Subprime Risk Plan: A Step in the Right Direction

No, it doesn't solve all our problems. No, it doesn't mean those that are over-leveraged (cough SIV cough) aren't still in trouble. But news that major mortgage servicers are nearing an agreement on a mass loan modification is tremendous news for senior ABS and CDO holders.

As Calculated Risk and others have reported, in a perfect world banks would do classic loan mods. They'd look at every loan and use a combination of modeling, experience and judgement to decide which loans might benefit from a mod and which are incurable. But in the world we find ourselves in, there just aren't enough people and resources to look through all the problem loans one by one.

I know many in the blogosphere are viewing this with great skepticism. I for one am done with pretending that a good solution is out there. Look, there are enough loans that just shouldn't have been made over the last 3 years to fill a Mon Calamari Cruiser. But nothing we do now is going to change that. No amount of righteous indignation. No amount of finger pointing. No amount of crying moral hazard. And I'm not even saying that the finger pointing is useless, because we need to fix the system that allowed all these loans to be made. The view at this blog was that CDOs deserve a lot of the blame, and by extension, the divorce between loan originator and loan risk holder. We need to fix that. But I for one believe that we need practical solutions to the financial crisis in which we find ourselves. And it sounds like the Hope Now Alliance is a step in the right direction. Even if its name does sound a bit Orwellian.

What we have now, in a sense, are borrowers, as a group, playing a massive game of chicken with banks and investors. Borrowers, racing toward their reset, are implicitly threatening banks/investors with default. Banks, racing toward reset, are implicitly threatening borrowers with eviction. But really neither wants to make good on that threat.

So it is in both of their best interests to slow the resets down. Will banks lose money? Yes, because their cost of funds are going up but their loans won't reset as expected. Or put another way, the loans were valued assuming a value for the reset, which now isn't going to happen.

Are the borrowers being bailed out? Yeah, they are. Is there potential for moral hazard here? Yeah, a little. But I really don't think borrowers, who were lying awake at night worried about their rate reset, are going to come out of this thinking what a great decision that ARM was, no matter what happens.

And who really benefits? - senior holders of ABS paper. Look, the subordinate holders are probably toast anyway. Maybe they get a little bit more in coupon payments. Maybe. But subordinated holders of subprime paper aren't likely to see much in principal payments anyway. And anything that reduces losses, even by a relatively small degree, will improve senior note performance markedly. If you look back on our discussion of senior note recovery, you can see that senior notes can typically handle a large amount of losses before getting touched. That means that if we can take a pool which was going to suffer 40% foreclosures and 20% losses, and turn that into 30% foreclosures and 12% losses, that will make a huge difference for senior holders.

Not only that, but the plan will likely extend the timing of losses. This is also hugely important for senior holders. That is because ABS and CDO deals typically amass a collateralization account over time. That's a sort of slush fund where a certain amount of excess interest gets deposited just in case there are any interest short falls. Well, we know there are going to be interest short falls, so the more that account can build up, the better for senior note holders.

Of course, among the biggest beneficiaries of this will be mortgage insurers and monoline bond insurers. Mortgage insurers get to at least delay the need to pay their policy. The monolines are probably looking at diminished losses, at least on the direct RMBS stuff. The CDO^2 stuff is still in serious trouble, and I don't see how they don't take big losses on this regardless. Note that stocks like Ambac (ABK), MBIA (MBI), PMI (PMI) were all up more than 10% Friday. Freddie Mac (FRE) was up almost 20%.'

To reiterate, this plan sure isn't ideal. And we don't have all the details yet, so it might turn out to be less impactful than hoped. But I really think it's a step in the right direction.

Comments

[vboring]

any homeowner in their right mind will walk away from their loan if they are already underwater today and expect further declines before the market recovers.

a leveraged investment in a depreciating asset with high transaction costs is fit to be abandoned at any interest rate.