CFPB mortgage servicing rules eliminate excuses not to provide transparency for RMBS

The Consumer Financial Protection Bureau announced its new mortgage servicing rules that eliminate any excuse the structured finance industry has for not providing observable event based reporting on residential mortgage-backed securities.

Under the new rules, mortgage servicers, the firms that manage the loans, will now be required to credit a borrower's account the day a payment is receive.  In addition, the mortgage servicers must provide borrowers with regular statements that show a breakdown of payments by principal, interest, fees, and escrow as well as recent account activity.

For anyone who is familiar with looking up their credit card account on-line, the CFPB has said that mortgage servicing firms need to provide similar information in a timely manner.  From an IT perspective, this is easy to do because both mortgages and credit card databases update whenever there is activity on the account.

I can not stress enough the importance of the CFPB's mortgage servicing rules.  The ability of mortgage servicers to comply with these rules means by definition that observable event based reporting can be provided for all residential mortgage-backed securities.

As regular readers know, observable event based reporting involves reporting all activities like payments or delinquencies involving the underlying collateral to market participants before the next business day.

This is the same information that mortgage servicers need to "report" to borrowers.

As a result, there is no longer any excuse for the structured finance industry to block the provision of observable event based reporting.

To prevent harm to consumers in routine payment processing, our rules also require common-sense policies and procedures. Payments must be promptly credited as of the day they are received.... 

In general, servicers must maintain accurate and accessible documents and records. They must be able to provide accurate and timely information to borrowers, mortgage owners (including investors), and the courts. 

These provisions will prevent the egregious “robo-signing” practices that were rampant from ever happening again. These obligations apply even through transfers of servicing rights between firms; both the transferor and the transferee have the same duties to maintain accurate information about an account. This cuts off yet another frequent source of harm to consumers.

Sheila Bair's Rx for fixing the financial system includes disclosure

While most of the attention is focused on her skewering Tim Geithner and bank bailouts, Sheila Bair put forth 13 simple fixes for the financial system.

The two I would like to call readers attention to are her suggestions to 1) close Fannie Mae and Freddie Mac and 2) improve disclosure for structured finance securities.

Regular readers know these two suggestions are linked.

In fact, the FHFA knows these two are linked.  That is why the FHFA proposed to oversee the construction and ongoing operation of a data warehouse to provide the disclosure needed to support the issuance of mortgage-backed securities from covered bonds through hybrid bonds to private label securities.

Regular readers and the FHFA know that without observable event based reporting, investors will not buy mortgage-backed securities without a government guarantee.

It is only observable event based reporting under which all activities like a payment or default involving the underlying collateral are reported before the beginning of the next business day that provides investors with the current information they need to monitor and value mortgage-backed securities.

It is only with observable event based reporting that investors know what they own.

It is only observable event based reporting that allows the Fannie Mae and Freddie Mac to be closed without a significant disruption to the mortgage finance market.

Mortgage plan seeks single securities platform

The Financial Times wrote an article about the push by the Federal Housing Finance Agency (FHFA) to create a data warehouse for mortgage backed securities.

Regular readers know that your humble blogger has been advocating for the creation of this data warehouse since before the financial crisis (full disclosure:  I have a US patent that may cover this data warehouse; however, patent or no patent, a data warehouse is needed if a new model for mortgage backed securities is to emerge that doesn't have the problems that exist with the current model).

The US may create a public utility to process all mortgage securitisations in the future after the main regulator of housing finance said it wants to invest in a single platform. 

In a strategic plan published on Tuesday, the Federal Housing Finance Agency said that it aims to build a single securitisation platform for Fannie Mae and Freddie Mac, the two housing finance agencies that guarantee and bundle most US mortgages. 

The plan points to a revolutionary future for the $8,500bn US mortgage-backed securities market, in which all public and private issuers use a single platform to process and track payments from mortgage borrowers through to MBS investors, and Fannie and Freddie may no longer exist.

The platform should track and provide reports on the mortgages on an observable event basis.  An observable event for a mortgage includes, but is not limited to, a payment, delinquency, default, bankruptcy of borrower, or modification.

By tracking and reporting on an observable event basis, users of the data always have current information on the performance of the underlying mortgages.

Fortunately, observable event based data is obtainable from the mortgage servicers because this is the way their loan databases are designed -- they already track and report observable events for each mortgage.

“Right now, Fannie and Freddie each have their own proprietary systems,” said Edward DeMarco, acting director of the FHFA. He said it made little sense for taxpayers to keep investing in two different platforms when they could instead build a single system that could be used regardless of whether Congress keeps Fannie and Freddie or scraps them. 

“It’s about building out an infrastructure for the secondary mortgage market but doing so in a way that is not dependent on any particular policy path,” said Mr DeMarco. In the medium-term, such an infrastructure could mean a single agency MBS, instead of different Fannie and Freddie securities....

The role of the state-backed US mortgage originators has come under the microscope. 

Politicians across the spectrum in the US want to scale back the government’s role in guaranteeing mortgages but Congress has not yet decided whether to keep Fannie and Freddie or scrap them. ... 

“We want to gradually shift some of the mortgage credit risk that Fannie and Freddie are taking on today back to the private market,” said Mr DeMarco....

The data warehouse is the key to bringing back the private market for mortgage backed securities.  With observable event based reporting, market participants can actually independently value these securities.  This is the first step in making an investment decision.

Banks tighten loan terms amid property-price fears

The Irish Independent ran an article on banks tightening loan terms that could have appeared in any EU country or the US and been equally valid.

As this blog has repeatedly pointed out, it is very difficult for banks to lend money when they see the value of the collateral that would secure their loan declining.

In addition, the effect of banks tightening loan terms exacerbates the impact on credit availability caused by the frozen structured finance market.

With the structured finance market unavailable, banks have to hold onto the mortgages they originate.  With the financial regulators pushing for higher capital ratios, banks have an incentive to limit their loan portfolios.  Combining long term credit risk with limited capacity naturally leads to a focus on only highly qualified borrowers.

BANKS are making it harder for people to get mortgages because they believe house prices will keep falling and fear the economy will continue to slow down. 

The lenders are imposing tougher conditions before they will grant mortgages, a Central Bank survey on lending has found. 

Regulators said banks would continue to turn down applications for mortgages despite the Government boosting the tax reliefs it will pay new buyers this year, and banks claiming to be willing to lend. 

Although banks have cut the interest rates they charge on mortgages, at the same time they are demanding larger deposits, the Central Bank said. 

But it is not just a reluctance to lend that is keeping the property market in a price-fall spiral. Demand for home loans weakened in the last three months of last year due to economic uncertainty. 

House prices have fallen by half since the peak of the property bubble in 2007, with an international study last month concluding that prices in Ireland were now among the most affordable in the world. 

But the Central Bank survey found that lenders were being put off by the likelihood that prices would keep falling and have responded to this by making it harder to get approved for a mortgage. 

"The tightening of credit standards in respect of mortgage lending was attributed to less favourable expectations regarding economic activity, along with diminished prospects for the housing market," the survey stated. 

Hopes of an uplift in the property market have been dashed by a comment in the survey that "credit standards are expected to tighten on loans to households with loan demand anticipated to remain unchanged".

The availability of finance was the biggest stumbling block for the property market, the Royal Society of Chartered Surveyors Ireland (RSCSI), whose members include estate agents, said in a report this week. 

A lack of banking funding means up to a quarter of house purchases are now made by cash buyers. 

The RSCSI said: "On the residential side, only those in secure roles either in the public service or from high-profile, international firms are being offered mortgages, despite claims to the contrary from the banks themselves."...

A spokesman for the Irish Banking Federation said banks were engaged in prudent lending to prudent borrowers.

Fannie and Freddie to start providing loan-level data for structured finance deals they guarantee

In an effort to improve transparency, Fannie Mae and Freddie Mac will start to provide loan-level data for the new structured finance securities that they guarantee.

According to Fannie Mae's press release, this data will be updated on a once per month basis.

Regular readers know that once per month is the same frequency that performance data is disclosed for opaque, toxic sub-prime mortgage backed securities and is inadequate for investors to know what they own.

For investors to actually know what they own would require updating the loan-level data on an observable event basis.  An observable event includes a payment is received, the loan becomes delinquent, the borrower defaults or the borrower files for bankruptcy.

With observable event based reporting, investors know what they are buying or selling because they always know the current status of every loan backing the security.

By adopting once per month reporting, Fannie and Freddie are reaffirming the standard for opacity set by sub-prime mortgage backed securities.

How Paulson gave hedge funds advance word

Bloomberg has another terrific article on the problem with regulators having a monopoly on the useful, relevant information for financial institutions.

In this case, the article discusses a meeting between then US Treasury Secretary Hank Paulson and a group of hedge fund managers.  At the meeting, Paulson discussed Fannie Mae, Freddie Mac and the possibility that the government might put them into receivership.

The reason that I highlighted the article are the following paragraphs

Morgan Stanley and BlackRock Inc. both helped the Federal Reserve and OCC prepare the reports on Fannie Mae and Freddie Mac that Paulson told the New York Times would instill confidence the morning of [July 21, 2008 when he and hedge fund managers attended] the Eton Park meeting.

Paulson learned by mid-August that the Federal Reserve had found the GSEs “unsafe and unsound,” he told the Financial Crisis Inquiry Commission, which was appointed by President Barack Obama and Congress to probe the causes of the financial collapse. 

“We’d been prepared for bad news, but the extent of the problems was startling,” he wrote in “On the Brink.”

The Federal Reserve and the OCC had Morgan Stanley and BlackRock Inc. prepare reports on Fannie Mae and Freddie Mac with the intent of instilling confidence in the market.

Why exactly are the Federal Reserve and OCC having reports written to instill market confidence?

This blog has repeatedly said that the only way to instill market confidence is to disclose all the useful, relevant information in an appropriate, timely manner.  Market confidence flows from market participants being able to use this information to independently assess the risk of an exposure.

The fact that the Federal Reserve and OCC were in a position to consider having these reports written is a function of the fact that the regulators' monopoly on all the useful, relevant information meant that there was inadequate disclosure to market participants.

Like all financial institutions, Fannie Mae and Freddie Mac should be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Mr. Paulson confirms that there was a regulatory failure to properly assess the information from Fannie Mae and Freddie Mac on which the regulators have a monopoly.

This is another problem that would be resolved with ultra transparency.  The market participants could help the regulator by providing them with their assessments.

In sign Irish banks a long way from solvency, Irish property prices continue to decline

According to an Irish Times article, the decline in the price of houses in Ireland is accelerating.

This would be a problem for the Irish banking system if it were already current in recognizing the losses on the mortgages on the banks' balance sheets.

This is a bigger problem given that the banks have so far deferred working with the borrowers and calls into question the "solvency" of the two re-capitalized Irish banks.

Irish house prices continued to fall last month with the rate of decline actually increasing when compared with 12 months ago. 

The latest figures from the Central Statistics Office (CSO) indicate that prices dropped 1.5 per cent in September and they show the decline since the beginning of the year now standing at 14.3 per cent.... 

The comprehensive index, which was first published by the CSO earlier this year, gives detailed data by type of property (house/apartment) and by geography (Dublin/non-Dublin).... 

Looking at the broader picture, house prices in Dublin are now 49 per cent lower than at their highest level in early 2007 while apartments in Dublin have fallen by 59 per cent since February 2007. The fall in the price of residential properties across the rest of the State is 40 per cent.

Fed's focuses monetary policy on housing market

According to a Bloomberg article, the Fed is pursuing zero interest rate, quantitative easing, Operation Twist and other policies to support the housing market.

One of the policies that the Fed has been pursuing is extend and pretend.  By not requiring the banks the Fed supervises to write-down the value of their real estate loans, the Fed is artificially propping up house prices.

As this blog has mentioned previously, the cost of this extend and pretend policy is that banks have a hard time making loans to small businesses.  Banks are senior secured lenders and it is difficult for the banks to assess the true value of the real estate these businesses have to pledge as collateral given that extend and pretend policies might end.

As William Dudley, President of the NY Fed said,

Bolstering the housing market is “particularly important” because it’s a key factor in household wealth ... 

“Continued house price declines could lead to even more defaults, foreclosures and distress sales, undermining wealth, confidence and spending,” Dudley said in his speech. “Breaking this vicious cycle is one of the most pressing issues facing policy makers.”...

“If prospective homeowners no longer fear that prices could decline further, they will be more willing to enter the market to take advantage of reduced prices and low financing costs, and existing homeowners will feel more confident about spending,” Dudley said. 

“A vicious cycle could be replaced by a virtuous circle, in which stabilization in house prices supports spending, growth and jobs.”

Is this a case where the Fed's policies are self-defeating?

So long as the Fed is pursuing policies to artificially support the housing market, isn't that a sure sign that prices on houses are too high?

Perhaps the economy would be better off if the Fed abandon all of its policies designed to help the housing market?

I realize that abandoning these policies would require banks to realize their losses and to wipe out the accounting construct known as book equity.  However, in a financial system with deposit guarantees and where banks are required to make detailed disclosure of their assets and liabilities, this would not necessarily be a bad thing.

FHFA lawsuit against banks over mortgage-backed securities documents Wall Street's informational advantage

The FHFA lawsuit on behalf of Fannie Mae and Freddie Mac memorializes the informational advantage that Wall Street had regarding mortgage-backed securities and how Wall Street used this advantage to the detriment of other market participants.

Regular readers know that Wall Street invested in and purchased sub-prime mortgage originators and servicers to gain an informational advantage over other market participants.  Their investments and acquisitions put Wall Street's traders in the position of having tomorrow's news today while all other market participants had tomorrow's news several days or weeks later.

Your humble blogger has talked about this informational advantage since before the credit crisis.  My focus has always been on the need to eliminate this informational advantage to restore confidence in and attract investors back to the private RMBS market.

It is the FHFA lawsuit that has shown how the informational advantage could be used for fraud.  Courtney Comstock wrote a long post discussing the FHFA lawsuit, Goldman Sachs and Dan Sparks.

And there are two big reasons why the FHFA says Goldman's actions were fraudulent. In short, they are the money it paid to get a window into the mortgage origination process and Dan Sparks. 

Here's the first. From a key sentence in the FHFA lawsuit: 

Because the information that Goldman provided or caused to be provided [to ratings agencies] was false, the ratings were inflated... [and] also that Goldman Sachs knew, or was reckless in not knowing, that it was falsely representing the underlying process and riskiness of the mortgage loans... because Goldman’s longstanding relationships with the problematic originators, and its numerous roles in the securitization chain, made it uniquely positioned to know the originators had abandoned their underwriting guidelines... [and because] as a result, the GSEs paid Defendants inflated prices for purported AAA (or its equivalent) Certificates, unaware that those Certificates actually carried a severe risk of loss and inadequate credit enhancement.

The big thing here is that Goldman funded mortgage originators, who encouraged property appraisers to inflate home values by firing them if they didn't and gave half million dollar loans to people like hairdressers and gardeners.... 

Goldman is also on the hook because it saw the poor quality of the loans it bought from the mortgage originators it funded (the lawsuit says Goldman received daily updates on how many loans were delinquent), retained third-party due diligence providers to analyze those loans that it considered securitizing regardless of the delinquencies (a smart move considering that it might have absolved Goldman of responsibility for any poor-quality loans in the Securitizations) but Goldman didn't listen to the companies' recommendations to exclude a significant number of loans. Goldman included the loans in its Securitizations anyway. Then it got the ratings agencies to rate them attractively. But it stated in offering documents that the loans had generally met the guidelines of the due diligence review.

Please re-read the highlighted section of the lawsuit again.

Your humble blogger has been saying since before the start of the financial crisis that all structured finance market participants should have access to daily updates on all the observable events that occurred involving the underlying loans.  Observable events include payments and non-payments/delinquencies!

Compare and contrast the use by Wall Street of observable event based information to the once-per-month disclosure that the Wall Street dominated industry trade groups (American Securitization Forum and the European Securitisation Forum/Association for Financial Markets in Europe) have argued is adequate to the SEC, ECB, BoE and CEBS - regulators who tried to bring asset-level performance transparency to structured finance.

Clearly, the trade groups are trying to protect Wall Street's informational advantage.  However, with the FHFA lawsuit, Wall Street's informational advantage is over as all market participants will have to have access on an observable event basis.

Faced with lack of disclosure, investors migrate to government guaranteed debt

To nobody's surprise, government guaranteed debt is emerging as the biggest source of debt in the capital markets.  This is completely expected when regulators fail to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner on non-government guaranteed debt.

It is one thing for market participants to buy a non-government guaranteed debt security when they know what is in it, but quite another to buy a non-government guaranteed debt security when they do not know what may or may not be in it.

This blog has held up structured finance securities and financial institutions as examples of where inadequate disclosure leaves investors guessing at what may or may not be standing behind the debt repayment.

When market participants cannot analyze the risk, they do not know if they are being compensated for it.  As a result, market participants have an incentive to purchase securities where they can analyze the risk and see if they are being compensated for it.  Today, those securities tend to be government guaranteed.

According to a column in the Financial Times,

By the time you read this column today, a fascinating shift will almost certainly have occurred in the nature of US finance: for the first time the government will be the biggest source of outstanding home mortgage and consumer credit loans in the US, eclipsing private sector banks or investors. 

Or that, at least, is the forecast recently made by Investor Business Daily, a US publication. 

... What should investors make of this? There are at least three lessons to ponder. 

First, the data provide a powerful sign of just how distorted the US financial system remains in the aftermath of the great credit crunch. This might not seem obvious to investors or voters; after all, in recent months the large banks have repaid their troubled asset relief programme funds, stock markets have rallied and credit spreads have shrunk. 

But behind this veneer of normality, banks are still deleveraging, and the private sector mortgage securitisation world remains almost dead. Indeed, were it not for the activity of Fannie Mae and Freddie Mac, the giant state institutions, mortgage finance would, in effect, have seized up in the past three years. 

Actually, what the data shows is that there is a buyer's strike going on until market participants have access to all the useful, relevant information on private sector mortgage securitizations in an appropriate, timely manner.

As predicted under the FDR Framework, zero interest rate policies were not going to lead to blindly chasing after yield in the structured finance market.  Market participants learned their lesson with the credit crisis that these securities do not have adequate disclosure. Notice how the lack of buyers in this $2 trillion market expressed itself with prices for non-government guaranteed mortgage-backed securities slumping almost 20% when the Fed tried to sell its $30 billion AIG portfolio.

The second fascinating point, though, is the cognitive dissonance surrounding this pattern. Six years ago, when I first started writing about the credit markets, I often heard US financiers praise America’s capital markets as the most developed system of free market finance in the world. Indeed, techniques such as securitisation were presented as a natural outcome of American enthusiasm for free market ideals. 

One of the major themes of this blog has been that "free markets" have a role for both government and market participants.

The US version of free markets under the FDR Framework combines the philosophy of disclosure with the practice of caveat emptor (buyer beware).

• government is responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

• market participants are responsible for the outcome of any investment decision and as a result they have an incentive to adjust both the price and amount of their exposure based on the results of their analysis of this information.

The US version of free markets ceases to function when the government does not ensure access to all the useful, relevant information in an appropriate, timely manner, but instead claims that it is the investors' responsibility to require disclosure. [See Treasury Secretary Hank Paulson's speeches and the Presidential Working Group on structured finance.]

Investors have limited ability to require disclosure.  Instead, they go on a buyer's strike covering the types of securities with inadequate disclosure.  While waiting for the government and issuers to provide adequate disclosure, investors turn to alternative investments that do provide adequate disclosure.  It is only when the issuers provide all the useful, relevant information in an appropriate, timely manner that the buyer's strike will end.

But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate. 

After all, with the US remaining wedded to free market ideals, it is uncomfortable to admit that “capital markets in the US have become reliant on government guarantees”, says Viral Acharya, an economist and co-author of a thought-provoking book.* 

Capital markets in the US are not "reliant" on government guarantees.  They use these guarantees as a substitute for access to all the useful, relevant information in an appropriate, timely manner.

If the US wanted to reduce the total amount of government guaranteed debt, it could simply provide access to all the useful, relevant information in an appropriate, timely manner instead. This would allow the guaranteed debt to runoff and be replaced by non-guaranteed debt.