Subprime Foreclosure Woes: More on Securitization Creating Bad Incentives

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One of our pet peeves is that the powers that be are desperate to recreate status quo ante, as far as the financial crisis is concerned, when that is what created the mess in the first place. And the tinkering being done around the margins is not sufficient to remedy many of the shortcomings.

Take mortgage securitizations. It is now blindingly obvious that they led to lower quality borrower due diligence. Why bother if you are reselling the loan? And in keeping, while just about every other innovation has a historical precedent (the first derivatives and mutual fund was in Ur, 1788 BC, for instance), loans apparently were never traded prior to our brave new world of banking. That suggests it might not be such a hot idea. Aside from the initial screening, another activity that was once intrinsic to banking was monitoring the borrower. That too goes out the window with securitization.

We’ve seen some attention to the first set of problems, the incentives for the originator to simply cut costs, which means as little screening as he can conceivably get away with and still unload the paper. The idea of having the party that sourced retain 5% simply is not enough to make a difference in behavior; making it easier for investors to sue in case of deficient originator due diligence would probably do more promote the desired response. But regardless, the priority is to restart the securitization machine, not fix the problems with the process.

One of the obvious, oft-discussed ones is the near impossibility of mortgage mods. In down real estate markets far less bad tahn this one, lenders would try to keep viable borrowers in the house. Since they at least knew the community, and had decent loan files from the initial screening, they could decide what to do on an individual basis. Aside from not being in a position to make informed decisions about particular borrowers, servicers are not set up to do anything on an individual basis. They are factories, with standard procdures for most activities. And of course, most servicing agreements limit or bar mods.

Now we have a new side effect of securitization: trusts dumping foreclosed houses. This looks to be a tragedy of the commons. While it seems rational for owners of foreclosed houses to liquidate inventory and move on (in theory, price discovery and market clearing are a good thing), the servicers are selling in bulk. If you have a lot of sellers dumping inventory at the same time, that is likely to produce an overshoot of housing price declines below historical levels in terms of relationship to rental prices and incomes.

The Wall Street Journal profiles the development in Atlanta, and Georgia has one of the fastest foreclosure timetables in the country, so this trend will be coming to your market soon.

From the Wall Street Journal:

The U.S. housing market is facing new downward pressure as holders of subprime-mortgage bonds flood the market with foreclosed homes at prices that are much lower than where many banks are willing to sell.

While nationwide figures are scarce, a review of thousands of foreclosures in the Atlanta area shows that trusts managing pools of securitized mortgages sold six times as many properties as banks during the six months ended March 31. And homes dumped by subprime bondholders sold for thousands of dollars less on average than bank-owned properties, the data show.

Yves here. That does not prove conclusively that the servicers are truly getting worse prices. The banks presumably were able to offload the best homes, and what is left will probably sell at deeper discounts. Back to the story:

Experts say this is a bad omen for residential real-estate prices and homeowners trying to sell or refinance, because the fire sales, many to cover soured subprime loans, put downward pressure on the value of nearby homes. All of this undermines federal efforts to stabilize the housing market and revive the broader economy….

In the Atlanta area, hit hard by foreclosures and declining home values in the past two years, mortgage-backed securitization entities completed 6,260 foreclosures in last year’s fourth quarter and the first quarter of 200…

Of those foreclosures, securitization entities sold 2,963 homes during the same period for an average of 62% of the original loan amount. Banks unloaded just 442 of the homes they foreclosed upon, with an average selling price of 69% of the original loan amount.

There still is much more inventory that mortgage-servicing firms are racing to sell for securitization trusts. Such entities tend to sell in bulk so that they can cut losses, finding it more cost-efficient to move homes through foreclosure and subsequent sale than to try to restructure the mortgage with the borrower…

According to Karen Weaver, global head of securitization research at Deutsche Bank AG, the steepest losses are on subprime loans, where lenders generally are recovering just 26% of the original loan amount….

Yves here. Read that last sentence again. Stunning. But that also says you could do ridiculously deep principal reductions and still come out ahead.

In March, the mortgage-processing firm that works on behalf of a Goldman Sachs Group Inc. mortgage trust sold a house in southwest Atlanta for $17,000 — a markdown of 87% from the original loan value. A Goldman spokeswoman declined to comment.

In the fourth and first quarters, Bear-issued trusts sold 29 properties in Fulton County, which includes Atlanta, for a total of $3.5 million. That was 60% of the combined original loan amounts of $5.8 million.

The loans were pooled in the vehicle during a period of Bear securitizations that were sold to investors prior to the firm’s sale to J.P. Morgan Chase & Co. a little more than a year ago.

A J.P. Morgan spokesman said the depressed prices are representative of a housing market correcting itself in a period that is vastly different from a few years ago. Many of the regions facing the largest declines in value are the same ones that soared and saw a frenzy of construction during the housing boom.

In comparison, Countrywide Financial Corp., now owned by Bank of America Corp., completed the sale of 23 properties in Fulton for $3.7 million, or 86% of the original loan amount during the same time period, the real-estate records analyzed by Data Intelligence show.

A Bank of America spokesman said prices being fetched in the Atlanta area for the Countrywide portfolio reflect a reluctance to dump properties far below prevailing market values. The bank is getting an average of 99% of the appraised value of homes on an average sale, while selling within one year 99% of the properties that end up on its books.

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  1. MutantCapitalism

    "Where's the logic?" some might ask in dumping REOs at give-away prices? Why the rush to 'get out of Dodge' post foreclosure? These mortgages have been milked dry, not only by mortgage servicing fraud utilized to manufacture defaults so insiders could rig their CDS bets for lucrative payouts. Nobody want to hang around and have to deal with condo fees, property taxes, maintenance and vandalism. Anything not covered by mortgage insurance makes for a sweet writedown.
    Mortgage servicing, defaults and foreclosures are more profitable than i-banks would have us know.
    While many PSAs do not allow for mortgage modification, the notion mods are the pathway to salvation is a joke, despite the fact that mortgage servicers have now been given some 18 Billion in TARP funds to that end. Yes, the incentives here are all wrong.
    " Foreclosure is frequently more profitable to servicers than loan modification. Therefore servicers are incentivized to foreclose rather than modify loans, even if modification is in the best interest of the MBS holders and the
    homeowners. "

    short 5 page piece worth reading.

  2. "DoctoRx"

    Belief in the status quo ante is the key and brilliant core point.

    Thomas Kuhn in "The Structure of Scientific Revolutions" pointed out that the practitioners of the old paradigm had to literally die off for the newer, better one to be accepted.

    Thus zombie banks in the US despite all the lectures to the Japanese about them over 10 yrs ago.

  3. ComparedToWhat?

    I've seen mention, on Calculated Risk and elsewhere, of homeowners going through the foreclosure process but at the last minute the mortgage-holder doesn't complete the process. So the homeowner is out of the home but still legally responsible for it. No payments are being made on the loan and the house sits in limbo. From what you quote of this article, at least what's being done should enable the market to clear. With unnecessary brutality and at great social cost, of course, but that's why USA has such a tremendous comparative advantage in creating innovative financial products and hence can spend as much on "defense" as the rest of the world put together.

    I wonder if selling in bulk means selling to those who have deep pockets and connections. Too damn easy to imagine gaggles of connected former Masters of the Universe taking possession of these homes from their juniors, in an opaque manner and at fire sale prices. I don't have a WSJ sub so can't know if method of sale is addressed in the article.

    BTW Yves, I wonder why you don't include journalists' names when possible rather than just citing WSJ or whatever. If there's a byline, why not mention the writer's name?

  4. russell1200

    For reasons that somewhat allude me, Georgia is in its own little bubble land crash.

    Why Atlanta and not Raleigh or Charlotte, I don't really understand.

  5. Bruce Krasting

    We know this securitization thing did not work. Because there was no risk retention the trash was created and passed.

    But without a securitization market that functions we are in big trouble. There is only $10T of private sector lending available from our banks. If they take the mortgage loans on book then they have no room for C&I, CC, or other loans.

    Without a mortgage market that functions for properties in excess of the FHFA caps high end homes are going to take a very big fall. If and when they do there will be a second wave of the mortgage crisis. This will not be focused on the Agencies and $200k mortgages. The next wave will hit the Jumbos.

    How fall can RE fall? I think it will go to 15 times annual rental. If I am right than hang on to your socks, the worst is yet to come.

  6. VacantHomes

    The 26% recovery on subprime loans doesn't shock me at all. In my neighborhood, the loss severities are running between 70% and 110%, probably averaging around 90%. Granted, this is in Detroit in a neighborhood which saw a fair amount of mortgage fraud. It is also true that the foreclosures are now moving up into the larger mansions/jumbo loans.

  7. moslof

    The "good ol' boy" network in Georgia in 2000/2001 with a huge power center at the Augusta National Golf Club started pumping up prices using their influence with all the "wannabe" members/bankers using what to me resembled a pyramid scheme. The locals didn't know but the real push was coming from the "Big Boy" Augusta National members from Wall Street who wanted to securitizeand sell the loans. I had a close association with a member and know a little about the inner workings of this "machine" that was based on entrenched arrogance/complacency. Another Georgian, Robert Prechter has been predicting a 90% decline and the end of all securitization for the foreseeable future. This I also believe will come true.

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