I just got off the phone with a former colleague of mine, who was wondering
who the losers are in the subprime
freeze. What will this do to the balance sheets of banks and buy-side institutions
who ultimately own the loans being modified? (Or, as Floyd Norris puts
it, "Why is it good for a lender to be forced to make concessions to
borrowers?")
The more I talked to him, the more I convinced myself (if not him) that this
really is a positive-sum game, and that everybody is going to win, and that
there will be precious few losers. I’ve already said that I think there
will be very few lawsuits from irate investors who are losing money as a
result of reduced cashflows. But thinking about it more, I actually think there
will be very few investors losing money in the first place.
The reason is that pretty much the entire financial system uses some semblance
of mark-to-market accounting these days: there aren’t many institutional investors
who buy mortgage-backed securities, put them on their books at par, and just
keep them there, at par, until those securities either default or are repaid
in full. But if those investors do exist, this plan changes nothing –
if they haven’t seen the need to revalue their securities until now, there’s
no reason that they should revalue them just because there was a high-profile
announcement in Washington.
Most investors, then, are marking their securities to something: call
it mark-to-market, mark-to-model, mark-to-fantasy, whatever you like.
As we all know, marking to this particular market is very hard, because the
tranche sizes are tiny and liquidity is nonexistent. That’s why banks mark to
model. They plug in the parameters of the debt issue in question, put them all
into a black box, and out the other end comes a valuation. If you change only
one variable, and reduce the interest rate paid on performing loans from say
10% to 7%, then the model will spit out a lower valuation. On the other hand,
if along with a lower interest rate you also put in a lower foreclosure rate,
then you’ll probably end up with a higher valuation, especially if your loss
given foreclosure was high enough to begin with. And if the general discount
rate you use comes down on the grounds that the mortgage freeze has reduced
downside risks to the housing market as a whole, then your model’s valuation
will go up even further.
That’s why the American Securitization Forum has found it so easy to embrace
this proposal: all its buy-side members are likely to look at it and decide
that net-net they’re going to make money, not lose money, from it. To be sure,
there will be a tranche or two here or there which, at the margin, is a loser.
But those tranches will be more than offset by other tranches which are gainers.
Why am I so sure? Because the one thing which is always true in the world of
mortgages is that performing mortgages are worth more than delinquent or foreclosed
mortgages. And the subprime freeze is extremely careful to slice up the universe
of mortgages so that only those which increase in value upon modification are
eligible for that modification.
If you have good credit and are current on your mortgage, you’re not eligible
for the freeze. If you have bad credit and you are behind on your mortgage,
you’re not eligible for the freeze. The only way that you can be eligible for
the freeze is if you have bad credit and you’re current on your mortgage, and
it will reset to a higher rate after January 1, and your mortgage servicer
determines that you won’t be able to make your mortgage payments after they
reset.
Looked at this way, it’s almost guaranteed that the lender will make money
on the modification. Without modification? Foreclosure, and massive losses.
With modification? A steady income stream in the healthy 7% to 8% range, which
the borrower has already proved capable of paying. What’s not to love?
Or, look at it another way. Try naming a single investor who claims this plan
will cause him losses, or who has threatened to sue servicers for implementing
this plan. I certainly haven’t see one. The people complaining about bondholder
losses and violation of the sanctity of contracts tend to be people with no
real skin in the game at all. Meanwhile, the bondholders themselves, through
the ASF, have signed up for this deal quite happily. Which speaks volumes, I
think.