securitization

The Reality Of Mortgage Modification

/ erdosfan / 17 Comments

Also published on the Atlantic Monthly’s Business Channel.

Why A Decline In Home Prices Should Not Cause Defaults

It seems that we have taken as an axiom the idea that if the price of a home drops below the face value of the mortgage, the borrower will default on the mortgage. That sounds like a good rule, since it’s got prices dropping and people defaulting at the same time, so there’s a certain intuitive appeal to it. But in reality, it makes no sense. Either the borrower can afford the mortgage based on her income alone or not.  However, it does make sense if you also assume that the borrower intended to access the equity in her home before the maturity of the mortgage. That is, the home owner bought the home with the intention of either i) selling the home for a profit before maturity or ii) refinancing the mortgage at a higher principle amount.

If neither of these are true, then why would a homeowner default simply because the home they lived in dropped in value? She wouldn’t. She might be irritated that she paid too much for a home. Additionally, she might experience a diminution in her perception of her own wealth, which may change her consumption habits. But the fact remains that at the time of purchase, she thought her home was worth X. And she agreed to a clearly defined schedule of monthly payments over the life of the mortgage assuming a price of X. The fact that the value of her home suddenly drops below X has no impact on her ability to pay, unless she planned to access equity in the home to satisfy her payment obligations.  Annoyed as she might be, she could continue to make her mortgage payments as promised.  Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.

In short, if a home drops in value, it does not affect the cash flows of the occupants so long as no one plans to access equity in the home. And so, the ability of a household to pay a mortgage is unaffected in that situation. This is in contrast to being fired, having a primary earner die, or divorce. These events have a direct impact on the ability of a household to pay its mortgage.

I am unaware of any proposal to date which offers assistance to households in need under such circumstances.

The Dismal Science Of Mortgage Modification

Simply put, available evidence suggests that mortgage modifications do not work.

[IMAGES REMOVED BY UST; SEE REPORT LINK BELOW]

The charts above are from a study conducted by the Office Of the Comptroller of the Currency. The full text is available here. As the charts above demonstrate, within 8 months, just under 60% of modified mortgages redefault. That is, the borrowers default under the modified agreement. If we look only at Subprime mortgages, just over 65% of modified mortgages redefault within 8 months. This may come as a surprise to some. But in my mind, it reaffirms the theory that many borrowers bought homes relying on their ability to i) sell the home for a profit or ii) refinance their mortgage. That is, it reaffirms the theory that many borrowers were unable to afford the homes they bought using their income alone, and were actually speculating that the value of their home would increase.

Morally Hazardous And Theoretically Dubious

Why should mortgages be adjusted at all? Well, one obvious reason to modify is that the terms of the mortgages are somehow unfair. That’s a fine reason. But when did they become unfair? Were they unfair from the outset? That seems unlikely given that both the borrower and the lender voluntarily agree to the terms of a mortgage. Although people like to fuss about option arm mortgages and the like, the reality is, it’s not that hard for a borrower to understand that her payments will increase at some point in the future. Either she can afford the increased payments or not. This will be clear from the outset of the mortgage.

So, it doesn’t seem like there’s much of a case for unfairness at the outset of the agreement. Well then, did the mortgage become unfair? Maybe. If so, since the terms didn’t change, it must be because the home dropped in value and therefore the borrower is now paying above the market price for the home. That does sound unfortunate. But who should bear the loss? Should the bank? The tax payer? How about the borrower? Well, the borrower explicitly agreed to bear the loss when she agreed to repay a fixed amount of money. That is, the borrower promised “to pay back X plus interest within 30 years.” This is in contrast to “I promise to pay back X plus interest within 30 years, unless the price of my home drops below X, in which case we’ll work something out.” Both are fine agreements. But the former is what borrowers actually agree to.

Not enforcing voluntary agreements leads to uncertainty. Uncertainty leads to inefficiency. This is because those who have agreements outstanding or would like to enter into other agreements cannot rely on the terms of those agreements. And so the value of such agreements decreases and the whole purpose of contracting is defeated. In a less abstract sense, uncertainty creates an environment in which it is impossible to plan and conduct business. As a result, this type of regulatory behavior undermines the availability of credit.

But even if we do not accept that voluntary agreements should be enforced for reasons of efficiency, mortgages represent some of the most clear and unambiguous promises to repay an obligation imaginable. The fact that a borrower was betting that home prices would rise should not excuse them from their obligations. There are some situations where human decency and compassion could justify a readjustment of terms and socializing the resultant losses. For example, the death of a primary earner or an act of war or terrorism. But making a bad guess about future home prices is not an act that warrants anyone’s sympathy, let alone the socialization of the losses that follow.

The Elephant In The Room

This notion that Subprime borrowers were victimized as a result of some fraudulent wizardry perpetuated by Wall Street is utter nonsense. Whether securitized assets performed as promised to investors is Wall Street’s problem. Whether people pay their mortgages falls squarely on the shoulder of the borrower. Despite this, we are spending billions of public dollars, at a time when money is scarce and desperately needed, on a program that i) is demonstrably ineffective at achieving its stated goals (helping homeowners avoid foreclosure) and ii) rewards poor decision making and imprudent borrowing. Given the gravity of the moment, a greater failure is difficult to imagine. But then again, we live in uncertain times, so my imagination might prove inadequate.

The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps: Part 1

/ erdosfan / 15 Comments

A Higher Plane

In this article, I will return to the ideas proposed in my article entitled, “A Conceptual Framework For Analyzing Systemic Risk,” and once again take a macro view of the role that derivatives play in the financial system and the broader economy.  In that article, I said the following:

“Practically speaking, there is a limit to the amount of risk that can be created using derivatives. This limit exists for a very simple reason: the contracts are voluntary, and so if no one is willing to be exposed to a particular risk, it will not be created and assigned through a derivative. Like most market participants, derivatives traders are not in engaged in an altruistic endeavor. As a result, we should not expect them to engage in activities that they don’t expect to be profitable. Therefore, we can be reasonably certain that the derivatives market will create only as much risk as its participants expect to be profitable.”

The idea implicit in the above paragraph is that there is a level of demand for exposure to risk. By further formalizing this concept, I will show that if we treat exposure to risk as a good, subject to the observed law of supply and demand, then credit default swaps should not create any more exposure to risk in an economy than would be present otherwise and that credit default swaps should be expected to reduce the net amount of exposure to risk. This first article is devoted to formalizing the concept of the price for exposure to risk and the expected payout of a derivative as a function of that price.

Derivatives And Symmetrical Exposure To Risk

As stated here, my own view is that risk is a concept that has two components: (i) the occurrence of an event and (ii) a magnitude associated with that event. This allows us to ask two questions: What is the probability of the event occurring? And if it occurs, what is the expected value of its associated magnitude? We say that P is exposed to a given risk if P expects to incur a gain/loss if the risk-event occurs. We say that P has positive exposure if P expects to incur a gain if the risk-event occurs; and that P has negative exposure if P expects to incur a loss if the risk-event occurs.

Exposure to any risk assigned through a derivative contract will create positive exposure to that risk for one party and negative exposure for the other. Moreover the magnitudes of each party’s exposure will be equal in absolute value. This is a consequence of the fact that derivatives contracts cause payments to be made by one party to the other upon the occurrence of predefined events. Thus, if one party gains X, the other loses X. And so exposure under the derivative is perfectly symmetrical. Note that this is true even if a counterparty fails to pay as promised. This is because there is no initial principle “investment” in a derivative. So if one party defaults on a payment under a derivative, there is no cash “loss” to the non-defaulting party. That said, there could be substantial reliance losses. For example, you expect to receive a $100 million credit default swap payment from XYZ, and as a result, you go out and buy $1,000 alligator skin boots, only to find that XYZ is bankrupt and unable to pay as promised. So, while there would be no cash loss, you could have relied on the payments and planned around them, causing you to incur obligations you can no longer afford. Additionally, you could have reported the income in an accounting statement, and when the cash fails to appear, you would be forced to “write-down” the amount and take a paper loss. However, the derivatives market is full of very bright people who have already considered counterparty risk, and the matter is dealt with through the dynamic posting of collateral over the life of the agreement, which limits each party’s ability to simply cut and run. As a result, we will consider only cash losses and gains for the remainder of this article.

The Price Of Exposure To Risk

Although parties to a derivative contract do not “buy” anything in the traditional sense of exchanging cash for goods or services, they are expressing a desire to be exposed to certain risks. Since the exposure of each party to a derivative is equal in magnitude but opposite in sign, one party is expressing a desire for exposure to the occurrence of an event while the other is expressing a desire for exposure to the non-occurrence of that event. There will be a price for exposure. That is, in order to convince someone to pay you $1 upon the occurrence of event E, that other person will ask for some percentage of $1, which we will call the fee.  Note that as expressed, the fee is fixed. So we are considering only those derivatives for which the contingent payout amounts are fixed at the outset of the transaction. For example, a credit default swap that calls for physical delivery fits into this category. As this fee increases, the payout shrinks for the party with positive exposure to the event. For example, if the fee is $1 for every dollar of positive exposure, then even if the event occurs, the party with positive exposure’s payments will net to zero.

This method of analysis makes it difficult to think in terms of a fee for positive exposure to the event not occurring (the other side of the trade). We reconcile this by assuming that only one payment is made under every contract, upon termination. For example, assume that A is positively exposed to E occurring and that B is negatively exposed to E occurring. Upon termination, either E occurred prior to termination or it did not.

sym-exposure2

If E did occur, then B would pay N \cdot(1 - F) to A, where F is the fee and N is the total amount of A’s exposure, which in the case of a swap would be the notional amount of the contract. If E did not occur, then A would pay N\cdot F. If E is the event “ABC defaults on its bonds,” then A and B have entered into a credit default swap where A is short on ABC bonds and B is long. Thus, we can think in terms of a unified price for both sides of the trade and consider how the expected payout for each side of the trade changes as that price changes.

Expected Payout As A Function Of Price

As mentioned above, the contingent payouts to the parties are a function of the fee. This fee is in turn a function of each party’s subjective valuation of the probability that E will actually occur. For example, if A thinks that E will occur with a probability of \frac{1}{2}, then A will accept any fee less than .5 since A’s subjective expected payout under that assumption is N (\frac{1}{2}(1 - F) - \frac{1}{2}F ) = N (\frac{1}{2} - F). If B thinks that E will occur with a probability of \frac {1}{4}, then B will accept any fee greater than .25 since his expected payout is N (\frac{3}{4} F - \frac{1}{4}(1 - F)) = N (F - \frac{1}{4} ). Thus, A and B have a bargaining range between .25 and .5. And because each perceives the trade to have a positive payout upon termination within that bargaining range, they will transact. Unfortunately for one of them, only one of them is correct. After many such transactions occur, market participants might choose to report the fees at which they transact. This allows C and D to reference the fee at which the A-B transaction occurred. This process repeats itself and eventually market prices will develop.

Assume that A and B think the probability of E occurring is p_A and p_B respectively. If A has positive exposure and B has negative, then in general the subjective expected payouts for A and B are N (p_A - F) and N ( F - p_B) respectively. If we plot the expected payout as a function of F, we get the following:

payout-v-fee4

The red line indicates the bargaining range.  Thus, we can describe each participant’s expected payout in terms of the fee charged for exposure. This will allow us to compare the returns on fixed fee derivatives to other financial assets, and ultimately plot a demand curve for fixed fee derivatives as a function of their price.

Securitization Demystified

/ erdosfan / 10 Comments

What Is Securitization?

Securitization is a process that allows the cash flows of an asset to be isolated from the cash flows of that asset’s original owner. There are countless variations on this theme, and since our purpose here at derivative dribble is to foster clarity and simplicity, we will discuss only the main theme, and will avoid the Glen Gould variations.

Cui Bono?

We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.

The Nuts And Bolts

The overall process is quite simple and reasonable, despite its portrayal in the popular press. We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B, using money from the investors, and issue notes to those same investors.

So, the SPV owns the mortgages since B is completely bought out by the cash from the investors. And the notes issued to the investors are basically bonds issued by the SPV with the mortgages as collateral. As a result, B is out of the picture from an investor’s perspective. In reality, B might still service the mortgages (i.e., sending bills to borrowers, maintaining address information on borrowers, etc.) but because the mortgages have been sold to the SPV, the notes issued by the trust have no credit risk exposure to B. So if B goes bust, the assets in the SPV are safe and will continue to pay.

So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee.