Subprime Foreclosure Woes: More on Securitization Creating Bad Incentives

One of our pet peeves is that the powers that be are desperate to recreate status quo ante, as far as the financial crisis is concerned, when that is what created the mess in the first place. And the tinkering being done around the margins is not sufficient to remedy many of the shortcomings.

Take mortgage securitizations. It is now blindingly obvious that they led to lower quality borrower due diligence. Why bother if you are reselling the loan? And in keeping, while just about every other innovation has a historical precedent (the first derivatives and mutual fund was in Ur, 1788 BC, for instance), loans apparently were never traded prior to our brave new world of banking. That suggests it might not be such a hot idea. Aside from the initial screening, another activity that was once intrinsic to banking was monitoring the borrower. That too goes out the window with securitization.

We’ve seen some attention to the first set of problems, the incentives for the originator to simply cut costs, which means as little screening as he can conceivably get away with and still unload the paper. The idea of having the party that sourced retain 5% simply is not enough to make a difference in behavior; making it easier for investors to sue in case of deficient originator due diligence would probably do more promote the desired response. But regardless, the priority is to restart the securitization machine, not fix the problems with the process.

One of the obvious, oft-discussed ones is the near impossibility of mortgage mods. In down real estate markets far less bad tahn this one, lenders would try to keep viable borrowers in the house. Since they at least knew the community, and had decent loan files from the initial screening, they could decide what to do on an individual basis. Aside from not being in a position to make informed decisions about particular borrowers, servicers are not set up to do anything on an individual basis. They are factories, with standard procdures for most activities. And of course, most servicing agreements limit or bar mods.

Now we have a new side effect of securitization: trusts dumping foreclosed houses. This looks to be a tragedy of the commons. While it seems rational for owners of foreclosed houses to liquidate inventory and move on (in theory, price discovery and market clearing are a good thing), the servicers are selling in bulk. If you have a lot of sellers dumping inventory at the same time, that is likely to produce an overshoot of housing price declines below historical levels in terms of relationship to rental prices and incomes.

The Wall Street Journal profiles the development in Atlanta, and Georgia has one of the fastest foreclosure timetables in the country, so this trend will be coming to your market soon.

From the Wall Street Journal:

The U.S. housing market is facing new downward pressure as holders of subprime-mortgage bonds flood the market with foreclosed homes at prices that are much lower than where many banks are willing to sell.

While nationwide figures are scarce, a review of thousands of foreclosures in the Atlanta area shows that trusts managing pools of securitized mortgages sold six times as many properties as banks during the six months ended March 31. And homes dumped by subprime bondholders sold for thousands of dollars less on average than bank-owned properties, the data show.

Yves here. That does not prove conclusively that the servicers are truly getting worse prices. The banks presumably were able to offload the best homes, and what is left will probably sell at deeper discounts. Back to the story:

Experts say this is a bad omen for residential real-estate prices and homeowners trying to sell or refinance, because the fire sales, many to cover soured subprime loans, put downward pressure on the value of nearby homes. All of this undermines federal efforts to stabilize the housing market and revive the broader economy….

In the Atlanta area, hit hard by foreclosures and declining home values in the past two years, mortgage-backed securitization entities completed 6,260 foreclosures in last year’s fourth quarter and the first quarter of 200…

Of those foreclosures, securitization entities sold 2,963 homes during the same period for an average of 62% of the original loan amount. Banks unloaded just 442 of the homes they foreclosed upon, with an average selling price of 69% of the original loan amount.

There still is much more inventory that mortgage-servicing firms are racing to sell for securitization trusts. Such entities tend to sell in bulk so that they can cut losses, finding it more cost-efficient to move homes through foreclosure and subsequent sale than to try to restructure the mortgage with the borrower…

According to Karen Weaver, global head of securitization research at Deutsche Bank AG, the steepest losses are on subprime loans, where lenders generally are recovering just 26% of the original loan amount….

Yves here. Read that last sentence again. Stunning. But that also says you could do ridiculously deep principal reductions and still come out ahead.

In March, the mortgage-processing firm that works on behalf of a Goldman Sachs Group Inc. mortgage trust sold a house in southwest Atlanta for $17,000 — a markdown of 87% from the original loan value. A Goldman spokeswoman declined to comment.

In the fourth and first quarters, Bear-issued trusts sold 29 properties in Fulton County, which includes Atlanta, for a total of $3.5 million. That was 60% of the combined original loan amounts of $5.8 million.

The loans were pooled in the vehicle during a period of Bear securitizations that were sold to investors prior to the firm’s sale to J.P. Morgan Chase & Co. a little more than a year ago.

A J.P. Morgan spokesman said the depressed prices are representative of a housing market correcting itself in a period that is vastly different from a few years ago. Many of the regions facing the largest declines in value are the same ones that soared and saw a frenzy of construction during the housing boom.

In comparison, Countrywide Financial Corp., now owned by Bank of America Corp., completed the sale of 23 properties in Fulton for $3.7 million, or 86% of the original loan amount during the same time period, the real-estate records analyzed by Data Intelligence show.

A Bank of America spokesman said prices being fetched in the Atlanta area for the Countrywide portfolio reflect a reluctance to dump properties far below prevailing market values. The bank is getting an average of 99% of the appraised value of homes on an average sale, while selling within one year 99% of the properties that end up on its books.