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Category Archives: Mortgage Rates

In my previous post Mortgage Spreads too High? I had used the formula: 

53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion

Let me explain. This is a standard expected loss formula adapted to our current situation. It takes the form:

Expected Loss = Prob of Default *  Severity of Loss

Given no reworking of loans, the probability of a default is 53%. The Severity of Loss is the average loss as a percentage of the loan, in this case 35%, multiplied by the average loan value. Depending on which paper you read, the average residential mortgage loss varies between 20+% to 60+%. The generally accepted figure is 35%. 

Given that a very large proportion of the loans are subprime, one can expect a Loan-to-Value (LTV) ratio of 100%, i.e. the average loan amout was the value of the property or $250,000.

I added an additional 20% to the loss as on a 100% LTV the unrecoverable loss needs to include the depreciation in house prices of 20%. This is appropriate as average losses are monotic and subadditive.

There is an important lesson here.

The formula tells us that if banks foreclose on a property they will have to realize the additional loss from the 20% house price depreciation. If banks have the capital to hold on to these foreclosed properties until the economy revives and house prices appreciate, then these banks do not require the government bailout funds, and should not be allowed access to the bailout funds.

This raises the question, how are banks using the bailout funds? If the bailout funds are being escrowed into reserve accounts for when a foreclosure is realized, then expect further deterioration in the mortgage markets in 2009; because the bailout funds are being used to stopgap bank losses but not to address the cause – the real economy.

If the funds are used to rework and rewrite mortgages so that 85% of the toxic mortgages are now viable, then we can expect a recovery in the mortgage market in 2009, because banks are addressing the problems in the real economy.

Now we know why Sheila Bair of the FDIC proposed a workout of 2,000,000 residential mortgages. In the long run it will actually help save the banks.

Unfortunately, as Paul Kruger pointed out in his New York Time’s blog, the spreads have increased to unprecedented highs. So don’t expect a recovery in the real economy of the mortgage markets until mortgage spreads come back down.

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Paul Krugman in his New York Times blog wrote,

… there’s still a huge spread between mortgage rates and rates on federal debt … the spread between conventional 30-year mortgages and 10-year Treasuries  … was historically stable at about 150 basis points, but has been nearly double that lately.

This market behavior is significant for what it portents. Investors, i.e. the market, voting with their dollars are saying that they do not have as much confidence in the mortgage industry as they did prior to 2008, despite efforts like TARP.

CNN reports in When mortgage rescues go bad, that U.S. Comptroller of the Currency (OCC) found that 53% of borrowers who had their mortgages modified in the first half of 2008 were already at least two months delinquent again.

Unfortunately this was not the whole story, there is some more to this story.

Michael Van Zalingen, director of home ownership services for Neighborhood Housing Services of Chicago, says that one-third of his clients modifications wound up with housing payments equal to a whopping 50% or more of their gross incomes. That is, many of these modifications are resulting in higher real dollar payments! 

A Credit Suisse study reported redefault rates of only 15% when modification results in lower real dollar payments.

Looking at these news items I have to agree with the FDIC Chairperson, Sheila Bair’s plan to modify more than two million loans. The only real way to resolve this mortgage mess is to go back in and rework all delinquent loans until acceptable outcomes are reached. 

Lets look at the consequences:

a. Interest Rate Reduction:
If, as some estimates put it, there are about $500 billion in toxic loans, then a 100 basis point reduction in loan rates results in $5 billion loss of income to investors per annum.

b. No Rate Adjustment:
If we don’t do anything than, at a default rate of 53%, a standard severity of loss of 35%, and an average house price ($250,000) depreciation of say, 20%, will result in total loss of 53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion.

Options (a.) and (b.) clearly explains what market spreads are showing. The undesireable consequenses of not reworking the ‘expensive’ mortgages, is in fact less expensive that not doing so.

I do hope banks figure out what the market is pointing to before it is too late, otherwise we may have a second mortgage/banking implosion in 2009. 

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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