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Obama Second Term To Challenge Big Banks

It will be in the mid 40s for the second inauguration of Barack Obama, but  behind the secenes things will be a lot hotter.

One of the big themes of the next four years concerns banks, lending and clarity. In the past few weeks thousands of pages of new regulations have been published as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, regulations which will substantially alter the way we create mortgages and finance real estate.

For example, according to the Wall Street Journal, 61 percent of all subprime borrowers qualified for better financing in 2006. (See:Subprime Debacle Traps Even Very Credit-Worthy, December 3, 2007).

At the time loan officers could be paid on the basis of a yield spread premium (YSP) — the higher the cost of the mortgage the greater the compensation to the loan officer. Today YSPs are illegal which means there is no incentive to drive borrowers into higher-cost loans, toxic financing or unsuitable mortgages and as a result many foreclosures and short sales will be prevented.

Lenders can now charge whatever they want for mortgage financing, BUT if a loan has points and fees which total more than 3 percent of the loan amount then the financing cannot be considered a “qualified mortgage” — and if you’re a lender you only want to make QMs to avoid liability.

There’s no usury rate for mortgages under the new rules, BUT if the mortgage rate is more than 1.5 percent above the Average Prime Offer Rate it cannot be a qualified mortgage.

Mortgage lending has become a huge profit center under the new rules but what about other bank operations? How risky are derivatives trading and off-the-books entities?

We have to know these things. Why? To avoid another financial meltdown.

Banks, Books & Clarity

The whole idea of the bank bailouts, the justification for them, was to assure that the banking system was safe and secure. Recent reports of bank profits suggest that the bailouts were a success, but that’s only true if you don’t read the fine type.

For instance, what’s the “fair market” value of foreclosed loans and real estate at today’s prices? Do bank books reflect the full value of derivative liabilities? What is the real financial impact of variable-interest entities not carried on bank books or fully disclosed? Who will go to jail for rigging the LIBOR rate, wrongful foreclosures or selling sub-standard mortgages worth billions of dollars to Fannie Mae, Freddie Mac and the FHA.?

Ask yourself: If banks are in such great condition why do many have shares priced below book value? If bank regulation is so sure and effective why did the financial system need a bailout? Why must the Fed continue to buy mortgage-backed securities worth $40 billion a month? Is there no buyer from the private sector?

The next financial battle in Washington will be very simple: Investors and the public need to know the financial condition of our major banks — and right now we don’t. It’s time America had a full, fair and understandable accounting of the banks we bailed out, a sure way to bring real stability to the financial system.

Mr. Obama will never again face the electorate. He has no 2016 campaign to fund. Now, finally, is his chance to make a difference and one historic step would be to simply assure that the financial system is really in order.

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Our thanks to the National Park Service and photographer David Barna for providing the image above from the 2008 presidential inauguration. The picture was taken from the Washington Monument looking toward the U.S, Capitol.

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Big Bank Derivative Bets Nearly Double In Six Years

America’s major banks now hold derivatives with a notational worth of $225 trillion – about a third of the world total. No kidding. Trillion.

And that’s up from a mere $120 trillion six years ago. Rather than being weened off derivatives, America’s big banks are more deeply entrenched then ever.

Hopefully Wall Street has it figured out just right and there won’t be any major losses, say a few billion here or there. After all, when has Wall Street ever been wrong about financial instruments?

“Derivatives are dangerous,” says Warren Buffett. “They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.”

While many in Washington would like to limit derivatives trading, make such trades open to public scrutiny or both, Wall Street is vehemently against regulation.

In fact, there’s a simple way to resolve derivative worries. Allow unlimited derivatives trading — but only by individuals and partnerships willing to personally take the risk of profits and losses.

What’s A Derivative?

In basic terms a derivative is a bet tied to the movement of anything that can be valued. We could have a derivative bet which says the price of a mortgage-backed security (MBS), Hungarian currency or lemonade indexes will go up by a certain date. If the value rises then one party to the derivative will make money and the other will lose. And vice versa.

Notice, however, that derivatives are not like stocks or bonds — or mortgages or home loans.

First, unlike mortgages there’s no limit to the size of a derivative bet or the size of the derivative marketplace because none of the bettors actually are required to own the underlying asset. For instance you might bet that the price of oil will rise or fall without owning a single drop. The bet concerns the movement of value and not the ownership of the oil.

Second, there’s huge leverage because not much cash is needed to enter into a derivative agreement.

Third, if you bet on a derivative you typically make an off-setting bet to limit risk. Hopefully you do it right.

$648 Trillion

According to the Bank for International Settlements (BIS), the notational value of derivatives at the end of 2011 was $648 trillion.

The gross credit exposure from these securities was believed to be $3.912 trillion according to the BIS — that’s up from $3.5 trillion at the end of 2009.

But what if the estimates are wrong? For instance, let’s say losses are just one tenth of one percent bigger than expected. Not a big deal, except in the context of international derivative levels that’s more than $640 billion.

Do taxpayers have exposure? You bet. According to the FDIC, at the end of June 2012 all depository institutions held derivatives with a notational value of $224,998 trillion. However, such bets are not spread across the entire banking system. Banks with at least $10 billion in assets hold virtually all derivatives, securities with a notational value of $224.803 trillion. While the FDIC insures deposits in some 7,200 banks and savings associations, only 59 FDIC-insured institutions have deposits of more than $10 billion. Your little community bank, savings association or credit union likely has no derivatives department.

Social Benefit

Derivatives are simply bets. They finance no factories, no research, no colleges, no homes and no cars. Any jobs they produce are incidental and inconsequential relative to the potential risk they represent, the risk that credit exposure has been incorrectly figured by hundreds of billions of dollars if not more. Since big banks hold virtually all derivatives, and since taxpayers can face massive costs if big banks fail, it follows that something should be done to limit taxpayer risk.

“In banking,” said Buffett in 2003, “the recognition of a ‘linkage’ problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a ‘chain reaction’ threat exists within an industry, it pays to minimize links of any kind.”

How can we control derivative worries? If they’re so necessary and safe, let bankers and traders take the risk. Personally.

This can be done with regulations which restrict the ownership of derivatives and derivative interests to individuals and partnerships. Federally-regulated banks, savings associations and credit unions would be prohibited from originating, buying, selling, brokering, owning, trading, holding or financing derivative interests, directly and indirectly, for themselves or for another party.

Such rules, of course, would apply to regulated financial institutions as well as their subsidiaries and partnerships, both in the US and abroad. And the regulations would also apply to financial products which fit within the definition of a derivative, even if called something else.

Under this system, derivative profits would be owned entirely by individuals and partnerships. And derivative losses? They too would be owned entirely by individuals and partnerships. No longer would taxpayers be forced to pick up the pieces if something goes wrong.

For those who believe in less government regulation here’s your chance….

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This posting has been updated and expanded from material published originally by the author on the Huffington Post.

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How Paper Mortgage Losses Turned Real

The question that keeps coming up is this: If only a small portion of all mortgages are failing how come the general financial impact has been so enormous?

To resolve this mystery, let’s go back to the 1970s when the mortgage-backed security — the MBS — was developed. The MBS was a financial device designed to resolve a problem for investors. The problem? Imagine that you’re a loan investor and bought the mortgage on a single-family home. Your total income from the investment would be impacted if your one borrower was late, didn’t make a payment or was foreclosed.

With a MBS you own a security which is supported by a large number of mortgages, perhaps thousands. If someone misses a payment your income continues with little disruption.

In theory mortgage-backed securities make a great deal of financial sense.And in practice, until the past few years, mortgage-backed securities worked well.

Today mortgage-backed securities are troubled, especially those which include subprime loans. But why should this be? Even with subprime loans, the overwhelming majority of borrowers are making their payments.

About as good as an answer as you’ll find comes from Lew Ranieri, one of the developers of the MBS concept. As Ranieri told John Cassidy in The New Yorker, today MBS securities are fundamentally different from the paper that was invented several decades ago.

“They have created the perfect loans,” Ranieri says with irony of today’s mortgage-backed securities. “They didn’t know what the home was worth, they didn’t know what the borrower earned and the borrower wasn’t putting any money into the purchase. The system had gone completely nuts. A loan without a full appraisal, thorough underwriting, and full income verification was never what anyone envisioned when we started the market for mortgage-backed securities.” (See: “Subprime Suspect,” March 31, 2008)

You listen to Ranieri and it becomes obvious why mortgages have been so freely-available during the past few years. The answer has nothing to do with a push for more homeownership or some sort of philosophical imperative: If Wall Street is going to sell more high-profit mortgage-backed securities it needs a basic feedstock. What is that feedstock? More loans.

If it happens that a mortgage fails, who suffers? The loan officer has already been paid. The “lender” is often not a lender in the sense of a company with a vault stuffed with cash, but instead a retailer that instantly re-sells any loan it originates. If the borrower makes payments for a few months, the originating lender is then largely not responsible if the mortgage goes downhill.

With mortgage-backed securities the folks on Wall Street make money selling paper, real estate brokers make money selling homes, governments make tax money every time a home is sold or refinanced, title companies and attorneys make money with each closing. The list goes on but you get the idea.

What started out as a conservative way to protect investors morphed into something strange. You could buy a typical MBS or you could get a little more interest if you bought a somewhat riskier portion of a mortgage-backed security. But why worry — credit-raters gave MBS paper strong marks.

Unfortunately, the push for higher returns outpaced the push for financial sanity. Loans without full appraisals, stated-income mortgage applications, exploding ARMs, option ARMs and large numbers of interest-only loans will inevitably produce large numbers of distressed borrowers and outright foreclosures. Add in a gross lack of federal regulation — regulation that could easily have prevented the current mortgage meltdown — and the results we see today were pre-ordained.

Once a few mortgage-backed securities failed it meant that the assumptions used to value and rate all MBS paper needed to be reviewed. The value of MBS paper fell, so investors suddenly had less net worth and thus a lot less interest in once-attractive mortgage-backed securities.

For the folks on Wall Street, the problem was not lower MBS ratings but fewer MBS buyers. Essentially, brokerages and investment banks got caught with MBS and other sagging securities in their portfolios.

And this gets worse. There are not only mortgage-backed securities (MBS) and collateralized debt obligations (CDOs — securities backed with a variety of debts, including mortgages), there are also derivatives.

Derivatives are simply bets. While there is a limit to the number of MBS and CDOs you can have, there’s no limit to the number of derivatives. The value of these derivatives amounts to hundreds of trillions of dollars.

The good news? Most derivatives are hedged so that the investor has little financial exposure. The bad news? When you deal with hundreds of trillions of dollars a minor “whoops” can be worth billions and billions of dollars.

And that’s how a few foreclosures upset the strange world of mortgage-backed securities, CDOs and derivatives.

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Published originally by The Real Estate Professional and posted with permission.

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Foreclosures & The Multiplier Effect

If we’re just having a subprime crisis, then how come the impact is worldwide? That’s the essential question raised by Ben Stein, an attorney and economist who you may also know as a droll actor and TV pitchman.

Writing in the New York Times, Stein points out that we have a $10.4 trillion mortgage marketplace in the U.S. “Of that,” he writes, “a little over 13 percent, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14 percent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 percent is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion.”

“The rate of loss in subprime mortgages keeps climbing. In time, perhaps it will double, maybe back to $67 billion. This is a large sum by absolute standards, and I would sure like to have it in my bank account.”

But, says Stein, “the fears and terrors about subprime mortgages have helped knock off 6.7 percent of the stock market’s value in recent weeks. This amounts to about $1.1 trillion, or more than 30 times the losses so far in the subprime market. In other words, these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.”

So is Stein right? Are subprime losses out of proportion to the financial turmoil we’re now seeing?

The answer is this: The apprehension and mayhem we’re seeing in stock markets worldwide is not just a by-product of a subprime melt-down. It’s largely an outgrowth of far-bigger worries.

One Link In The Chain

“In a global sense the subprime implosion is just a small part of the worldwide financial marketplace,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading foreclosure marketplace. “The growing anxiety — and the real cause of apprehension — is different: The worry is not so much that we’re having a subprime debacle, rather it’s that rising foreclosure levels throughout the U.S. mortgage system will set in motion a series of bigger problems in related financial instruments.”

While a growing volume of subprime foreclosures is plainly an issue, the increasing concern is about loan formats, how mortgage repayment terms are arranged.

If you want a dull, boring loan with full docs you’re in. The easy financing choices now include conforming, 30-year, fixed-rate loans; self-amortizing ARMs and loans backed with FHA, VA or private mortgage insurance (MI).

What’s out are the toxic mortgage products which have flooded the market since 2000 — loans with little down and small up-front payments such as interest-only mortgages, option ARMs, 2/28 and 3/27 ARMs and loans generated with “stated-income” mortgage applications. Investors are increasingly unwilling to buy such “nontraditional” loans from originators. Without investor demand, lenders who continue to originate toxic mortgages are forced to hold such loans in portfolio — something few lenders want to do.

It’s Not The Mortgages

Looming in the background is something potentially far more dangerous than large numbers of foreclosures. There is a multiplier effect at work which greatly magnifies mortgage market ups and downs.

Derivatives are essentially bets that some asset or index will have more or less value in the future. Derivatives are purchased with substantial leverage, meaning that a small number of dollars can produce enormous profits — or losses.

To reduce the risk of highly-leveraged derivatives, investors — meaning hedge funds, large corporations, insurance companies, pension funds, short-term money market funds and international investors — try to balance their bets by acquiring an array of derivatives so that no matter which way the market moves losses are offset by gains.

It might seem that if bets are absolutely balanced then losses would be avoided — and profits would also be impossible. But, say advocates, complete balance is not the goal. Instead, profits can be made when computer models identify a small advantage in the marketplace. A small advantage multiplied many times can produce a massive profit.

Unfortunately, leverage works in both directions. Computer modeling systems assume there are predictable levels of symmetry, but when old benchmarks fall then risks can suddenly become totally unbalanced. In effect, once-prudent economic models will suddenly become risky.

There’s no question that the value of derivatives is substantially greater than the value of all mortgages because while mortgages must by secured with real property, derivatives only require an off-setting gamble by another investor. In effect, while the number of mortgages is limited, the number of derivatives is not.

No one knows the actual size of the derivatives marketplace, but it’s huge. For instance, there are believed to be 8,500 hedge funds worldwide with assets of $1 trillion, according to the International Monetary Fund.

Leverage At Work

How much have investors bet on derivatives? Again, no one knows, but we do know that tremendous multiples can be involved: As one example, according to the IMF at the start of 1998 a Greenwich, CT hedge fund named Long-Term Capital Management had capital worth $4.8 billion as well as derivative contracts amounting to roughly $1.3 trillion.

By September 1998, nine months later, the IMF says “LTCM’s equity (net asset value) stood at just $600 million and supported balance-sheet positions in excess of $100 billion, implying balance-sheet leverage of 167 times capital.” A consortium of financial sources put up $3.6 billion to rescue the fund when bad bets caused liquidity worries.

Why would anyone want to bail out a hedge fund? Because hedge funds leverage their bets with borrowed money. Big capital sources such as banks, insurance companies, pension funds and stock brokerages have loaned or invested billions of dollars with hedge funds. If hedge fund bets turn sour, then those loans — and the institutions that made them — can face massive losses if there are insufficient dollars to repay the advances.

If one hedge fund with $4.8 billion in capital can hold derivative contracts worth $1.3 trillion, then how much is held by 8,500 hedge funds as well as other investors?

The worry is that huge investors have borrowed from banks and other financial sources and then placed many of their leveraged bets on the movement of mortgage-backed securities. With a growing volume of foreclosures the value of mortgage-backed securities are less than they were six months or a year ago, meaning once-profitable computer models are no longer on target.

“Computer models based on the assumption of old default levels have resulted in derivative purchases by some bettors which are now totally unbalanced,” says Saccacio. “In the same way that leverage magnifies profits, leverage also magnifies losses. Small value changes multiplied many times can produce big results, and that’s why some funds are adding billions of dollars to shore up endangered investments.

“It is the threat from derivatives to financial institutions which increasingly worries investors worldwide, not just foreclosures in Flint, Miami or Stockton.”

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

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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.”

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

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