Sunday, June 1, 2008

The Next Wave of Mortgage Losses

A deceptively simple rule of accounting is that a bank or other company doesn't have to record a loss unless the loss belongs to it. This seems obvious enough. Why should one have to record a loss that belongs to someone else?

But as with so many other things in the mortgage crisis, there's more to this notion than meets the eye. There were many players involved in the process of creating mortgages, mortgage-backed securities, and CDOs and other alphabet soup derivatives backed by mortgages. These included borrowers, mortgage brokers, mortgage bankers, investment banks, investors, credit rating agencies and government sponsored enterprises like Fannie and Freddie. The process was complex at all levels. Borrowers were of uncertain creditworthiness and appraisals may have been inflated. Mortgage payments were unpredictable in amount after an initial teaser rate. A plethora of fees designed to enrich middlemen without necessarily providing borrowers with anything of value increased burdens on homeowners. Bankers didn't do enough to verify the limited borrower information that came their way, apparently figuring that since they didn't plan on bearing the risk of default, there was no point to being fussbudgets about prudence. Investment banks underwriting mortgage-backed securities and derivatives were too busy booking fee income to think through the risks they were taking. Investors were promised that AAA-rated investments could be created from subprime debt, an alchemy that credit rating agencies too readily believed in.

Complexity such as this creates fertile ground for efforts to pass the buck. Lenders try to impose losses on borrowers by foreclosing and then pursuing borrowers for any remaining unpaid debt. Borrowers refuse to pay and make claims against mortgage brokers and lenders for deception and other alleged unfairness. Investors make claims against investment banks for overstating the qualities and understating the problems of derivatives and/or the mortgages underlying them. Investment banks, mortgage banks, mortgage brokers, and credit rating agencies, faced with claims from many directions, become well-practiced finger pointers. With all the complexity, confusion and finger pointing, a bank or other company may be able to avoid owning up to losses for quite a while.

However, the unbooked losses here may run into the hundreds of billions--too big for people to just swallow and move on. They will be pursued until they're settled or resolved by a court. That process is ongoing, with some results emerging. A bankruptcy judge in Oakland, CA recently ruled that when borrowers inflated their incomes in an all too obvious way and the bank did not follow its own guidelines for evaluating the borrowers' stated income, the bank would not be allowed to collect the unpaid mortgage debt remaining after foreclosure. The bank, it would appear, was deemed to have been irresponsible in the way it made the loan and would not be allowed to collect anything beyond the collateral. This case could have gone either way, since both the borrowers and the bank could be said to be at fault. The judge chose to put the loss on the bank. Given the large number of no doc, liar and similar loans made by mortgage brokers and bankers in recent years, widespread judicial application of the principle underlying this decision could result in significant additional losses for banks.

Investors in mortgages and mortgage-backed investments have been trying hard to make lenders repurchase loans that go into default. Repurchasing in effect places the losses of default and foreclosure on the lenders, not the investors. While the lenders may not be required to repurchase all defaulting mortgages, they could easily get stuck with the ones where fraud or deceptions on the borrowers occurred, or where mistakes in the loan underwriting process were made. That could amount to a lot of mortgages. Investors like Fannie and Freddie are facing potentially big hits, and are pushing back vigorously. Bond insurers, who might also be on the hook for mortgage defaults in mortgage-backed investments they've insured, are also passing the hot tamale as much as possible.

Millions of adjustable rate mortgages are re-setting this year, producing even more defaults. The credit rating agencies now review mortgage-backed investments on a continuing basis. As the underlying mortgages get hinkier and hinkier, the ratings on these investments could be lowered. Every time they are lowered, more losses are suffered.

Some high ranking government officials and pundits have recently made soothing noises about the mortgage crisis. Be cautious about believing them. As legal processes proceed and claims are resolved, unbooked losses from the mortgage crisis will be allocated and recorded. That won't be a pretty process.

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