Saturday, March 10, 2007

Mortgage Fraud

One of the questions swirling around bankruptcy attorney circles is: where is the fraud?

We are seeing people facing mortgages where the monthly payments are increasing 40% or more in a 2-2.5 year period. Chapter 13 bankruptcy trustees are beginning to require proposed plans deal with the mortgage payments at their highest possible level rather than what the loan currently calls for.

It started me thinking. Everyone (that supported bankruptcy reform) is going blame the consumer for agreeing to mortgages that they had no chance of ever repaying. The consumer is going to blame the mortgage originator that told them they could refinance before the adjustments started. The mortgage originators are going to offer, the consumer knew the risks...of course, we are watching mortgage lenders flee the scene like cockroaches.

A typical bond is sold based on the interest rate earned. Because the rate of the bond is fixed, as interest rates move, the price moves inversely. Mortgage back securities (MBS) operate in a generally similar way. Although there are many more factors and risks involved, the issue is "what is the rate of return"?

For a good overview of the MBS market, check out this Fannie Mae page.

That said, let me share some numbers.
A $200,000 loan, 3/27 ARM, initial rate 8.5%, index 9.5%+LIBOR, 6 month adj, 11.5% initial cap, initial monthly payment $1,537.83.

Based on current LIBOR, if this loan was issued in 2004(it was), then on Jan 1, 2009, the payment will be $2,401.51, a 56% increase. This does not include any amounts for, or changes in, property taxes or insurance.

If the loan goes to maturity, the effective rate over the term would be 10.48%
Ignoring all the risk factors, what would the basis for purchase price of this loan be?
The 10.48% yield?
The 8.5% initial yield?
The 9.52% index yield?

Assuming a Fannie Mae MBS was priced to yield 6.5% on a pool of 1000 of these?

Value of 10.48% yield $322,557.53 x 1000
Value of 8.5% yield $261,538.46 x 1000
Value of 9.52% yield $292,923.08 x 1000

If I borrowed $2,000,000 from you at 5.5% and loaned it to 10 people at the 3/27 ARM rate indicated. The potential profit on reselling the loans in 90-120 days is enormous. Of course defaults and early repayments seriously affect as a buyer of the MBS, I might be a little miffed if the underlying loans crash and burn.

The scenario I see unfolding (originally) is that as more money is made, it chases more and more potential loans with huge index spreads...this would drive DOWN the initial interest rates as lenders compete. As the market begins to crash (when there are no more people obtaining loans (you have already dreged the bottom), then the interest rates are going to climb to ...the index yield, 9.52%, at least.

What happens to a bond price when the interest rate climbs 3000 basis points?

Care to answer Fannie Mae? Chairman Bernanke?

There may be no interest rate acceptable to the market for these securities. If that happens, the MBS market will crash and the largest holder of MBS is Fannie Mae.

Bernanke may have no good options to deal with the situation. Large banks and securities firms will have no choice but to purchase the MBS originators at losses to protect their own positions as large scale bankruptcies would all but eliminate funding for the MANY hundreds of billions of loans resetting with millions of borrowers unable to qualify for a standard loan.

Let me be a scare-monger. It is possible that as many as 90% of ARMs sold in the last 2-3 years will default eventually.

And who do you think will be blamed?

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