Why Lenders Love the Mortgage-Freeze Plan

I just got off the phone with a former colleague of mine, who was wondering who the losers are in the subprime freeze. What will this do to the balance sheets of banks and buy-side institutions who ultimately own the loans being modified? (Or, as Floyd Norris puts it, "Why is it good for a lender to be forced to make concessions to borrowers?")

The more I talked to him, the more I convinced myself (if not him) that this really is a positive-sum game, and that everybody is going to win, and that there will be precious few losers. I've already said that I think there will be very few lawsuits from irate investors who are losing money as a result of reduced cashflows. But thinking about it more, I actually think there will be very few investors losing money in the first place.

The reason is that pretty much the entire financial system uses some semblance of mark-to-market accounting these days: there aren't many institutional investors who buy mortgage-backed securities, put them on their books at par, and just keep them there, at par, until those securities either default or are repaid in full. But if those investors do exist, this plan changes nothing – if they haven't seen the need to revalue their securities until now, there's no reason that they should revalue them just because there was a high-profile announcement in Washington.

Most investors, then, are marking their securities to something: call it mark-to-market, mark-to-model, mark-to-fantasy, whatever you like.

As we all know, marking to this particular market is very hard, because the tranche sizes are tiny and liquidity is nonexistent. That's why banks mark to model. They plug in the parameters of the debt issue in question, put them all into a black box, and out the other end comes a valuation. If you change only one variable, and reduce the interest rate paid on performing loans from say 10% to 7%, then the model will spit out a lower valuation. On the other hand, if along with a lower interest rate you also put in a lower foreclosure rate, then you'll probably end up with a higher valuation, especially if your loss given foreclosure was high enough to begin with. And if the general discount rate you use comes down on the grounds that the mortgage freeze has reduced downside risks to the housing market as a whole, then your model's valuation will go up even further.

That's why the American Securitization Forum has found it so easy to embrace this proposal: all its buy-side members are likely to look at it and decide that net-net they're going to make money, not lose money, from it. To be sure, there will be a tranche or two here or there which, at the margin, is a loser. But those tranches will be more than offset by other tranches which are gainers.

Why am I so sure? Because the one thing which is always true in the world of mortgages is that performing mortgages are worth more than delinquent or foreclosed mortgages. And the subprime freeze is extremely careful to slice up the universe of mortgages so that only those which increase in value upon modification are eligible for that modification.

If you have good credit and are current on your mortgage, you're not eligible for the freeze. If you have bad credit and you are behind on your mortgage, you're not eligible for the freeze. The only way that you can be eligible for the freeze is if you have bad credit and you're current on your mortgage, and it will reset to a higher rate after January 1, and your mortgage servicer determines that you won't be able to make your mortgage payments after they reset.

Looked at this way, it's almost guaranteed that the lender will make money on the modification. Without modification? Foreclosure, and massive losses. With modification? A steady income stream in the healthy 7% to 8% range, which the borrower has already proved capable of paying. What's not to love?

Or, look at it another way. Try naming a single investor who claims this plan will cause him losses, or who has threatened to sue servicers for implementing this plan. I certainly haven't see one. The people complaining about bondholder losses and violation of the sanctity of contracts tend to be people with no real skin in the game at all. Meanwhile, the bondholders themselves, through the ASF, have signed up for this deal quite happily. Which speaks volumes, I think.

Comments

[RW]

So the way I understand it is, the banks will not loose money with this deal, they just will not make the money they expected to or forcast when they made the loans?
End result is that it is still bad for share holders, just not as bad as it could have been.

[clipi]

I am planning on sueing because I financed my house at a fixed rate. Call me crazy for being responsible but I didn't want to face a higher payment down the road . I should get the lower ARM teaser rate for the next 5 years. I would save myself $28,275 in interest! Tell me that's not worth fighting for.

Craig

[john haskell]

24 hours after Bush announced the program, Felix Salmon "certainly hasn't seen" anyone who says they will sue. Well I guess that means no one will sue then!

[vboring]

everyone underwater on their loans should wake up and walk away.

a leveraged depreciating asset is a loss at any interest rate.

except for the rare case where they would have to pay more to rent than to service their loan.

[matt...]

Good for lenders maybe, but the freeze means that essentially these borrowers are stuck with negative amortization loans..These are by the requirements, not people with large amounts of disposable income so how are they supposed to reach positive equity in any reasonable time frame (less than 10 yrs)? That's essentially a credit card then, where their balance keeps growing...

[dcp]

this plan still doesn't address the real issue of a housing market with ridiculously inflated prices prompting an oversupply of inventory

those folks who got into problem ARMs now face a difficult spot, no doubt, but when you get an intro rate you can barely afford to begin with and that you know, by definition, is going to adjust once interest rates rebound from historic, temporary lows... call me cold-hearted, but how can i feel sympathy for someone so foolish? (this excludes those unfortunate few who were truly duped by dishonest lenders/brokers)

regardless of my personal issues, the rate freeze won't help these troubled home owners in the long run anyway, unless they are among the minority that can refinance to a fixed rate, are able to break even on a sale, or receive a hefty raise... these people are eventually going to have to pay up or sell at lower prices because delaying this inevitable market correction is not going to magically produce more consumers willing and able to purchase these properties at their current "values"

people have to face the reality that the market has, over the last 5 years, experienced appreciation far greater than historical averages, while median income has not kept pace, to say the least... the relationship between these two has to return (at these somewhat) to its equilibrium... this type of cycle cannot continue to thrive indefinitely simply because the "median citizen" on the median income cannot afford the median-priced home

the bush/paulson band-aid is simply delaying the inevitable and only serves to prompt doubt in the sanctity of financial contracts and create uncertainty in the markets

nix the government "fix", let the markets work it out

[Living Off Dividends]

the only problem is that no one qualifies for this stupid program.

here are some of the parameters:
1. you must be a subprime borrower
2. you must be facing some hardship that makes is impossible for you to make your mortgage payments
3. you must not be delinquent on your mortgage.

the only reason there are no losers here is because no ones playing the game.

lets face it. Bush and his scoundrels have pulled another fast one.

[http://easyclickhomes.com/blog]

Living off Dividends' comment is completely without base. More people will qualify for this program than you think. easyclickhomes.com/blo.../

This is to curb the market from foreclosures, not to prevent them. This is keep our future brighter, not to make an immediate change in people's poor judgement.