Jul. 7, 2011: 4 Episodes to Help See Where We are Today
Rob Chrisman

[I am away from the computer on a daily basis, and my access to e-mail is sporadic and not timely. In my place are daily commentaries from a series of very knowledgeable mortgage industry people with different backgrounds, and they have been given very little direction about what to write about – the latest is below. Our views may or may not coincide, but I thank them for their time in volunteering and helping out.]
 
Four selected episodes over the last 25 years that can help us better understand today’s mortgage market
 
Falling Oil Prices Opens the Door to Servicer Consolidation
When oil prices declined in the mid-eighties, several states suffered severe economic dislocation, most particularly Texas and the Rocky Mountain region.  As home prices fell and jobs were lost, defaults soared.  For the first time servicers in these states were exposed to large numbers of VA no-bids, which imposed unexpected financial burdens on these servicers.  At the time, it was common for mortgage bankers to retain servicing rights and so, instead of a few mega-servicers having commanding market share, ownership of servicing rights were spread far and wide.  Within a few short years, several firms went bust, several were forced to sell or merge while other firms simply decided the risk/reward profile of servicing loans didn’t make sense and thus exited the servicing portion of the business.  At the time, the largest (or one of the largest) pure player in the mortgage banking space was Texas based Lomas and Nettleton.  Don’t remember them?  For a host of reasons they dropped off the map, not least of which was likely their outsized exposure to a slowing Texas economy and, by implication, falling oil prices.
 
The Berlin Wall Falls, Sub-Prime Becomes (Temporarily) Respectable 
Southern California has long had the reputation as the home, if not the birthplace, of sub-prime lending.  The most common explanation for this is that salaries are high in Southern California so the higher margin sub-prime loan was the only way to cover higher Southern California operating costs. I think most would agree that the argument that sub-prime margins are somehow higher hasn’t really panned out.  However, in addition to higher labor costs, Southern California had, at least through 1990, experienced several decades of post-WWII boom with a growing economy and steadily higher home prices.  A large part of this economy, particularly in the Los Angeles area, was centered on the defense industry.  Not surprisingly, when defense budgets were cut after the Berlin Wall came down, unemployment rose and home prices (temporarily) fell.   High home prices had made affordability an issue and one common loan product of the era had a lower note rate than a 30 year fixed rate loan but carried either a 5 or 7 year balloon feature. Believe it or not, these balloon loans were agency eligible and automatically reset for the final 25 or 23 years if the borrower had not been delinquent during the prior twelve months.  Unfortunately for laid-off defense workers, their balloon payments came due when they were ineligible for the automatic reset because they had been late once or twice in the preceding twelve months.  Fortunately for the nascent sub-prime industry, these were perfect sub-prime borrowers – they had equity in their homes, they were on the path to restoring their credit, they understood loans that carried a balloon feature and they were not eligible for an agency loan. Thus set the stage for the rise of the sub-prime mortgage market, its subsequent fall, its rise from the ashes, and its (probably temporary) fall once again.
 
Enron Implodes in an Accounting Scandal, Fannie and Freddie Cede Swaths of the Market to Wall Street
 
In 2002, Enron blew up in the wake of accounting improprieties.  Little noted at the time, Enron and Freddie Mac shared the same accounting firm, Arthur Anderson.  Freddie Mac changed accounting firms to PriceWaterhouseCoopers which promptly scrubbed Freddie Mac’s books and declared that Freddie Mac had understated it profits for years in an effort to smooth earnings.  Over the next year, both Fannie and Freddie were ensnared in this issue until they finally relented, restated earnings and replaced several key executives.  The commonly accepted viewpoint is that management manipulated earnings in order to maximize their bonus compensation.  However, I think it can be argued that the commonly accepted argument is too simple, and that with the Enron, MCI and Sunbeam accounting scandals in their recent past, the public accountants were predisposed toward finding issues even where issues might not legitimately exist.  If recollection serves, the major accounting issue was one that was very specific to Fannie and Freddie and involved the valuation of the interest only component of their portfolios.  For years, both firms had separately devised very similar methodologies for valuing these assets and each of their outside auditors had validated the agencies’ approaches without exception in every prior year.  Post Enron, that wasn’t good enough and both agencies spent the next several years resolving accounting issues, changing executive leadership and otherwise stepping back from the market while they mended fences.
 
The GSEs Accounting Issues Open the Door for Wall Street to Arbitrage the Mortgage Market
Nature abhors a vacuum and with the GSEs temporarily sidelined, Wall Street stepped right in.  Stepping in, in this instance, took the form of realizing that in the absence of the GSEs an arbitrage opportunity existed.  By purchasing pools of loans which are inherently unrated, structuring them into bonds and then having rating agencies such as Moody’s and Standard & Poor’s rate the bonds, a credit arbitrage profit on the difference between the unrated individual mortgages and the rated bonds could be earned.   It can be argued that this credit arbitrage had been the province of Fannie Mae and Freddie Mac (implicitly stated in the form of the guaranty fee they charged) but by expanding underwriting guidelines and capitalizing on the uncertainty that surrounded the GSEs immediately after their accounting scandal, Wall Street (and others) reduced GSE (and GNMA) market share and effectively privatized (momentarily, as we shall see) large swaths of the mortgage market.  This is all well and good, but arbitrage opportunities don’t last forever.  The first private label deals carried higher coupons and were backed by higher quality collateral than did later deals. Over time, coupon rates came down and the quality of the underlying collateral eroded until the arbitrage opportunity was gone.  Markets being markets, the arbitrage opportunity may have been gone but bonds were still being issued because markets tend to overshoot before they find equilibrium.  We’ve seen this behavior at least once before, when Wall Street issued high yield (so called “junk”) bonds in ever increasing amounts to finance increasingly expensive mergers and acquisitions (from which Wall Street also profited) right up until the high yield market collapsed taking Drexel Burnham and, arguably, the S&L industry and several life insurers (i.e. Executive Life) with it. In my opinion, and I willingly state that it is hard to point to a single decisive data point that supports me, this is about the time that the GSEs re-entered the market and began dabbling in “Alt A” and other esoteric products with which they had little actual experience.  They saw Wall Street and others profiting greatly and taking market share and, as a result, dove into the market at precisely the wrong time, buying the sketchiest collateral at the highest dollar prices.  As a result, we now have a greater understanding of whether the Treasury guarantee offered to the agencies was implicit or explicit and just what a GSE conservatorship entails.

I offer these four apparently unrelated episodes for a couple of reasons.  First, turmoil and change has been a constant in the mortgage industry and we’ve always worked our way out of it.  Ask someone that was servicing mortgages in Texas in 1987 whether today’s mortgages are performing much worse than their, admittedly local, mortgages were performing then.  Second, much of what drives our industry, for better or worse, is not of our own making or easily managed but we somehow find a way to develop products that both serve the customer, as with sub-prime in Southern California, and keep our doors open.  Third, it is easy to vilify the mortgage industry, even when the root causes lie far afield as with Enron’s accounting issues. Fourth, be careful of what you wish for – you may actually get it. For political, economic and accounting reasons the GSEs temporarily stepped back and we momentarily experienced a much more “pure” expression of the mortgage market.  I need not remind you that such pure expression did not end well.  Capital will flow into an arbitrage opportunity, be it a rate arbitrage or a credit arbitrage, until that arbitrage opportunity no longer exists, after which it will not flow at all.  Many, if not most, of the proposals floated to reform real estate finance seemingly forget this basic fact and, if implemented, would be pro-cyclical  - meaning they would serve to provide too much mortgage capital during boom periods and too little during times of slowdown.  Before we wish away Fannie or Freddie or GNMA, we’d be wise to remember this.

 
Anthony B.
anthony@abadvisory.com
 

If you’re interested, visit my twice-a-month blog at the STRATMOR Group web site located at www.stratmorgroup.com . The current blog takes a look at near-term news for non-agency securities, such as jumbo residential loans. If you have both the time and inclination make a comment on what I have written, or on other comments so that folks can learn what’s going on out there from the other readers.