sean o, please decode

[jk]

sean o, i can't quite understand the following, perhaps you can help out.
from bill fleckenstein's site- a reader writes:

THE NEXT MTG BLOW-UP COMING TO A NEIGHBORHOOD NEAR YOU...BIGGER THAN SUB-PRIME!

Wait until you hear this one...Option ARMs make up some 40% of all PRIME loans in the coastal regions over the past couple of years. Countrywide, Wamu, World (Wachovia) and Bear sell and securitize the majority of these. Several smaller lenders such as Downey, First Fed, American Home Loans, etc. also do half of their porduction in opt arms.

BIGGER BLOW-UP THAN SUB-PRIME COMING IN PRIME...It is a Federal regulation that banks
cannot charge a prepay penalty if the loan resets. Most option arms have 1 to 3 yr. prepays because the mortgage broker community gets huge rebates from the lenders when they sell loans with prepays and high margins. Because of the high margins, the loans are going to their maximum of 115%, 110% and 125% (max negative varies amongt lenders) very quickly and it is estimated that this year they will start hitting maximum negative very rapidly due to the rising short-term rates and have to reset.

The problem lies in the fact that the lenders sold the loan into the secondary market as a prepay loan at an elevated price, and it was securitzed as such. When it becomes a non-prepay loan, who is going to have to make up the loss and how is the lender's balance sheet affected?

You will have Billion and billions in lost prepay dollars and revenue to the nation's largest lenders.

Nobody even knows about this one yet.

If you ever want to know juicy mortgage insight shoot me an email. I am a 20-year mortgage banking vet and forgot more than most mtg industry ANALysts will ever know.

[SeanO]

Re: sean o, please decode

sean o, i can't quite understand the following, perhaps you can help out.
from bill fleckenstein's site- a reader writes:

A couple of thoughts:

1) Neg-am loans have a maximum allowed amount of negative amortization, say to 115% of original loan amount. At that point the loan is "recast" to not allow further negative amortization. While there is much talk about rate resets in ARM's, these max neg-am resets will also result in "surprise" payment increases for homeowners that they may not be prepared for.

2) I'm not familiar with the federal regulation he cites, though it seems reasonable that the lender shouldn't be able to create a situation that the borrower can't afford and then charge them a penalty to get out of it.

3) His assertion that the lenders inability to charge prepayments after resets will result in billions in losses seems ridiculous to me. Reasons: a) it should have been clear to anyone with a pulse that these resets would occur and therefore remove the prepay penalty, b) prepay penalties are typically 2-3 years, and as such will likely run out around the same time anyway, and c) prepayment penalties aren't earned until the borrower prepays - as such the only impact they can have is on projected revenue - that is not a "loss" as the revenue was never earned, and it doesn't affect the existing balance sheet - at worst it would just be poor foresight for a lender to count on that income.

Sean

[jk]

Re: sean o, please decode

3) His assertion that the lenders inability to charge prepayments after resets will result in billions in losses seems ridiculous to me. Reasons: a) it should have been clear to anyone with a pulse that these resets would occur and therefore remove the prepay penalty, b) prepay penalties are typically 2-3 years, and as such will likely run out around the same time anyway, and c) prepayment penalties aren't earned until the borrower prepays - as such the only impact they can have is on projected revenue - that is not a "loss" as the revenue was never earned, and it doesn't affect the existing balance sheet - at worst it would just be poor foresight for a lender to count on that income.

i think he's saying that the neg-am maxima would trigger refi's earlier than the presumed prepay period, and that the fed reg he cites would exempt the refi from penalty. [assuming the borrower CAN refi.] then if i'm correctly reading the following:

The problem lies in the fact that the lenders sold the loan into the secondary market as a prepay loan at an elevated price, and it was securitzed as such. When it becomes a non-prepay loan, who is going to have to make up the loss and how is the lender's balance sheet affected?

this implies that because of the prepay penalty provisions, these loans were ascribed a higher value when securitized. if the neg-am triggers premature refis which are EXEMPT from penalty, then the payment characteristics of these loans turn out to be worse than expected. suddenly the mbs or cdos containing these loans turn out to be worth less than expected. does this reading make sense?

[SeanO]

Re: sean o, please decode

i think he's saying that the neg-am maxima would trigger refi's earlier than the presumed prepay period

This seems unlikely to me. Given say a 115% cap, the allowable neg-am on a $200k loan is $30k. Given the typical prepay penalty is 1-3 years, that is more than $1k/mo neg-am. It would take some pretty ugly loan terms to reach that point on a $200k loan.

and that the fed reg he cites would exempt the refi from penalty. [assuming the borrower CAN refi.] then if i'm correctly reading the following: this implies that because of the prepay penalty provisions, these loans were ascribed a higher value when securitized. if the neg-am triggers premature refis which are EXEMPT from penalty, then the payment characteristics of these loans turn out to be worse than expected. suddenly the mbs or cdos containing these loans turn out to be worth less than expected. does this reading make sense?

Yes, I think you've read him correctly. But the math is just too simple for me to see where the sudden surprise is. It is just too easy to model how much neg-am would occur and when it would trigger the recast. And even if they did screw that up, I still fail to see how it results in a "loss".

The point of prepayment penalties is to insure a sufficient minimum return to justify the cost of making the loan. The assertion that might not happen because of the max neg-am recast is hard to fathom given the amount of neg-am required to reach recast.

If this is truly a surprise to the MBS and CDO market they deserve everything they get.

Sean

[SeanO]

Re: sean o, please decode

Here's where I think the unexpected surprise might be:

Take 115% neg-am recast scenario above. Apply it to a 80% first made in 2005, the market peak. Add 15% to the principal balance for accumulated neg-am. Deduct 10% in sales costs to resell the home. Deduct 5-25% in market correction (depending on market). Even using a reasonable 10% market correction, that loan balance is now 15% higher than the value that can be achieved on sale. This is the big picture, the rest will seem like mice nuts in comparison.

Ohh... and what about the holder of the 20% second in the scenario above? Yes, completely wiped out.

And the 2004 loans? Even with 20% appreciation from 2004 to 2005, the reality is that those 2004 firsts are barely securitized at this point, and the 2004 2nd's are essentially worthless. Yet the market still seems to think that only the 2006 pool is impaired.

Sean

p.s. for those thinking 10% sales costs are high, consider that the bank bears all the foreclosure costs, the carrying costs during and after foreclosure, eviction costs, and repair costs on top of the regular closing costs and commissions. 10% is likely low.

[jk]

Re: sean o, please decode

thanks sean.