by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
Over 13 years ago, I tried to explain how mortgage securitization would cushion losses to investors and lessen the negative effects of mortgage defaults to real estate prices:
Basically, the Titans of Wall Street never had to answer for the performance of these loans because the money managers wanted that last little bit of yield the risky or exotic mortgages produced. The rising housing market would disguise the loose guidelines (defaults would just be refinanced) and everyone would make their little golden crumbs as the vanishing loaf was buried deep in the breadbox. If that wasn’t enough, the lenders would buy securities firms and the securities firms would buy lenders, all of them buying time before the cat got out of the bag.
Then Alan Greenspan raised interest rates and all hell broke out. Rapid growth in housing arrested and the refinance boom stopped. Alas, the lenders and Wall Street Titans kept the easy money machine flowing. Think about it, it wasn’t their money, it is yours…so why close the bar tab if you never intend to pay it ?
Now…here is the part where you should be infuriated but don’t have to be… This crap has been buried in so many funds that it won’t have too much of a lasting effect. The debacle that we read about will be paid for by you, Mr. and Mrs. America with the $57,254 balance in your IRA account. And it is going to hurt you, probably to the tune of two or three grand. That means these HUGE default rates we read about MAY lower your IRA balance to $54,819 next year. If you’re 50 years old, it means that the monthly check you draw from that IRA when you are 70 years old WILL be some 38 bucks lighter because of this mess.
I was correct in THEORY but things never work out theoretically, right? Just 18 months later. I posted that same article with a Mea Culpa:
I’m kicking this one up to the top, in honor of today’s events. It’s a historical look about the early MBS markets. Now before you jump me for my incorrect conclusion, I didn’t realize that the hedge funds leveraged their loan holdings 10 to 1 (or more). That “38 bucks a month” translates to a loss of about 6%. In hindsight, with full knowledge of the leverage employed, I’d have thought that your “IRA” would lose half its value.
I had no idea that Wall Street borrowed against the loans before stripping them, insuring the stripped parts, and selling them to unsuspecting investors. Collateralized mortgage banking is a simple enough theory to understand. A lender makes a loan and sells it a servicer. The servicer sells it to the Wall Street investment bank which packages up a basket of those loans, pledges them as collateral, and issues mortgage-backed securities against them. The lender makes loans, the servicer accepts payment on those loans and remits them to the investors– lenders and investment banks are transactional agents and servicers and investors are more like principals.
While there is no evidence that stripping is playing a large role in todays collateralized mortgage banking market, leverage still is a factor: servicers borrow money to purchase the loans from lenders before selling to the investors. More importantly, servicers are on the hook for the obligation to the investor whether the borrower makes the payment or not. Back when COVID lockdowns started, the Federal Reserve Bank mandated that servicers accept forbearance requests without addressing the notion that servicers weren’t sugar daddies. Predictably, a liquidity crisis hit and the FHFA had to “bail out” mortgage servicers with a cash infusion. If your neighbor refinanced a loan in March under 3%, and you applied in April, you discovered that mortgage rates were higher than they were before COVID lockdowns hit– that’s because the servicers were broke and lenders had nobody to sell the loans to.
That’s the background you needed. Here is the ticking time bomb which gets me worried; while more and more homeowners are “curing” their mortgage forbearances (a good thing), an unsettling number of “hopeless” cases is rising.
When the first wave of COVID-19-related forbearance plans reach the 12-month expiration period, the longest allowed by the CARES Act, in March 2021, the current pattern suggests there would still be a million excess delinquencies. Given that early-stage delinquencies have already fallen below pre-pandemic levels, the bulk of those delinquencies will be seriously so. While serious delinquencies tend to peak 3-4 months after a natural disaster event, there has been no such peak as yet, instead there have been five months of increases.
This is big a problem if interest rates spike and spike they may. The US Treasury is adding debt at a stupendous trajectory and sooner or later the Federal Reserve may not be able to soften the blow. Here is how the “correction of 2021 could unfold”:
1- Forbearances hit the 12-month mark in April-ish of 2021. The logical solution would be for investors to permit “work outs” with borrowers and let servicers recapitalize the mortgages (tack deferred payments on the back end of the loan).
2- A large portion of “hopeless” borrowers walk away from the homes anyway
3- Servicers aren’t prepared to handle the volume of defaults and a lose liquidity.
4- Servicers stop buying certain loan down-payment loans
5- prices decline
6- investors with large down payments step up but demand larger prices concessions
7- Eventually, price discovery happens in residential real estate.
I have been underestimating the effect of forbearances because most of them are curing themselves organically but I am reminded of not knowing what I couldn’t know in 2008– the effect of leverage on the collateralized mortgage banking system. Thirteen years ago, I had no idea how leveraged investment banks were. Six months ago, I had no idea that servicers were as leveraged as they were.
I am a relatively bright guy who has worked the mortgage supply chain from MBS trading to originating a loan at a kitchen table and I don’t know what I don’t know. Do you? Does anyone?
