December 7, 2007

The Internet is alive with discussion of the sub-prime bail-out announced by George Bush yesterday:

Representatives of HOPE NOW just briefed me on their plan to help homeowners who will not be able to make the higher payments on their sub-prime loan once the interest rates goes up — but who can at least afford the current, starter rate. HOPE NOW members have agreed on a set of industry-wide standards to provide relief to these borrowers in one of three ways: by refinancing an existing loan into a new private mortgage, by moving them into an FHA Secure loan, or by freezing their current interest rate for five years.

Lenders are already refinancing and modifying mortgages on a case-by-case basis. With this systematic approach, HOPE NOW will be able to help large groups of homeowners all at once.

The first question to occur to both Naked Capitalism and Jim Hamilton of Econbrowser was: how is this legal?

The natural question is then, Why did lenders volunteer to receive a lower interest rate than that to which borrowers had previously committed? And why was the announcement coming from the government rather than the creditors themselves?

Joshua Rosner – last mentioned in this blog in connection with an early – if somewhat self-serving – attack on the Credit Rating Agencies was quoted by Bloomberg:

“The modification of existing contracts, without the full and willing agreement of all parties to these contracts, risks significant erosion of 200 years of contract law,” said Joshua Rosner, managing director at Graham-Fisher & Co., an independent research firm in New York.

This got me interested in the actual contract language, so I went back to the security issue that I have been using as an – unscientifically chosen and possibly completely unrepresentative – example of a tranched RMBS CDO : Bear Stearns Asset Backed Securities Trust 2005-1. In order to find out what the contract between the securities holders and the securities issuers says, I’m going to try my hand at reading the contract. Old-fashioned of me, I know, but I’m an old-fashioned guy. The prospectus says by way of warning:

Modifications of mortgage loans agreed to by the master servicer in order to maximize ultimate proceeds of such mortgage loans may extend the period over which principal is received on your certificates, resulting in a longer weighted average life. If such modifications downwardly adjust interest rates, such modifications may lower the applicable interest rate cap, resulting in a lower yield to maturity on your certificates.

Continuing a text search for the word “modification” (finding out that “modification” was the right word to search on to find this stuff took me an hour last night, so I hope this post is greatly appreciated) we find the good part in the section “COLLECTION AND OTHER SERVICING PROCEDURES”:

EMC, as master servicer, will make reasonable efforts to ensure that all payments required under the terms and provisions of the mortgage loans are collected, and shall follow collection procedures comparable to the collection procedures of prudent mortgage servicers servicing mortgage loans for their own account, to the extent such procedures shall be consistent with the pooling and servicing agreement and any insurance policy required to be maintained pursuant to the pooling and servicing agreement. Consistent with the foregoing, the master servicer may in its discretion (i) waive any late payment charge or penalty interest in connection with the prepayment of a mortgage loan and (ii) extend the due dates for payments due on a mortgage note for a period not greater than 125 days. In addition, if (x) a mortgage loan is in default or default is imminent or (y) the master servicer delivers to the trustee a certification that a modification of such mortgage loan will not result in the imposition of taxes on or disqualify any trust REMIC, the master servicer may (A) amend the related mortgage note to reduce the mortgage rate applicable thereto, provided that such reduced mortgage rate shall in no event be lower than 7.5% and (B) amend any mortgage note to extend the maturity thereof, but not beyond the Distribution Date occurring in March 2035.

So – the legality of proposed loan modifications looks clear enough. The servicer has discretion, provided:

  • New rate is not lower than 7.5%
  • New maturity date is not later than the Distribution Date in 2035
  • “procedures comparable to the collection procedures of prudent mortgage servicers servicing mortgage loans for their own account” have been followed

So there you have it. It is the Prudent Man Rule that applies to loan mods, and all that Bush and New Hope Alliance have done is changed the definition of what may be prudently done.

Prof. Nouriel Roubini, as always, writes a very insightful and entertaining commentary:

Also the actual legal challenges to these loans modifications – that a number of authors have expressed concerns about – are also way overstated: leaving aside technical legal issues litigation will be very limited only because investors in these instruments are better off under this plan than the nightmarish alternative of massive defaults and foreclosure; investors are not stupid and will find out on their own that they are better off in a world where mortgage are orderly and massively restructured.

Naked Capitalism has an entire post devoted to what Prudent Men used to do in the old days and claims that in the rough and tumble of corporate law, there might be enough ammunition to inflict damage on the New Hope Alliance. I don’t buy it – at least, not yet, and not as far as the Bear Stearns Asset Backed Trust prospectus is concerned. If you have all these people saying (i) it’s prudent, and (ii) it’s what they do when servicing mortgages they own themselves, I can’t see a judge saying that they’re not prudent according to contemporary standards.

Would I go to court on this? Not in a million years. I’d get the advice of a real lawyer, and that would be AFTER I’d spent a full week reading the entire prospectus extremely carefully myself. But I haven’t seen this explained anywhere else, so I thought I’d take a stab at it. Anyway, it was once explained to me that the first thing you learn as a law student is that a contract is holy. The first thing you learn as a practicing lawyer is that a contract is a reasonably convenient place to start. So let’s not hear any more about contracts, OK?

Accrued Interest asks a much more interesting question: what’s in it for me?:

So my view is that the deal benefits senior tranche holders, and REALLY benefits monoline insurers, who mostly care about the senior holders. If the odds of senior holders remaining whole for a longer period of time goes up, that’s certainly good for AMBAC, MBIA, etc.

Moody’s commented:

Moody’s has cited insufficient use of loan modifications, along with underlying loan defaults and home price depreciation, as a contributing factor to recent subprime RMBS downgrade actions. (See the October 11, 2007 Special Report “Rating Actions Related to 2006 Subprime First-Lien RMBS”.) We believe that judicious use of loan modifications can be beneficial to securitization trusts as a whole.

Based on our recent servicer survey results, the number of modifications to date has been relatively small. The proposed framework seems to provide a reasonable approach for identifying borrowers suitable for streamlined modifications and should expedite the number of modifications going forward. Time will tell how successful servicers are in identifying and modifying the loans most appropriate for modification. The ability of servicers to determine a borrower’s eligibility for FHA Secure or other refinancing options may vary, since a servicer’s expertise generally lies in servicing and not in underwriting. Larger servicers with both servicing and origination arms may be better equipped to manage this process.

Generally speaking, a higher level of interest rate modifications should decrease delinquencies post reset, thereby also potentially contributing to ratings stability for securities backed by subprime collateral.

Fitch has also weighed in:

Fitch Ratings believes that on balance, by mitigating the impact of ARM resets on borrower default rates, the framework can help to reduce the risk of principal loss on senior subprime RMBS. Increased refinancing opportunities via FHA and other programs are also important to stabilizing default rates. The implications for subordinated RMBS classes are unclear, as they may be exposed to a complex interaction of variables that can be difficult to analyze. Implementation of the proposed data reporting will aid analysis of the impact of streamlined modifications, and analysis of loan modifications generally.

If substantial number of borrowers prove to be eligible for streamlined modification and accept the five-year fixed rate, this should lead to lower default and loss rates than might be expected, if borrowers incurred a large payment increase at ARM reset. A major concern regarding the large-scale conversion to five-year fixed-rates is that excess interest within RMBS will decrease. Excess interest is an important source of credit enhancement which compensates for loss of cash flow due to mortgage losses. Uncertainty around the benefit of loan modifications is centered on the relative reduction in loss, versus reduction in excess interest that could be incurred. On balance, Fitch believes that stabilization of loss rates can outweigh excess interest reduction when analyzing the impact on senior RMBS. Greater refinancing opportunity can also help senior bond performance, as it will cause those bonds to prepay and reduce the risk of principal loss.

For subordinated RMBS, excess interest is a much greater component of credit enhancement, and in some instances only substantially lower loss rates would offset a reduction in excess interest. Fitch also notes that extensive use of rate ‘freezing’ will lead to lower collateral weighted average coupon (WAC), which in turn could lead to more extensive Available Funds Cap (AFC) interest shortfalls. AFC shortfall risk is not addressed by Fitch’s credit ratings.

and, as far as everything else goes:

“At best, it may stop some of the hemorrhaging of the housing market, but it doesn’t necessarily turn things around,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “The fundamental problem with housing is oversupply.”

Existing home prices may fall as much as 15 percent by 2009 from their peak last year, even if interest rates are frozen on one fifth of 2006 subprime loans resetting next year, said Mark Zandi, chief economist at Moody’s Economy.com, a unit of New York-based Moody’s Corp. About 2.8 million mortgage loan defaults will occur in 2008 and 2009, Zandi said in Dec. 5 testimony before the U.S. Senate Judiciary Committee.

Meanwhile, US ABCP yields are spiking:

Yields on commercial paper backed by assets such as credit cards and mortgages rose at the fastest pace in at least a decade as investors retreated from buying debt that may contain subprime mortgage assets.

Yields on 30-day asset-backed commercial paper rose 91 basis points to 6.06 percent this week, or 82 basis points more than the one-month London interbank offered rate, the largest gap on record, according to data compiled by Bloomberg.

What makes this even more interesting is that outstandings fell another $23.1-billion this week and are now down to $801.2-billion from the July month-end level of $1,186.6-billion. However … the Super-Conduit/MLEC is up and running!

The banks also began marketing the fund to smaller institutions, aiming to raise $75 million to $100 million, including their own undisclosed contributions, said the people, who asked not to be named because details of the SuperSiv haven’t been made public. The banks, the three largest in the U.S., are set to meet with potential contributors on Dec. 10.

Well … up and stumbling, anyway. The three big sponsors are making undisclosed contributions? Perhaps this is just my lack of marketting skills showing up again, but it seems to me that if the sponsors really wanted it to fly, they’d have a big news conference announcing that they’d put $1-billion each into the things capital notes.

But capital notes aren’t looking too good nowadays:

Standard & Poor’s said it lowered credit ratings on capital notes of 13 structured investment vehicles and placed debt of 18 SIVs on negative outlook as the funds struggle to finance themselves.

Orion Finance Corp., managed by asset manager Eiger Capital Ltd., became the fourth SIV to enter “enforcement mode,” requiring the appointment of a trustee to protect senior debt holders. Premier Asset Collateralized Entity Ltd., an SIV sponsored by Societe Generale SA is close to breaching capital tests that would trigger enforcement, S&P said in a statement.

Expectations for a massive easing by the Fed are being reduced:

Futures contracts on the Chicago Board of Trade indicated a 24 percent chance that policy makers will lower the 4.5 percent target rate for overnight lending between banks by a half- percentage point at their meeting Dec. 11, compared with a 36 percent likelihood yesterday. The odds of a quarter-point cut were 76 percent.

… while Prof. Gilles Saint-Paul of Toulouse encourages the Fed to play tough:

To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

PerpetualDiscounts were up again today. *yawn* Remember the old days, when they sometimes went down? Life was more interesting then.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.95% 4.94% 101,050 15.58 2 -0.0817% 1,048.5
Fixed-Floater 4.83% 4.91% 94,137 15.64 8 +0.0111% 1,031.8
Floater 5.53% 5.62% 84,686 14.37 2 -1.1660% 859.1
Op. Retract 4.86% 3.64% 80,462 3.80 16 +0.0540% 1,034.5
Split-Share 5.31% 6.16% 96,587 4.08 15 -0.0998% 1,025.9
Interest Bearing 6.24% 6.48% 69,446 3.72 4 +0.9559% 1,067.3
Perpetual-Premium 5.81% 5.31% 82,500 5.85 11 +0.1807% 1,012.6
Perpetual-Discount 5.47% 5.51% 362,682 14.40 55 +0.2875% 928.6
Major Price Changes
Issue Index Change Notes
BAM.PR.B Floater -1.8325%  
BNA.PR.C SplitShare -1.8041% Asset coverage of just under 4.0:1 as of October 31, according to the company. Now with a pre-tax bid-YTW of 7.61% based on a bid of 19.05 and a hardMaturity 2019-1-10 at 25.00. This may be compared to BNA.PR.A (6.11% to 2010-9-30) and BNA.PR.B (6.81% to 2016-3-25).
CM.PR.P PerpetualDiscount -1.3878% Now with a pre-tax bid-YTW of 5.70% based on a bid of 24.16 and a limitMaturity.
HSB.PR.D PerpetualDiscount -1.0989% Now with a pre-tax bid-YTW of 5.66% based on a bid of 22.50 and a limitMaturity.
BMO.PR.H PerpetualDiscount -1.0651% Now with a pre-tax bid-YTW of 5.22% based on a bid of 25.08 and a limitMaturity.
SLF.PR.E PerpetualDiscount +1.0864% Now with a pre-tax bid-YTW of 5.27% based on a bid of 21.40 and a limitMaturity.
BAM.PR.J OpRet +1.1064% Now with a pre-tax bid-YTW of 4.81% based on a bid of 26.50 and a softMaturity 2018-3-30 at 25.00.
SLF.PR.A PerpetualDiscount +1.1312% Now with a pre-tax bid-YTW of 5.32% based on a bid of 22.35 and a limitMaturity.
PWF.PR.I PerpetualPremium +1.1788% Now with a pre-tax bid-YTW of 5.43% based on a bid of 25.75 and a call 2012-5-30 at 25.00.
SLF.PR.B PerpetualDiscount +1.4925% Now with a pre-tax bid-YTW of 5.35% based on a bid of 22.44 and a limitMaturity.
GWO.PR.G PerpetualDiscount +1.5222% Now with a pre-tax bid-YTW of 5.41% based on a bid of 24.01 and a limitMaturity.
POW.PR.D PerpetualDiscount +1.9010% Now with a pre-tax bid-YTW of 5.50% based on a bid of 23.05 and a limitMaturity.
PWF.PR.K PerpetualDiscount +2.0399% Now with a pre-tax bid-YTW of 5.44% based on a bid of 23.01 and a limitMaturity.
ELF.PR.G PerpetualDiscount +2.4246% Now with a pre-tax bid-YTW of 6.36% based on a bid of 19.01 and a limitMaturity.
ELF.PR.F PerpetualDiscount +2.4390% Now with a pre-tax bid-YTW of 6.43% based on a bid of 21.00 and a limitMaturity.
BSD.PR.A InterestBearing +3.1317% Asset coverage of 1.6+:1 as of November 30, 2007, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.82% (mostly as interest) based on a bid of 9.55 and a hardMaturity 2015-3-31 at 10.00.
BAM.PR.M PerpetualDiscount +3.5126% Now with a pre-tax bid-YTW of 6.43% based on a bid of 18.86 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
CM.PR.J PerpetualDiscount 115,265 Now with a pre-tax bid-YTW of 5.46% based on a bid of 20.90 and a limitMaturity.
BNS.PR.L PerpetualDiscount 58,540 Now with a pre-tax bid-YTW of 5.30% based on a bid of 21.51 and a limitMaturity.
CM.PR.I PerpetualDiscount 54,600 Now with a pre-tax bid-YTW of 5.48% based on a bid of 21.66 and a limitMaturity.
BNS.PR.M PerpetualDiscount 52,050 Now with a pre-tax bid-YTW of 5.32% based on a bid of 21.43 and a limitMaturity.
CM.PR.H PerpetualDiscount 42,786 Now with a pre-tax bid-YTW of 5.47% based on a bid of 22.20 and a limitMaturity.

There were thirty-five other index-included $25.00-equivalent issues trading over 10,000 shares today.

One Response to “December 7, 2007”

  1. [...] My quotation from the Bear Stearns Asset Backed Securities Trust prospectus on December 7 was well received, with both Econbrowser and Calculated Risk kind enough to credit me in their posts. My interest was more regarding the investor in the conduits being concerned the cash flows from the pool were being reduced; these two commenters are more interested in Treasury involvement. [...]

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