Why We Shouldn’t Help Brent and Whitney

Why the Fed and Treasury Can’t Renegotiate Securitized Subprime Loans      

Brent and Whitney bought a condo in Corona, California in 2005 for which they paid $275,000. They put down the $25,000 they borrowed from their parents and signed up for a $250,000 mortgage. It was an adjustable rate loan which reset in 2008. I don’t have to explain the rest. They bought at the top of the market, home prices cratered, the condo is now worth $160,000, and they are way upside down. Whitney lost her job at a mortgage brokerage and they haven’t paid the mortgage for the last two months. They were paying about $1,650 a month (PITI) and have been told the new payment will be about $1,800 a month.

Whitney calls the company where she sends the check every month and is told they only collect cash and that she would have to discuss it with the service company H.Q. in L.A. She calls the service company. A week later they call back and tell her there’s nothing they can do about it because the loan owned by several entities in a complex arrangement and that they have no authority to renegotiate. Whitney swears at the snitty phone rep and decides to move out. Rents down the street for a similar condo that was foreclosed and resold are only about $1,100 a month. Since she and Brent live in California, they have no personal liability on the loan. They move out and send the keys to the service company.

A major part of President Obama’s plan to revive the economy is to renegotiate mortgages and make them less costly for homeowners. Also he wants to protect homeowners from foreclosures. According to the Wall Street Journal mortgage service companies are being hit by a Tsunami of foreclosures. This is the case despite the fact that Freddie and Fannie have declared a moratorium on foreclosures for their loans.

Part of the problem is that the lenders who originated many of these loans have no control over them. They were packaged up into mortgage-backed securities and sold to investors. So whoever originally underwrote and made the loan is gone from the scene.

The Milken Institute reports that of the $10.6 trillion of mortgage debt, about 59%, or $6.25 trillion, was securitized. Of this the government, through Fannie and Freddie, only controls $2.9 trillion, and the private sector controls $3.35 trillion. So, of the total of all mortgages, 32% are tied up in mortgage-backed securities. About 8% of all mortgages are considered to be subprime, and 80% of those were securitized.

There is a reason that Brent and Whitney can’t find a willing ear to renegotiate their mortgage. The mortgage-backed security that owns their mortgage has no ability or authority to do that.

Let’s use the example of the subprime security that I analyzed in some detail last year in my article Peeling Back the Onion. I dissected the operations of a very complex trust instrument that was created by Washington Mutual (WaMu Asset-Backed Certificate WaMu Series 2007-HE2 Trust Issuing Entity). This was a huge $1.6 billion entity that contained 6,723 mortgages. This was just one of many they issued. I called them junk mortgages.

They took the mortgages, classified them as to quality, and then divided their income streams into 15 tranches, or separate slices. These slices were graded from AAA+ (highest) to BBB- (lowest) in quality. The documents were written so that the senior tranches got lower returns but were better secured. If you bought the lowest tranche you may be entitled to a much higher return, but if something went wrong, your principal investment was at the most risk. Here’s how it worked: the top tranche (AAA+) has everyone’s return of income and principal subordinated to their return of income and principal. The next tranche, AAA, was superior to everyone except the AAA+ holder. The BBB- tranche was last in line for distributions.

This thing was structured air-tight. The entire security was held as a trust which was controlled by trustees who couldn’t break the structure even if they wanted to. A mortgage service company controlled by WaMu collected the rents and handled defaults and foreclosures. The senior tranches have the voting control and they don’t care if the junior tranches don’t get paid. In fact, unless the whole portfolio tanked, the mortgages were cleverly selected to minimize risk (geographic diversity; quality diversity). Since most of the mortgages are paying off for the senior tranches, if defaults occur, the likelihood is that only the junior, nonvoting, tranches would be affected. Why would the senior tranches want to change that?

Like most goals and programs of the government, they often fall to the Law of Unintended Consequences. Politicians always want to solve their constituents’ demands, like “fix this mess,” or “Help, I’m losing my home!” But is a “solution” possible?

The first thing is you have to ask about Brent and Whitney is, why they would want to renegotiate the loan in the first place. Their condo tanked in value and nothing will restore that value. Bad investment; start over. Let’s just admit that they didn’t have much skin in the game and they should take the hit.

What could the government do to bail them out? Since they have no power to break the trust, they would have to buy the mortgage down somehow to 50% of the current value, to $128,000, to achieve an 80% loan to value ratio. Brent and Whitney would now have a payment of about $900 PITI. This is a huge gift from the taxpayer to the borrower. What’s the point? According to data released in December by federal banking regulators more than 40% of borrowers were at least 60 days past due eight months after their loan was modified. There is no incentive for them to keep paying the mortgage if they also fall further behind in paying off their student loans and credit card debt.

There is no point in trying to prop up a bad real estate market. The housing market has lost an estimated $6.1 trillion of value since the peak in 2006 according to Zillow.com. There is absolutely nothing the government can do to revive this market. The $50 billion of housing support that is being proposed by the Obama Administration is nothing but a vote-buying welfare payment that will do nothing except create another $50 billion for taxpayers to pay. It won’t keep people in their homes, and it won’t stem the decline in housing prices. It’s too big for even the federal government to handle.