Arnold Kling  

Subprime Daily Update, Dec. 11

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Today's focus is bank capital.

More added at 1 PM EST, including comments on widespread fraud.

The Washington Post reports,


"The problem in the banking system is not one of liquidity, but of a potential shortage of capital," said Carnegie Mellon economist Marvin Goodfriend.

By that theory, the best thing that can happen would be for banks to raise more money.

There was an example of that Monday when UBS, Europe's largest bank, said it was raising $11.5 billion from two foreign investors, and mortgage-lender Washington Mutual said it will raise $2.5 billion by issuing convertible stock.


Commentary on Singapore's rescue of UBS can be found in the Wall Street Journal. More on WAMU's woes can be found in The New York Times.

I think it's great the individual banks are shoring up their capital. However, as I've said before, I worry that thin markets in asset-backed securities could be forcing banks to sell securities to raise capital. That would create a sort of vicious spiral.

1 PM UPDATE: Tyler Cowen points to James Surowiecki, who writes.


Postponing rate resets doesn’t change the fact that too many people spent far too much borrowed money on houses with prices that were far too high, and that they are now stuck in homes that they can’t really afford and can’t sell.

Sounds like an echo of what I wrote yesterday.

Tyler also points to Mark Thoma who in turn points to a column by Sean Olender.


But unfortunately, the "freeze" is just another fraud - and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.


A lot of these mortgages are defaulting within the first twelve months, and I've said before that back when I was at Freddie Mac (this was the stone age, when home owners actually had to put money down to buy homes) we presumed that anything that defaulted that early was fraud. It was up to the institution that sold us the loan to prove otherwise.

The difference between Freddie Mac and the typical private packager of mortgages is that Freddie Mac guaranteed investors against loan defaults, regardless of cause. If the loan was originated fraudulently, then that was an issue between Freddie Mac and the originator who sold us the loan. We tried to make lenders repurchase loans if we found fraud. Our loan sellers were representing to us that they had underwritten the loans properly. They were giving us a warranty that the documentation of the loan was accurate. These "reps and warrants" provided our legal basis for forcing repurchase.

Private packagers work differently. But somewhere in the process between loan origination and the owner of the mortgage-backed security, there probably are "reps and warrants" that have been violated. They could be small, technical violations, such as an inappropriate document used to verify income. Or they could be more egregious violations, such as falsifying the name on the loan application. A lot of those violations are from the loan seller to the loan packager, neither of whom currently bears the risk of the loan default.

Further up the food chain, there could be "reps and warrants" about the mortgage pools making up the securities that might provide a basis for legal action. That is, the packagers presumably have to make some "reps and warrants" to investors.

If you are an investor, I assume that the people you want to sue are the packagers, i.e., the companies that bought from the brokers and sold securities. But the problem there is that you are suing them on the basis of what they represented about their entire mortgage pool. It's not worth going through loan by loan. What you want to do is force them to repurchase the whole pool on the grounds that the violations of reps and warrants were systematic, so that the packager was deceiving investors. I have no idea how easy or hard this would be to prove. I have never looked at the offering circular of a private mortgage pool, so I don't know what the reps and warrants look like.

UPDATE: My comments on Olender were mild compared with Felix Salmon's.


But investment banks were just the middlemen, funneling subprime mortgages from originators to investors who were desperate for yield. I don't see how they should suddenly be forced to buy back all those mortgages at par, and I'm quite sure that they have no legal obligation to do so.

Again, it would help to read the offering circulars to see what rights the investors do and do not have with respect to the investment bankers.


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COMMENTS (7 to date)
John Thacker writes:

However, as I've said before, I worry that thin markets in asset-backed securities could be forcing banks to sell securities to raise capital. That would create a sort of vicious spiral.

It seems to me that that same sort of vicious spiral is possible if banks foreclose on loans and auction off homes at their new lower value quickly. Wouldn't that also reduce the valuation of the property and force the banks to raise more capital because of capital requirements? And wouldn't the wave of selling make the housing market even weaker, and possibly contribute to the spiral? I could be very off here, but it seems that that same kind of worry of a vicious cycle is why banks don't want to go ahead and rapidly find the bottom, as you've been proposing.

John Thacker writes:

WaMu is also, sensibly, cutting its massive dividend some as well.

Bob writes:

Selling securities does not raise capital (in fact, if it requires the bank to recognize an unbooked loss, it lowers capital), although it generally raises capital ratios. The potential downward spiral is similar, though. The alternative way to raise capital ratios by shrinking the balance sheet - to let existing loans pay down while not making new loans - is no more desirable but, IMHO, more likely.

Arnold Kling writes:

John,

I'm assuming that home prices will not fall below the level at which legitimate home buyers would step in and buy them. However, with securities and banks, my fear is that there are not enough big banks with enough spare capital to step in and buy securities at a fair price.

John Thacker writes:

Arnold,

I don't claim to understand the mortgage market all that well, so I don't want to generalize too much from experience. Nonetheless, it's all I have with the current market. I have a co-worker who was renting a townhouse built in 2005, purchased by someone during construction as an investment. The owner had a tradition 20% down prime mortgage, with fixed payments. The owner was intending to flip, but, naturally, was unable to with the softness in the market developing in northern VA in late 2005. Instead, he rented the property, intending to wait until home prices had recovered.

With rents so low, the market average rent did not cover his mortgage payment. Several weeks ago, with prices dropping even further, the owner decided to let the bank foreclose on the townhouse. Since the house was bought at the absolute peak, some ridiculous $700k for a townhouse figure, the owner owed more than the present value of the house despite putting 20% down.

The home reverted to the bank, and has gone to auction. My co-workers attended the first attempt at auction. There were apparently very many properties owned by banks up for auction. The banks started each of the properties at a value near the original mortgage level, far above what a current buyer would be willing to pay. None of them sold-- with the exception of one house whose mortgage had started longer ago, back in 2000 or 2001. All the bidders who showed up only would bid on the one house.

My question, then, is why would the banks not lower the initial asking price on these homes? Why would they not let the asking price fall to a market-clearing level? I don't have a good answer. Another co-worker who claims to understand the market offered the opinion that if the bank sold the house for substantially less than the mortgage amount, the bank would have to take a writedown on the house. Currently, the repossessed house is valued at the original mortgage price. If they sold it for less, it would make their capital position look worse, not better, and they would have to shrink their balance sheets. Essentially he argues that the capital and bookkeeping requirements cause the banks to prefer owning an empty house valued at a higher price to selling it for a lower price-- note that that argues that capital requirements outweigh liquidity in some sense.

I don't have a good answer for this argument. I don't quite buy it, but I don't have a better theory for why the banks in the area seem willing to let the houses lie vacant (or lived in by former renters now squatters.)

Gary Rogers writes:

Wait a minute! Where did the capital go? I was just reading where UBS AG took another 10 billion dollar write-down and it struck me that the write-downs do not reflect reality in the mortgage markets. Yes, some people are running into problems with their mortgages, but most are not. Even when mortgages do go through foreclosure, they still are worth quite a bit, depressed market or not. Also, don't most sub-prime loans have mortgage insurance by law? It seems that I read somewhere that banks are writing their mortgage backed securities down to zero, which does not paint an accurate financial picture. Are we panicking because of bad accounting practices?

jb writes:

In my ongoing saga of home ownership at sensible levels in Metro DC, I've noticed that houses in some metro areas are starting to fall from "only a complete idiot would buy this" prices down to "you'd be pretty stupid to pay this much" prices. This is a good sign that the banks are tired of seeing their foreclosure inventory go up. Having said that, for a given neighborhood, pricing 10% of the homes at 60-70% of the price of the other (non-foreclosed) homes is going to depress all the prices.

I'm still waiting for "you'll feel stupid if the market continues to fall" price. That's a price that I can live with, but there's still a ways to go.

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