Sep102015

Liar loans: Mortgage securitization disaster 2.0

Securitizing liar loans will work out well for early adopters, but as these loans proliferate, they destabilize the market and lead to disaster.

If at first you don’t succeed, try, try again. Then quit. There’s no point in being a damn fool about it.

W. C. Fields

liar-loanWere liar loans an innovation we should revisit? Is there a good way to underwrite loans without verifying whether or not the borrower can repay it? Personally, I don’t think so. When lenders underwrite new loans, one of the fundamental tasks they perform is determining whether or not the borrower can repay; therefore, allowing borrowers to simply state their income with no verification is an abdication of an underwriter’s responsibility.

Stated-income loans (aka liar loans) were the worst financial innovation of the housing bubble because these loans undermined investors’ faith in borrowers’ capacity to repay, causing investors in mortgage-backed security pools to question the financial representations of all borrowers in all loan pools. In 2007 this doubt about the veracity of loan qualifications spread from the pools that specifically allowed liar loans to all MBS pools, causing investors to abruptly stop buying mortgage-backed securities.

The shining light of verified income is the way forward. Allowing liar loans back into securitization pools is not a step forward; it’s a plunge back into darkness.

Liar Loans Redux: They’re Back and Sneaking Into AAA Rated Bonds

Matt Scully, Jody Shenn, September 8, 2015

  • Homebuyers are taking on debt again without much paperwork
  • Wall Street spreads legal risks through new bond deals

… Years after the great American housing bust, mortgages akin to the so-called liar loans — which were made without verifying people’s finances — are creeping back into the market. And, like last time, they’re spreading risks far and wide via Wall Street.

Today’s versions bear only passing resemblance to the ones that proliferated in the mid-2000s, and they’re by no means as widespread. Still, they reflect how the business is starting to join in the frenzy that’s been creating booms in everything from subprime car loans to junk-rated company bonds. …

For as much as I would like to keep an open mind about “innovative” loan products, I can’t see any reason stated-income loans (liar loans) should be allowed to exist.loan_qualification

Liar loans were responsible for the abrupt halt of the flow of investor money resulted in the mortgage credit crunch of August 2007 that triggered the financial collapse of 2008. Regulations should be very wary of liar loans given the risk these loans pose to the financial system.

Soon Velocity was bundling the $1.92 million mortgage and hundreds of other loans into securities through Wall Street’s securitization machine. Kroll Bond Rating Agency … rated AAA. Marketing documents for the offering, which was managed by Citigroup Inc. and Nomura Holdings Inc., characterized the buyer as an “investor.” …

But when a reporter recently knocked on the door in Manhattan Beach, the buyer answered and said he never planned to rent out the place. Nor, he said, had he signed documents stating he would. He was living in the house with his family. …

That’s because federal regulations put in place following the crash effectively outlawed liar loans. Under so-called ability-to-pay requirements, lenders must take specific steps to ensure homebuyers actually can afford the mortgages. If they don’t, homeowners can sue and potentially win damages that can dwarf the value of the homes. …

the rules exempt mortgages made for “business purposes.”

In other words, lenders found a loophole they hope to push a lot of money through. What could go wrong?

Chris Farrar, Velocity’s chief executive officer, says his company takes steps to ensure customers really are buying homes for business purposes. These include having every borrower hand write and sign letters testifying to their plans.

“Our goal is to never make a consumer loan,” Farrar said. Velocity’s lawyers have advised the company, previously known as Velocity Commercial Capital, that its processes would put it on solid ground even if it somehow failed to weed out inaccurate applications, he said.

numbers_do_lieSo as long as the lie is opaque enough to avoid a lender’s feigned attempt at compliance, everything is copacetic. Nice.

As Velocity and others hunt for profits, the question is also how carefully these lenders are vetting customers and loan brokers.

Their incentive is not to be very thorough.

In Velocity’s recent bond deal, an outside due-diligence company reviewed about 30 percent of the loans. The post-crisis standard in residential transactions has been at least 90 percent. ..

“That’s a question for Velocity, I think: How do they make sure when they’re making a loan that it’s not owner-occupied,” Bhasin said.

The attorneys will enrich themselves figuring that one out.

fair-lending rules can make it risky to turn down customers “because I think you’re a liar.”

And since lenders want to make the loan, they really don’t want to know.explain_loan_documents

Dan Perl, the CEO of Citadel Servicing, said savvy underwriters and careful documentation will protect lenders and investors. Like the others, his company demands borrowers put their intentions in writing.

“If they say, ‘you should have known what my intent was,’ we’re going to hold up that document,” Perl said. “It’s a sad state of the world, but we’re looking to make sure we’re not going to be harmed on it.”

Do any attorneys want to opine on the strength of that defense?

It’s difficult to say how far the problems might go, but industry experts agree that mortgage lending is nowhere near as sloppy as it was during the last go-round, which created a bust that produced about 6 million foreclosures.

They aren’t that sloppy yet, but if investors keep demanding these products, lenders will respond by lowering standards to do more business. It’s inevitable.liar_loans

To Naimon, the real danger would be if unscrupulous mortgage brokers once again encouraged homebuyers to get in over their heads.

“I’m much more worried about a case involving unsophisticated borrowers that get tricked by a broker into doing it,” he said.

It’s only a matter of time.

Tragedy of Securitization

The problem of securitizations of loans like these is similar to the tragedy of the commons. The individual incentives of companies that create securitizations is to package up large groups of these loans and slice and dice them into tranches. In a stable housing market, only a small percentage of these loans will go bad, so the bottom tranch is AAA safe. Unfortunately, if these products proliferate, it destabilizes the entire market, and if the entire market crashes, a very large percentage of these loans will go bad and even the AAA tranches get wiped out. While no single securitization has this power, collectively a large number of them has already proven to have this effect.

IMO, this collective action leading to destabilization is the problem with securitizing any of the toxic loan products of the bubble. If lenders and investors didn’t learn this lesson in the 2008 collapse, then we certainly will repeat the cycle. Let’s hope they aren’t that stupid.

mortgage-brokers-life

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