The Hutchens Blog

The rally among home-loan bonds without government backing is being fueled by errors made by “most market participants” in translating current prices to potential returns, Amherst Securities Group LP analysts said.

Investors are overestimating potential yields in part because they are failing to consider how many loans are becoming delinquent for the first time and partly because they are arriving at incorrect conclusions on how long it will take to liquidate seized homes, the New York-based analysts led by Laurie Goodman wrote in a report yesterday. Those issues can influence both the size of foreclosure losses and how quickly bonds get paid down.

“Do your homework, and sell securities which are being evaluated incorrectly by the marketplace,” the analysts wrote.

Non-agency home-loan bonds have soared from record lows or near-nadirs in March amid speculation that Treasury Secretary Timothy Geithner’s Public-Private Investment Program, or PPIP, will add as much as $40 billion of demand to the market, and that the longest U.S. recession and worst housing slump since the Great Depression are easing.

For example, the most-senior classes of 2006 and 2007 securities backed by prime-jumbo mortgages have rallied to more than 80 cents on the dollar, from as low as 55 cents, according to Amherst. So-called super-senior bonds backed by “option” adjustable-rate mortgages have jumped to about 48 cents, from the “low 30s,” the analysts wrote.

Insufficient Analysis

Investors also have been doing too little analysis of the differences, such as the level of home equity, among borrowers with currently non-delinquent mortgages backing non-agency bonds, which lack guarantees from government-supported Fannie Mae and Freddie Mac or U.S. agency Ginnie Mae, they said.

After correcting two of the three common mistakes by investors, the potential yield on a Countrywide Financial Corp.- issued option ARM bond now trading at 48 cents on the dollar would fall to 6.49 percent, from 12.67 percent, assuming the London interbank offered rate remains unchanged, Amherst said. Adjusting for all three reduces the yield on a Wells Fargo & Co. jumbo-mortgage note bought at 85 cents to 7.15 percent from 11.52 percent, the analysts wrote.

That is “much lower than most market participants believe they are receiving on the security,” they said. “Moreover, the yield must be evaluated in conjunction with the level of uncertainty about our assumptions” around whether borrowers will continue to refinance at the “fast” pace of recent months and how many borrowers with “negative equity” will default.

Third Point Profits

Scott Simon, mortgage-bond chief at Newport Beach, California-based Pacific Investment Management Co., the world’s largest fixed-income manager, told Bloomberg Television on Aug. 4 that “from a long-term point of view, a lot of this paper still will yield a lot after losses.”

A buyer last quarter of at least some kinds of home-loan bonds was Third Point LLC, the hedge fund run by Daniel Loeb, which entered the market amid lower prices after profiting from bets against subprime-mortgage bonds in 2007, according to a July 31 investor letter from the New York-based firm.

Third Point bought $160 million in mortgage bonds and made more than $20 million in profits from April through July, Loeb wrote. He estimated that under “severe economic distress” where all of the underlying loans default and home prices drop another 20 percent, the debt the fund held as of June 30 would return 10 percent based on the prices it paid. The debt would return 17 percent to 20 percent under “our base case economic assumptions,” he said.

Pleased Investor

Loeb may “eventually” increase his fund’s mortgage-bond investments to 10 percent to 15 percent of invested capital, up from a previous target of 5 percent to 10 percent, depending on other opportunities, he said.

“Although four months is certainly too brief of a period to ‘declare victory’ in the mortgage markets, I am pleased with our timing, security selection, and ability to obtain choice offerings from the Street,” Loeb said.

Goodman is the former head of fixed-income research at UBS Securities LLC whose team there was top-ranked for non-agency mortgage debt in a 2008 poll of investors by Institutional Investor magazine. Amherst is a securities firm specializing in trading and advising investors on home-loan debt.

The U.S. government announced July 8 that the PPIP would begin with nine managers raising as much as $10 billion, and receiving as much as $30 billion in taxpayer capital and loans to buy mortgage bonds originally rated AAA.

Option ARMs

Jumbo mortgages are larger than Fannie Mae or Freddie Mac can finance, currently $417,000 in most areas to as much as $729,500. Option ARMs allow borrowers to pay less than the interest they owe, tacking on the difference to their debt and creating the potential for bills to spike.

A Markit ABX index of credit-default swaps tied to a type of subprime-mortgage bond rated AAA when issued in the first half of 2007 climbed to 29 yesterday, up 18 percent from a June low, according to Markit Group Ltd.’s Web site. The swaps offer protection if the securities aren’t repaid as expected, in return for regular insurance-like premiums. Subprime mortgages went to borrowers with poor or limited credit or high debt.

Posted by Sandy Hutchens

The cost of fixed-rate mortgages rose to its highest level for ten months as more borrowers took out loans to buy new homes, according to figures published yesterday.

The Bank of England said that the average five-year, fixed-rate mortgage had risen from 5.54 per cent to 5.7 per cent between June and July, the highest level since October 2008, when the base rate was 4.5 per cent, compared with 0.5 per cent now.

Meanwhile, the number of homeowners taking out a mortgage to buy a home rose by 23 per cent to 45,000 in June, the highest for a year, according to the Council of Mortgage Lenders, after a rise in demand from new homebuyers.

Economists said that mortgage rates would continue to rise for the rest of the year, stifling the market at a time when demand for fixed-rate mortgages was increasing. Rate rises are a result of lenders passing on the higher cost of funding but also reflect bigger margins and a reluctance by banks to take on new business.

Paragon Mortgages, a lender, said that a record seven in ten buyers had applied for fixed rates in the three months to June as borrowers looked to capitalise on an historically low base rate. However, those opting for trackers, which follow the base rate, fared better: the average rate of these deals stayed the same at 3.81 per cent.

Separate government figures yesterday from the Department for Communities and Local Government showed that high demand relative to low supply had contributed to a 1.6 per cent rise in house prices in June to £191,423, bringing the annual fall from June to June to 10.7 per cent in England. The average price paid by first-time buyers rose by 2 per cent between May and June to £140,222.

Knight Frank, an estate agency focusing on the top end of the market, said that there were so few properties coming on to the market that some of its offices might run out of homes for sale by the end of the month. It said that the worst stock shortages were in parts of the country where there were few forced sellers of prime properties, such as Hereford. Some vendors were waiting until September before putting their properties on to the market.

Sandy Hutchens likes fixed-rate mortgages and would like to see them locked in at a reasonable rates.

What is Interest?
Interest is the price that someone pays for the temporary use of someone else’s funds. To repay a loan, a borrower has to pay interest, as well as the principal, the amount originally borrowed.

Interest is the compensation that someone receives for temporarily giving up the ability to spend money. Without interest, lenders wouldn’t be willing to lend, or to temporarily give up the ability to spend, and savers would be less willing to defer spending.

Interest rates are expressed as percents per year. If the interest rate is 10 percent per year, and you borrow $100 for one year, you have to repay the $100 plus $10 in interest.

Because interest rates are expressed simply as percents per year, we can compare interest rates on different kinds of loans, and even interest rates in different countries that use different currencies (yen, dollar, etc.).

What are “APR” and “APY”?
“APR” stands for “Annual Percentage Rate,” and “APY” for “Annual Percentage Yield.”

The APR includes, as a percent of the principal, not only the interest that has to be paid on a loan, but also some other costs, particularly “points” on a mortgage loan.

Points (a point equals one percent of the mortgage loan amount) are fees that the mortgage lender charges for making the loan. In a sense, points are prepaid interest, or interest that is due when the loan is taken out.

Some lenders charge lower interest rates but more points than other lenders. The APR therefore provides a useful gauge for comparing the total cost of mortgage loans.

For example, a 30-year mortgage with an interest rate of 8.0% and four points would have an APR of 8.44%, while a mortgage with an interest rate of 8.25% and one point would have an APR of 8.36%.

The principal used in calculating the APR is equal to the amount of the loan the borrower actually has to use at any time. Consider two one-year loans of $1,000, each with an interest rate of 10%, or $100 in interest.

The second loan has a higher APR, even though the amount of interest paid ($100) is the same on both loans. The second loan has a higher APR because the second borrower, unlike the first borrower, does not have the use of the entire $1,000 for the entire year, because the second borrower repaid $500 of the loan after six months. (Another reason the second loan has a higher APR is that the borrower paid half of the interest after six months and half at the end of the year, rather than all the interest at the end of the year.)

“APY” is the effective interest rate from the standpoint of a person receiving interest. If you have $1,000 in each of two bank accounts, each paying the same interest rate, but the interest is credited more often (let’s say, every month, rather than once a year) on one of the accounts, that account will have a higher APY, because the interest will build up more rapidly than on the other account.

Why Does Interest Exist?
From the lender’s point of view:

* Interest compensates lenders for the effects of inflation, or rising prices. Prices go up every year, so lenders are repaid with dollars that can’t buy as much as the dollars they lent; the lenders must be compensated for that loss of purchasing power
* Interest also compensates lenders for the risks they take. One risk is that nobody knows for certain how much prices will go up during the time that the borrower has the lender’s money. Other risks are that the borrower won’t repay the loan fully, on time, or at all
* For a lender such as a bank, interest covers the costs of staying in business, including the cost of processing loans, and interest also provides the profit that a lender needs to stay in business

From the borrower’s point of view:

* Individuals are willing to pay interest to borrow money in order to be able to spend now, rather than later, on cars and many other items
* Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own
* Individuals are willing to pay interest on loans to pay for education, which can increase their earning ability
* Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits
* Some borrowers are willing to pay interest on certain loans because of the associated tax advantages. Mortgage interest, for example, is tax deductible. That means that in calculating how much income tax you have to pay, you can subtract the mortgage interest that you pay from your income
* Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit
Interest: Cost to Some, Income to Others?
Interest is income to people willing to give up the temporary use of their money. When you put money into a bank account, or when you buy a U.S. Savings Bond, for example, you receive interest income.

Interest is a cost to borrowers. You pay interest, for example, if you don’t pay your entire credit card bill at the end of the month, if you take out a mortgage loan to buy a house, or if you own a business that borrows in order to invest in machinery.

Interest is a signal that directs funds to where they can earn the highest rates, or to where loans can do the most for the economy.

Interest is a measure of the cost of holding money. The rate of interest that you could earn by lending your money is the cost to you of holding your money in a way (such as in cash) that doesn’t earn any interest. Economists use the term “opportunity cost” to refer to what you give up by choosing a certain course of action. By holding money, you give up the interest that you could have earned, so the interest rate measures the opportunity cost of holding money.

Sandy Hutchens takes a look at the mortgage mess.

Who is to blame for the mortgage crisis? America, go look in the mirror! You don’t pay your bills and if you do, you let interest and late fees accumulate until you can’t pay them. This means that your credit score gets lower and lower with each missed payment or increase in debt. Then you whine because no one wants to lend you money anymore and the bank is taking back the house you bought with no money down and the seller paid your closing costs.

As a mortgage professional, I have seen it all! There are so many stories; I had a lady tell me she had good credit and then yell at me because I told her that she had been late every month for the last year. She said she didn’t think that being slow on payments should make a difference on her credit and that it wasn’t fair, at least she paid her bills.

I caused many an argument between husband and wife because they kept bad credit secrets from each other. I once had a man claim that he had excellent credit, only to learn that his credit was in the low 500’s because his wife hadn’t paid the bills on time and they were carrying a balance of $16,000 to Nordstrom’s, not to mention the other $25,000 of debt they were carrying. I believe that was the beginning of divorce proceedings because she was only reachable at the vacation home after that.

During the 1990’s, the sub-prime markets were born. This was creative financing to help those that had fallen on hard times, to re-establish credit and still be able to buy the things that those with “good credit” could buy, just at higher interest rates. Wall Street was selling these loans, in bulk, like hot cakes on the secondary market and investors were singing all the way to the bank.

It got to the point that you could file Chapter 7 bankruptcy on Monday and on Tuesday, with 15% down, could go and buy a new house. The bankruptcy laws being as forgiving as they were, you probably still had your home and could sell it and use the equity as your 15% down payment. If you still managed to keep your credit score at 580 (creditors only report to the credit bureaus every 3 months), this same deal could be done with just “stating” your income instead of actually verifying that you could make the payment.

After 9/11 the economy took a major hit and lenders once again came up with more creative financing to help struggling buyers. These programs combined with low interest rates that the Federal Reserve kept dropping, got to the point that I was able to put families into a new home with zero money down, the seller paying up to 6% of the closing costs and get the buyer 100% financing. I had one buyer walk out of escrow pocketing $800 for buying a condo because the seller had paid all the closing costs and she was credited by her real estate agent.

The most lucrative thing lenders came up with was the Adjustable Rate Mortgage or ARM.

These were a good deal for the lender, the loan officer and the buyer, if they were disciplined and listened to an ethical mortgage professional. There were two types; those that had the possibility of negative amortization and those that didn’t. This was an ethical issue for most loan officers because lenders were paying up to 4 points yield spread premium on the loans that had the negative amortization clause. This is money that most buyers aren’t even aware of because it doesn’t always have to be disclosed, depending on the licensing of the broker and the money doesn’t come out of the buyers pocket at escrow. Mortgage companies were selling these to anyone and everyone, regardless of whether it made sense. This means on a $400,000 loan, $16,000 could be paid to the broker in addition to the other fees charged. Everybody got fat and happy and the borrowers had no idea what they had done, until the payment adjusted and they couldn’t make the new payment.

Regardless of whether this was explained to you or not, America, you didn’t want to listen! You saw a $1500 per month payment for a $400,000 house and went for it because you wanted to impress your wife, family, neighbors and co-workers. Buying a home is the American dream and you wanted your piece of it, now! Not when you could save enough money because America doesn’t save money anymore. You spend it all and live paycheck to paycheck.

Just in my own experience, I explained and explained and disclosed and you didn’t listen. However, my borrowers got the loans that didn’t have the negative amortization clause. It still meant they had to pay their mortgage and bills on time. At the point right before the loan adjusts in rate they were to call to see what rates are doing and either stick with it because rates are down or refinance because they qualify for a lower rate.

However, as much as I hold the American home buyer responsible, I have to say that the mortgage industry is also guilty. It is rampant with criminals and liars. The Department of Real Estate can’t keep up with the complaints and the fraud that just keeps escalating.

The scheme is common in big and well-know retailing companies and it’s quite simple: salesperson writes duplicate bill and sells it to an invoice factory or employer, who wants to optimize taxes. Such scheme can be used only when cash register allows issuing duplicate receipts without note on them on it.

Alo Ivask, the CEO of Rautakesko which operates K-Rauta said that the company is familiar with that.

“Tax and Customs Board (MTA) sent an enquiry on a duplicate receipt. We started to investigate it and it came clear that by now a former employee has done that,” Ivask said.

He noted that that employee said that “a friend asked” and “I didn’t think” as explanations.

These false receipts amount to about EEK 20,000.

Much more risk-free is the case where employee uses receipts a client didn’t want.

“I can’t exclude it hasn’t been done since it’s nearly impossible to check what happens to receipts customers don’t take along or throw away,” Oleg Gross, the owner of Gross store chain said.

He added that you don’t have to be a salesperson to make that scheme – a buyer can grab thrown receipts along as well.

Egon Veermäe, the head of audit department at MTA said that the management usually hears of such schemes from MTA, since people are clever. MTA has caught more than ten such companies in the past months.

“We haven’t done separate action for it. There just have been questions with some receipts when auditing some companies and we’ve found companies and people who have been issuing them,” he said.

Usually the companies are caught when auditing the company which buys the service. Veermäe said that a “service provider” may have more than one customer.

Fee for such a service isn’t big – about EEK 30-50 per EEK 1000 receipt.

Quite common are cases where customer asks to write goods to the receipt, which won’t match the purchases and salesperson does that. Veermäe noted that salesperson often don’t think there’s something illegal in it.

Sandy Hutchens said that because of the difficult times we are experiencing more employees are likely to make money with invoice frauds and useing fictitious duplicate bills.