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.