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New Paradigm? The Rise of Mortgage-Backed Securities


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2006 Oct 24, 7:11am   15,628 views  174 comments

by HARM   ➕follow (0)   💰tip   ignore  

Option-ARM

This is a topic that seems to come up fairly often and I think is worth exploring: Does the rise of Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) represent a true "paradigm shift" in how risk is decoupled from mortgage originators/lenders and transferred to individual investors and taxpayers? Is this a temporary trend soon to follow unprofitable Dot.coms into the dustbin of history, or a true revolution in risk transference?

MBS/CMO goal: Privatize profits, socialize risk

We have often derided those in the REIC over the past year or so who have claimed that the unprecedented run-up in housing prices over the last 6 years was a "new paradigm", i.e., a permanent, historic shift in severing the traditional relationships between incomes, rents and RE prices. But what if there's a kernel of truth to this?

We must remember that MBS/CMOs are what have made issuing NAAVLPs and I/Os profitable, even with tiny risk premiums, because of that oh-so-critical risk-transference. Even the most toxic option-ARM is profitable to the originating lender –in fact, the fees & points (profits) are far higher on toxic loans than they are on traditional 15/30-year FRMs or amortizing ARMs. If you're a lender, why wouldn't you want to take boat-loads of risk-free (for you) money? You'd have to be crazy not to, right? Of course, there's always the possibility of repurchase agreements or class-action lawsuits if things get really bad, but, hey that's for some other guy to worry about. You're in it for the short-term profits and couldn't care less about the long view, right?

The new MBS/CMO risk transfer model has been working SO well for lenders that I fear only a complete economic meltdown (resulting from it) would deter banks from voluntarily continuing its use in the future. And, as Randy has pointed out, the current anti-regulation/pro-banking bias in government is so strong, involuntary regulations (with real enforcement) are pretty much out of the question –for now.

I believe our best hope where toxic loans are concerned is for MBS investors to begin to recognize that the underlying risk has been severely under-priced and demand greater premiums and/or risk disclosure. This should result in higher mortgage interest rates and the return of "quaint" things like full-documentation, which in turn would deter widespread use of these loans. Of course, this would require FB defaults on a massive scale, something we could expect to see beginning next year, and continuing in waves for several more years.

"Next year, a trillion dollars worth of mortgages will have their rates reset, said Dan Mudd, chief executive officer of Fannie Mae. That's a significant share of $9 trillion in mortgages outstanding, he said."
Source: Reuters

Add to that the roughly $.5 Trillion that started resetting this year, and another $1 Trillion that will start resetting in 2008, and you have approximately $2.5 Trillion in neg-ams and option-ARMs that will be resetting monthly by end of 2008. We're not talking small resets either. When you factor in a typical 1-2% "teaser" shooting up to LIBOR + 2-3% (typical mark-up for option-ARMs), PLUS the loans starting to amortize (having to start paying back principal as well as full interest), payments could shoot up 100-200% for Mr & Mrs. Howmuchamonth.

Thoughts, opinions...?
HARM

#housing

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124   requiem   2006 Oct 25, 10:36am  

Assuming Dr. Cagan's data is good, and that he is simply being hopeful that prices won't fall too far, we can simply slide down the rows in his disclaimer to find the appropriate numbers. He may say "X foreclosures over the next n years", but we can read that as "here's how foreclosure rates are affected by price drops".

125   OO   2006 Oct 25, 10:49am  

The opium analogy is fitting, until we get hooked on the same opium.

I am all for printing money in exchange for real goods from China, and then depreciate the hell out of their reserve, that's what I would do if I were running this country, and I had a whole country of smart and disciplined people to work with. However, that's not the reality.

The status of the world's reserve currency is something that the American ancestors fought hard to garnish. With that status, we as Americans can enjoy higher standard of living at a lower cost, if you ever lived elsewhere outside the US, you would understand that this is about the only place on earth that quality of life comes at such a cheap price, until the housing bubble forms. The whole US economy is largely based on one important assumption: cheap energy. We are able to enjoy cheap energy partially because of our reserve currency status. If we lose that, how much do you think a carton of milk will cost? How much will your amazon shipping cost be? How can people continue to live in the boonies on acres of land, especially in the northeastern corner?

The job migration to China is not worriesome in the sense that it displaces our lower-strata citizens. It is disturbing that in the longer run, once they have a monopoly of supply chain on certain goods, that's when their pricing power begins to take hold, and their knowhow leaps ahead of ours. For example, do you know that starting from 2005, almost 100% of the notebooks in the world are assembled in an industrial area just outside of Shanghai called Kunshan? Notebook assembly used to be spread across Malaysia, Taiwan and Singapore, now, regardless of who you order from, all notebooks are shipped straight out of Shanghai. Grant it, they are still quite low on the food chain, but the extreme concentration of manufacturing in one base is alarming. And, it takes time to break up that clutter of supply chain vendors, even if we want to migrate certain functions to another country in search of even lower cost. They are determined to climb up the food chain, and if we continue to act stupid, they will.

Therefore, it is much better for us to crash now, while having them share the cushion of blow, than crashing later, when they have climbed high enough to help engineer our fall.

126   Peter P   2006 Oct 25, 10:49am  

For a fleeting moment, I sometimes wish for an out-and-out depression….

Sometimes I wish for the Judgement Day.

127   astrid   2006 Oct 25, 11:40am  

Person,

Huh? Option on option? Sounds like a bad deal - double the chance of getting someone screwing you out of your winnings and complicates legal recourses. I'm also pretty sure that it would qualify as gambling and securities and be subject to both state law AND the SEC. (Though I'm too lazy to actually backup this opinion with sources).

SP,

DinOR usually has a fit when I bring it up, but I really don't think there should be separate tax treatments for investment income or retirement plans (given that this pretty much drives DinOR out of business - no wonder)

I will now do some preemptive poxing on my own chosen profession, once I completely figure out what that might be.

DinOR,

I don't need a time machine to 1999. A time machine to last year is just fine. I'm not greedy -- two or three multistate powerball jackpots will sustain me just fine.

Lunarpark,

What worries me are the $120K-200K/yr families who bought their primary residence before 2002 and just acquired 3 or 4 "investment properties." Half of my parents' friends and associates seem to fall into this category.

I'm still having trouble processing the YouTube acquisition. My head flash back to 2001 when seniors got great job offers (then lost their jobs within months of starting).

128   DinOR   2006 Oct 25, 11:52am  

Stop the Presses!

My rent (In Accordance with the Oregon Residential Landlord Act ORS 90.240 (4) (a)), has been raised from $850 to $865 a month! Outrageous! I'm challenging this! Outrageous!

That's pricing power baby!

(pathetic)

129   Peter P   2006 Oct 25, 11:53am  

RE: bubble-proof markets

Too bad this bubble-proof-ness is already baked into the price. As a result, nothing is bubble-proof.

130   DinOR   2006 Oct 25, 12:06pm  

astrid,

It really wouldn't put me out of business (I also manage corporate, charitable and institutional accounts) as well. All I've ever asked for was a level playing field! With the 250/500K exemption on primary residence IT'S FORCING rank and file Americans to play the "buy all the house you can afford and then some" game! Isn't that what mortgage "planners/coaches" broadcast to their "clients"?

If we're going to say no pre-tax contributions to 401K/IRA's that's fine. While we're at it let's not only do away w/the 250/500K exemption let's not re-institute the "one time" exemption either! Just look at how lopsided things have become.

131   skibum   2006 Oct 25, 12:15pm  

ConfusedRenter,

I've been waiting to see how long it would take for you to cling on to the glimmer of RE bullish-ness from that cnn article. Thanks for obliging. Are you planning to use that in your next Realtor newsletter to send out to your clients?

As a counterweight, cnn/money has also published places NOT to buy, as they are "bad investment" areas because of "too much appreciation" recently:

http://money.cnn.com/popups/2006/biz2/newrules_wherenot/index.html

Looks like the vast majority are CA (central valley in particular). Yes, I know, this is just cnn/money talking out of their asses. But, what the hey.

132   skibum   2006 Oct 25, 12:16pm  

BTW astrid,

I've been having trouble getting to your greencrabs blog. Have you noticed any trouble today?

133   astrid   2006 Oct 25, 12:24pm  

skibum,

Unfortunately, all the blogspot blogs seem to be down right now. They did an upgrade this afternoon and the upgrade may be having trouble taking.

Sorry about that. It must be my bad karma against the preferential capital gains tax system.

134   astrid   2006 Oct 25, 12:27pm  

Confused Renter,

If you didn't bother to read the contents of the threads you posted on (which would answer your question very clearly), then what you really need is a reading tutor.

135   SP   2006 Oct 25, 12:49pm  

ConfusedRenter Says:
What are your thoughts if the Fed cuts rates back down to 4% from 5.25%?

ConfusedRealtor,
Why don't you just ask your proctologist to pull an answer out for you?
SP

136   SP   2006 Oct 25, 1:03pm  

RandyH - I just saw this artickle in the The Marin Independent Journal. “Home foreclosures in Marin County were up nearly 60 percent in the third quarter compared with the same period last year, Dataquick reported." SHOCKING! I was sure these homes would sell within a week for AT LEAST 100,000 over asking. Boy, was I wrong! What's worse, the artickle also said: "Marin’s foreclosure picture was still rosier than most of the other eight counties in the Bay Area, where overall foreclosures surged 89.2 percent in the third quarter."

Oh well, one mustn't wish harm or agony - so I guess I should just Enjoy the Whether. It was over 70 degrees in SF today.

ConfusedRealtwhore

137   monkeyinchief   2006 Oct 25, 1:12pm  

ConfusedRenter,

Any serious investor will tell you that the expected return on a illiquid investment should be at least be 3% points about a liquid investment to compensate for the risk. Even with if real estate matches stocks over the long haul (which is not possible due to residential real estate having no economic productive capacity after it is built), it's still not a good investment.

The Fed doesn't control mortgage rates, only the federal funds rate. Even without the default risk that has not be properly priced into MBS, 6% is too little return on a 30 year callable fixed investment. Mortgage rates are headed up in the long run regardless of the fed's action. The S&P 500 is up over 10% for the year. The strong stock market performance will shift investment from fixed income to equities.

138   skibum   2006 Oct 25, 1:34pm  

@SP,

Keep the ConfusedRenter spoofs comin'. I enjoy the occasional chuckle.

Funny you think i’m a realtor. Can you remind me again what your background/occupation/story is?

CR, Why don't you search some of the previous threads and find out. I'm sure it's there. I'd point you to the right thread, but then again, "this blog is so enthusiastic, that by the time i turn around, i can’t find what i posted anymore."

139   DinOR   2006 Oct 25, 1:46pm  

SQT,

Actually the ML article said that Merrill has backed down from their original position of rate reductions starting as early as Jan. 07 to Mar. 07! Had Cornfused Realtor read further he might have noted that Credit Suisse is of the opinion that we'll be at 5.25 for quite some time. Not to knock Merrill but Credit Suisse has an equal right to their forecast.

I'll agree, even if we lowered the overnight lending rate back to 1% it would only add volatility, not salvation.

140   DinOR   2006 Oct 25, 1:48pm  

Allah,

Aren't 1,2,3 usually the same person?

141   DinOR   2006 Oct 25, 1:52pm  

Allah,

LOL! Would it have killed you to just come out and say it? I know, I know we don't want to come off as being prejudicial to FB's!

142   Randy H   2006 Oct 25, 2:03pm  

SP

Thanks for the enjoyable satire on a pretty rough evening. I saw the Marin surge in foreclosures too, and I'm happy to see it (and not ashamed either). Although I don't think we'll see this translate into price action for some months yet to come, but it is a promising *leading indicator*. A banker guy a was talking to over the weekend (who may or may not have known what he was talking about, but he was good enough to fool me) said that it usually takes 4-6 months for foreclosed properties to re-enter the primary housing market. It came up when I was asking about how badly banks do or don't want to assume homes, in the context of my questions about short sales, credit fraud, etc.

His quite insistent take was that banks almost never want homes, unless it's a credibility thing. I told him my complex "game theory" argument about banks needing to signal intent to other banks vis-a-vis borrowers. He laughed at me and said I was being far too generous in my assessment of most banks strategic planning. Oh well, so much for theory, lol. (Actually his first response was something about me smoking crack).

Anyway, he said the banks will usually dicker around for a couple of months trying to avoid foreclosure, putting the homeowner on this and that structured plan. Then they try short sales and some other stuff I didn't quite understand the difference from short sales. Finally, they'll foreclose. From that point forward it's a couple months to actually foreclose. He said no sooner than 60 days in CA, usually 90 in Marin. Then the bank takes another 30-60 days to sell the property to a foreclosure investor -- the guys who buy foreclosures at auctions. Sometimes they don't auction the home, but sell direct to some foreclosure investor they've worked with before, depending on the situation. Expensive homes get auctioned. Finally those guys will resell the home again to the regular homebuying public, after fixing up any damage and marketing it; or they'll transfer it to an agency they work with that buys inventory. A bunch of tax stuff is apparently involved too.

So if this guy's for real, then it'll be up to half a year before any of those foreclosures start to move prices. Ugh.

(Oh, and the rate isn't 80some% foreclosures, but an increase in the *rate* of 80some%. An increase from 2% to 3.6% is an 80% increase in the rate).

143   Randy H   2006 Oct 25, 2:08pm  

Allah

….and it is because of this that RE will not be sticky this time.

You are too much, my friend. You're continually confusing sticky with something else. You studied engineering, if I recall. So you understand continuous functions versus threshold discontinuities. Sticky just means the latter. It is ironically *necessary* for fast price movements (when the value passes through a discontinuity).

If it makes you feel better, we won't say "sticky", we'll just call it Allah Price Movements (APMs).

144   skibum   2006 Oct 25, 2:19pm  

So you understand continuous functions versus threshold discontinuities. Sticky just means the latter. It is ironically *necessary* for fast price movements (when the value passes through a discontinuity).

A more general engineering analogy is that RE prices exhibit hysteresis on the way up vs. down.

145   Randy H   2006 Oct 25, 2:19pm  

Person,

Putting your scheme into an option pricing formula will tell you exactly why your scheme won't work. The "odds" are too far to the extreme. It's not like writing a call on oil at a $90 strike with, say $70 underlying today. It's more like writing that $90 strike with $0.000001 underlying today. Remember, the tickets themselves sell for $1 in the open market, with 0% volatility. Given the odds of a winner (even counting all the minor winners), your options would be essentially worthless.

146   Randy H   2006 Oct 25, 2:22pm  

Allah,

and what I believe everyone else means by it other than you

Excuse my mistake. And here I thought many others agreed with me, not the least of which *the people who coined the term "sticky" in the first place*. I will agree that there is a widely held misunderstanding.

Sticky is independent of intent. Some is buyer psychology. Some seller psychology. Some simple transactional friction and lack of liquidity.

Skibum,

Thanks for untangling my statement :) I did say it's a rough evening. Telecoms. Ugh.

147   SP   2006 Oct 25, 3:27pm  

ConfusedRenter Says:
I’ve found real estate to be sticky on the way down, and less sticky on the way up.

[surfer-x emulator ON]

Come to think of it, troll, your mom is the same way. But can you please get her to eat less corn? Thanks much.

[surfer-x emulator OFF]

SP

148   chuckleby   2006 Oct 25, 3:45pm  

i'm sure this will be all over the place soon enough:

http://sfgate.com/cgi-bin/article.cgi?file=/c/a/2006/10/26/HOMESALES.TMP

not quite a bloodbath...yet.

149   SP   2006 Oct 25, 4:57pm  

from the news today: http://tinyurl.com/ymocbq
"The worst is behind us as far as a market correction — this is likely the trough for sales," said David Lereah, the Realtors' chief economist.

Liarreah, you ignorant slut - the worst is still behind you, so you and your realtwhore buddies better grease up.

SP

150   astrid   2006 Oct 25, 9:48pm  

Person,

Soooooooo you want to be a gas station attendant? They already sell lotto in 1 dollar increments in gas stations. I agree if you limit yourself to that role, you probably won't be hearing from the CA gaming commission or the SEC.

Or it might just be my limited perception...

151   DinOR   2006 Oct 26, 1:11am  

Allah,

Great article. Socketsite is actually pretty cool. The only thing I didn't care for was the inference that the pain will be concentrated on those that are "new" to home ownership! Oh to be sure that crowd is toasty but guess what? Even if you're in your 40's or 50's and have NEVER been a renter but have managed to completely tap out your equity welcome to hard times!

The fact that Barings Bank was established in 1762 didn't stop Nick Leeson from bringing it down.

152   DinOR   2006 Oct 26, 1:18am  

I'm not sure why there haven't been more posts this morning I can only assume that everyone else is struggling to get their mind wrapped around the largest median price drop since 1970?

Trust me, I'M struggling! Kind of like those cheesy Time/Life books "The Year in Review" deals? To help me put this in perspective 1970 was the year I discovered that not all girls were "icky".

153   DinOR   2006 Oct 26, 1:44am  

Allah,

Now damn it, I hadn't thought of that!

One of the most indescribable "sinking feelings" is watching a stock position that you were SO confident about just prior, begin to wane. It's then that you learn that there are others that share your approximate cost basis and haven't been the least bit reluctant to take profits.

Now you're not so sure. As your profitability slides towards that of a bank return each time you re-calculate you've found that you are now painted into a corner. Sell NOW or hold long term.

It's not that you're in a "bad" position but you decide to sell and be less "analytical" next time. Done and done.

154   DinOR   2006 Oct 26, 1:46am  

O.K. In 1968 ALL girls were "icky". What do you want me to say?

155   Different Sean   2006 Oct 26, 1:49am  

re sticky, housing also suffers from a 'ratchet effect', i.e. sticky in one direction only. one reason for the ratchet effect is the high transaction cost of property transfer, which can be added to the nominal book value. e.g. if someone bought a place for $300K and had to pay $10K in stamp duty and $2K in lawyers fees (and possibly buyers agents fees and other closign fees), they tend to want to recover at least $312K when they sell, especially in the case of flippers or other short term holding patterns. doesn't everyone agree on the basic conception of sticky here tho, i would've thought it was an intuitive jargon word implying price viscosity...

156   skibum   2006 Oct 26, 1:51am  

I expect September’s record for the biggest recorded nationwide median YOY fall to last precisely one month.

@ajh,
Oh, but you're forgetting the NAR's best weapon in the numbers-manipulation game: using "revised" numbers, as in, The YoY decline compared to October 2005's REVISED median is... let's see what those liars come up with next.

157   DinOR   2006 Oct 26, 1:59am  

George,

Well they haven't made it down to the studio yet but Tom Stevens and Lawrence Yun are already putting a positive spin calling it the peak for inventory build up! Rally?

I still can't get my mind wrapped around this thing. This is huge, anyway you slice it. Oh, btw Allah, I was born in 1959 but it just makes this whole situation that much more unreal for me. Let's call a spade a spade, this is a free fall!

158   Randy H   2006 Oct 26, 2:01am  

A couple of real, referenced, definitions of the apparently controversial word "sticky", as it applies to economics:

The Economist

From Mankiw et. al.

The best irony of all this that gives me a smile is that, in the *real world*, _all prices are sticky_, in every market, period. That's because there are no theoretically perfect markets. Arguing that prices won't be sticky this time is the same thing as saying the real world is irrelevant, and pure theory tells how it will go down. That at least one person here doesn't appreciate that irony is the best entertainment of all.

159   DinOR   2006 Oct 26, 2:05am  

Randy H,

Judging by today's numbers this market is looking about as sticky as........ somebody help me out here!

160   Randy H   2006 Oct 26, 2:11am  

DinOR

Sticky just means that prices aren't readjusted all the time, in real-time. Seeing big drops in house prices actually proves price stickiness, not disproves it. That's the irony; a basic misunderstanding of the concept. Non-sticky prices would mean there wouldn't be any big, instant drops.

161   skibum   2006 Oct 26, 2:11am  

Judging by today’s numbers this market is looking about as sticky as…….. somebody help me out here!

@DinOR,

Sorry man, the only analogies I can come up with are uncouth and involve KY jelly.

162   DinOR   2006 Oct 26, 2:20am  

Randy H,

O.K, I can go along with that. By that definition the final "closing price" would be determined by the LAST document signed at the title office. So we started the process 2 weeks ago at 750K with a known quantifiable "rate of descent" and would have closed at 739K but the escrow agent got held up in traffic so it's now $738,750.

Thank God for the seller she didn't call in sick that day!

163   skibum   2006 Oct 26, 2:21am  

@allah,
I think what Randy's trying to argue is this. Using a mechanical analogy (KY jelly aside), think of the market as a mechanical piston. If friction (stickiness) is low (lubricated), it slides smoothly back and forth without difficulty. If friction (stickiness) is high, you'll have to force it to move along it's shaft, and it gets stuck at points along the way. But once you get it going, there are relatively small movements that are herky-jerky as the piston slides along its path and gets stuck in various positions.

God, that's a nasty analogy if you think about it! Lubrication, shaft, stickiness, it's all there!

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