Anyone know a lender that considers salary growth potential & other factors

I found this on a financial forum - authored by someone called Mike Holmes. It is a very witty and thorough analysis of the state of the American mortgage market. I don't necessarily agree with all of it, but the sentiment is clearly right -



In a manner of speaking. The way modern mortgage finance works is:

Algie borrows from Bertie the lender/broker/bank.

Bertie sells the loan (or technically the income stream arising from the
loan) to Clarence.

Clarence collects 1000 mortgages and turns them into an asset backed
bond (mortgage-back) which makes a monthly payment which is the
aggregate of the mortgages in it. Clarence may insure this against
default (with credit default swaps); against interest variance (interest
rate swaps); or against currency risk (currency swaps). One of the
problems to note in this market is that mortgage-backs tend to have
individualised contracts (see later).

Clarence sells his package to Daniel who collects a whole bunch of
mortgage-backs. These get a credit rating from one of the agencies who
rate how likely a bond is to go into default or credit-imapirment.
Usually the rating will be below best (best is AAA in the jargon).
However Daniel wants to sell AAA bonds because they fetch a good price
and are rated highly enough to be held in pension funds etc. Daniel
needs to turn mortgage-backs rated only B into AAA assets.

To manage this alchemy Daniel takes his bunch of mortgage-backs and
makes a CDO (Collateralised Debt Obligation). He splits the CDO into
tranches. Contracts are set up so that the first defaults hit only the
bottom tranche ("toxic waste" in the lingo), then the next up
("mezzanine") and then the rest ("equity"). So most of the risk is piled
on the very bottom tranceh, some on the rest, ad the top tranche only
gets hit when all the others have been wiped out. These tranches are then
rerated with the equity tranches hopefully this time getting a AAA rating.

These then get sold to Eddie the Hedge Fund Manager. Eddie obviously
prices his bids such that he gets much more interest if he takes on
mezzanine or toxic waste bonds. Often enough though these will be hard
to sell at a good price and Daniel will just hold them on his own
books.

Eddie typically gets a billion or so of his subscribers money and then
borrows nine billion on the back of that from an investment bank so that
he can buy loads and loads of CDOs and lever up his profits (and his
annual bonus).

Of course the flip side is that if these somehow drop in price by 10%
then the net investment of his clients goes to zero. An 11% drop means
the bank is then losing its money. If that happens though, Eddie will
wind up the fund and start another one where he'll do the same. In a
good year Eddie's fund gets 20% of multi-billion rises and in a bad year
zilch. For Eddie, the good years generally cover the bad ones enough to
keep him in yachts made of caviar.

Part of what Eddie is holding is the risk of the CDO going into default
and he's effectively being paid for that in interest. If however he
doesn't want to hold that risk then he can transfer risk portion to Freddie
the Insurance Guy. Freddie is in the business of rating risks and
taking a premium to insure derivatives against default.

Freddie now has an income stream coming in from insuring the CDO.
That's just the sort of stream that an asset-backed bond can be made out
of. Freddie takes a bunch of these, splits them into tranches as with
the CDO and then sells these on to Gary the derivatives trader. These
are "synthetic CDOs". This one's a "CDO Squared" but there are CDO
Cubed derivatives as well which have been round the lather, rinse,
repeat cycle one more time.

So far, so straightforward (OK I simplified). So what's gone wrong?

Well, the trouble with all these CDOs is that nobody really knows what
they're worth. There are some lovely equations that will tell anyone
who wants to know (just as there were telling the PhD's and Nobel
prizewinners at LCTM that if they held out long enough, the market would
conform to their theories) exactly how to value them. These values were
all priced as "held to redemption" which means based on the idea that
they'd pay their interest on time every month and then return the
capital value when they expired.

This seemed a pretty good bet because so few people would default on the
mortgages on which the whole edifice was based. After all, prices
hadn't fallen in the US since The Great Depression in the 1930's
(technically The Great Depression II since the 1880's depression was
also accorded that title). Thus anyone in trouble with the mortgage
could just sell the house, pocket the profits and pay any outstanding
mortgage arrears out of those.

It was such a good bet in fact that ever more money was thrown at it.
The Japanese have generally found themselves with an embarassment of
savings and their own banks had an interest rate of zero. This was as a
result of Japanese house prices falling by 50% through 90% between 1989
and now as a result of an awfully similar setup in Japan in the 1980's.

But everyone figured that lightning doesn't strike twice, and a six
percent return looks pretty damn good when the alternative is zero, even
if deflation is automatically hiking the value of cash under the mattress.

Then there's the Chinese. Their currency is low against the Dollar and
they make most of the stuff consumed in the US because a low
currency, plus low wages, makes stuff cheap. So the yanks raise as much
cash as possible to buy Chinese goods. They raise this by remortgaging
the house to "realise" the money they've made by their houses rising in
price. This of course also creates a whole bunch more mortgage-backs and
CDOs. The US then gets a trade deficit of 6% of GDP (a size which
killed Argentina) and the only thing the yanks export to China is
Dollars to pay for it all.

So what's your average Huan to do with a few trillion Dollars? If he keeps
them under the mattress he'll need a spacesuit to sleep. So he sticks it
into the banking system and it all ends up in Jim-Bob's hand when he
remortgages and uses the loot to buy more Chinese made plasma screens.
All this leveraged cash being bid on housing (nobody ever bid rationally
when they were bidding with someone else's money) guaranteed that [rices
would rise, thus closing the loop.

That then is the nice little virtuous circle of money that's been running
the world economy pretty much since the bonds crash of '94.

Remember that part where the pricing was predicated on "held to
redemption"? Well, that there's one of the flies in the ointment.

The warnings were there in 1994 when Countrywide (big big US mortgage
guys) saw the mortgage defaults climbing on their mobile homes unit.
In that business though, the way to deal with defaults is to grow the
business faster than the rate of defaults is rising, that way the
percentage of overall business which comprises the defaults will fall,
and that will keep the creditors and the shareholders happy.
Surrendering business to competitors by being more careful with loans is
not the way you get to be, or stay, Numero Uno

Lather, rinse, repeat across the entire business and everyone is trying
to expand their loans book. After all, it's not like they're on the
hook for the loans. They make 'em, sell 'em on and with the money from
the sale they can make new loans. They get a sparkly fee on every one
and they get income for servicing them every month too. There are no
prizes for being too careful. It's what's called "perverse incentive"
amongst folks paid to be less than credulous about the wonders of
markets.

Thing is that when around two thirds of folks already own homes, the
other third are pretty much deadbeats who can't even keep their car
loans or credit cards current. Still, if they're the market then they
gotta be sold more loans. What's interesting is that these guys also have
their own perverse incentives.

Let's say you start with zilch. You can get a 100% loan on asset A.
Every year asset A appreciates by 10%. You do this and after a year
you've made 10% of the value of asset A from nothing. After ten years
you've made 100% of the value of asset A (more if you include
compounding). There are only two catches. One is that every 90 years
asset A goes down by maybe 90%. The other is that you have to be able to
service the loan.

On catch one. If you start with zilch and you hit the bad year, you go
bankrupt and end up back where you started. If you hit any of the good
years, which is much more likely, then you're in the money. It's a
no-brainer: having nothing to lose is a positive asset on that bet.

On catch two. That's where the creative business comes in. The lender
will offer a 2-28 loan. The first two years will be discount years.
You might only have to pay the interest but no capital. You might not
even have to pay all the interest (a "negative amortisation" or "neg-am"
mortgage). They'll roll it up into the capital. Sure, you'll have to
pay the normal subprime rate (2 to 3 percent above that of a normal
monrtage) plus capital repayments (remember that rolling up part?) but
by then house prices will have risen 20% so you can remortgage with 20%
down and get a prime mortgage. Sorted!

In fact, a better plan would be to buy a house bigger than you want or
can afford and then at the two year mark sell and buy the one you do
want. That way you maximise your profits. Sure, you can't afford the
full payments on it, but this way you'll never actaully have to make
them see? Of course your income statement needs to show that you can,
but this is a "no-doc" loan where you don't have to prove it and we will
never check. If you tell me you earn twice as much as you really do,
I'm obliged to believe you. Sign here, and here....

So the bankers have the incentive to make loans without regard for
whether the borrowers can pay and the borrowers have the incentive to
take loans regardless of whether they can pay. The bondholders, square,
cube, or dododecahedral meanwhile have everything priced for perfection
and keep on shovelling cash into the maw of the beast.

So everyone ignores the mobile homes ructions and buries them in a slew
of new loans. The trouble starts when some folks start going into the
28 part of the 2-28 and some others who have never been able to make two
months of payment in a row on a car loan are running into trouble on the
third month of their home payment. Some folks never even make anything
but the first payment they made when they signed the forms and just live
rent-free until the courts run out of patience. Meanwhile the Mafia
have noted the "we don't check" part of things and are taking mortgages
on houses that don't even exist (we don't even check that!) and
vanishing with the cash.

So subprime mortgage defaults ratchet higher and higher. Some of the
more creative lenders see defaults nearing 20%, though 5% and climbing
is around average.

A finance house called Bear Stearns runs two hedge funds which play the
CDO markets. They're borrowing in one case ten and the other five times
the cash their investors put up. As noted above, the market doesn't have
to drop so far to run the value to zero. Their bankers notice these
subprime defaults and a little lightbulb goes off in some worrywart's
head and he gets on the phone to ask for more deposit or call in some
loans.

The price of CDOs based on subprime have been falling and these hedgies
have some problems repaying just at the moment. They ask for help. The
other houses, remembering that Bear Stearns were the guys who refused to
help bail out LTCM when it looked like global finance was about to
collapse, decide to give 'em some of their own medicine and refuse.

The hedgies have to quickly raise cash to repay the bank. They decide
to sell some CDOs on the open market. The first lot go at 80% of value
and the mood quickly sours. By the time bids are down to 30% of alleged
value, the other funds figure that if stuff actually sells at that and
the price gets recorded, they'll have to mark their own assets down so
far that they'll be in trouble too. They get the auction called off
by promises to help the hedgies in trouble. Sooner or later though
investors in one fund are told they'll get nothing and the others will
get pennies on their billions.

Over the next month everyone else starts to take note and worry about
what's on their own books. Bondholders quit buying subprime CDOs,
mortgage-backs or indeed anything to do with them and sell whenever they
can actually get a bid.

Subprime banks can't resell their mortgages due to this. If they can't
resell, they can't make more. The subprime market grinds to a halt. If
you can't make new mortgages, not only can't you earn fees but you can't
keep drowning the defaults in an ever-expanding business. With no new
business, every default increases their percentage. This looks bad to
bankers and investors. They want their money back.

There's worse to come. All those mortgage-backs are individual
contracts. Many say that if 6 months of payments aren't made on time,
they can be sold back to the bank at the original price. Bad loans
start piling in. Mortgage banks, some of them big ones, start going
bankrupt. A hedge fund and a mortgage bank a day go bankrupt, some in
Australia, France and Germany. Financial contagion starts.

Folks then start to worry about Alt-A mortgages. They're not subprime.
Typically they're second mortgages of prime borrowers who took out
another loan to borrow the 20% deposit. Defaults are climbing on those
too. The Alt-A markets start to shut down.

Then there's the jumbo loans. Big loans made on big houses to folks who
are prime borrowers. These start to look dodgy and things grind down
there too. By now 60% or so of the mortgage markets in the US are having
difficulty making loans.

Demand for houses has been dropping leading to a mismatch between
sellers and buyers and now most buyers may not be able to get credit.
Folks know that this will ratchet down prices yet more. With 4 million
homes about to hit the 28 part of the 2-28 in the next 18 months, this
means that a bunch of people will be unable to sell out of a foreclosure
(reposession) situation because they're already in negative equity.

This means that defaults will ratchet up yet more and put more
mortgage-backs and CDos into trouble. Conservative estimates based on
this and the current default rate are that foreclosures will easily hit
a rate of 2 million per annum.

Congress tries to organise help for homeowners in trouble through
renegotiating loan terms. However, any individual loan they look for
was packaged with another 999 and sold. Then these were wrapped up with
other packages and sliced and diced and sold again. Then these were
reinsured, packaged and sold, then sliced and diced and sold again. Try
finding your own mortgage in that lot to renegotiate it and then repeat
the trick two million times. Many folks are stuck just trying to find
the guy who owns their mortgage, never mind get a deal. This while
they're on the clock for having their furniture put on the lawn.

Besides, it turns out that a lot of the contracts at some point of the
proceedings specify that loans can't be renegotiated or that only a
small percentage can. The renegotiation effort runs into the sand.

Some of the banks try to organise bailouts of some mortgages that can be
saved. However there's a problem. Remember those credit default swaps
which pay if a bond goes into default? The guys holding the other end of
those deals will make money when things go awry and they've been making
their monthly payments on that basis. They're an essential part of the
mortgage markets. When the banks try to save mortgages, these guys sue
for breach of contract and interference in the markets. It's essentially
insider trading. The banks thus have their hands tied too.

The latest knights in shining armour are being called to the battle.
Fannie Mae and Freddie Mac. These are the twin mortgage supergiants who
insure or own 90% of US prime mortgages. They have 1.4 trillion of
mortgages on their books with capital of about 3% of that (readers
who've been following the bits about leverage will spot the flaw here).

Their markets have not seized up mainly because bondholders figure that
the Federal Reserve (US central bank) will always bail them out if
there's trouble. This ain't written down anywhere, but Fannie and
Freddie get preferential borrowing rates on the back of it, which
explains how they competed to get 90% of their markets.

However Fannie and Freddie have been naughty. They played fast and loose
with their numbers, somewhat like Worldcom and Enron, and lost or hid 15
billion or so between them. Even they don't know because a veritable
army of accountants are still trying to figure out their numbers for the
past few years. The financial cops spanked them by limiting the amount
of mortgages they could speculate in by holding them on their own books.

What they and their friends want now is for them to have the limits
moved or removed so that they can ride in and save the day. Those
who've read my meanderings in the past will know I have had them pegged
as Ground Zero for a future credit crunch. That future is now and the
irony is not at all lost on me. Who knows though? Perhaps taking a
bunch more dodgy mortgages onto their own books will be the straw that
breaks the camel's back

 

Nice article. Thing is I can see the UK's dodgy self cert mortgage market being just as bad. The type of people who self cert often take out huge personal loans etc, and with higher interest rates now, it wouldn't take much for the default rates to rocket.

Perhaps a fall in house prices is also on the cards, given that the average actuarial type cannot afford a decent house anymore...

 

Around November 2003, either Panorama or "The Money Programme" did a programme on the self cert scandal ("lie to buy" mortgages) and interest rates began to rise at the same time. I thought that was the peak then - the perils of trying to predict market tops and bottoms. I personally believe if the BOE had not eased in 2005, but had continued tightening then the US would not be a year or so ahead in the cycle.

 

I feel I should put in the famous Warren Buffett quote here


"It's only when the tide goes out that you learn who's been swimming naked."

When everyone is enjoying good times, you don't know who has taken on excessive risks.

 

Interesting stuff Cardano...my question is, what happens next? Won't the Federal Reserve lower interest rates and provide some breathing space? Although many of these funds are revealing themselves to be worthless, surely the us government will intervene and bail them out - it's in their interest to keep the whole charade going?

Forgive me if my questions seems simple, the bulk of my economic knowledge comes from CT7 so blame the Institute...(actually I did follow up and read 'the death of economics' by Paul Ormerod and 'the money machine' by someone whose name escapes me and I will admit it rather than googling it!)

 

12345, When you have a massive credit expansion, then the accumulated debt will either be liquidated by deflation ( the preferable option) or hyperinflation ( the worse option) or hyperinflation followed by deflation (the nuclear option).

The Fed's panic action last week is an indication it would like to liquidate it by inflation, but it is only a half hearted move at the moment. The discount rate is the rate at which the Fed lends to banks, not the Fed funds rate which is more akin to the BOE base rate ie the rate at which banks lend to each other. However I expect this to follow next week.

The problem is America doesn't control its own interest rates as the US is the world's largest debtor nation. If China and Japan and a few other oil producing nations (eg Saudi Arabia) don't like what America does they can just sell their vast stocks of US Treasury bonds and force up US interest rates. Speculators can also do the same thing using derivatives but unlike the aforementioned crediter nations they will then be short and have to buy them back

Likewise mortgage rates are not decided by the Fed or even the mortgage company's/ banks they are decided by the buyers of the Mortgage Backed securities, or collateralised debt obligations. If those buyers have massively rerated the default probabilty, as they will almost certainly have done in the last few weeks, then they won't be asking 8% for subprime loans, they'll be asking 18% or 28%. There will also be a rerating of the prime loans as well as we enter a real estate bear market. Thus there is a limit to what the Fed can do.

"Helicopter Ben Bernanke" made his reputation by studying the depression and has said in the past he would chuck money out of helicopters in order to stop another one. He is unfortunately in for a a rude awakening as China and Japan are not going to allow that.

After my PhD I postdoc ed in Germany for a year and the stories that made such an impact on me were those about the East front (particularly Stalingrad) and those about The Weimar republic. You may be unfamiliar with what happened under the Weimar republic, but if Ben starts raining money down from helicopters, there won't be enough helicopters in America to keep up. The US will have an inflation rate exceeding Zimbabwe's.

The best that can be hoped is that this is staved off for another cycle. ie if the Fed eases and the money ends up being borrowed to bid up the price of some other speculative commodity (shares, land, tulip bulbs etc etc). If it ends up bidding up the price of food, fuel, clothes etc then the Fed will have to raise rates as soon as they drop them.

I personally believe we have reached then end of the road. People are so endebted they just can not borrow anymore, but precisely how quickly this unravels and what precisely happens is anyone's guess. My advice to you or anyone else reading this is to work hard, pass your exams, be nice to people as you may need them over the next few years, save your money (in T-bills not in banks) and for god sake rent a flat don't buy a house.

Be in no doubt Britain is in a lot worse position than the US

 

Thank you for the lucid response Cardano. I'm very interested in seeing who this whole sub-prime fiasco works out particularly as nations like Russia, China and all have a lot of cash to throw around.

I rent and certainly won't be suckered in to bidding up an already overvalued property market, although the t-bills advice is intriguing - why them rather than domestic banks?

 

The banking system usually fails in a debt liquidation regardless of whether the liquidation is deflationary or hyperinflationary.

Incidentally if the British government does hyperinflate make sure those T-bills are Swiss Francs. (Short term government bonds are just as good). By the way I am old enough to remember inflation at 25% in the mid 1970's. The Barber boom was liquidated in this manner and the secondary banking system collapsed.

Any short term government instrument is generally safe in an advanced economy, due to fact that government needs to roll them over in the near future. The long term bonds/gilts are less so as the government control the rules and can reduce the coupons or extend the terms and there is SFA anyone can do about it. The Government does not need to roll over its long terms debts. Long term bonds are also an incredibly bad investment in an inflationary environment

 

A quick look at the bond rates offered (http://www.smartmoney.com/bondmarketup/) indicates short term (3 month) rates of about 3.12% - surely at the moment I would be better off putting cash in an ISA which can return a higher rate? Are you specifically referring to the "what if..?" scenario of hyperinflation?

Please forgive the layman..

 

12345 - I don't think it matters too much what you do over the next few months as I doubt the situation will develop so quickly.
I am going to remove all my money from the banking system over the next few months just as a precaution, though I think any full blown crisis might be several years hence. How the situation develops remains to be seen. If I had a crystal ball I would be a billionaire.

Incidentally this is worth a read

http://canada.theoildrum.com/node/2871#comments

 

Those are based on US Treasury bills, can't really c.f. with UK cash ISAs.

 

No of course, I realise that all of this is speculative, just trying to process the information received in some logical fashion.

King - I thought T-bills were US Treasury Bills? When T-bills were being discussed, that is what I took them to mean, which may be where I've confused myself. Re-reading it all, I think the T-bills term is used to discuss government bonds in general?

 

T-bills is basically a generic term for any government's short term instruments issued at a discount.
I probably should have used the term more carefully as short term gilts/bonds are just as safe in any financial crisis and they are of course available in small denominations and longer terms

 

I guess you're right in that 'T-bills' is more commonly used to describe US Treasury Bills. The comparison with ISAs threw me - sorry.

 

The first building society failure occurred today

http://www.mortgagestrategy.co.uk/cgi-bin/item.cgi?id=149462&d=11

As far as I know this is only the fourth bank failure in Britain since the secondary banking crisis of 74/75 (including BCCI, which was a money laundering exercise). I suspect it will be the first of many

 

On the 19th December 1973, a fraught meeting occurred in the Bank of England between the then Governor and representatives of a fringe bank "Cedar Holdings". It was decided that the Bank of England could not let "cedar Holdings" fail and it acted as lender of last resort and bailed out the first secondary bank.
Yesterday a similar meeting occurred betwen Mervyn King and representatives of the board of "Northern Rock". The result was the same.

In case anyone is interested in the history of the collapse of the Barber boom and you all should be, because what is happening now could possibly be the most important financial event of your actuarial lives, this book is very good

http://www.hindsight-books.com/detail.php?catid=1890

 

Phil is this still your considered opinion 8 months on?

I don't think I would put you in charge of my money and I would hate to think what damage you could do in a responsible actuarial position

 

Bring on the house price crash!

Just hope I'm still in a job to take advantage of the change in economy.

 

Just how many times can/will the BOE keep bailing out others with emergency lending? There has got to be a tipping point where even they start to worry about getting their money back? I know at present they are doing it because the alternative isn't worth contemplating, but if they start to belive they can't make a difference anymore, what then? I suppose they could just keep lending at an ever higher rate, but again there will be a tipping point where the rate is just to high to comtemplate. Then one by one, banks/building socities etc will be refused more credit and then we see the start of the collapse of half (more?) of the banking system. Matter of months? I think these things tend to happen quite fast once a little bit of momentum gets going!

 

soz wrong msg

 

To be fair to Phil, your original worst case scenario has not yet materialised.