Thanks to Tanta at Calculated Risk, we have a rush transcript from a presentation by Lew Ranieri at the Milken Institute conference on financial innovation. Ranieri is credited with creating the mortgage backed securities business, has continued to be active in the industry, and has sounded warnings on subprimes.
I found three points to be particularly interesting.
First, while the explosion in subprimes has often been discussed in the press as a 2005-2006 phenomenon, I had suspected that the growth might have had something to do with the new bankruptcy law, which was signed at the end of April 2005 and became effective on October 24 of that year. The reason I had thought there might be a link was because the law made it much harder for individuals declaring bankruptcy to shield their homes from creditors. Under the new law, a house purchased less than 5 years before the declaration of bankruptcy was fair game. I had dismissed the idea because I had assumed the profligate lending had started before the law was signed, hence no link (or at least no strong link).
Ranieri says that the aggressive phase of subprime lending started at the end of the third quarter of 2005. Thus the new bankruptcy law may well have played into it.
Second, Ranieri says that roughly 50% of the mortgages extended to borowers could have been issued through traditional channels (FHA, Fannie Mae, Freddie Mac) at much lower cost to consumers. He estimates these borrowers would have gotten 6.5% mortgages versus the effective 9.5% (the average across the first and second mortgages on the same asset). Ranieri is saying that many consumers were exploited by lenders, and may also say that some of the ones who are defaulting due to high interest charges might well have been able to support the mortgage balance had the mortgage been at a market rate for their credit risk, as opposed to an extortionate rate. Thus much of the subprime problem may very well be self inflicted damage by greedy lenders. If this factiod gets the coverage that it deserves, just wait until the powers that be get hold of it. This is an invitation for the imposition of regulations against predatory lending.
We’ve argued that it makes sense to protect borrowers. If products are so complex that buyers can be suckered into paying well above market for a loan when other, considerably cheaper options were available to them, something is drastically wrong.
Third, Ranieri goes into more detail on a problem that has been discussed before, namely, the difficulty of renegotiating these subprime loans. In the old days when Ranieri helped create the industry, a MBS would be issuer specific, so if you had a problem, you could go back to one bank, which had one mortgage agreement, and either renegotiate the terms of those loans, or identify a problem group within the pool and figure out how to deal with them. But now the mortgages from different mortgage companies have been pooled before before packaging them into securities, and these securities have then often been further recombined into collateralized debt obligations. It’s well nigh impossible to even find what security a single mortgage is in, and on top of that, it is too costly, even if you could find where various mortgages reside, to renegotiate them on a case by case basis (you need waivers from all the bondholders in a pool….)
From Ranieri’s remarks:
People asked, you know, is financial innovation, you know, reaching a stabilization point in housing and I think the last four years shows that’s not true. It’s been a halcyon period in terms of taking financial innovation and using it to put housing much more deeply into the population. I mean, we’ve been able to franchise many, many more lower middle income and minority home–individuals into home ownership, over the last four years, than probably, in the 10 or 15 years prior to that.
Unfortunately, we’re now facing a trial, which in many ways, I think, will determine how well we can continue to innovate into the future and part of it is [subprime] . . . And we also have the typical regulatory reaction to a potential series of risks, in terms of passing somewhat more restrictive legislation. And some might argue [this] is exactly the point in the cycle where we don’t, particularly, need it but I think the real key of navigating through this is being able to deal with what is euphemistically called the subprime mess.
The subprime mess is simply – and first, I think the important thing to understand, is this a creature of a very narrow window. It starts at the end of the third quarter of ’05 and carries through, principally, the fourth quarter of ’05 and ’06. And what it is, is that in those five or six quarters, a series of attributes which were largely in existence already, took on a life . . . of their own and in combination, created risk layering, which on one hand, enabled many, many people to get into housing who might not otherwise have.
And on the other hand, unfortunately, put many, many people into houses they couldn’t afford and not simply lower middle income people but combination, the layering, was also attributable to many middle income borrowers. In fact, at – we had a two-day conference in Washington yesterday, which was called the Housing Round Table. It’s all the participants in housing and we get together three times a year and at that there was an argument from a number of the economists in the room.
As I said earlier, we’re in a housing recession but more importantly, they argued that looking at the production, the subprime production, in those five or six quarters that as much as 50 percent of that production could have gone to the agencies, meaning, Fannie, Freddie and FHA. That’s a pretty profound statement because a subprime loan is, at best, [an] eight plus coupon.
And usually, there’s a second mortgage with a 12 coupon, so you’re talking about an average coupon, a little bit over nine and you know, an agency piece of paper would’ve been a 6.5, so if you translate that into what he said, in another way, he was arguing that half these loans, the homeowner could have been put into a coupon at 6.5 versus 9.5 and that led to the question, the 800-pound gorilla in the room we dealt with, is the system broke?
Is there a problem, you know that it’s not simply a function of normal economics but is there a break in the system, you know, what is the responsibility of the system to deliver . . . the appropriate, you know, housing finance structure? The real dilemma for me and I think the real issue . . . will be, we’ve never had to do substantial restructurings in housing in mortgage securities.
They were always in portfolios, and that made it very easy or at least, we didn’t have to get 409 people or we didn’t have to rent the Nassau Coliseum to have a bondholders meeting; we could do it very quickly. The vast majority of these loans, all of these theoretically, problem loans, are in securities, which have been tranched and then tranched and then re-tranched . . . [in] mortgage securities and then some tranch is put in CDOs. In a very long meeting, last Monday, where we tried to collect virtually everybody in a room, it became evident that there are a whole host of unforeseen technical problems if you try to restructure or do large amounts of restructuring within the security, some of which, we had never even heard of or thought about.
One of the accountants – you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can’t do that. If you restructure that many loans, you’re going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you – when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you’ve just tainted 140 and Q election.
Boy that was a big deal and I’ll use that as a simple example of one other I’ll give you, is the ability to put everybody in a room, even if you could find them all and get their assent, is slim – I mean it’s not very practical.
Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don’t know how long it would take us. I mean, you know you’ve just basically told us we now have a problem that we don’t quite exactly know how we’re going to fix – and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we’ve done this many times, we actually really know what to do.
We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we’re talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we’re talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.
We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don’t have that freedom because you’ve got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I’ve been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I’m doing that now, too and we were told, well you’re doing it wrong. You’ve got to send out a 1099.
That’s an incredibly dopey idea. We’re restructuring a loan around a borrower; he can’t afford the loan and now we’re going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?
Tanta provides additional insight:
Someone who is considered “the father of MBS” did not anticipate the difficulties of modifying securitized loans, given the constraints of the true-sale requirement (which means that the sponsor/servicer cannot “control” the collateral, and you’d have to get 400 bond holders in the Coliseum to vote on a loan modification). This is to say that a mortgage financing mechanism intended to mitigate risk is less able to respond quickly enough and efficiently enough to stave off losses than an unsecuritized portfolio or a simple agency pass-through.
Bondholders who may well understand that it is in their best interest to allow modifications of loans will discover what it will cost in legal and accounting fees to do that, costs that are there only because these loans are securitized; a similar restructure of a portfolio would not have those costs. Risk “dispersion” means never being able to get all your risk holders into the same room to hammer out a plan.
Some senior bondholder is going to sue some issuer for SFAS 140 violations (modifications, with or without a 1099) that were intended to cut the losses for the subordinate holders, but which would have the effect of maintaining some credit support for the senior notes, too. Besides the simple extraction of legal fees here, you have a situation in which losses will simply continue to mount while each tranche and the sponsor argue in court about whose interest is or is not being served. Meanwhile, borrowers get further behind.