FYI | Nov 26 2007
By Greg Peel
There were many who believed the US subprime crisis, and hence the global credit crunch, had reached its nadir in August following discount and cash rate cuts from the Fed. They were wrong. There were those prepared to believe big write-downs by US investment banks in the third quarter were the last of it. They were wrong. The world has now accepted that there is more to come for another quarter or two, and thus we have seen global share markets retreat once more. But the bargain-hunting has begun once again. However, a court ruling in Ohio could well place a spanner in the works.
As the US housing crisis worsens, more and more Americans are defaulting on their mortgages. As mortgages go into delinquency, it is in the interests of both the lender and the borrower that the mortgage is renegotiated rather than immediately foreclosed upon. The bank doesn’t want to sell a house into a falling market either, so if it can fiddle the interest rate, perhaps lengthen the time to maturity, or change other conditions to prevent default, it will. This may not be possible for subprime mortgages, where no level of renegotiation would make a difference to mortgage holders who were and will remain to be uncreditworthy, but it might work for prime mortgages and perhaps even adjustable rate mortgages.
Indeed, this is exactly the policy being pushed by the US government, mostly via the government sponsored mortgage lenders Freddie Mac and Fannie Mae. But with or without government policy support, any lender is going to try to renegotiate first and foreclose second.
But if default is the only option, then default it is, and the bank is forced to make a foreclosure sale into a weak market where any buyers are fully aware of the circumstances. In other words the bank will take a hit, but at least it recovers something against its loan, if not the full amount.
The comparison has oft been made between the traditional mortgage of days gone by and mortgages in the burgeoning securitised credit derivative market. If you have a straightforward mortgage issued by your bank – one which remains on the bank’s ledger – then such a renegotiation of mortgage terms in the case of delinquency is not a difficult task. However, if you have borrowed from a non-bank mortgage lender, who has sold the mortgage to a bank, who then packages it up with several others into a collateralised debt obligation, who divides that CDO into tranches and sells those tranches off to an offshore hedge fund, having provided the hedge fund with significant leverage in order to buy the CDO in the first place, then it’s quite possible the guy you need to talk to your mortgage about is not your bank, but some cowboy investor in Tokyo, or London, or Berlin.
This would tend to make mortgage renegotiation problematic, for the truth is the risk of default really lies with the original non-bank lender even though he sold the mortgage to the bank. He may not even be solvent anymore, and even if he were, he can’t renegotiate a mortgage that has been sold, packaged, and resold as an integral part of a larger instrument. This means it is more likely that mortgage will go straight to foreclosure. This is one reason why foreclosures are building, and why CDOs have plummeted in value. Banks have been forced to take billions in CDO positions back onto their balance sheets or face their leveraged loans to conduits, SIVs and hedge funds similarly defaulting.
But at least, at the end of the day, the bank picks up the value of whatever the house can be sold for. It doesn’t cover all of the loss, but it should cover most of it. US housing prices are, after all, only down about 10% from last year’s equivalents in the worst hit areas of the US. From trough to boom in the housing bubble they rose 20%.
However, is the house really the bank’s to sell when complex CDO structures have been put in place?
Last week a judge in Ohio ruled that Deutsche Bank had no legal right to foreclose on 14 homes in Cleveland – one of the worst hit US mortgage belt areas – for which the owners were in delinquency. On a legal challenge, the judge found that Deutsche Bank had no claim over the “collateral” of the mortgage – the house – at all. Indeed, it is yet to be determined, under the CDO structure of bundled loans, just who does own an individual mortgage. In theory, while the collateral of a mortgage is the house in question, the collateral of a “collateralised” debt obligation are the loans, not the houses.
One might wonder why this has only come up in November when subprime foreclosures began early in the year and foreclosures in the whole spectrum of mortgage quality have been accelerating ever since. The reason is apparently that no one ever challenged their foreclosures until now. Deutsche Bank’s agents had been foreclosing on mortgages and banking the proceeds all this time without anyone assuming there to be a problem. Every mortgagee has been working on the traditional premise of “I don’t own my house, the bank does”.
But when the Ohio judge asked Deutsche to produce the actual legal title for the 14 homes in question, it couldn’t. Indeed it could not produce anything which suggested Deutsche bank had the right to foreclose and collect the proceeds. All it could come up with was an “intent to convey the rights in the mortgages”. This is where the difference lies.
CDOs are known loosely as derivative instruments. While some derivatives represent an actual charge over a primary commodity (a deliverable copper futures contract for example, or an option to buy shares) others merely imply the right to a cash return based on the price movement of a primary commodity. For example, if you buy call options over a share price index and ultimately exercise those calls, you don’t receive “the index”, but rather a cash equivalent of the relative price movement. The argument thus follows that a CDO provides only a right to the return from mortgage payments, but no charge over the actual houses in question.
So what happens now?
If all mortgage holders suddenly decide they will legally challenge foreclosure, then the scene is set for a devastating legal battle. If banks do not have any right to sell houses they don’t supposedly own, then who does? In the meantime, US house prices could go into a much more catastrophic tailspin. One US financial author – F. William Engdahl – has described it as a financial tsunami. Engdahl suggests house prices may fall as much as 50% instead of 10%. And the value of CDOs, which have already been collectively written down by US$50bn across the globe, may need to be written down a helluva lot more. After all, the focus has moved from subprime mortgages to adjustable rate mortgages (ARM) which jump significantly in interest rate after a specified period. The peak of these loan adjustments occurs in January, and delinquency rates are expected to follow suit.
