Sunday, April 13, 2008

Early signs of mortgage distress

One of the most pressing issues for the whole mortgage mess is the question of how to fix the system so that new mortgages can be issued and securitized without a recurrence of the lack of confidence in the risk assessment of mortgages and securitized mortgage debt that we have recently seen. That begs the questions of not only what went wrong, but how early it started to happen and when did auditors and regulators start to detect that something was seriously amiss. The article in the New York Times by Vikas Bijaj and Julie Creswell entitled "A Lender Failed. Did Its Auditor?" offers some clues as it chronicles the meltdown at New Century Financial, one of the early mortgage mess casulaties as the chickens came home to roost. For example, they tell us that:

According to the report, Mr. Zona and some of his fellow directors did ask New Century's management and KPMG whether the lender was setting aside enough money to repurchase loans rejected by Wall Street.

In 2005 and 2006, the number of mortgages sent back to New Century skyrocketed as some borrowers became delinquent in payments as early as the first few months after taking out a loan, indicating shoddy lending practices, according to the report.

On the evening of Sept. 7, 2006, a senior New Century executive, Kevin Cloyd, sent an e-mail message to the chief executive, Mr. Morrice, and Patti M. Dodge, the company's chief financial officer, saying, "We got our teeth kicked in with regard to repurchase requests in Aug. and thus far in September," according to the examiner's report.

An hour later, Mr. Morrice sent a livid e-mail response, criticizing Mr. Cloyd for the timing of this revelation, especially because it came shortly "after sending a positive report" to New Century's board.

Yet the very next day, New Century issued a press release about its August lending levels, which it said had climbed 9 percent from July. Saying it had "strict underwriting guidelines" and "skilled risk management," the company asserted in the release that the increase in repurchases because of early-payment defaults at the end of August "has been modest."

In short, the meltdown was not something that started only in 2007, but early signs were already occurring back in 2005 and had become a major issue by August 2006. This raises the question of who knew back then and why the problems were not raised to the level of where appropriate regulators would have or could have or should have taken some actions to alert people of a simmering systemic problem with mortgage-backed  securities.

Even I had heard about mortgage industry chatter about widespread "liar loans" and "jingle mail" back in 2006, but it had still not been considered a regulatory problem.

One of the issues is that even in the best part of any business cycle there are always people defaulting on mortgages. All it takes is a lost job or a moderate health-care issue or broken marriage or a rate reset and suddenly somebody is unable to make their mortgage payments. I would guess that there are historical "norms" for defaults, but maybe people realized that with lower down payments and "no doc loans" the risk was rising so that the historical norms were no longer accurate. That raises the question of what default rate was considered "normal" for New Century back in 2005 and early 2006.

Maybe defaults were still relatively low in 2006. Maybe. But that email quoted above says that New Century was feeling that "We got our teeth kicked in with regard to repurchase requests in Aug. and thus far in September" and the CFO had this information in September 2006.

And obviously if New Century knew about the "repurchase requests", people on Wall Street who were making the "repurchase requests" had to know as well, both for the nature of individual requests and their volume. That means that there was some complicity on Wall Street. Now the open question is who those Wall Street players were and why they did not sqwawk, but they may not have had a financial incentive to sqwawk as long as the mortgage issuer honored the "repurchase requests".

This was a good example of solid journalism by the Times. If only all of their work was to this same level of quality reporting.

Now the question is whether the reporters will follow up and tell us about the Wall Street parties that were making those "repurchase requests" and why they were not raising the issue with regulators. That is an important part of the problem that needs to be fixed. Either the SEC or Federal Reserve, or somebody needs to be informed of mortgage defaults and MBS "repurchase requests". For my part, I want to see a regulator Web page where I can go to view these numbers on a monthly if not weekly basis.

On to the next layer of the onion!

-- Jack Krupansky

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