Jimmy Lathrop

Lax Underwriting , Foreclosures, and Credit Crunch Stimulate Misery Industries

Hello Mike, I'm glad to see you are still following my posts.

The situation that I was describing in the above article deals with loans that are owned by Mortgage Backed Securities. That is, Trustee bank as Trustees for the Pass-Through Securities for Series blah blah blah.

If the loan was held by the original underwriter, there is a big incentive for the bank to work out a loan modification. Why? Because they can take a cut of the principal and still count on future payments to fund more loans which they can underwrite. A nonperforming loan can be written off the books, or counted against loss reserves, or whatnot. The important thing to remember is that a portfolio bank has the leverage to modify these loans.

Now lets look at a loan which is held by a Mortgage Backed Security pool. Some of these loans have limited recourse, which means, if a loan defaults they can send it back to the original underwriter who will replace it with performing loan. What if the original underwriter is out of business? What if the loan was from New Century or IndyMac and the bankruptcy trustee or the Federal receiver refuses to take it back? Remember, once the original underwriter goes under, the fiduciary responsibility changes. Now you have the Trustee for these Mortgage Pools caught in a bad place - if they try to modify the loan, the junior or senior tranches may call "foul" and bring a shareholder derivative suit against the Trustee Bank for not protecting their interests. A bank's interest is to stay solvent and protect itself as an ongoing business. A mortgage backed security only exists to generate yield. It doesn't underwrite loans. It can't replace loans if the original underwriter is gone. Will the original AAA insurer honor its commitment? Whats the process to unwind these securities? Who is going to "unwind" them? Is it going to be like a bankruptcy?

The point is, these mortgage backed securities have less leverage to modify loans than a portfolio loan. Five points to anyone who can name the recent commentator on CNBC who called MBS "the heroin of the financial world" . This is your housing market on drugs.