relevant. (I highly doubt that some
municipalities whom lost millions of dollars within Norway and Ireland would
agree with this analogy.) As a mortgage professional of 25 years and having
been responsible of helping over 10,000 clients, I believe when names such as
Countrywide Home Loans, GMAC Mortgage, and American Home Mortgage (all defunct)
show up on a bond, investors should show a certain level of concern. Moody’s
also compares the 12-month default rates of prime (1.6%), subprime (3.7%), and
Alt-A (3.1%) mortgages. They then discuss the expected default rate of this
portfolio at 5.4%. However, if you where to look at the research done by both
CoreLogic and the U.S. Federal Reserve, it appears that the rate of default rate
continue to increase as time progresses for the years referenced in the portfolio
– especially for loans originated during years 2004-2006. Thus, for loans
originated during this time, that are within the said portfolio, the default
rate continues to climb.
Moody’s also mentions that the weighted average updated loan-to-value
(LTV) ratio was 60.7% and FICO score was 697. What was not mentioned was the average
combined-loan-to-value (CLTV) in the portfolio. During the 2001-2006 period, a
very popular mortgage product was the 80/20. Meaning, one would acquire an 80%
first lien position mortgage and simultaneously obtain a 20% second lien
position mortgage. This would establish a 100% combined-loan-to-value
transaction. This exact transaction, that was prevalent during 2001-2006, is
what prevents these borrowers from refinancing or selling today. Another
consideration is the extremely low interest rate environment and steady
increase of home prices over the last few years. Many loans in this portfolio
could be sitting on adjustable rate mortgages on either their first mortgage or
second mortgage. When interest rates rise (and it is not “if” they rise, just “when”)
this will negatively affect the borrowers whom these loans are issued.
Combining increasing interest rates, with a reversal in home prices, and these “new”
mortgage backed securities that have loans that have been traded, swapped, and
repackaged numerous times could once again create catastrophic results for the
bond holders and borrowers.
I have been working as full-time professional in the
mortgage industry before, during, and after the subprime mortgage crisis. This
has perhaps given me a little more insight then most. Perhaps my opinion is
skewed due to what I have seen and lived through. However, when it comes to
some of the mortgage-backed securities that have been recently introduced and received
such high ratings from the Big Three creit rating agencies (Moody’s, Fitch, and
Standard & Poor’s) I have serious concerns. From the opinion of a “street
guy”, who meets with clients every day, I have to honestly say that if these
borrowers who took out loans between 2001-2006 could refinance, they would. The
reason is, mortgage rates from 2001-2006 for a 30 year fixed rate mortgage ranged
from the 7.15% to 5.23%, and the current interest rate environment is at 3.75%.
However, something is preventing them from doing it. Whether it be too high of
a LTV or CLTV, too low of a credit score, not showing enough income, or not
having the right characteristic standards established – it takes just ONE of
those items to prevent them from obtaining a new mortgage. The same items that
prevent these borrowers from obtaining a new mortgage are the same reasons their
existing mortgage maintains a greater risk for the bondholders who purchase the
portfolios that are holding these loans.
The advantage to these portfolios is they have loans in them
that have an interest rate that is well above today’s existing interest rate environment.
Investors love the high rates of return these mortgage backed securities from 2001-2006
can produce. However, in some cases, these investors are restricted in what they
can invest in; held to only investing in securities that are AAA rated by the
credit agencies. The supply of these types of mortgage-backed securities with
high returns are low; the demand for these types of bonds with high returns with
AAA ratings are very high. However, as it has been for a very long time, without
the ratings the bonds are much less valuable. Wall Street has a huge incentive
to get these securities into the hands of investors at the highest rating
possible. When there are huge incentives for some, the likelihood of misrepresentation
or self-interest actions are much higher. My skepticism prevents me from just
accepting the 60.7% average LTV, the average FICO score of 697, and the 88.4%
of the loans being current or with only one 30 day late in the last 24 months. Anyone
who understands both statistics and mortgage lending could cherry pick
individual loans that could produce a good looking portfolio, that creates strong
averages, but could be a time-bomb just waiting to explode. I say proceed with
extreme caution before trusting a credit agencies rating – we saw what happened
last time!
4 comments:
Anthony: 82/100 You wrote "... some municipalities whom lost ...", but you should use "who" in this spot (-6) You wrote "... affect the borrowers whom these loans are issued ..." — what exactly does that mean? (-6) You also wrote "... Big Three creit rating agencies ...". (-6)
Anthony, you know the scene in A Christmas Story where Ralph brings his teacher the gigantic Christmas present? I felt that way when I first saw the size of your post. They do not need to be this big, and there's no extra points in it if they are. And unfortunately, a big post can open up more opportunities for markdowns. Just saying.
As far as content goes, this is an excellent post. Let me note for everyone else that I am OK with something that isn't this in depth, or so relevant to one's current job. But if you've got the inclination, there's a ton to learn from writing or reading a post like this.
I think Moody's is in a tough spot on this one. They have to rate issues based on historical evidence of default rates. And they have to use a window that weights more recent default rates more heavily. So I have a hard time seeing how they come up with anything other than AAA for a securitization like this.
I would point fingers at Congress, the Federal Reserve, and other regulatory authorities about this though. The thing is, the security might be AAA now, but it's Moody's job to revisit that rating as the payment history of the underlying assets evolve. But this is where they run into a problem that many financial institutions are pushed into holding a high portion of their assets in AAA form. So if one of these securities drops a rating level, some institution may have to sell it off. This will cause its price to drop. But generally, its price will have already dropped reflecting the increase in underlying default rates. It's this "selling into a storm" that's really problematic.
I think this points to the real problem. Mortgages have always been bought and sold: both the good and the bad ones. Securitization is just another way to do this, and I have a hard time seeing how it is inherently worse. The real problem in 2007-9 was dumping these assets when they were going south. I'm not saying that an assetholder always should hold on to a bad asset, or that a financial institution shouldn't be encouraged to get out of a bad situation. But we all know what dumb investors do: buy because everyone else already did, and sell because everyone else already did. Why do our regulations encourage that?
A few thoughts…
Who, whom - tomāto, tomäto - potāto, potäto. I just like to fancy-up the way I communicate! When I use “whom” it make me feel like I am drinking fine imported cognac, smoking Cuban cigars, while wearing a smoking jacket and velvet tuxedo slippers. (Basically, it makes me feel like Hugh Hefner! What guy doesn’t secretly want be Hugh Hefner for a few hours occasionally?) In reality, with all due respect, the correct word should have been “that”, and not “whom” nor “who”. Nevertheless, I made the mistake and deserve to be punished (or at least corrected)! However, perhaps you will give the 6 points back, since you incorrectly suggested using “who” versus "that"? ;-)
When I discuss the higher interest rates negatively effecting borrowers, I mean that when borrower's interest rates rise, it creates a negative effect on household monthly cash flow. Rates go up and borrower’s payments go up, leaving less cash for the movies, going out to dinner, and other non-essentials. (But then again, you already knew that – my sentence was just not well written!)
I deserve failing this assignment for misspelling “credit”, as I have written that word thousands of times! Too fast was my typing and too slow was my brain to catch it before publishing.
The difference between me and lil’ Ralphie Parker is that Ralphie brought the huge fruit basket because he wanted an A+ on his paper, so he can get his Red Rider BB Gun. I, on the other hand, would have been content with the C+ Miss Shields gave him! I recently had another professor tell me, “You have a tendency to turn a nursery rhyme into a novel, usually a fairly well written novel, but a novel never the less”. I apologize for this unique characteristic flaw of mine!
continued...
Finally, in regards to the serious content of my paper. Please note that when you mention “Mortgages have always been bought and sold: both good and bad ones. Securitization is just another way to do this, and I have a hard time seeing how it is inherently worse.” I think you may have a misunderstanding of what we traditionally think of when we talk “buying and selling of mortgages”. The buying and selling of mortgages that consumers are very familiar with is the buying and selling of the “servicing rights” of the underlying mortgages. Meaning, who is collecting the payments for the actual owner of the mortgage. Therefore, companies such as Wells Fargo, Chase, Green Tree, PNC, and even State Bank of Southern Utah retain, buy, or sell the servicing rights from one another. However, Fannie Mae, Freddie Mac, Ginnie Mae, or Wall Street firms actually own the mortgages. The GSE then allow servicing companies to retain 25-50 basis points annually to service the mortgages. My concern is that companies have been stripping and rebundling mortgage backed securities in a way that cherry-picks loans to create these highly rates bonds. Credit rating agencies, which are hired by the Wall Street firms to assign a rating, are only running “sample reviews” of the portfolio’s loans. I believe that this creates a huge conflict of interest and allows the companies that issue the bonds an opportunity to manipulate portfolio by looking at each individual loan, hand-selecting specific characteristics from each one. Therefore, driving averages up for each individual line item that the issuer knows the credit agency are looking for. This is an easy task to accomplish by anyone with statistics and mortgage knowledge. I am concerned that pension funds, municipalities, and even your retirement plan at Southern Utah University, may contain some very risky bonds. I would not sleep so easy knowing that my "supposed AAA rated bonds", that are going to help me through retirement, may be full of subprime and Alt-A loans from 2001-2006.
Our regulators, in all their brilliance, through Dodd-Frank regulations, imposed a requirement on the mortgage industry that appraisers have no influence upon them by the lending institution hiring them. The industry turned to appraisal management companies that the lenders would place an appraisal order with, in turn the appraisal management company would hire and exclusively communicate with the appraiser. This prevented any influence, by the lender, on the appraiser performing the asset evaluation.(As a side bar, it also increased costs for the borrower.) Why would regulators not encourage the same type of arrangement with the Big Three credit agencies who are actually performing asset evaluations on the mortgage-backed securities? Take a close look at many of these securities; look at how the investment firm stay with a specific credit agency when the ratings come in high on their portfolios. However, when the ratings come in lower, there is a unique tendency to see a new credit rating company being selected by the firm. Perhaps, our regulators should be encouraging more independence between the Wall Street investment firms and the credit agencies they are hiring?
Anthony Graham: 50/50 No I won't give the points back on who/that. Yes, "that" is better than "who", but I was trying to redline what you did write, not change your style to something you did not.
I'm bemused by the rest of your first comment. Part of me wishes that business schools didn't constantly hear from our advisory boards that we have to do something to improve the writing of students before we let them graduate.
Anthony Graham: 41/50 I pasted part of your comment here, with 3 corrections in capitals.
I believe that this creates a huge conflict of interest and allows the companies that issue the bonds an opportunity to manipulate portfolioS by looking at each individual loan, hand-selecting specific characteristics from each one. Therefore, driving averages up for each individual line item that the issuer knows the credit agency IS looking for. This is an easy task to accomplish by anyone with statistics and mortgage knowledge. I am concerned that pension funds, municipalities, and even your retirement plan at Southern Utah University, may contain some very risky bonds. I would not sleep so easy knowing that my "supposed AAA rated bonds", that are going to help me through retirement, may be full of subprime and Alt-A loans from 2001-2006.
Our regulators, in all their brilliance, through Dodd-Frank regulations, imposed a requirement on the mortgage industry that appraisers have no influence upon them by the lending institution hiring them. The industry turned to appraisal management companies that the lenders would place an appraisal order with, in turn the appraisal management company would hire and exclusively communicate with the appraiser. This prevented any influence, by the lender, on the appraiser performing the asset evaluation.(As a side bar, it also increased costs for the borrower.) Why would regulators not encourage the same type of arrangement with the Big Three credit agencies who are actually performing asset evaluations on the mortgage-backed securities? Take a close look at many of these securities; look at how the investment firm stayS with a specific credit agency when the ratings come in high on their portfolios.
As to the second comment, I think you are right about servicing versus sales. Actual sales of mortgages between private financial institutions used to be much more common.
I do not have any problem with financial firms slicing and dicing mortgages to produce securities with desirable properties. Cherry-picking is fine, as long as all the pieces of the original security end up in some derivative security.
I have more of a problem with those desirable properties being driven by regulations in other sectors. Those desirable properties are hurdles that financial professionals have to get a security to clear. It should not be surprising that when regulatory pressure increases the demand for securities that can clear the hurdles, that the hurdles themselves start to shift. I don't think this is much different than grade inflation at universities being driven by employers increasing use of GPA as a filtering tool for applicants.
It's interesting that you think more and better firewalls are the solution. Maybe. I'm worried about incentive structures; can we build firewalls that are stronger than the incentives to game the system? I'm not sure.
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