PrefBlog

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.

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

After CIBC’s earnings release this morning, Moody’s announced that it had:

affirmed the ratings of Canadian Imperial Bank of Commerce (CIBC) and rated subsidiaries and changed their rating outlooks to negative from stable. CIBC is rated B- for bank financial strength, Aa2 for long-term deposits, and P-1 for short-term obligations. This rating action follows CIBC’s earnings report for the fourth quarter of 2007 in which it disclosed details of a hedged portfolio of Collateralized Debt Obligations (CDO). 

The change in outlook is based on Moody’s view that this exposure highlights weaknesses in the firm’s strategic risk management. Moody’s concern centers on the concentration of counterparty risks to which it has exposed itself via a rapid and recent build-up of its CDO activities. Though Moody’s believes that any losses related to these particular exposures are manageable for CIBC, risk management weaknesses may expose the firm to further risks. Moody’s is also concerned that it has cited CIBC in the past for risk management weaknesses, and despite expected improvements, it now appears the bank has not fully addressed appropriate risk-taking at a senior, strategic level.

In other words … Moody’s is saying that CIBC got away with it this time, but they’ve been more lucky than smart.

In Super-Conduit/MLEC news, yet another bank is acting immediately:

Rabobank [RABN.UL] is taking the remaining assets of its structured investment vehicle (SIV) Tango Finance onto its balance sheet, the unlisted Dutch bank said on Thursday.

Rabobank, which manages Tango with Citigroup (C.N: Quote, Profile , Research), said the SIV has only 5.2 billion euros ($7.6 billion) in cash assets, down from 9.7 billion in July. Rabobank had warned on Wednesday that Tango’s size had almost halved as it has been selling off assets.

And the Northern Rock auction is running into trouble:

U.S. buyout firm J.C. Flowers’ offer to buy British bank Northern Rock (NRK.L: Quote, Profile , Research) was in doubt late on Thursday as people familiar with the matter said its interest had cooled.

J.C. Flowers remains interested in buying Northern Rock but is finding it increasingly difficult to meet the requirements of shareholders and the government, Bank of England and regulators, all of whom are involved in the auction, a person familiar with the matter said.
…
A consortium led by Virgin Group [VA.UL] has been picked as preferred bidder, but Flowers was considered its nearest challenger.

A consortium led by investment group Olivant is expected to submit a revised offer for the bank by Friday, sources have said.

And that’s all the colour for today! There wasn’t too much of interest anyway, other than the American Sub-Prime Plan, which has attracted considerable comment, not to mention buying.

But how about them PerpetualDiscounts, eh? Holy smokes … if they can keep up this performance every day for a couple of months, it’ll be a good year.

I didn’t understand it on the way down … I don’t understand it on the way up.

I feel reasonably confident when I say “on the way up”, because this looks just as much like a buying frenzy as anything else I’ve seen in the past … um … year, but who knows? Maybe everything will reverse itself tomorrow … and finding out is what makes it interesting to get up in the morning.

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

I am fascinated by the unfolding story of the Florida State Board of Administration’s Money Market fund that I discussed on December 3. Bloomberg reports that the Executive Director has quit:

Coleman Stipanovich, the head of an agency managing a troubled $14 billion Florida investment pool for local governments, quit as officials approved a plan by BlackRock Inc. to salvage the fund.
…
Stipanovich, whose brother J.M. “Mac” Stipanovich is a Tallahassee lobbyist and Republican strategist who ran former Governor Jeb Bush’s campaign for governor in 1994, was appointed executive director of the state board in 2002.

In the late 1990s, Coleman Stipanovich worked as a lobbyist for PaineWebber Inc. in Florida and was paid $7,500 per month to help the firm win municipal bond business.

Stipanovich, a Vietnam veteran, has a master of science degree in criminal justice administration from Michigan State University and a bachelors of science in criminology from Florida State University.

Pretty impressive credentials for running an investment management firm with $184-billion under management, eh? There’s a small biography on the site:

As Executive Director of the State Board of Administration of Florida (SBA), Coleman Stipanovich serves as the Chief Investment Officer of the fifth largest pension fund in the United States. Total assets under management at the SBA are in excess of $150 billion, which includes the Florida Retirement System Pension Plan (Defined Benefit Trust Fund) and Investment Plan (Defined Contribution Trust Fund). Under broad authority granted by the Trustees, the Executive Director has administrative and investment authority and responsibility, within the statutory limitations and rules, to develop investment policies and tactically manage investments. The Trustees are Governor Charlie Crist, Chief Financial Officer Alex Sink, and Attorney General Bill McCollum.

But look at him:

Isn’t that just the kind of distinguished look that investment counsellors should all have? I haven’t been able to find any CV on the web that might possibly shed some light on why this man was considered suitable to run a large asset management firm – all I’ve found is a story about his 2002 appointment and a record of his reappointment. If anybody has information that might clarify the question of his qualifications, please share it.

But I suspect it’s just political patronage. Investment counsellors are all a bunch of overpaid yumps who, on average, perform averagely, right? So I suppose that since any idiot can do it and get paid extremely well while doing so, it doesn’t make any difference who you hire.

Just for comparison, let’s look at the CV of Jim Leech, CEO of Teachers.

Mr. Leech joined Teachers’ in 2001 to lead Teachers’ Private Capital and succeeded Claude Lamoureux as President and CEO in 2007.
…
Before joining Teachers’, Mr. Leech was President and CEO of Unicorp Canada Corp., one of Canada’s first public merchant banks, and Union Energy Inc., then one of North America’s largest integrated energy and pipeline companies.

Now, I don’t know Mr. Leech. I haven’t worked with him, I haven’t studied his career in detail, I haven’t even spoken to the man. But I have a lot of respect for Teachers’ and whether or not Mr. Leech is the perfect man for the job, it seems to me that this is the way public funds should be run … a guy with a solid CV runs a division for six years, THEN gets to be boss. Maybe that CV is in investment management, maybe it’s in some other industry … but it’s solid.

I last reviewed Prof. Stephen Cecchetti‘s series on subprime on November 28. Part 3 of the series, Why Central Banks should be Financial Supervisors talks about some countries’ separation of function that are elsewhere combined:

In places like Italy, the Netherlands, Portugal, the United States and New Zealand, the central bank supervises banks. By contrast, in Australia, the United Kingdom, and Japan, supervision is done by an independent authority.

He notes that Bernanke is an ardent supporter of combination:

[Bernanke Speech]  Its supervisory activities also allow the Fed to obtain useful information about the financial companies that do business with the banking organizations it supervises. For example, some large banks are heavily engaged in lending and providing various services to hedge funds and other private pools of capital. In the process of ensuring that banks prudently manage these counterparty relationships, Fed staff members, collaborating with their colleagues from other agencies, learn a great deal about the business practices, investment strategies, and emerging trends in this industry.

The other side of the coin is:

[Cecchetti essay] the most compelling rationale for separation is the potential for conflict of interest. The central bank will be hesitant to impose monetary restraint out of concern for the damage it might do to the banks it supervises. The central bank will protect banks rather than the public interest. Making banks look bad makes supervisors look bad. So, allowing banks to fail would affect the central banker/supervisor’s reputation.

In this same vein, Goodhart argues for separation based on the fact that the embarrassment of poor supervisory performance could damage the reputation of the central bank.

Cecchetti quotes an amusing example of the benefits of combination:

On 20 November 1988 a computer software error prevented the Bank of New York from keeping track of its US Treasury securities trading. For 90 minutes orders poured in and the bank made payments without having the funds as normal. But when it came time to deliver the bonds and collect from the buyers, the information had been erased from the system. By the end of the day, the Bank of New York had bought and failed to deliver so many securities that it was committed to paying out $23 billion that it did not have. The Federal Reserve, knowing from its up-to-date supervisory records that the bank was solvent, made an emergency $23 billion loan taking the entire bank as collateral and averting a systemic financial crisis. Importantly, only a supervisor was in a position to know that the Bank of New York’s need to borrow was legitimate and did not arise from fraud.
…
[note] At the time, computers could store only 32,000 transactions at a time. When more transactions arrived than the computer could handle, the software’s counter restarted at zero. Since the counter number was the key to where the trading information was stored, the information was effectively erased. Had all the original transactions been processed before the counter restarted, there would have been no problem.

(I should point out that computers, per se, are not to blame for the error – assuming that the malfunction happened as described, this was an example of poor programme management, design and testing as indicated in the main text, rather than a hardware error as implied in the note) … and then an example of the evils of separation …

Shortly after Bank of England Governor Mervyn King sent a letter to the Treasury Committee of the House of Commons,⁶ the U.K. Financial Services Authority made it known both that Northern Rock was on the verge of collapse, and that supervisors had known this for some time. Contrary to wide-spread perception of the position taken just a few days earlier in the Governor’s letter, the Bank of England was forced to make a substantial emergency loan, substantially tarnishing their public image.
…
I will say is that things surely would have gone more smoothly had the Bank of England had supervisory authority so that the officials with intimate knowledge of Northern Rock’s balance sheet would have been sitting at the table on a regular basis with the management of the central bank.

Cecchetti is very persuasive! The arguments make a lot of sense to me – but I’ll keep my eyes open for something from the other side. His fourth and final essay in the series, Does Well-Designed Monetary Policy Encourage Risk Taking, is not nearly as interesting – as far as I’m concerned he could have written finis after the first sentence:

Yes, but isn’t that what it’s supposed to do?

… but he had to fill it out a little. I have often argued in this blog that by way of policy objectives, what we want is a rock-solid, highly regulated banking sector, well insulated from the outer (much more fun) layer of innovation and speculation. He concludes:

Some observers worry that recent central bankers’ responses to the subprime crisis of 2007 will encourage asset managers to take on more risk than is in society’s interest. I believe that this is wrong. Punishment is being meted out to many of those whose risky behaviour led to the problems, while central banks’ actions have, so far, reduced the collateral damage that this crisis could have inflicted on the economy.

As far as the series is concerned, he has made the following four concrete proposals:

• Trust, but verify. Investors should insist that asset managers and underwriters start by disclosing both the detailed characteristics of what they are selling together with their costs and fees. This will allow us to know what we buy and understand our bankers’ incentives.
• Standardisation and trading. Governments could help clarify the relative riskiness of assets by fostering the standardization of securities and encouraging trading on organized exchanges.
• Deposit insurance. A well-designed, rules-based deposit insurance scheme is essential to protecting the banking system from future financial crises. Lender of last resort actions are no substitute for deposit insurance.
• Central banks should be financial regulators. Central banks should have a direct role in financial supervision. In times of financial crisis – as in times of war – good policy-making requires a single ‘general’ directing the operations.

Item 1 is not really a policy issue – it’s a matter for investors, their investees and their advisors. Just make sure people are, in fact, feeling some pain from bad decisions and not bailed out – that’s enough policy.

Item 2 – I argued against this on November 19. However, it may be that in ensuring the stability of the banking system, margin & capital requirements could well be raised to the point at which exchange-trading (and clearing houses with daily mark-to-markets) become competitive. However, an exchange cannot function in a thin market – which Mr. Cecchetti, I am sure, will say is addressed by his urging for increased standardization. By way of policy … make sure the banks are stable, ensure capital requirements are conservative, and let exchange trading and standardization look after themselves.

Item 3 – full agreement from me!

Item 4 – very persuasive arguments have been put forward, but I’ll reserve judgement until I hear more from the other side. I am confident that each example of the benefits of unification can be matched with an example of harm.

PerpetualDiscounts continued to rock-and-roll today, while floaters just rolled over and played dead. Sadly, there are only two issues in this sub-index, both BAM, so it’s very hard to determine just how much is due to credit concerns, how much is Floater concerns and how much is just random vagaries of the market. There was reasonably good volume, a reasonable number of trades, and a reasonable time between the decline of prices and the market close, so I’d have to say this move is as real as anything else.

But really, how about them PerpetualDiscounts? I KNOW it’s only three days into the month and a lot can happen, but let me enjoy it while I can, won’t you? It’s been a long year.

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