When writing articles about foreclosure, the mantra seems to be “the banks want your money“, they are willing to negotiate and help you keep your home. The pesky reality, however, is pointing in another direction. According to a recent AP article, US July Foreclosures Rates were Up 93% from a year ago. So, if the banks used to like your money, now they seem to be moving in to get your home.
This article is going to be rather dry and technical, and most probably is going to be a multi—part article. So bear with me.
The answer to the why of this change of attitude is at the core of the financial engineering that made possible the housing bubble in the first place. I am not going to go into detail about how this works, but John Mauldin, an investors’ advisor has been trying to explain to his subscribers how the alchemy works and why it was likely to stop. You can see his article here (subscription to the newsletter is free).
The Financial Engineering
Mauldin points out that “in the early ’90s, investment banks created a new type of security called an Asset Backed Security (ABS). Essentially, investment banks would take a thousand mortgages or car loans or commercial mortgages or bank loans and put them into a security. You could have a Residential Mortgage Backed Security (RMBS) or Commercial Mortgage Backed Security (CMBS) or a Collateralized Loan Obligation (CLO) and then a Collateralized Debt Obligation (CDO)“. If you are interested so far, you should read his whole article to learn how the CMBS are divided in tranches with different level of risks and different levels of return based on the quality of the loans securitized.
So far so good. We have low interest rates, the banks can loan money, sell the loan immediately to pension funds, and have money to loan more money. The problem is that this created an essentially inflationary environment in which there was an excess of liquidity (normally, banks would need to wait a few years to have enough money repaid on the loans to be able to loan more money).
With all that money and nowhere to invest it, the banks decided to go after new customers. Why not? It’s partially free money because if they need to borrow to make a loan, they borrow at 3, 4 or more points below the loan they make to a high risk customer. The only real cost there is the cost of the risk, but since the risky loans are securitized and packaged with better loans, the risk is assumed by whoever buys the RMBS. Neat, isn’t it? (Can you say Enron?).
As they provide more and more of these bad loans, they also lobby to have the bankruptcy law modified and make it harder for the middle class to protect their homes by declaring bankruptcy. When trying to find some quote to support that claim, I stumbled upon the article Bankruptcy Law Doesn’t Jibe with Modern Mortgages, a SmartMoney.com interview with Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys. He wants to change the current bankruptcy law to, among other things, “give people more tools to deal with foreclosures, including these exploding adjustable rate mortgages (ARMs) you see now, where payments just go so high because of the interest rate adjustments.”
Now, you need to wonder why they were doing this: Giving with one hand and getting ready to take with the other. The answer, I think, is on the RMBSs and the lower grade tranches. You see, as more and more bad loans go into default, the RMBSs become more risky and harder to sell. When the banks can’t sell these RMBSs they find they need to wait for the good loans to pay for them to have the moneys for more loans (the way it used to be). But the best loans have the lower returns, because the interest rates are some times half of those sub-prime loans, so now they see themselves in a pickle.
To solve the problem, they are moving into helping to concentrate real estate in the hands of a few excellent borrowers (basically REITs and other large real estate investors). From their point of view, this is a no-brainer. Instead of having, let’s say, 300 risky loans, they now have 3 high quality loans. The interest rate on these loans is lower than in the 300 risky ones, but who cares! Now they have 3 loans with the highest investment value and they can sell the RMBSs created for these loans to any institution.
My concern is that, at this juncture, banks have a real interest in liquidating bad loans and transferring those loans to lower risk borrowers, that’s why they are not making any real effort to salvage bad loans and are forcing foreclosures of risky loans that may harm their access to cheap new funds.
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