Tuesday, March 10, 2009

Is The Financial Crisis Humpty Dumpty?

Securitization has turned a mess into a disaster. The process of taking a loan, packaging it in a security and then selling that security to investors has resulted in a stagnation of the process that needs to happen in order to put our economy back together again. The problem is that many of the "bad" loans are not owned by one investor, but hundreds or thousands of investors.

Recently I reviewed a CMO (Collateralized Mortgage Obligation) from Bank of America issued in 2005. Think of the CMO as perhaps a mutual fund, its a pool of loans instead of a pool of stocks. 144 loans were grouped together, all with similar characteristics and sold as "tranche" of this CMO, basically you had one big entity with thousands of loans that were then grouped into smaller entities and then re-sold to investors. This particular tranche had 144 loans totaling $81 million on property worth about $120 million when issued. This "tranche" was broken into $1,000 denominations to make them look more like a bond and sold off to investors, potentially 81,000 different investors ($81,000,000 divided by $1,000). It is unlikely that there were 81,000 different investors, but its not impossible. Let's just pretend there were 810 investors who each bought $100,000 of this offering.

Let's now assume that this "tranche" didn't do so well, perhaps it had a lot of properties in California and lower credit scores as well as borrowers who had lots of second liens. The "tranche" starts to go bad and the borrowers start to default, while there are some protections, there aren't much if defaults are higher than 3%, which we will assume they are. Just how do you get those 810 investors to agree to modify the 144 loans that are in this portfolio?

Let's say you are the owner of a home whose note is sold and packaged into the above CMO and is in this particular "tranche". Your house has declined by 50% and the loan's interest rate is adjusting to the point where you can't afford the payment....what now? Simple, call your lender and as for help. So you call, turns out your lender is not your lender, but your "servicer," in this case Wells Fargo. Wells Fargo tells you that they will work with the investor to modify your loan.....then they realize that there are a total of 810 investors and there is no way possible to get full agreement.....they call you back and say no.

This is a hypothetical situation, but not unlike what is going on right now. Many loans can't be modified, even though that is what needs to happen. The only way to get agreement is to own at least 51% of that "tranche" and depending on the voting rights of that CMO, perhaps more (and perhaps you even have to own a related "B" class). As you can see, in order to modify this loan, the 81,000 pieces that have been sold off have to be put back together again. Its Humpty Dumpty....we know what happened with old Humpty, he couldn't be put back together again.

So what's the solution? I don't fully have one as I can't even fully understand or comprehend the depth of some of these securities, but what is clear is that something on the legal side will have to be done.....which may not be constitutional. I can tell you that "cramdowns" are not the solution, they will just force people who shouldn't be in bankruptcy into bankruptcy...which hurts all unsecured creditors as well.

On the Agency side there are simple solutions, on the non-agency side its much more difficult, which is why we had TARP.....which didn't do what it planned on doing, then the "bad bank" idea (which could work if done right).

My overall plan would be to force all of these assets into one entity in exchange for a share of that entity and a share of the losses based on the losses the assets you contribute actually end up losing. It would be a long term entity, all assets contributed at par and there would be some government offered downside protection to induce you to participate and excessive taxation if you choose not to participate (with certain exceptions). This would force assets into one place, not requiring a valuation until the assets have been worked out - which could take years.

Scott Dauenhauer CFP, MSFP, AIF