| WALKING TO THE END OF THE MORTGAGE CRISIS |
| Residential Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by one of the government sponsored structures: Ginnae Mae, Fannie Mae and Freddie Mac. Ginnie Mae (The Government National Mortgage Association) is a government agency, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are government sponsored enterprises, they have special authority to borrow from the U.S. Treasury, also provide certain guarantees but not backed by the full faith and credit of the US government. The government mortgage structures issue certificates on behalf of the pool of loans; these certificates are called securities, representing claims on the principal and interest payments made by borrowers on the loans in the pool. More complicated Mortgage-Backed Securities, known as Collaterized Debts Obligations are mortgage derivatives, designed to protect investors from or expose investors to various types of risk. An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. The secondary mortgage market consists of investors who purchase these securities collateralized by pool of residential mortgages. The holders of mortgage-backed securities are entitled to a pro-rata share of all principal and interest payments made on behalf of the pool of loans. When an important number of homeowners fail on paying their mortgage, claims to the cash flow of a pool of mortgage loans are in trouble, the authenticity of the mortgage-backed securities becomes in jeopardy and the secondary mortgage market operations can not play efficiently its major role of freeing up funds and ready to serve new homebuyers. In 2007, lenders initiated roughly 1-1/2 million foreclosures, up from an average of 950,000 in the preceding two years. Based on those statistics, investors are not interesting to buy mortgage-backed securities and their related derivatives. As a lender of last resort and in other to allow investment firms to take mortgage-backed securities off their balance sheets and convert them into liquidity, the Board of the Federal Reserve has created and approved a series of Lending Facilities aimed at providing liquidity to the Securitization Market in exchange of the Mortgage – backed Securities Certificates and related derivatives rated triple A. The Federal Reserve has already pledged liquidity support to the private capital market for a total of 436 Billions dollars, representing about 54% of their balance sheet which is worth 869 billions (CNBC Kudlow & Company). These Triple-A Securities are mixed with mortgage loans that could be in foreclosure. More than one in five of approximately 3.6 millions subprime adjustable-rate mortgages (ARMs) were either in foreclosure or ninety days or more past due. More than one-half of the foreclosure in 2007 were on subprime mortgages. The current high rate of delinquencies and foreclosures is not confined only to the subprime market. In 2007, about 45 percent of foreclosures were on prime, near-prime, or government-backed mortgages. From 1994 to 2006, subprime lending increased from an estimated $35 billion to $600 billion and represent about 20 percent of originations (Inside Mortgage Finance, 2007). Therefore, the Securities that the Fed is receiving as collateral, even though they were rating triple-A at the time of their issuance might now be considered as doubtful accounts receivables. The raise in the rate of foreclosure is most likely associated to falling house prices. According to recent surveys, it seems that nearly 30 percent of homeowners reported that their houses decreased in value over the past year, the market value of these houses could fall short of the value of the related mortgage, that means negative equity. Kristopher Gerardi a research associate at the Federal Reserve Bank of Boston analyzes homeownership in Massachusetts over the period 1989 to 2007 and reported that negative equity is not sufficient for default, because future house price appreciation may make it profitable to continue making mortgage payments. Cash flow constitutes another issue; if the market value of a property is lower than the balance of the underlying loan, a homeowner could find it may not make sense to sacrifice current consumption and continue paying the mortgage. But if the economy is in the mode of house price appreciation, the borrower may consent to make extreme sacrifices in term of current consumption, continue making payments and realize benefits in the distant future, they could consider and accept that they are to force to save for the future. Gerardi added that homeowners who have suffered a 20 percent or greater fall in house prices are about fourteen times more likely to default on a mortgage compared to homeowners who have enjoyed a 20 percent increase. Big Wall Street investment companies are taking advantage of the Federal Reserve's unprecedented offer to secure emergency loans, the central bank reported Thursday. Those large firms averaged $13.4 billion in daily borrowing over the past week from the new lending facilities. The Fed is making a huge bet by receiving those risky papers as collateral. But, Can the Fed win the bet? Yes, if the papers get value over time, the balance sheet of the Fed will be increased. If the papers do not get value over time, they may become liabilities for the taxpayers, as the balance sheet of the Fed is related to the federal budget: excess of funds absorbed by the budget, loss of funds covered by taxes. How to secure a win? A possible answer: unpack the mortgage-backed securities, sort and remove bad mortgage loans components. On the housing-credit front, University of Michigan economist Mark Perry, using data from the Mortgage Bankers Association, points out that of the 46 million mortgages outstanding, only 2.04 percent were in the foreclosure process in last year’s fourth quarter. And most of those were confined to Nevada, Florida, Michigan, and Indiana. Those bad mortgage loans could be modified and adjusted at the current market value of their collateral properties, using a housing price corrector specific to the area where the property is located. Then the related clause of non-assumption of the readjusted mortgage loans (if any) could be removed and the mortgage transferred to new homebuyers. After doing so, the loans will be repacked again into Mortgage-Backed Securities with a new face value and resell to investors. Confidence in the US financial market will be restored, investors included Sovereign Wealth Funds will restart purchasing US securities, price of commodities and gold will go down and the dollar will get value against the euro and the yen. In the meanwhile, economic indicators like home sales, durable goods orders, consumer confidence and spending, Personal Consumption Expenditures Price Index may continue to be lower until the end of the year. Fannie Mae and Freddie Mac can play a critical and beneficial role in the reevaluation of the secondary mortgage markets, as they have the ability and experience of packing loans, assigning face value or assessing risks of package of loans. James B. Lockhart Director, Office of Federal Housing Enterprise Oversight announced two days ago (March 18, 2008) a major initiative to expand that role of Fannie Mae and Freddie Mac by reducing the OFHEO- directed capital requirement for Fannie Mae and Freddie Mac from 30 percent to 20 percent further increasing liquidity and capital in the U.S. mortgage market. The initiative is expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market. If fully implemented this initiative will make permit the government sponsored enterprises to purchase or guarantee about $2 trillion in mortgages and mortgage-backed securities this year. That support will be for not just the Enterprises traditional conventional market but also for loan modifications, the subprime market, and the temporary jumbo conforming market. |