Should We Hedge Foreclosures?

Imagine you were facing foreclosure and that your lender was willing to work out a deal — a loan modification — so you could keep your home while the lender could avoid the costs of a foreclosure.

This sounds like a great outcome for everyone, except that it isn’t. Believe it or not, some folks oppose such accommodations because loan work-outs make mortgage-backed securities less risky.

Huh? You’re kidding.

Actually, I’m not. Let me explain:

When it comes to stocks and bonds we all pretty much get the idea.

It’s good when the shares you own rise in value — unless you “shorted” the stock, then you want prices to fall.

As to bonds, a higher price means a lower yield, while a lower price means a higher yield.

For instance, imagine that a bond pays 5 percent and costs $10,000. It generates interest worth $500 a year. If the price falls and the bond can be bought for $9,500 then the bond yields 5.2 percent ($500 divided by $9,500) — the $500 payment is the same, but since the bond’s cost has gone down, thus the effective yield has increased. If the bond is in demand and the purchase price rises to $10,500, then — again — the $500 payment stays the same but the yield declines to 4.76 percent ($500 divided by $10,500).

In other words, it’s possible to make money on Wall Street even if asset prices fall, something you can’t do with real estate.

It’s also possible to make money on Wall Street with various derivative mortgage securities, financial instruments that essentially allow you to bet on future price trends without actually owning the underlying financial asset.

Instead of looking at one bond, imagine that we want to look at large numbers of bonds worth billions and trillions of dollars. To make bonds easier to understand we would rely on independent ratings firms to judge the credit-worthiness of individual bonds backed by pools of mortgages that have been gathered together to generate income for investors. We could rank these mortgage-backed securities (MBS), calling the best ones “AAA” while securities which were more risky might be called “BBB-“.

Now we have a system in place which not only allows us to bet on mortgage-backed securities, but also differing classes of mortgage-backed securities. We might have one bet for mortgage-backed securities which represent prime mortgages and a second and very different bet for subprime mortgage-backed securities.

To make matters more complex we could add a few twists. For instance, someone might buy mortgage-backed securities and also derivative contracts hoping for the opposite result. If the value of the security goes down the worth of the derivative goes up — and vice versa. In effect, derivatives can be used as a kind of insurance for investors who hope to cut marketplace exposure.

Lastly, imagine an investor who buys derivative which predict rising interest rates and another set of derivatives which suggest falling rates. By matching the two sets of derivatives one would “hedge” their bets — and thus we now have the basis for the concept of hedge funds.

Hedge fund managers look for tiny inconsistencies in the marketplace and then place huge bets trying to benefit from microscopic discrepancies. Given that some of the largest fortunes created in recent years have been generated by hedge fund managers, it can be argued that such folks must know something. Alternatively, there have also been some spectacular flops and there could be more.

So what does all of this have to do with people losing their homes? Glad you asked.

“Mortgages have become commodities, involving multiple players,” says Sheila C. Bair, chairman of the Federal Deposit Insurance Corporation. “As a result, it may be easier to get credit but it’s much harder to resolve troubled loans. When the market turns as we’ve seen in recent months, workout strategies for troubled loans in securitized structures are much tougher to put together.”

As foreclosure rates have risen significantly in the past few years, a number of progressive lenders have begun to rethink foreclosure practices. After all, why rush to yank someone from their home when a foreclose typically means big losses for lenders? According to Lori Gay, president and CEO of Los Angeles Neighborhood Housing Services, a nonprofit lender, “it costs about $40,000 to $50,000 to foreclose on someone.” John Robbins, president of the Mortgage Bankers Association, also used the $40,000 loss figure in congressional testimony earlier this year.

Also, why foreclose when the public has become increasingly dissatisfied with lender practices, a dissatisfaction reflected in calls for sweeping lender reforms in Washington?

Here’s why:

Suppose that the loan pool represented by a mortgage-backed security includes 10,000 loans. Suppose that one expects 128 homeowners in the pool (1.28 percent) to face foreclosure and for 64 to actually lose their homes (because, says Robbins, “50% of foreclosures are worked out”). Given such a failure rate one might expect a mortgage-backed security to have a given value.

Now imagine that lenders change their foreclosure practices and try to modify loans. There would be fewer foreclosures. That’s great news for homeowners, great for lenders hoping to avoid losses, wonderful for neighbors who do not want to see falling real estate values, good for communities that want to keep up their tax base and terrific for investors who own mortgage-backed securities. Unfortunately, it’s bad news for derivative investors who made their bets expecting a certain number of foreclosures.

In other words, with fewer foreclosures the value of mortgage-backed securities increase — a big financial problem if you bet a few billion dollars that the value of mortgage-backed securities would fall.

We are now seeing complaints from hedge fund managers that their bets are being distorted by new foreclosure practices. One claim is that those who manage mortgage backed securities can manipulate outcomes by modifying mortgage agreements to avoid foreclosures and by taking other steps. In effect, hedge fund managers want lenders to return to the tougher and costlier practices of the past because saving the homes of people who have fallen on hard times is now reducing profits for billionaire hedge fund operators.

“Progressive and humane approaches to avoid foreclosure should be continued and expanded,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s largest marketplace for foreclosure properties. “Wall Street speculators should not be allowed to re-make the mortgage marketplace because their models failed to include the possibility of reasonable foreclosure practices. Such practices are simply another factor that savvy hedge-fund operators should have anticipated. Those who did are making money, those who did not are screaming for change.

“Let’s not forget,” Saccacio continued, “that real people who work hard every day are losing their homes. In a just society it hardly seems fair that some should needlessly be made homeless while those who already enjoy vast wealth should be made still-richer by increasing the number of homes that we foreclose.”


Published originally by RealtyTrac.com during June 2007 and posted with permission.

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1 Comment on "Should We Hedge Foreclosures?"

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  1. jw360 says:

    Woman, 90, Shoots Self During Foreclosure Eviction –
    Fannie Mae forgives loan for woman who shot herself


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