A Question for the Finance Types

I’m wondering if any blog readers can explain something to me.

Back in the old days, banks didn’t package and resell the mortgages they wrote. So when a homeowner got into trouble, they could go down and talk with the bank about working out some solution other than foreclosure. For instance, the bank could allow the borrower to pay back the loan over 30 years instead of 15 years, reducing the monthly payment.

Because foreclosure is so costly (I’ve heard estimates that a typical foreclosure costs the lender $60,000 to carry out), avoiding it can prove beneficial to all parties.

Now, most of the mortgages that are written are packaged and resold. Then, apparently, they are stripped apart into pieces so that different parts of a particular mortgage might then be held by multiple entities. If this is true, then it makes renegotiating bad loans extremely difficult, since all of the different debt holders have to be on board in order to make a deal happen.

I have four questions:

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don’t understand why it is so hard to value these mortgage-backed securities.

4) If indeed mortgages are stripped into pieces, weren’t people worried about the complications that would result when these mortgages were divided into pieces? Usually, economists think that smart people won’t write contracts that are incredibly inefficient.


Jim

So you have a choice. Here take $25 billion (and there's more where that came from) or use your own money to re-constitute the mortgages you originated.

You have 2 seconds to decide....

sean samis

I really appreciate comments like this because I am not an economist. If you guys are having trouble understanding what the heck is happening, then I am to some extent re-assured that my ignorance is not just a case of being too dense. It is THAT complicated.

caveat bettor

This is one of the best explainers I've come across:

http://www.youtube.com/watch?v=eb_R1-PqRrw

Steve

I've always believed that the real estate speculation industry and the foreclosure industry work hand in hand. At the beginning of every cycle, there needs to be a lot of cheap product available. A distressed market with lots of foreclosures is best for that. Then you ride the market up and dump it on the financially guileless just before the crash. A crash and foreclosure completes the cycle.

Who with any brains wants to hold these mortgages? Certainly not the local banker!

Scott Peppet

These are great questions, and I wish I could really answer them. My sense is that yes, the mortgages are stripped into pieces, yes this creates problems both for foreclosure and renegotiation, and yes these factors create inefficiencies in the contracts, but these were discounted as unimportant compared to the huge efficiencies that securitization offered generally. But, I'll leave really answering for someone in the industry.

Instead, I'm going to add two more questions.

First, how much of an identity infrastructure was in place in the securitization process? By this I mean, how much information about a given mortgage holder's identity (name, educational background, age, income, employer, etc.) was packaged and sent along through the securitization process, such that now one can reverse engineer a bundle of mortgages (or mortgage pieces) and sort "good renegotiation prospects" from not so good?

(My guess is "not very much." The finance people I know insist that it's "impossible" to do this reverse engineering. But I haven't really heard, from someone who really is in the thick of this, whether this identity information is really nonexistent, or just fragmented or incomplete.)

Second, can someone explain in full the foreclosure process that's going on with these securitized mortgages? For example, I've heard, again from finance folks, that huge percentages of the homeowners that have already been foreclosed upon (80%-90%) have received NO communication from anyone other than a letter to vacate and a place to send the keys. Is that accurate? My understanding is that third party companies are handling most of the foreclosures through computerized processes--form letters. True? And also that there is mounting evidence that these impersonal processes are contributing to large percentages of vacating homeowners damaging the homes as they leave. True? False?

Any first-hand info on any of this would be great.

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Kevin H

I'm curious what people who know more than me will answer for the first 3 questions, especially #2, but I can answer #4 right now. People will buy things they don't understand all the time. For the buyers of MBSs, they simply wanted something which looked like a secure hedge investment so that they could get on doing what they really wanted to do (and what they understood), making risky investments.

Think of it as paying for maid service. No one wants to do the boring task of cleaning a house, so you pay someone else to do it. At the same time, you don't check each of the chemicals your maid uses to clean to make sure they are safe, you delgate that responsibility.

Likewise, people who bought MBSs thought it was fine to delegate the details of foreclosure and the boring details, they just wanted a means to an unrelated end.

Mike M

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

Yes, definitely - these are called tranches which is French for slice. The more risky slices would be rated lower, but would pay a higher yield. The less risky were virtually "guaranteed," based on the assumptions that a) housing prices would rise indefinitely and b) foreclosure rates would remain very low. The more risky slices were targeted towards hedge funds, and the less risky were targeted towards pensions, insurance companies, etc. Of course, they all ended up being more risky than imagined because of the failed assumptions they relied upon. Risk was underrated and, consequently, the securities were overrated.

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

Not sure about this one. My hunch is that wherever the institution bought the original asset that was sliced up from is still the holder of the mortgage itself - everything else is just kind of synthetic.

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don't understand why it is so hard to value these mortgage-backed securities.

I don't know if they all were, but many were; it maximized (theoretically) potential return for the firms who structured and sold the products - if it didn't it wouldn't have been done in the first place.

4) If indeed mortgages are stripped into pieces, weren't people worried about the complications that would result when these mortgages were divided into pieces? Usually, economists think that smart people won't write contracts that are incredibly inefficient.

I think the problem is pretty complicated. First, the quant and structured finance guys are assumed to be these intellectual guys, probably the "smartest guys in the room," people with engineering/finance/physics backgrounds, some with PhD's and programming skills to boot. This lead to very few questions being asked about the products themselves. Also, when you start slicing up things, to put it simply, everything becomes more complicated - in this regard, especially relating to valuation based on historical performance. There really was no precedent set for how exactly these tranches should be a) valued, b) rated, or c) accounted for in terms of risk. The outcome has shown that neither a, b, or c were done correctly. The underlying cause though, in my opinion, is that risk was incorrectly calculated based on the failed premises outlined above and the lack of historical precedence.

So, after the products were structured, they were pitched to management, then filtered down to the guys doing sales, and then either to institutional or retail buyers. Generally they were sold as assets offering very little risk above government bonds, but delivering a substantially higher (than reason would dictate, that should have been a clue) yield.

That's my schpeel.

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Mark Hubbard

Watching what has been unraveling in the US mortgage market from New Zealand (and I point that out, because we have not had this securitisation activity here), I have been wondering the very same thing.

I'm hearing on CNBC that many mortgages are going on the block, well, who are the homeowners negotiating with?

erik george

Question 1: yes, for example, a $300K, 30 year mortgage could be broken up into 30 $1000 bonds, each theoretically going into different tranches with different associated risks.

Question 2: I presume, the administrator, often the originator, of the loan initiates the foreclosure.

Question 3: I have heard of instances of this in Louisville, KY where someone:
1) negotiates with the bank for a discounted payoff of the original mortgage
2) lines up a new mortgage for the homeowner in an amount greater than the buyout
3) collects the different between new mortgage and payoff amount of old mortgage

Question 4: The debt holders don't have to be on board. Early payment (including refinancing), default, etc are risks that the debt holders assume when buying a slice of the CMO, and these characteristics, of course, affect the interest rate on the tranche.

bode

I recommend you start reading CalculatedRisk. Here's a good place to start:

http://calculatedrisk.blogspot.com/2007/07/compleat-ubernerd.html

They've covered this topic in insane detail, far better than anyone else I've seen. I think the short answer is that in most cases the servicer managing the MBS can engage in this if it something they would do if they owned the mortgage themselves. Most of the rules are to prevent shenanigans and preserve the tax-exempt construct many of these products have.

If you do some googling around CalculatedRisk you will find out all the answers to the questions above, I have no doubt. Starting with MBS I, II and III and then searching for modification on the site would be a good plan.

AaronS

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

The mortgage itself is owned by the investors. However, they servicing of the loan(s) can be bought and sold among mortgage servicers. That is, while you may have bought the mortgage, you agree to pay me to send out the mortgage statements, keep track of payments, perform collections, etc. So the mortgage, as I understand it, is still in ONE PLACE and owned by the investors in the security.

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

The servicers deals with the foreclosure since that is simply the end result of collections (a servicing component--by the way, some mortgage servicers outsource collections--go figure!). The investors have most likely insured against such things, and they bear the responsibility.

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don't understand why it is so hard to value these mortgage-backed securities.

Absolutely. It's one of the big "get-rich schemes" you can see on late night television (buying for no money down, say). There are ways to determine which homes are in or near foreclosure. You could then call the person and say, "I see that you are about to in foreclosure and owe $120,000 (on your $350,000 home). I can save your home. Sell it to me for $120,000, I'll pay off your creditor and allow you to continue living there for X dollars a month." Or some other scheme. The bank cannot keep more than what is owed on the mortgage--but then again, they don't try to get anything more than that either. So it's a way to get something for cheap.

4) If indeed mortgages are stripped into pieces, weren't people worried about the complications that would result when these mortgages were divided into pieces? Usually, economists think that smart people won't write contracts that are incredibly inefficient.

Actually, it is highly efficient to group mortgages and place them on the secondary market. It frees up money for lenders, provides an investment vehicles for investors/speculators, etc. Further, while a certain percentage of loans are expected to go into foreclosure (and is figured into the secondary pricing--since, obviously, "A" loans are superior to "C" loans--subprime), in tough times such as today, where calculations don't hold up as expected, you can be pretty sure that investors will grant servicers the right to modify loans (within certain parameters) as a means of cutting/controling loses.

Hope this helps.

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yep

1 - Yes - it is true. Also they are stripped out into differrent tranches (categories of bonds) so that the first foreclosures that happen will wipe out the BBB bonds and only after they are copletely wiped out will the AAA bonds be affected.
2 - Another company (other than the bond-holder) will hold the Servicing Rights. For instance, when Countrywide did a large placement, they would retain the servicing rights. This earns them a small fee for collecting the mortage payment every month.
3 - Well that's a big problem, isn't it. If the servicing company is not the person who is getting the whole payment at the end of each month, do they really care if the person defaults? Do they have the right to renegotiate?
4 - When really smart people have an opportunity to make really large sums of money, you can rest assured that they will work diligently to make a boatload of money. They got their check.

Part of many of the plans being circulated about give servicing companies more leverage in negotiating with borrowers. Your questions highlight a lot of the difficulty and paralysis in the mortgage market right now.

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Tom M

Hi Steve, I will take a stab at a these:

1) Not necessarily. The most simple type of MBS is called a mortgage pass-through. With this type of security the interest and principal payments from a pool of mortgages are passed directly "through" to owners of shares in the pool, all of whom are equals. In a Collateralized Mortgage Obligation though (CMO) however, the cash flows from a pool of mortgages are stripped and sold into different tranches. This is where different owners own different pieces of the portgage pool. Owners of the different CMOs or tranches have different rights to cash flows generated by the pool. For example, the cash flows from a pool of loans could be entirely stripped into two tranches that are Interest Only (IO) and Principal Only (PO). IO owners have the right to all interest payments and PO owners have the right to all principal payments. So, the individual mortgages themselves are not necessarily stripped but it is the cash flows from the overall pool that are stripped and sold off.

2) In a mortgage pass-through, foreclosure is not as tricky becasue the interests of all the security holders are aligned. The administrator for a pool of mortgages with CMOs has a tougher job. Each CMO has a prospectus which is a legal document clearly outlining what cash flows investors are entitled to. So, it may save money to foreclose in a mortgage pass-through pool but in our IO/PO strip case, which investors would be entitled to the cash flows? I am not involved in the administration of these pools but I would suspect the administrators are required to manage the pool according to what is written in the prospectus. I would also imagine that many lawsuits would result from investors on both sides of the fence.

3) Mortgage pass-throughs are easier to value, and since the holders of these securities have interests that are aligned it would be much easier to work out a deal with the borrowers. Administrators of the pools certainly could restructure deals like this if their clients all agreed but I don't know enough about the law there. I actually think a lawyer would be able to better answer this because it is more a legal than a finance question. It's the CMOs that are tougher to value because foreclosures are so hard to model. The underlying assets haven't had enough research done on them and so it is impossible to say how forclosures would affect the different tranches. Take for example a pool of mortgages divided up into 5 CMOs numbered 1-5. #5 which is BBB rated pays the highest interest rate but is the first to take on losses from bad loans. #1 which is AAA rated pays the lowest rate of interest but is the last to take on losses from bad loans. #5 may be totally worthless. The valuation question is then how far into the tranches will foreclosures reach. Is #4 also totally worthless? etc.

4) I don't think people were as worried as they should have been about these complications and that is one of the reasons for the crisis. The problem is that no one's models really forecasted a drop in home prices, not Moody's, S&P, or Fitch. Many people think the people who wrote these contracts just looked the other way. The structured finance people at many of the now defunct investment banks cared only about the fees they earned upon creating these securities. Once they were created the risk was effectively transferred to the owners of the securities and they were in the clear.

Hope that helps!

-Tom M., CFA

I highly reccomend this article for people who want an easier to understand article about the crisis that contains not just numbers but also a human element:
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?print=true

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AlleyGator

1. Mortgages get sold in pools. The pools are a single gross entity, but they take all the money coming in and divide it up into slices (tranches) of "equity shares" and "yield shares". If everybody pays their mortgage, both shares make the same amount of money, but if only a few people pay their mortgage, the yield shares get paid first. So nobody is splitting a mortgage, but by buying a tranche you are exposing yourself to certain potential losses.

2. The losses from Foreclosures are split up amonst the tranches according to how they are structured. The super-senior tranches take losses last. In addition, part of your investor yield goes to pay somebody else to do the servicing of the mortgages. That is, making sure people keep paying, or foreclosing on them if they're not.

3. PennyMac (as it was called) was one fund out there to try and buy up mortgages cheaply to make money off of them. The reason it's hard to value these mortgages is because you don't know how much money is going to be paid back in total at the end of the day.

Ask yourself this: If an "evenly shared" lottery ticket is $1, how much should you pay for a lottery ticket where you only get paid out 100% of the jackpot fully if nobody else wins when you hit the jackpot?

4. The understanding was that losses in the future would be like losses in the past. Default rates would never be higher than a few percent... For a long time, default rates were nearly ZERO, because houses were appreciating so fast that anybody in trouble could pay for their monthly loan with either a HELOC or by refinancing. Worst case, they sold for break-even.

Why would you worry about writing down the value of a home when home prices are increasing by 15% per year? ;)

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Mike Thebado

To answer your questions:

1) An individual mortgage is not actually broken into pieces owned by different entitites. Individual mortgages are sold and placed into "pools" of mortgages. Then the rights to, for example, principal payments and interest payments from the pool may then be sold to different parties.

2) Each individual mortgage has a single "servicer", who collects and processes the mortgage payments, and handles communications with the mortgagee, including foreclosure proceedings. These servicers are acting on behalf ot the "issuer" who owns the mortgage, and has created the "pool" into which the mortgage has been placed. The issuer, such as Fannie Mae, Freddie Mac, or any number of private issuers is the one who initiates forecloser proceedings and/or mortgage re-structuring efforts. The effects of pre-payments (or failed payments" are felt by the owners of the relevant pieces of the "pool", but the issuer acts on their behalf with regards to foreclosures, and the servicer helps to administer them.

3) I don't know if there are individual private firms actively trying to "arbitrage" the opportunities in failing mortgages. However, the difficulty in valuing mortgage-backed securities comes from the fact that no-one can accurately project individual mortgag failures in uncertain conditions, and from the fact that mortgage pools themselves are frequently combined into more exotic synthetic instruments, and combined with various forms of "insurance" which no one knows the value of.

4) The underlying mortgages are not actually stripped into pieces, rather the rights to various cash flows from mortgate pools, and pools of pools, are sold to different investors (see above). Did anyone think through the complexities that result from that arrangement? They actually did. However, they all made assumptions that things would work more smoothly than they have, that the various participants would remain largely solvent, and that markets for all of these exotic securities would not freeze up in the panic we are now witnessing.

Was the creation of these mortgage-related securities a good thing or a bad thing? They had some positive effects, at least initially. However, as usual, the industry got too smart for its own good by half, and personal and institutional greed and wishful thinking blinded everyone to the new house of cards that we had built, as they always do.

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mike

with regard to #4, maybe smart people didn't write the contracts. Perhaps they were greedy.

with regard to the cost to foreclose, only financial institutions seem to have the incredibly high cost -- wonder why. People who are in the business of buying and selling and lending, etc, etc get by with much much lower costs -- and they make money.

TJ

I've got another question I'd like to see answered. Darrell Issa posed this during the panel convened following his and Kucinich's grilling of Kashkari, and it wasn't really answered:

"Imagine a foreclosed house is sitting there. It catches fire and burns to the ground. Insurance Company X writes a check for the full value of the home. Are you telling me that this check will go uncashed because no one knows where the mortgage has gone?"

RM

I'm not a finance type but am an old hand at residential foreclosures (but my primary work now is in bankruptcy, so this info may be dated). My understanding is that the mortgage itself isn't "stripped into pieces," but has multiple, and discrete, owners.

Foreclosure is, typically, initiated by the servicer (and the mortgage insurer, see below), based on pre-determined criteria (length of default being primary).

An unseen but very important player in the residential mortgage default game is the mortgage insurer, whether a gov't entity like HUD or VA or a private insurer. Because the terms of the policy are that the mortgagee will get all or most of the prinicpal back from the insurer on foreclosure, there's no incentive to sell the mortgage at a discount.

Derek Bough

Steven,
First of all, I read your book 'Freakanomics' last month and loved it. I've been following your blog ever since.

Now for your questions:

1) No single mortgage actually gets stripped into multiple pieces. What happens is that good and bad mortgages are bundled together and sold in the form of mortgage-backed securities. The bundle may then become fragmented as different investments buy and sell these assets.

2) There is always a single servicing company that the borrower will interact with and they would be the ones to initiate the foreclosure process or renegotiate the terms of the loan.

3) Someone out there knows the true value of these loans but, with 50% of loans that were renegotiated six months ago back in default already, no one is willing to accept the reality of what these loans are worth. Taxpayers are being asked to step in because the investors smart enough to value these loans will not buy them.

4) Greed always trumps smarts unless you're an economist. Everyone was making money.

Derek

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Giacomo

I am not a finance type myself, but I may recommend Gary B. Gorton, "The Panic of 2007", NBER Working Paper No. 14358.

He begins his overview by noting (p. 12) that "The defining characteristic of a subprime mortgage is that it is designed to essentially force a refinancing after two or three years."

He also makes it clear (p. 71) that "When loans are sold in the secondary market, the mortgage servicing rights that are created are typically not sold." He goes on to quote a Form 10-K from Countrywide:

"When we sell or securitize mortgage loans, we generally retain the rights to service these loans. In servicing mortgage loans, we collect and remit loan payments, respond to customer inquiries, account for principal and interest, hold custodial (impound) funds for payment of property taxes and insurance premiums, counsel delinquent mortgagors and supervise foreclosures and property dispositions. We receive servicing fees and other remuneration in return for performing these functions."

The main gist of his argument, unless I misread it, is that by design subprime mortgages required short-run house prices appreciation to work, and could not be sensibly refinanced without it.

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