Wall Street Updates Forecasts in light of Announced HARP Modifications

Wall Street firms updated their forecasts on mortgage prepayments in light of the Obama administration’s announcement this week on modifications to the Home Affordable Refinance Program (HARP).  The consensus is for a significant increase in prepayments on Fannie Mae and Freddie Mac guaranteed mortgages, particularly those originated between 2006 thru 2008.

The Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie, announced on Monday changes to its HARP program.  Initiated in June 2009, the program was designed help underwater homeowners that were current on their mortgages refinance at lower market rates.  To date, program participation has been disappointing, with fewer than 900,000 mortgages being refinanced.

The announced changes are expected to kick start the program.  Specifically, the FHFA is relaxing the representations and warranties that the new mortgage originator would have to make to either Fannie or Freddie.  The concern has been that the originator could be required to repurchase the loan from one of the agencies if it was found that the original underwriting on the mortgage was found to be deficient.  In addition, the cap on the qualifying loan to value (LTV) for fixed rate loans, previously set at 125% of the loan balance, has been waived.  Finally, the program has been extended from June 2012 until December 2013.

JP Morgan estimates that the HARP program would apply to a universe of 4.6 million mortgages aggregating  $740 billion.  Of this they estimate that an additional 1.1 million mortgages or roughly 25% will actually be refinanced through HARP.  Assuming a 2% reduction in rate, that would amount to annual reduction in debt servicing of $3.5 billion.  JP Morgan projects a significant impact from the new changes and concludes, “in our view, the market is under-estimating the potential impact of HARP 2.0”.

Nomura Securities notes that most refinancing to date under HARP has been made by the same servicer that underwrote the original loan.  A different bank or servicer has been reluctant to refinance that loan for fear of assuming the rep and warranty liability.  Nomura argues that relaxation of the reps and warranties, if substantive,  would foster significant competition to refinance.  Nomura also points out that extending the program until December 2013 gives originators the requisite time horizon to make a significant investment in a refinancing effort.  Depending on vintage and coupon, Nomura projects prepayment speed increases of 7% to 14% depending on cohort.

Additional details on HARP are expected on November 15.

Profile of Tim Cook, CEO of Apple Computer

Steve Jobs passed away and the world lost a business icon.  Apple Computer’s $390 billion market capitalization makes it the most valuable company in the world, having surpassed that of Exxon-Mobil this year. Apple has changed the way the planet thinks.

When Steve Jobs formally stepped down as CEO this past August, Tim Cook assumed the title of CEO.  Cook had held this position intermittently when Jobs had previously had health issues but the passing of the baton was now official. 

The $64 billion questions are: who is Tim Cook, what kind of leader is he and what impact will he have on the company in the years ahead? 

One thing is for sure.  Absent a colossal failure, he is likely to be with the company for many years.  On the day of his appointment, the Board granted him one million restricted stock units, half of which will vest in five years and the balance five years later. At $420 a share, the math is not complicated.

Tim Cook will turn 51 this November and his career path reflects a focus on operations, sourcing and logistics.  His CV reads like the man who gets things done but not as the one who dreams up new products.

A native Alabaman, Cook graduated with a degree in industrial engineering from Auburn University and receiving an MBA from Duke in 1988.  Cook worked for 12 years at IBM, prior to and after business school, his last position as Director of North American Fulfillment.  He  also held positions at Intelligent Electronics Inc. as Chief Operating Officer of their Reseller Division and then VP for Corporate Materials at Compaq Computer, responsible for all parts procurement and logistics. Cook joined Apple in 1998 as Senior VP for Worldwide Operations and became Chief Operating Officer in 2005. 

Cook’s compensation has been heavily skewed to restricted stock awards, encouraging a long term management approach.  In 2010, his total compensation was $59 million of which $52 million represented stock awards. 

Cook sits on one outside Board, Nike, having been a member since 2005.  Per Nike’s proxy statement, “Mr. Cook was selected to serve because his operational executive experience and his knowledge of technology, marketing, and international business allow him to provide the Board with valuable perspectives and insights.” 

The Wall Street Journal profiled Cook in 2006 and the picture that emerges contrasts with that of his former boss.  While Jobs is portrayed as autocratic, Cooks is described as “low-key”, “quiet” and “courtly”.  

Industry analysts have mixed views on the new boss.  Mordechai Beizer, a Managing Director at Gupton Marrs, the technology consulting firm, sees continuity and no major outside expansion.  Beizer notes “Cook has an operations background, not mergers and acquisitions.  Also, he's basically been running the company on and off during the last eight years. There is no reason to believe that he is going to do things drastically differently.”  Steven Brand, an Apple aficionado and the CEO of Sidecastr, a tablet application venture, is concerned about Cook's ability to inspire.  "The challenge for Cook is going to be earning the trust and loyalty that Apple employees had for Jobs that translated into superhuman performance.”  

Brand concludes, “people killed themselves to perform brilliantly enough to get noticed by Jobs. That's never going to happen at the same level for Cook. Best he can hope for is to convert loyalty to Jobs into loyalty to Apple”.

Mortgage Market Anticipating Changes to HARP Program in Coming Days

There has been a lot of chatter over the past few weeks about forthcoming changes to the Home Affordable Refinance Program (HARP), administered by the Federal Housing Finance Agency (FHFA).  Launched in 2009, the program’s goal was to facilitate refinancing of mortgages guaranteed by Fannie Mae and Freddie for borrowers that were current on their payments but had insufficient equity in their homes to meet the necessary underwriting requirements for refinancing.  Specifically, the program gives borrowers the ability to refinance mortgages with loan to values (LTV) of up to 125% on mortgages originated prior to June 2009.
 

Through the 2^nd quarter of 2011, only 838,000 mortgagors have taken advantage of HARP.   The relatively disappointing results reflect  mortgage banker concerns of incurring additional liability by originating a new mortgage.  Originators are required to make representations and warranties to Fannie and Freddie such that, in the event a loan is subsequently deemed underwritten outside agency criteria, the originator could be forced to repurchase that loan at par.

The FHFA  regulates Fannie and Freddie as well as the twelve Federal Home Loan Banks and and is working on relaxing the rep and warranty language so as to facilitate more activity.  As home prices have continued to decline, the Agency is also considering raising the LTV above the current 125% limit.  The issues are complex because on the one hand, reducing borrower rates is a net positive for Fannie/Freddie’s credit exposure (lower rate means less likelihood of default)  but on the other hand, any refinanced mortgage means less income for the agencies’ investment portfolios as well as other holders of Agency mortgage backed securities. 

At the September 21 FOMC meeting, the Fed announced the implementation of what has come to be known as  “Operation Twist”.   Through June 2012, the Fed plans to sell $400 billion of short-dated treasuries and reinvest in longer dated securities with the goal of pushing down long term interest rates.  To a large extent, the market has anticipated this policy action and mortgage rates have come down significantly, with 30 year mortgage rates approaching 4% (see chart below). 

 

Source: Freddie Mac

Many borrowers that have been unable to refinance have mortgage rates exceeding 6%.  Assuming they could access today’s current rates, many could lower their interest payments by 2% or more.  On a $300,000 mortgage balance, that could translate to an annual savings of more than $4,000.  That $4,000 per household could represent a powerful stimulus to an economy facing many headwinds.

There is some talk that President Obama may himself be making the HARP change announcement.  If so, that would underscore the very real importance the Administration places on this policy initiative to jumpstart the economy.

Acceleration of Transition Rates from Delinquency to Foreclosure to put Additional Stress on Housing Market

Bank of America strategists  Chris Flanagan and James Nguyen report that mortgage servicers have accelerated processing delinquent mortgages after a relative hiatus related to fall 2010 "robo-signing" controversy.  That controversy  had led many lenders to voluntarily suspend foreclosure actions.  Bottom line: mortgage servicers appear to have gotten their act together and are working through the legal process to foreclose and ultimately liquidate the overhang of properties associated with the pandemic of delinquent mortgages.

The report's methodology is to apply a credit transition model  to the stock of existing and projected delinquent mortgages.  For example, the model may forecast that x% of 30 day delinquent mortgages will transition to 60 days delinquent in one month.  The following month, the model may project that y% will become 90 days delinquent and so forth until the property is foreclosed upon and eventually sold. 

                                             

The study's results are, for want of a better word, frightening.  The report forecasts that there will be 552,000 homes liquidated in the second half of this year, followed by 1,351,000 in 2012, peaking at 1,487,000 in 2013 and then 1,330,000 in 2014 and 960,000 in 2015.  In all, through 2015, 5.7mm homes will be sold/auctioned/liquidated as part of a foreclosure action (see table below).  Of this total, 63% or approximately 3.6mm mortgages  are held or guaranteed by a US agency.



We are talking about a lot of families.

The onset of this supply could not come at a worse time given the anemic growth in the US economy and the headwinds associated with the US employment picture.  Concerns about a global slowdown correlated with the European debt crisis and a deceleration of the Chinese economy further darken the picture.

Flanagan and Nguyen argue that urgent action is required NOW.  In particular, the authors cite the need to convert REO (real estate owned) properties to rental units.  Because the government effectively owns the risk on so many of these properties, it should be reasonably manageable to implement a government sponsored program, in alliance with private capital, to convert delinquent borrowers into current renters.  The goal should be to keep the borrower in the home and the home off the market.  

The US housing market risks continuing to be in a negative feedback loop from a weak economy and a housing market under duress.  A foreclosed property will in turn hurt neighboring real estate values which in turn compounds the problem.  Keeping that property out of foreclosure is a key component to any policy solution.

Former Fed Vice Chairman Encourages Mortgage Action

Alan Blinder, the former vice-chair of the Fed gives a cogent analysis of the state of the US real estate market in a WSJ oped today.  Blinder underscores the seriousness of the situation and argues against a laissez-faire let the chips fall where they may approach.

His policy prescriptions pick up a number of threads outlined in a New America Foundation report published last week (see Oct. 11 blog entry).  Specifically, Blinder recommends a fast track, streamlined refinancing program on Fannie and Freddie Mac guaranteed mortgages.  Second, he argues that some form of principal reduction program is necessary.  At the same time, Blinder acknowledges the moral hazard issue and would structure the program so the lender offering the reduction shares in any potential upside if and when real estate prices recover.  Finally, Blinder suggests a program to convert vacant properties to rental units.  He suggests some kind of financing program for private capital to facilitate these conversions.

This is all good stuff.  But as Blinder correctly points out, we need the vision and political will to move these ideas forward.  Right now, our friends in both parties seem to think it's business as usual.  There seems to be little understanding of what is at stake here.

Refinancing deal as part of broader mortgage settlement?

The Wall Street Journal reported today that large US banks were in talks with state attorney generals and were putting a refinancing carrot on the table, presumably as a quid pro quo to settle charges of abusive foreclosure practices.

The details are murky and the California Attorney General Kamala Harris, a key player in any kind of comprehensive settlement, denies even being aware of the proposal.  That said, the idea being floated is that banks would offer to refinance borrowers on bank owned mortgages (i.e. have not been securitized and sold off) and where the borrower is current on their payments.  These borrowers would normally not be able to refinance because they are upside down on their mortgage.

Separately (see 9/8/2011 blog post), there is continued discussion on FannieMae and FreddieMac relaxing their underwriting criteria on mortgage loans they already guarantee to enable borrowers to  refinance.  As reported by the Wall Street Journal, Treasury Secretary Geithner suggested back on October 6 that some meaningful proposals would be forthcoming in the weeks ahead.

Stay tuned.

Some green shoots for private capital participation in the US Mortgage Markets

The Wall Street Journal reported this week that the Obama administration, under the auspices of the Federal Housing Finance Agency (FHFA),  is considering ways for US mortgage agencies Fannie Mae and Freddie Mac to effectively syndicate the risk of the guarantees backing various pools of mortgages.  This would be done by selling off a “first loss” piece on pools of mortgages  to private capital/investors, who in turn would be compensated with a higher yield for the risk they would be assuming.  The example cited suggested the bottom 5% or 10% of a pool would be “engineered” and sold to institutional investors.  Any underlying losses would be directed against the first loss slice.  The appeal to investors would be a function of the offered yield and the fact that agency underwriting standards have become increasingly conservative and projected losses on a given pool of mortgages would be muted.

Since the advent of the 2008 financial crisis, there have only been three public securitizations on new origination mortgages totaling less than $1 billion.  Contrast that with 2005 and 2006 issuance that both exceeded $1 trillion.  Since the summer of 2007 when the Bear, Stearns Hedge Funds were liquidated and the market discovered that AAA wasn’t really AAA,  private mortgage securitization has effectively been frozen.  The flip side of that coin is that essentially all securitized mortgages have needed a government guarantee to attract investor interest.  As a result, the pool of capital available for non-conforming mortgages, i.e. those that do not meet Agency underwriting criteria, is severely diminished and is essentially restricted to portfolio lending.

The FHFA initiative may represent a first step to attract private capital and simultaneously reduce the market’s quasi exclusive dependence on Uncle Sam to finance residential mortgages. 

New Report Outlines Mortgage Policy Recommendations

A new 35 page report released today by the New America Foundation provides a comprehensive analysis of the causes of the current financial and economic crisis and recommends three core “pillar” solutions to help facilitate a sustainable long term U.S. and global economic recovery.  In particular, the report advocates for a concerted effort at alleviating the corrosive effects of the mortgage debt overhang resulting from the past decade’s real estate bubble.

The Way Forward, authored by Professors Nouriel Roubini of NYU and Robert Hockett of Cornell University and Daniel Alpert, Managing Partner at Westwood Capital, a boutique investment bank, cautions that the current economic crisis does not mirror that of a traditional business cycle and that misinterpreting the ailment will lead to ineffective prescriptions.  Their analysis traces the current predicament to what they refer to as the “Great Credit Bubble”.  From 1996 to 2009, US debt (the majority of which is households and the financial sector) has grown to unsustainable levels from 247% to 380% of GDP.  We are now in the process of working these debt levels down but the process will take many, many years.  Additional factors weighing on an economic recovery are the rise of export driven economies which has impacted US job growth/wages and the record levels of income inequality.

Against this backdrop, the authors argue that absent significant mortgage debt relief, the economy risks accelerating into negative feedback loop.  To address the issue, the authors segment the problem into three broad categories: borrowers that have positive equity in their homes; borrowers with negative equity in their homes but are capable of sustaining some level of mortgage debt; and the more traditional “subprime” borrower whose profile is more suitable to that of a renter.  A key policy goal is to keep the borrower in the home and the home off the market.

For delinquent borrowers with positive equity but unable to meet payments due to a weak economy, the authors suggest a bridge loan facility and cite various state programs that have been effective.  The argument goes, because the borrower has equity in his/her home, they have an incentive and want to stay in their home.  Some kind of temporary assistance is both in the interests of borrower and lender until such time as the economic environment improves.

The report cites an estimated  25% of US mortgages are in a negative equity position.  To date, mortgage modifications have focused largely on capitalizing delinquent interest and reducing the mortgage loan rate.  These types of modifications have had limited success and the authors recommend implementing some kind of principal reduction or forbearance for those borrowers that are able to sustain some reasonable level of mortgage debt.  The underlying recognition is that unless the loan balance  approximates the market value of the home and monthly payments are affordable, the borrower has too great an incentive to default.  The study does recognize the issue of moral hazard associated with a principal reduction program (i.e. the borrower essentially gets a check back for not honoring their contractual debt) and would require some kind of borrower earn-out in order to participate.

Finally, there remains that category of borrowers with negative equity who in any realistic scenario are incapable of repaying their mortgage debt.  To be blunt, many if not most of these borrowers never should have been given the credit green light to become homeowners and it’s a testimony to the magnitude of the credit bubble that these would be renters became borrowers.  The recommendation with respect to this last group is to convert borrowers back into renters and lenders into landlords.  Again, the issue of moral hazard rears its head and the authors are cognizant that any policy implementation has both a carrot and a stick.

The Way Forward  also addresses those borrowers who are non-delinquent on Agency  guaranteed (Fannie Mae, Freddie Mac, Ginnie Mae) mortgages but are unable to refinance their mortgages for underwriting reasons.  In total, the agencies guarantee the majority of all outstanding mortgages, to the tune of approximately $5 trillion.  A significant subset of these borrowers is unable to refinance at today’s rates (30 year mortgages are hovering around 4%) due to negative home equity.  The report recommends facilitating a streamlined refinancing.  The argument is that since the government already bears the risk of guaranteeing payment on these loans, lowering the borrower rate would actually reduce the risk by making the payment more affordable.

A copy of the report can be accessed at the link below.

http://newamerica.net/publications/policy/the_way_forward

SEC looking at Leverage in Mortgage REIT's

An SEC request for comments on the interpretation of a clause in the 1940 Investment Company Act is wreaking havoc on the prices of publicly traded agency mortgage REITs.  These REITs typically apply leverage ranging from four to eight times capital based on the interpretation that their holdings of mortgage securities exempt them from Investment Company Act leverage restrictions.

Annaly Capital (symbol NLY) is the poster child and 800 pound gorilla in the industry and the stock has fallen 11%  since September 21 to a close today of $15.68.  The market capitalization of approximately $15 billion easily dwarfs its nearest competitors. (Other agency REITs include American Capital (AGNC), MFA, Hatteras (HTS), Invesco (IVR) and Anworth (ANH)). Per their most recent quarterly statement, the company employs a leverage factor of 5.7, implying that their capital supports an asset base of $85 billion in mortgages, mostly Fannie Mae and Freddie Mac MBS pass thrus.  

Because of the relative steepness of the US agency yield curve, employing that degree of leverage has allowed Annaly to generate dividend yields in the mid-teens.  Given the absolute low level of interest rates, that kind of yield has attracted significant investor demand.  In 2011 alone, the company has issued three secondary offerings totaling 270 million shares, raising capital proceeds of close to $5 billion.  With the Federal Reserve officially signaling “exceptionally low levels for the federal funds rate at least through mid-2013”, all manner of investors want to jump on the borrow short, lend long bandwagon.

The clause under review, section 3(c) (5) (c) to date has exempted  some money managers from Investment Company status, status which in turn would limit any leverage to 50% of assets.  The specific language excludes “any person purchasing or otherwise acquiring mortgages and liens on and interests in real estate”.  At the same time, any issuer which “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities” does fall under the Investment Company Act definition.  The problem is that mortgage-backed securities, which only came into being post 1968 arguably fall under both definitions.

The SEC request for comments was circulated on August 31 and will remain open until November 7.  In the event a narrower definition prevails, mortgage REITS will become net sellers and their headline dividend  yields will decline commensurately.  Recent price action would argue market participants are beginning to discount a very real possibility of that occurring.