NYT: Wall St. Finds Profits by Reducing Mortgages

[haithman]

As millions of Americans struggle to hold on to their homes, Wall Street has found a way to make money from the mortgage mess.

Investment funds are buying billions of dollars’ worth of home loans, discounted from the loans’ original value. Then, in what might seem an act of charity, the funds are helping homeowners by reducing the size of the loans.

But as part of these deals, the mortgages are being refinanced through lenders that work with government agencies like the Federal Housing Administration. This enables the funds to pocket sizable profits by reselling new, government-insured loans to other federal agencies, which then bundle the mortgages into securities for sale to investors.

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http://www.nytimes.com/2009/11/22/business/22loans.html?pagewanted=1&partner=yahoofinance

[MrSilverMaC]

I am not understanding how refinancing with the feds for a lower mortgage is risky, can someone explain that to me?

[haithman]

I am not understanding how refinancing with the feds for a lower mortgage is risky, can someone explain that to me?

Are you asking about the risk on the part of the homeowner or that on the part of the govt. agencies?

The homeowner really doesn't assume any more risk and in some instances may have their risk profile reduced. The problem arises on the side of the govt and government agencies who are holding these securities after they have been securitized (into mortgage backed securities). One of the issues with this whole crisis (from the pov of investment banks) was that they held many of these securities on their books that they hadn't yet sold to investors. Now, the government will act as the counterparty on these securities and in the event that homeowners default, the investment banks/hedge funds wont face the losses but rather the government (ultimately the taxpayer) will incur the losses.

[MrSilverMaC]

Eh, I think I probably mis-read this sentence:

"Brian Chappelle, a mortgage consultant, said loans to people like the Alvas, with modest incomes and scant savings, could turn out to be risky."

I understand how it is risky for the gov, I wasn't understanding how it could be risky for the owner but I think it was just a case of me reading too fast, lol

[Destino]

They should have renegotiated mortgages from the start. Think about it this way. The government should have moved faster to allow it.

Loan for 500,000 secured by the house. House is now worth $340,000. Homeowners can no longer afford the loan.

Option1: foreclose, Homeowners miss 4 months of payments. Pay asset managers. Pay 6% in real estate commission. Have to price the home competitively because of the down market. Often time they have to make repairs needed to pass home inspections.

Option2: Renegotiate loan to $340,000. Begin collecting amortized loan payments immediately (which are almost entirely interest on the front end).

[Hubbs]

Destino, that's simply not possible on a widespread basis. It would instantly bankrupt every bank in the country.

And SilverMaC, I don't think the article is saying that this is generally "risky" for the homeowners, it's saying that this is generally risky in terms of national solvency. The FHA has, erm, "guaranteed" over a trillion dollars in mortgages that are defaulting at a faster and faster rate. It's turned into another financial black hole, just like Fannie and Freddie. Stuff like this is the cause.

[Destino]

Destino, that's simply not possible on a widespread basis. It would instantly bankrupt every bank in the country.

Expand on that please. Not saying you are wrong but elaborate if you would because I'm interested.

[Hubbs]

Expand on that please. Not saying you are wrong but elaborate if you would because I'm interested.

Well, determining the solvency of any organization involves comparing the total value of its assets to the total value of its liabilities. If the liabilities exceed the assets, the organization is bankrupt. (That's a really, really nutshell way of putting it - there are all sorts of regulations that dictate how different types of asset/liabilities are valued - but that's all you need for this.)

The financial industry holds trillions of dollars in real estate-related investments as assets. Imagine that a bank gave you a loan for $500,000 so you could buy a house. The bank would be allowed to count this $500,000 loan as an asset, because, under normal conditions, the property you bought would probably be worth a bit more than that. (Crazy as it sounds, there was a time, many moons ago, when banks wouldn't hand out loans for the entire freaking purchase value of a home. You had to have a bit of cash saved up on your own to contribute.) If you didn't pay up, the bank would be able to make back the value of the loan when it repossessed and then sold the house on its own. Thus, the mortgage is an "asset," as the bank expects to be receiving the $500,000 over time one way or another. In fact, the bank is even allowed to count the interest on the loan as an asset, so it will actually mark the value of the loan higher, with the interest included.

With your $500,000+interest considered to be an asset, the bank is allowed to take on roughly that same amount in liabilities. (There has to be a certain buffer, but it's very, very small if the world goes into crisis mode.) In a normal real estate market, the losses stemming from the occasional deal-gone-bad would be outweighed by the interest earned on all the good mortgages. But if you have a systemic devaluing of mortgages, the bank is destroyed. Notice that I said mortgages, not housing prices. Technically, if your house has collapsed in value to $340,000, your mortgage is still valued at $500,000 as an asset until you refinance, or until the bank forecloses upon you and has to sell the property itself for whatever it can get. If you manage to finagle a refi at $340,000, then the value of the mortgage as an asset to the bank becomes $340,000 (plus interest), because that's the new amount that you owe. Now, remember, the bank has taken on nearly $500,000 in liabilities based on the old value of your mortgage. Multiply this effect across real estate in the entire country, and all of a sudden, the bank's got a lot more in liabilities than it has in assets.

Again, that's a nutshell inside of a nutshell, but it's the basic idea. The banks have liabilities that were based on housing bubble-level asset values. Widespread refinancing results in widespread devaluation. Poof. Instant bankruptcy.