Risk Synergy for Investors in Mortgage-Backed Securities

One of the major failings of the credit markets in the Great Housing Bubble was the failure to take a holistic view and evaluate the systemic risks involved. A standard credit analysis reviews various risk parameters and attempts to rate the impact of each. The implicit assumption is that the total risk is equal to the sum of the parts; however this is not necessarily the case. Synergy is when the whole is greater than the sum of its parts, and there is a strong synergy in default loss risk in collateralized debt obligations that became apparent during the Great Housing Bubble. The credit rating agencies failed to identify this risk synergy until after the fact.

The risk of default loss in a tranche of a collateralized debt obligation is directly related to the default loss risk in the underlying mortgage notes. There are six general areas of credit default loss risk that may be evaluated independently, but their interactions are often synergistic in nature: creditworthiness risk, high combined-loan-to-value default risk, high debt-to-income ratio risk, fraud and misrepresentation risk, investment perception risk, and resale value risk. Of these general areas of risk, market valuation is most responsible for creating synergistic effects and amplifying default losses. Since many of the more "innovative" loan programs entered the market during a time of rising prices, there was no history of performance of these securities in other market conditions making it very difficult to assess the impact a down market would have on default rates. As it turns out, exotic loan programs do not perform well in any conditions other than a raging bull market.

Every mortgage loan that is originated contains an evaluation of the creditworthiness of the borrower who is responsible for making timely mortgage note payments. The most common evaluation tool is the FICO score. Prime borrowers have the highest FICO scores, they are considered the lowest default risk, and they receive the lowest interest rates as a result. Subprime borrowers have the lowest FICO scores, they are considered the highest default risk, and they receive the highest interest rates. This is the best documented and most carefully evaluated risk parameter. Before many of the loan programs were introduced during the Great Housing Bubble, FICO scores strongly correlated with default rates. This correspondence broke down in the price decline when the bubble popped because the other risk factors proved to have a greater influence than expected.

The combined-loan-to-value (CLTV) is the total debt of all mortgage obligations as a percentage of the appraised value of a particular property. A high CLTV generally corresponds to a low downpayment, but as resale values fell in the market crash, the CLTV rose for many borrowers as a consequence of falling prices. Although all borrowers with high CLTV loan balances show high default rates, it is important to distinguish between those borrowers who had a high CLTV because of a low downpayment and those who had a high CLTV because of falling values. Even though downpayments are a sunk cost and irrelevant to the market value of a house, they do have a strong psychological impact on the behavior of homeowners. People who put little or no money of their own money into the purchase of real estate exhibit greater default rates because they are not losing much of their money. Most people really do not care if the lender loses money, particularly if they will not have to repay the lender for the loss or incur tax penalties on the forgiven debt. When borrowers have less of their money in a transaction they are less likely to sacrifice to stay current on their mortgage note obligations, and they are more likely to default if resale values decline, particularly if their payments are greater than the cost of a comparable rental.

Most purchasers of collateralized debt obligations did not realize there was a huge amount of fraud and misrepresentation in the underlying loans they were purchasing. High CLTV financing, particularly the widely offered 100% financing, became the ideal tool for fraud. Fraudulent transactions require "straw buyers" willing to sacrifice their credit for a fee (or identity theft,) appraisers willing to inflate the houses value, and realtors and mortgage brokers either willing to go along with the transaction for cash or too ignorant to see the truth. In a transaction, the straw buyer purchased a house for greater than its true market value, and the excess payment was used to pay off the corrupted parties. Fraud was much easier to commit with 100% financing because the bank loaned the full amount of an inflated appraisal. It is much harder to commit fraud when the bank only loans 80% of a property's value. Most often the seller was in on the scam and was using the transaction to get out of a bad deal, but sometimes sellers were also innocent victims. The straw buyer had no intention of repaying the loan from the start, and the property quickly went into foreclosure.

A more common problem was misrepresentation of income. Stated-income loans, also known as "liar loans," were very common during the bubble rally. People would simply make up a number that qualified them for a loan and state it on their mortgage application. One of the assumptions purchasers of CDOs made was that the originators of the underlying loans made sure the borrowers in reality made enough money to pay back the loan. Often times the extent of the loan originators' due diligence was examining the borrower's signature on the loan application and trusting in the veracity of the signatory. This was a very serious problem for valuing an interest in a CDO because there was no way to accurately determine the viability of the income stream when the income of those responsible for paying the underlying mortgage notes was in doubt.

The debt-to-income ratio is the total amount of payments compared to gross income expressed as a percentage. A lender evaluates the DTI of the mortgage loan as well as the total DTI of all borrower indebtedness when making a determination of creditworthiness. Historically, a borrower could not have a mortgage DTI in excess of 28% and a total DTI greater than 36% to qualify for a loan because debt burdens in excess of these figures proved to have high default rates. Despite this historical knowledge, lenders widely ignored these standards in the Great Housing Bubble in the quest for more customers. During the rally, few of these people defaulted because they were offered even more debt through home equity lines of credit from which they could make mortgage payments, and the few who did get into financial problems simply sold their house to pay off the mortgage. During the rally, people were keen to take on mortgage debt because interest rates were low, and it was a necessary tool for obtaining real estate and its commensurate appreciation benefits. It did not matter to buyers if 50% of more of their gross income was going toward debt service if the property itself was providing the additional income necessary to sustain their lifestyle. Of course, this only works when prices are increasing rapidly. Once prices stopped rising, the property could no longer provide additional income, and the borrowers had to make the crushing payments out of their true income. Without the benefits of appreciation, borrowers quickly found the burden of a high debt-to-income ratio overwhelming, and many borrowers defaulted because the payments were too much to handle, just as the lessons from history said they would be.

One of the biggest fallacies pushed on the general public is the notion that residential real estate is a great investment. This idea caused people to view houses as an investment and treat them accordingly. When the participants in a housing market perceive houses as an investment, they will more easily default on the loan than if they viewed the house solely as a home for their family. People develop emotional attachments to their family homes, and they will sacrifice much in order to keep it. People behave in a more businesslike manner when they view a house as an investment, and they are willing to give up the house if the investment does not perform as planned. When faced with the reality that house prices were not going to continue to go up and payments were in fact going to continue to cause losses, many people decided to stop making payments and allow their investment go into foreclosure. Financially, it was the logical decision given the alternative of continuing to make payments on a losing investment. When the "Great American Dream" of home ownership was tainted by investment motives, it became a nightmare for speculators and CDO investors alike.

The biggest risk faced by buyers of collateralized debt obligations is the default loss risk of the underlying mortgage when the collateral for the mortgage (the house) is overvalued in markets characterized by low affordability. The greatest risk of default is based on changes in the resale value of homes. All other default loss risk factors are masked when prices are increasing, and they are amplified when prices decline. Valuation risk is the ultimate synergistic factor.

Article Source: http://mylilpeanut.com

Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall? Learn more and get FREE eBooks at: www.thegreathousingbubble.com/ Read the author's daily dispatches at The Irvine Housing Blog: www.irvinehousingblog.com/ Visit Risk Synergy for Investors in Mortgage-Backed Securities.

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