patrick.net

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