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Monday, July 21, 2008

Covered Mortgage Bonds

Update: It's not just me. Bloomberg has an article detailing the problems with the proposal. This is no sort of a solution at all.

Hahahaahahahahhahaha! Is Paulson dreaming?
Treasury Secretary Henry Paulson, aiming to create a new source of U.S. mortgage financing, wants banks to start issuing covered bonds without waiting for legislation from Congress.

Regulators can provide the guidance that lenders are asking to be set in law, said a Treasury official working on the issue who declined to be identified. Banks want a standardized definition of a covered bond, which requires the lender to make good on payments if homeowners default, and guidelines on bondholder protections.

Paulson is promoting the debt as an alternative to mortgage-backed bonds, the securities that sparked more than $426 billion in writedowns and credit losses as delinquency rates soared. Covered bonds also offer a way to diminish the role of Fannie Mae and Freddie Mac, the troubled firms behind more than two-thirds of new U.S. mortgages, according to the Treasury.
This is sidesplittingly hilarious. The basics of a covered mortgage bond are that there is a pool of mortgages or MBS securing the bond payments, but ownership/credit risk of the mortgage pool remains with the lender or consolidator under terms written into the bond agreement. There will usually be an intermediary holding the pool, and loans in the pool can usually be swapped - essentially, the issuer buys back or swaps loans to maintain the required collateralization level.

Obviously, the prospective buyer still depends on the credit rating of the issuer, although the prospective buyer won't be left flat if the issuer goes bust. Instead, the buyer will claim the mortgage collateral forming the pool. However substantial counterparty risk remains for the prospective buyer, because the issuer is the guarantor. Now you can add credit enhancements and other bond insurance, but we all know that counterparty risk is popping up there too. My theory right now is that any bond insurance company which is prepared to write insurance on a pool like this is desperate and a very bad risk.

If one is not confident that the issuer will remain a going concern, the real security is the pool of mortgages themselves, and mortgages are selling at a discount. The latest in the saga of covered bonds:
The Federal Deposit Insurance Corp., rebuffing requests by banks, issued a final rule on covered bonds on July 15 that will allow investors to access their collateral more quickly in the event of a bank failure. The regulations alleviate some of the industry's concern about how regulators will treat covered bonds when a bank goes under.
Do you find that reassuring? It's 45-90 days. Now, the issuer could theoretically have substantial overcollateralization in the mortgage pool. FHL had about double collateral value for its loan to IndyMac:
Outstanding advances from the Federal Home Loan Bank of San Francisco to IndyMac Bank total $10.1 billion. These advances remain fully secured pursuant to the Federal Home Loan Bank of San Francisco’s agreements with IndyMac Bank. The Federal Home Loan Bank of San Francisco has a perfected security interest in approximately $21.6 billion in mortgage loans (unpaid principal balance) and mortgage-backed securities (par amount).
Personally, I think that says something; for one thing, these FHL boys aren't fools, and as a side note, Chuck Schumer is a chap who should have his butt paddled in public, which fact I have mentioned before - but I feel like dwelling on this particular fact. Don't be surprised if the man's name keeps popping up for a while. I may take to posting pictures of paddles along with his name around election time.

The final rule for covered bonds (the only current culprits are WaMu and Bank of America) has various provisions, but this is the main point:
As conservator or receiver for an IDI, the FDIC has three options in responding to a properly structured covered bond transaction of the IDI: 1) continue to perform on the covered bond transaction under its terms; 2) pay-off the covered bonds in cash up to the value of the pledged collateral; or 3) allow liquidation of the pledged collateral to pay-off the covered bonds. If the FDIC adopts the first option, it would continue to make the covered bond payments as scheduled. The second or third options would be triggered if the FDIC repudiated the transaction or if a monetary default occurred. In both cases, the par value of the covered bonds plus interest accrued to the date of the appointment of the FDIC as conservator or receiver would be paid in full up to the value of the collateral. If the value of the pledged collateral exceeded the total amount of all valid claims held by the secured parties, this excess value or over collateralization would be returned to the FDIC, as conservator or receiver, for distribution as mandated by the FDIA. On the other hand, if there were insufficient collateral pledged to cover all valid claims by the secured parties, the amount of the claims in excess of the pledged collateral would be unsecured claims in the receivership.
Without overcollateralization, the bondholders go to the end of the line in the event of bank failure. So here the FDIC is warning the prospective buyers that they only get the value of the bonds "covered" by the collateral. The banks who really might need to do this probably would get lower interest payments from the FHLB system, so one assumes that the theory is that suckers will step up to buy these things with less collateralization than FHLBs want, which means that the bondholders will lose money if the bank collapses. Needless to say, if a big bank collapses and the FDIC has to go shopping a lot of this paper around, the market price for it will fall.

How this is supposed to be a good option escapes me. Here I am truly tempted to assume that the reason Paulson thinks this is such a wonderful idea is that the pool consolidators will be entities like Goldman Sachs and JPM, who are looking for a revenue source to replace all that Asset-Backed Commercial Paper stuffed into those lovely SIVs. No doubt such folks have been making earnest representations of the incredible potential here now that they figured out not to borrow short and lend long. Nope. There's a new plan in town - borrow long and don't lend at all, but collect significant fees from desperate banks.

There is incredible potential - for the intermediary who collects the fees and takes no risk at all. The bondholders could well get beat, and the hapless bank isn't going to gain much liquidity if wary investors demand OC a la FHLB, plus it will be paying a higher interest rate than to an FHL bank. Since the investment banks have proved that they don't understand mortgages, and since the ratings firms have proved that they don't understand mortgages (they now revise their ratings after default), no doubt these bonds will be flogged as "can't lose" vehicles.

Needless to say this is not really a good source of liquidity for new mortgages, but rather a way to move unsaleable paper. Pooled mortgages only truly spread risk if they are FNMA-type pools without the area risk, with relatively uniform guidelines, and with a well-understood default methodology in which the pools aren't being stuffed with bad paper by a bank about to fail. Needless to say, institution-originated pools wouldn't produce a source of liquidity that would allow a bank to offer low rate mortgages. One would have to be truly idiotic not to demand a big premium on these things compared to agency paper. I think the supply of investing idiots is diminishing due to failures, so I wouldn't count on anyone handing money over near agency rates. I'm sure the ratings firms will be willing to rubber-stamp these bouncing newborns ("an infant of such promise!', they will cry while accepting a check), but truthfully, most institutional investors are no longer convinced by the ratings of the ratings firms. Something about the stream of red ink in their portfolios now generates a subliminal sense of unease when "AAA" is juxtaposed with "mortgage".

This is weirdest, wackiest scheme I have seen proposed aside from the bank-written ones a la our dear friend Howard Milstein.

I do have some risk-management proposals:
A. Bonds from these pools should not be sold to any foreign entities in a country which has nukes, for fear of retaliation. That lets out everyone from France to India to China, so the prospects are pretty narrow.
B. Bonds from these pools should not be sold to any foreign entities in Canada or Mexico. It is true that they will not nuke us, but I consider the danger of cross-border retaliatory raids too great for comfort.
C. Bonds from these pools should not be sold to any foreign entities in any countries that export substantial oil, for fear that we'd be forced to pay up regardless.
D. Bonds from such pools should not be sold to hapless fund managers of 401K capital, because we have a public interest in ensuring that our retirees to have money to eat.
E. Bonds from such pools should not be sold to state and local investment pools because they have problems enough already.

Of course, this leaves truly stupid individual investors, stupid banks, and the investment banks to buy. Hmm.

Somehow I don't think the sausage makers will buy the sausage. The supply of stupid banks will shortly be much diminished. Therefore, if someone sidles up to you and offers you a great deal on any investment having anything to do with mortgages, I suggest that you blow a whistle as hard as you can and run toward a lighted area. You might also want to consider martial-arts classes, or move to a locality that has a Right to Carry law. Some of these salesmen can be aggressive and persuasive.

I couldnt find your email. this comment is a great one!

MaxedOutMama writes:
Jon Shayne - Tanta "picks on" GM because she is writing a series of articles about the current situation that fail to ask the important questions and instead promulgate a false narrative.

If you were in the lending industry, you'd understand.

Here we are talking about major spending of public money, and we haven't even stopped to consider how we got here. Tanta is angry at GM because she isn't talking about the real issues, but instead is writing for her next Pulitzer with a predetermined slant which obfuscates the real public policy issues.

The bottom line for most individuals is that to build wealth one must live within one's means, build a savings account to handle unexpected means, and keep one's debt obligations to reasonable limits in comparison to income.

Read Tanta's articles on DAP (downpayment assistance programs), and see the kind of info that GM could be giving us.
MaxedOutMama | Homepage | 07.20.08 - 9:35 pm | #
Thanks, SMC.
I see one way that this makes sense.

1) somebody totally new comes along - because no reputation at all is way better than that of all the existing players, and

2) Said new player originates all the loans to be pooled using really, really radical underwriting concepts: 20% down, 30 year fixed-rate, full documentation of income and other debt, 35% back-end DTI, independent appraisals - you know, absolutely crazy stuff nobody ever heard of before - and sell those in pass-throughs or some other simplistic package.

3) said new party also has a boatload of money for standing behind these things.

4) All the existing players go screw themselves. Especially Paulson.

Why is he advocating covered bonds, realistically? Dores he think that this new twist, with everything else left the same, will somehow prevent the inevitable "reversion
to mean" of house prices?
Bob - except that such a player still couldn't compete with FNMA. They have such broad coverage of the market that their loans will always be safer (they have the broadest possible risk spreading).

So your mythical new guy is going to have to charge higher interest rates for the mortgages themselves, which means that the new player will have to accept worse credit prospects or pay higher fees to independent mortgage brokers hahahahaha! which is a risk in and of itself. That is why, in fact, the independent securitization began around subprime and then moved into funny money loans. At its peak, Fannie's new loan originations dropped to about 25% of the market. Now they are at least back up to 65%.

Fannie's syndication process is extremely efficient, and their geographical coverage gives their loan pools a stability that no institutional lender can generate.

In theory, perhaps BAC and Citi could combine to generate similar coverage, but it's doubtful that they would make a whole lot of money off of it.

Isn't FNMA already screwed and loaded with crap paper?

Aren't they the ones allowing 97% LTV and DAP? And jumbos, thanks to the idiots in Congress?

That's why it needs to be someone new - so we have assurance that the bonds are not being loaded up with crap paper. Yes the mortgages will cost more - but very soon, they will be the only game in town because given an option, nobody with a brain would buy from the existing players, including the GSEs. I'm surprised the whole market hasn't already come to a complete screaming halt, GSEs and all.
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