A Mortgage Market Out of Balance By Peter Eavis New York Times DealBook Investment Banking Investment Services September 6, 2013. http://dealbook.nytimes.com/2013/09/06/a-mortgage-market-out-of-balance/?_r=0

The above linked article mentions put-back-risk as a possible cause for what, on its face, appears to be an economic anomaly in the current pricing of mortgages. Over the past couple of years, I’ve been reading articles which discuss mortgage put-backs and put-back-risk, and every time I see the phrase put-back-risk I wonder . . . whatever happened to “buyer beware” and I wonder, did Fannie and Freddie abandoned due-diligence in their processes while attempting to buy as many loans as they could buy in order to hit their mandated executive bonus targets?

RE: Put-Back-Risk

In the late 1990's Fannie Mae and Freddie Mac created automated underwriting systems. Fannie and Freddie encouraged mortgage originators to use their automated systems as “conduits” for underwriting and submitting loans to be purchased by Fannie and Freddie. If mortgage originators were using automated underwriting systems developed by the purchasers (Fannie and Freddie) why didn't the systems detect the poorly underwritten loans? Were there no audit procedures in place for ongoing audit and quality testing of the loans the GSEs were buying? I'd like to see an examination of the effect of the automated underwriting systems used by Fannie and Freddie.

In the mid to late 1990’s The GSE's also created the Mortgage Electronic Registration System (MERS) which is a mess because it lacked supervisory controls and audit controls on in-puts (mortgage records) which were supposed to record land title changes and supposed to record changes in mortgage note ownership.

Below, I’ve hyperlinked a couple of interesting articles which discuss important historical information about the competitive environment in the mortgage industry.

For more on this subject, see: Why Big Lenders Are So Afraid Of Fannie Mae and Freddie Mac” By Patrick Barta - Staff Reporter of The Wall Street Journal – pub. April 5, 2001, at: http://online.wsj.com/article/SB986417586751445153.html?cb=logged0.6522271920004229

And, Is FM Watch a Crusader With an Agenda? By Louis Sichelman – RealtyTimes, pub. 7/5/1999 at: http://realtytimes.com/rtpages/19990705_fmwatch.htm  

FAIR GAME

Find the Loan Behind the Loans

By GRETCHEN MORGENSON - New York Times - Published: September 7, 2013, at:http://www.nytimes.com/2013/09/08/business/find-the-loan-behind-the-loans.html?nl=todaysheadlines&emc=edit_th_20130908

Toward the end of the article the author, Gretchen Morgenson, makes this observation:

“The funding arrangements used by Western Sky and Cash Call are reminiscent of what occurred in the recent mortgage mania. The most egregious predatory lending wasn’t done, for the most part, by big national banks. It was done by smaller subprime mortgage companies like New Century, NovaStar and Fremont General, which made thousands upon thousands of loans.

But these companies wouldn’t have been able to make even 100 loans had they not gotten the money they needed from the big Wall Street banks. The warehouse lines of credit provided by those banks, therefore, enabled the underwriting of billions of dollars in dubious mortgages. Without access to that money, most of the worst loans would not have been written. When Wall Street cut off the credit spigot, these companies folded almost overnight.”

It’s interesting that Gretchen Morgenson focuses on “the Wall Street Banks” as enablers of predatory lending and dubious mortgages. When you consider Fannie's and Freddie’s aggressive purchasing of mortgages which later have been labeled predatory mortgages, or dubious mortgages, it would seem more accurate to include Fannie Mae and Freddie Mac, along with “the Wall Street banks”, as significant enablers of unqualified borrowers, predatory lending and dubious mortgage practices. 

After all, there are those who believe Fannie Mae's and Freddie Mac’s long-term practice of progressively lowering of mortgage qualification standards and their apparent lack of ongoing auditing of borrower qualification standards for the mortgages they bought were major factors enabling mortgage originators to unload their predatory mortgage originations, and their dubious mortgage originations.^(1)(2)(3)

Together, Fannie Mae and Freddie Mac were (are) the ten thousand pound gorilla that set the terms for competition in the mortgage industry (and, it seems they still are). And, perhaps more importantly, they had (and have) ‘government endorsement’ for the standards they set.

Footnotes:

1. Qualifications like: income, assets, employment, and if the borrower was actually going to be the resident in the property

2. From Automated Underwriting: “Each entity has its own system; yet despite the different names, the systems are intended to achieve the same goals. Fannie Mae calls her system Desktop Underwriter (DU), while Freddie Mac calls his Loan Prospector (LP). Portfolio and subprime lenders have trade names for theirs, as well.”

Moody’s Threatens to Cut Credit Ratings of Banks By Peter Eavis - pub. New York Times / Dealbook - August 22, 2013⁽¹⁾  

Comment from American Banker:

Downgrade Ahead? Moody's threatened to downgrade the nation's largest banks on Thursday, believing that the government is more likely to let them fail in the event of another financial crisis. The move, which could affect Goldman Sachs, JPMorgan Chase, Morgan Stanley, Wells Fargo, and possibly Bank of America and Citigroup, is likely to stoke the fire around the continuing "too big to fail" debate. "Moody's decision to review the ratings will reinforce the beliefs of those who say Dodd-Frank's measures are sufficient to deal with the 'too big to fail' issue," notes Dealbook. "But the actions of lawmakers who do not feel the act is adequate may have also contributed to Moody's actions." Standard & Poor's expressed similar sentiments about downgrading big banks back in June, believing that, while government bailouts were still a possibility, bondholders may be forced to shoulder losses, notes the Financial Times.

Questions:

Is the revenue model for the Nationally Recognized Statistical Rating Organizations (NRSROs)⁽²⁾ still ‘issuer pay’ (rather than ‘user pay’).⁽³⁾

Subsequent to the real estate bubble bursting and the subsequent great financial crisis has the Securities and Exchange Commission developed and implemented sufficient auditing procedures to test the efficacy of the ratings issued by the NRSRO’s.
If the government is strictly enforcing the rigorous stress testing of banks, and if these stress tests use adequate testing procedures and ungameable testing criteria, why wouldn’t the rating agencies be more willing to accept the output from those stress tests as testimony to the safety-and-soundness of the individual financial institutions?
Shouldn’t the government’s stress tests be a better measure of the safety-and- soundness of a financial institution, than is a NRSRO’s quality rating? In my mind, the government’s stress tests should be a better (and more objective) measure of a financial institutions’ safety and soundness, because the government is theoretically protecting investors and taxpayers, while the NRSRO’s may be somewhat conflicted by their ‘issuer pay’ revenue model.

 Footnotes:

1.  Moody’s Threatens to Cut Credit Ratings of Banks By Peter Eavis - pub. New York Times / Dealbook - August 22, 2013,at:http://dealbook.nytimes.com/2013/08/22/moodys-threatens-to-cut-credit-ratings-of-banks/?_r=0%20http://  

2. The history of the Nationally Recognized Statistical Rating Organizations, at: http://http//en.wikipedia.org/wiki/Nationally_recognized_statistical_rating_organization

3.  For more on the ‘user pay’ ‘issuer pay’ revenue models see The Credit Rating Controversy pub. Council on Foreign Relations Campaign 2102 Backgrounder, at: http://http//www.cfr.org/united-states/credit-rating-controversy/p22328

Worth reading side-by-side.

‘Political Genius’ Housing Plan Spurs Bubble Talk: U.K. Credit By Svenja O’Donnell - pub. Bloomberg News - August 20, 2013, at: http://bloom.bg/173vFEx

The Clinton Era Roots of the Financial Crisis Affordable-housing goals established in the 1990s led to a massive increase in risky, subprime mortgages. By Phil Gramm and Mike Solon - pub. Wall Street Journal - August 12, 2013, at: http://online.wsj.com/article_email/SB10001424127887323477604579000571334113350-lMyQjAxMTAzMDEwNTExNDUyWj.html?mod=wsj_valettop_email

Three more years: A year and one day after Bill Clinton was inaugurated into his second term as president a PBS NewsHour interview with Bill Clinton was aired. In the interview President Clinton proudly discusses his Affordable Housing Initiative, and how he used regulators to force banks to make loans to borrowers who otherwise couldn’t have bought houses. I’ve copied the relevant portion of the January 21, 1998 PBS NewsHour video interview.

The video clip featured below is a portion of a Sept. 8, 2010 Bloomberg interview with Edward Pinto, former Fannie Mae chief credit officer and a Bloomberg News guest Op-Ed contributor, in which he discusses the prospects for a second mortgage market meltdown and the regulation of Fannie Mae and Freddie Mac. Mr. Pinto talks with Carol Massar on Bloomberg Television’s “In the Loop.” (Source: Bloomberg).

If the SEC is really interested in stopping "insider trading", once the SEC finds the sources of the inside information, which has been sold to any advisor, the SEC should prosecute - to the fullest extent of the law - those sources that have provided the inside information .

One of the biggest motivations for hedge funds (and, for that matter, all actively managed institutional fund advisors) to buy "inside information" is that they can do so using their clients’ brokerage commission dollars to pay for the inside information (using order flow and soft dollar brokerage commissions).

If this kind of transaction is conducted with a 'full-service broker' the soft dollar portion of the commission is not disclosed and it is not transparent. (In the industry such arrangements are known as bundled undisclosed soft dollar brokerage arrangements.) This lack of transparency and lack of disclosure makes the discovery of the violation of insider trading laws [including Reg. FD] very difficult for regulators.

New York Attorney General, Eliot Spitzer's investigations of the brokerage industry in the late 1990's revealed the significance of undisclosed soft dollar commission arrangements. Because of the discoveries during Spitzer's investigations, the SEC was forced to implement the Global Research Analyst Settlement on several large brokerage firms where it had discovered conflicts-of-interest (where advisors' clients' brokerage commissions were used to influence brokerage & analyst favors and create conflicts-of-interest (e.g. late trading in exchange for order flow, mutual fund shelf space for order flow, IPO hot IPO allocation for order flow, early release of analyst opinions for order flow, and etc.).

Later, after a couple years considering how best to regulate soft dollars, former Chairman of the SEC, Christopher Cox was so frustrated at attempting to regulate undisclosed soft dollar brokerage that he sent letters to Senator Christopher Dodd and to Congressman Barney Frank requesting that Congress "repeal or substantially revise Section 28(e) . . . ." which is the law that defines the appropriate uses of institutional client's brokerage commissions.

To see the full text of the letter SEC Chairman Cox sent to Senator Dodd:

Please note: Chairman Cox's letter includes a computational error arising out of a semantic distinction. He says that in 2006 advisors directed almost one billion dollars of their clients’ soft dollar brokerage commissions. In fact, for 2006 the true estimate of institutional advisor directed clients' soft dollar brokerage commissions exceeded ten billion dollars of clients' commissions.

From some internet searches I performed at the beginning of the controversy about the Mortgage Electronic Registration System (MERS), I learned MERS was first proposed by representatives of Fannie Mae at a Mortgage Bankers' Annual Convention in the early 1990's. Some of the materials I saw on-line at that time said that mortgage bankers showed interest in the concept Fannie Mae presented, so Fannie Mae and Freddie Mac each contributed 2 million dollars (4 million total) to develop MERS. 

The articles I saw on-line said Fannie and Freddie hired a large D.C. law firm (Covington & Burling) to design and program MERS. And, these articles claimed that, once the design and programming was complete Fannie and Freddie incorporated MERSCorp. and hired Electronic Data Systems (EDS) as ‘facilities manager’ for MERSCorp.  Then Fannie and Freddie sold MERSCorp to a consortium of large mortgage industry participants (mortgage banker securitizers, and mortgages servicers).

It was also noted that as MERS was in development Fannie and Freddie modified some of their mortgage qualification requirements and documentation standards to favor MERS recordings. And, it was noted that without Fannie and Freddie’s interest and support for MERS, MERS probably would not have been a ‘successful’ venture.

I thought this history of MERS was interesting. I’ve also found it interesting that, as the controversy around MERS, and the controversy around the GSE's has brewed over the last few years, the documentation for the history of the creation of MERS and MERSCorp seems to have become more-and-more obscure.

Related information:

(1) Oregon State Supreme Court Media Release of Bart G. Brandrup, et al., v. Recontrust Company, N.A., et al., (USDC Case No. 311CV1390HZ, 311CV1399HZ, 311CV1533SI, 312CV0010HA) (SC S060281), at: http://www.ojd.state.or.us/SCA/WebMediaRel.nsf/Files/2013-06-06_Media_Release.pdf/$File/2013-06-06_Media_Release.pdf

(2) Is FM Watch a Crusader With an Agenda? By Louis Sichelman – RealtyTimes, pub. 7/5/1999 at: http://realtytimes.com/rtpages/19990705_fmwatch.htm

(3) Two Faces: Demystifying the Mortgage Electronic Registration System's Land Title Theory By Christopher L. Peterson University of Utah - S.J. Quinney College of Law, pub. SSRN, at: September 19, 2010, at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1684729

(4) Reston Based Company MERS in the Middle of Foreclosure Chaos By Brady Dennis & Ariana Cha Washington Post -October 8, 2010. http://www.washingtonpost.com/wp-dyn/content/article/2010/10/07/AR2010100702742.html

(5) The MERS Mess (a YouTube posted video-clip of a brief exchange describing some MERS problems taken from U.S. Congress testimony) at:

(6) MERS? It May Have Swallowed Your Loan An obscure company claims to hold title to roughly half of the home mortgages in the nation - 60 million loans By Michael Powell and Gretchen Morgenson - New York Times, March 6, 2011 at: http://www.nytimes.com/2011/03/06/business/06mers.html?emc=eta1&_r=0

Surveys Highlight Changing Role for Investors in Housing Market By Conor Dougherty - pub. Wall Street Journal – Developments, July 3, 2013 WSJ http://on.wsj.com/12FQq7q 

If you want to know more about the institutional investors’ role in the current housing market do a key words search on: REO to Rent.

I’ve read a couple of articles recently which mention that the institutions are slowing their purchasing of single family homes because they are not able to find qualified tenants and now they have an inventory of homes ready for lease that remain vacant. I’ve also read that some of the early institutional buyers have begun to sell the homes they purchased because they are satisfied with the gains provided by the bubble that has formed (Och-Ziff).

The above referenced article mentions all cash buyers do not use mortgages and therefore are insulated from interest rate changes. One of the things The Fed has been concerned about is investors ‘reaching for yield' (and taking-on excessive risk) in order to gain returns on their investments in this artificially low interest rate (Bernanke) market. The single family home buy-to-rent strategy seems to be a perfect example of investors reaching for risk when trying to make (uncertain) returns on investments. When interest rates change and yield can be found with less risk, will investors still be attracted to the buy-to-rent strategy? (Disintermediation)

And, the buy-to-rent phenomenon started with all cash purchases, but if you believe the institutions are insulated from interest rate changes key words search: ‘Deutsche Bank Buy to Rent Facility’. The buy-to-rent strategy and the returns promised by the managers selling the strategy were very speculative in the beginning, will the cost of leverage provided by these loans prove to actually work positively for the strategy, or will the interest charged on the loans be another drag on the hypothetical profitability of the strategy.

Another fly in the ointment, it seems many of the institutions which are in the buy-to-rent game may have always thought they could dump-the-risk by securitizing their total portfolio and enticing more (or other) investors to buy into the strategy (think, cash-out). But, it seems the rating agencies are reluctant to provide ratings for any of the proposed securitization plans the buy-to-rent managers and investment bankers have concocted for the strategy. Also, some of the buy-to-rent managers have done their deals using the REIT structure. It seems the SEC is becoming somewhat concerned about misuse and abuse of the REIT structure in some of these deals. Time will tell how the SEC’s concerns manifest in regulatory interpretation / changes.

Other people’s money: It’s interesting to note that the buy-to-rent managers are using institutional investors’ money (in many cases pension plan money) to fund their strategy. The managers receive a management fee off-the-top, the investors hold the riskiest part of the strategy.

“An Early Investor Says Buy-to-Rent Housing is Over” By John Gittelsohn Bloomberg News 6/6/2013 http://www.businessweek.com/articles/2013-06-06/an-early-investor-says-buy-to-rent-housing-is-over

Randy Newman is one of my favorite writer / musician / performers. He has family roots in Louisiana and, in his early music, he wrote about some of the cultural paradoxes he saw in that area of the south. 

This video-clip was taken from the last couple of minutes of a Bloomberg News interview with PIMCO's Bill Gross. In the interview he talks about the timing of Q.E. "tapering" and he mentions some structural issues which may be impeding the economic recovery. The 7.25% target he mentions is the Fed's unemployment rate target.