"Bad loans draw bad blood
Monday, October 09, 2006
By Ruth Simon and Michael Hudson
The Wall Street Journal
As the housing sector cools, the mortgage market faces an awkward question: Who takes the hit when loans go bad?
A generation ago, nobody asked. Banks made loans and suffered the consequences when borrowers didn't pay. Today, a complex Wall Street machine buys and sells mortgages and packages the loans into securities that are diced and sliced and sold again to investors world-wide.
Although the $9.1 trillion mortgage market has been relatively calm as the housing market has slowed, players on Wall Street and beyond are starting to grapple over bad loans, especially in the market for borrowers with scuffed credit -- so-called subprime customers.
Under contracts that govern the exchange of mortgages, lenders often must take back loans that default very early in their lives or that come with underwriting mistakes, such as flawed property appraisals. As the housing boom fizzles, cases of bad underwriting are popping up and more mortgages are defaulting early. That has investment banks and other mortgage buyers invoking these contract provisions and pressing lenders to repurchase mortgages that get sold to third parties, creating big losses for some lenders. "
(snip)"Of the $3.1 trillion in mortgages originated last year, 68 percent were packaged into securities, Bear Stearns said. In the past, most mortgages rolled into securities were standard loans packaged by government-chartered loan clearinghouses Fannie Mae and Freddie Mac. Investment banks increasingly have gotten in on the action, and they have helped fuel the growth of atypical mortgages, including risky ones that don't require down payments or income documentation.
"You had a well-oiled machine," said Thomas Lawler, a former Fannie Mae economist and now a consultant. As loan volume declined in 2005, lenders got "a little more creative" and loan quality declined.
Credit Suisse estimates early defaults more than doubled on subprime loans that didn't require income documentation between the first quarter of 2004 and the first quarter of 2006.
The current round of loan buybacks began in late 2005 and picked up steam in 2006. It probably will continue for several more quarters if mortgage delinquencies keep rising. "When you see foreclosures rise, you often see buybacks rise," said Doug Duncan, the Mortgage Bankers Association's chief economist. He expects a modest increase in delinquencies in the next year or two.
Mortgage delinquencies have been at historically low levels, and the perceived riskiness of mortgage-backed securities -- as measured by their yields compared with all-but-risk-free Treasury bonds -- has been relatively stable. Overall delinquency rates on mortgages edged up in the second quarter from a year earlier, with the biggest increases in adjustable-rate loans, according to the Mortgage Bankers Association.
Investment banks and others are showing an unwillingness to wait for loans to default before taking action. Some are turning to companies such as Clayton Holdings Inc., which uses computer-driven risk models to find troubling patterns, such as brokers that sold lots of bad loans. Mortgage investors and lenders are "sharpening their pencils and using a thicker magnifying glass," said Keith Johnson, Clayton's president.
Early defaults helped account for Option One's spike in loan repurchases. H&R Block chief executive Mark Ernst told stock analysts in an Aug. 31 conference call that investment banks have been especially aggressive at pushing back early default loans, rather than holding on to them with hopes that borrowers would start paying, as the banks might have done in the past.
"We experienced a significant and unanticipated increase in loan-repurchase requests from investors as first payment defaults accelerated," Mr. Ernst said in the call.
Impac Mortgage Holdings Inc., a Newport Beach, Calif., real-estate investment trust that earned $270 million last year, saw repurchases triple between the first and second quarters of this year, rising to about $100 million. Impac said its repurchases peaked in the second quarter.
When loans go bad, both the original lender and the current owner have an incentive to resolve the issue quietly: Lenders need to be able to sell their loans, and investment banks need loans to bundle together and sell as securities. In some cases, however, disputes are winding up in court.
In a lawsuit in U.S. District Court in Dallas, Bear Stearns's EMC Mortgage Corp. unit is suing MortgageIT Holdings Inc., New York, in an attempt to force it to buy back at least 587 loans totaling $70 million. The lawsuit alleges MortgageIT failed to repurchase defaulted loans, as required by sales contracts. MortgageIT, which is being acquired by Deutsche Bank AG, denies the allegations in court papers and vowed in a securities filing that it will "vigorously defend" itself. Representatives for Bear Stearns and MortgageIT declined to comment.
EMC was among 11 lenders that unsuccessfully sought more than $20 million in loan repurchases from a Belleville, N.J., lender, D&M Financial Corp., which is in bankruptcy-court proceedings. A lawsuit filed by EMC in federal court in Brooklyn accused D&M of a wide-ranging scheme involving "vastly inflated" appraisals and altered or forged down-payment checks.
Saul Berkman, an attorney for D&M, said its executives denied the fraud allegations. He added the company has little or no assets left to fund repurchases."(snip)
To put this in perspective (from an investor website)
"Three years ago, Freddie Mac blew up in an accounting scandal. The CEO and CFO resigned. To this day, Freddie has NOT produced a financial statement.
Two years ago, the same thing happened at Fannie Mae. To this day, Fannie has NOT produced a financial statement.
Fannie hasn't been de-listed from the NYSE, Freddie and Fannie both still issue bonds that the sheeple (many on this board included) hold in their mutual funds and money market funds--knowingly or not.
And the final insult can be found on the Website:
Whereby this Washington DC thinktank reports on the state of reform for Fannie and Freddie.
The current status?
NO reform will be passed this year!!!
Oh, and let us not forget that Fannie/Freddie hold or guarantee approximately $3.5 TRILLION in mortgages/MBS."
I suppose this means that the answer to the original question 'who takes the hit when mortgages go bad' is ... ultimately ... the US Taxpayer !
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