Estimating losses for prime mortgage books

I am struggling here with the modelling of prime and conventional mortgage losses. It matters because I am short Magic (see post). But it also matters to Fannie Mae et al.

Anyway think about a pool of mortgages which is following historical seasoning patters. For very high quality mortgages loss would be peaking (at low levels) at about year three. Subprime mortgages which are following historic seasoning patterns have losses that peak earlier.

Anyway – everything is tracking just fine – and then – for some reason the losses start ticking higher than predicted. Now you have to project what the ultimate losses will be.

By definition here you do not know. The losses are higher than expected – and they are diverging from projection. I am going to use the fashionable baseball analogy to talk about stages of the credit crisis from the perspective of bank-uncertainty.

• First base: loans are turning sour at an increasing rate. They won’t get worse for ever (nothing does) – but they will get worse for an indeterminate amount of time. You have no real basis for estimating how long they are going to get worse for. You might remember the last credit cycle and (for your business) the deterioration lasted 15 months. So you model the losses assuming a “burn out period” of fifteen months. This is highly speculative and the confidence around your estimate will be low. You might think you know what is causing the sudden deterioration of credit vis trend. But you generally don’t. Your guess will be highly speculative too – though that will not stop media and pundits from speculating. If you were going to put an honest confident interval around your estimate it would be high. You can make investments on this basis – but you are shooting in the dark.
  
• Second base: the loans are getting worse still – but they are getting worse at a lower rate. The new entrants into the 30-59 day delinquency bucket are falling and the serious delinquency buckets are rising – albeit at a much reduced rate. At this point you begin to get some confidence about the end losses. Your estimate should get more accurate because you can now see the “burn-out” rather than just having to guess it. You might get one or two write-backs but they are rare and they look desperate.
• Third base: delinquency is falling across the board. The foreclosures are humming along – the courts have caught up with the reality on the ground for foreclosures and your estimates will be pretty accurate. You can still be wrong – but it is getting obvious by now what is going on. You even have enough loan files to work out what has gone wrong. [In stage one and two nobody really knows how much is fraud and how much is ordinary credit cycle.] Write-backs of losses are regularly occurring though are less frequent than further write-downs.
• Home: the economy has caught up – some buckets are actually improving. There is still a backlog of real estate owned, but the property price has stabilised. Your estimates should be pretty good now. Write backs are more frequent than write downs.

And here is where the baseball analogy breaks down. Like baseball a lot of companies will be caught out (even insolvent) between bases. But unlike baseball you are never really home in this game. The economy could have a “double dip” recession – the so called W shaped recession. Certainty is not available.

Anyway in this schema I am fairly capable of modelling the credit losses once we get to the second base – and I am totally incompetent to model the credit losses on the first base. That is just reality. We have no real idea what is going on yet.

And at the moment we are clearly in the second base (or further) with respect to everything that was marketed as subprime 2006 and prior. If it is second lien marketed 2006 and prior we are probably in the third base because we know the loss severity too. (Loss severity = 100 percent!) And I feel pretty confident modelling it. I have even purchased a few stocks on that basis (notably Ambac which I have retained despite originally planning to sell some into the short squeeze).

But with prime mortgages we are at the first base. They are getting worse in every bucket at an increasing rate. It won’t happen forever – but if someone tells you about a model of these loans you know they are just making the key assumptions up. Maybe they are making it up with an educated guess (such as my 15 month burn out period). But they are still making it up.

And this is a problem for me because I have promised you an analysis of Fannie Mae’s credit losses – and I have also promised you that (at least on this blog) I will not make it up.

And I am not sure I can keep both promises.

I am short at least one stock because I guess the better part of their book will kill them. That stock is Magic. I think their subprime estimates are reasonable (though light) … but I sure that they do not have a handle on how the good parts of their book will behave and I am guessing the assumptions are optimistic.

However as I promised you an analysis of Fannie’s credit losses and I promised you that I wouldn’t make it up I have to come to a solution. The solution: get you to make it up!

So here are a few data series just for delinquency:

The two sequences all below 1% are Fannie and Freddie’s core book respectively. They are entirely mortgages below 80LTV and below the GSE threshold. This is the very best of the mortgage market. The books with secondary mortgage insurance are given in columns 2 and 4.

It should be observed that the good end of the credit market did not deteriorate at all until August last year. This is clear across a lot of the data I look at.

In August a lot of banks were “surprised” that the subprime crisis was spreading to their books. Well – give the management credit – if they had a true prime book and they were watching the data carefully – in other words if the management were everything you would hope they were – then they were surprised. Lesson to investors: do not call for the sacking of management who were surprised in August. [Be a little less forgiving of management who chose another month to be surprised.]

But it is pretty clear that this good stuff is getting worse at an accelerating rate. The last two months in particular have been bad.

And for the reasons explained that makes it very difficult to estimate where this deterioration is going to finish.

So – as I am not happy making it up can my readers have a go. What will be the delinquency for the insured and uninsured Fannie and Freddie books in twelve months? How about the Magic book?

Guesses anyone? Email or (preferably) in the comments.

John

Some corrections on statutory capital requirements

With one reader I have started modelling the statutory capital requirements of Magic. In the process I discovered that my understanding of the stat-capital rules was faulty - and hence some assertions made about them in this post and this post are incorrect.

If anyone is truly expert in the stat capital rules for mortgage insurers I would love an email.


John

Another blog milestone

This is the 101st post on Bronte Capital. I missed the hundredth.

On the fiftieth post I noted blog milestones. Here I will update them:

Number of large corrected mistakes was one and is now three. Correcting my own errors is one of the goals of this blog - but I would prefer not make them. [There are numerous small errors and probably some large errors I have not found...]

At post 50 cumulative visits were 3788. In the past month it has been 10848 and I have now had over 5000 unique visitors (up from about 2000). These numbers have taken off recently and I am now getting about 800 visits a day.

The subscribers have taken off - they were running at about 80 and are now about 430.

In the past the most popular posts were the first post about Barclays, and the first post about the fraudulent hedge fund in Santa Fe. They are now running at number 8 and 10 respectively.

The most popular post (surprise) is the post on Swedbank. At least that is partly because it turns up high on Google searches for the price of Eastern block hookers.

Funnily enough the throw-away on Wachovia comes in at number 2. I don't think it is amongst the most interesting things I have said.

The comments were almost non-existent at post 50 - but I was getting a small but loyal email following. The comments are now much more frequent - and for the first time getting annoying. I don't like being asked in a comment for instance how much a stock has fallen. [It is very easy to look up...] So far I have not edited or deleted any comment except when the author has emailed me and asked me to. [They emailed me because they made a mistake...]

Keep the emails coming.

J

From the comments: more on Magic

One of the reasons why I love doing this blog is that smart people disagree with me and send me emails.

And I am not wedded to any position. I change my mind.

Here from the comments is a comment that is accurate enough as per Magic now:

John...Thanks for your thoughts on Magic. We too were short the stock for some of its fall but have now gone long in significant size. Yes they underwrote a lot of crap, but the premium deficiency reserve which assumed a51% loss rate compensated for that. Now the remaining bulk RIF is only $3.5 billion per page 13 of the recent supplement. Total reserves are $4 billion or $34,000 per delinquent loan at June 30. If the cure rate is 50% (which is way below the historic number) then the reserve per real delinquent loan is more like $68,000. You are right to mention how Magic is cash flow neutral and thats important. We see Magic as generating $1.5 billion in pre provision pre tax earnings per year. Just take revenues minus operating expenses. That is alot of cash at $1.5 billion a year plus $4 billion of reserves to pay future claims. Recent book value was just below $23 per share and based on expected losses over next 6 quarters this should not get below $18 per share at year end 2009. At this point the real earnings power of Magic will shine through remember $1.5 billion pre provision pre tax earnings divided by 150 million shares = $10.00 per share. I guess you could say that makes us believe in Magic.

The Anon Guy is right in one key respect. The business is now cash flow neutral. It is however running very substantially statutory capital negative. They will run out of stat capital if the new business shows any substantial losses.

I do not believe that the deficiency reserve is adequate – but the level to which it is inadequate is not large enough to make me want to be short the stock. It exacerbates the stat capital problem but it is not lethal.

The question is whether you believe that the business they wrote in 2007 and early 2008 is sensible.

If the new business is sensible you believe in Magic. I am afraid that I do not believe but my data for that view is thin.

The trend on losses for mortgages originated in 2007 is not good. Indeed it is positively sick. The trend on Fannie Mae and Freddie Mac insured mortgages is looking not good.

In other words the core business is looking worse. However if it is only a little bit worse then my friend above is correct – and you should be be long Magic. I need the core business to deteriorate markedly to get paid on this short.

I think that happens – but any help in modelling would be much appreciated. Dear reders – send me your emails.

John

Postscript: My explanation of statutory capital requirements for Magic is slightly faulty. I have blogged about that here.

One email comment - about reserving at MTG

The GAAP reserving rules for mortgage insurers are very strange - almost prohibiting them taking reserves for anticipated defaults (except the premium deficiency reserve).

I might be harsh saying that they are under-reserved in a GAAP sense. I do not think I am harsh saying MTG is under-reserved according to common sense accounting. But I am open to being convinced otherwise.

J

Do you believe in Magic? [Fannie Mae part IA.]

This post has a couple of purposes. Firstly it is interesting in its own right – but more importantly it is key to understanding Fannie Mae’s credit profile. Consider it as Fannie Mae Part IA to go with my Fannie Mae Part I.

Mortgage Guarantee Insurance Corporation (MGIC or NYSE:MTG) is a mortgage insurance company. It was the mortgage company I hated most. I despised it. MGIC was always known as Magic – and almost whatever they said I didn’t believe. I would rather believe in witches and other black magic than almost anything the CEO of this company said.

You need a little background to know why I hated this company so much.

The changing role of mortgage insurance

There is a traditional role for mortgage insurance. The GSEs (Fannie and Freddie) were not allowed to underwrite mortgages with a loan to valuation ratio of greater than 80% without secondary mortgage insurance.

However realistically most first home buyers have never been able to put 20% down. So secondary mortgage insurance was required. This would bring the loan within Fannie Mae criteria. The traditional book of mortgage insurance companies was thus enormous piles of loans originated with 80-95 percent loan to valuation ratio – almost all loans to young couples for their first home where the total mortgage was somewhere between 100K and 200K. These loans were diversified by geography and time of origination – but not much else. They were also pretty safe.

Then a few things happened. By far the most important was that banks and the securitisation market started offering closed end seconds (CES). The idea was that you took a standard Fannie or Freddie mortgage (ie a GSE qualifying mortgage) and a second mortgage (or even two second mortgages) above that. This was the so called 80-10 product meaning an 80% GSE mortgage and a 10% second above that. There was also 80-20 product and 80-10-10 product describing different sizes of secondary mortgage.

The result was banks undercut mortgage insurers and the core product of the mortgage insurers looked obsolete. The mortgage insurers looked in a quandary – and several of the mortgage insurers had a hard time growing in the domestic market. According to the mortgage insurers association (MICA) the total mortgage insurance in force was 668 billion in December 2006 and 619 billion in December 03. That is not much growth in the most wild-ass mortgage market in the history of the USA. During that period premium rates actually fell – so revenue went nowhere to backwards.

The mortgage insurers compensated by doing other things – mostly riskier things – and that blew them apart.

• PMI went to Australia and purchased a stake in FGIC. FGIC is a bond guarantor that has been smashed.
• Radian funded a bond guarantor (Radian Guarantee – formerly Enhance Re) and blew up on it. They also invested in a fraudulent securitisation company (CBASS) I blogged about here.
• General Electric just decided it wanted to exit the space and wrapped its mortgage insurer in Genworth Financial and spun some out and sold the rest.
• Magic went subprime – and owned a stake in CBASS.

What Magic did

Magic went deep and scummy subprime. It started guaranteeing mortgages in the pools produced by the most dodgy of producers – it was particularly big into Novastar and ResCap (the GMAC mortgage business). Novastar were about as questionable as subprime mortgage providers got (and the money they owe Wachovia is a case-in-point about questionable exposures at Wachovia). ResCap by comparison were Vestal Virgins (and we know how f—ked about ResCap is). Herb Greenberg wrote more-or-less continuously about Novastar. He got a lot of flack – but he was right.

Anyway – insuring mortgages written by Novastar was a pretty quick way to the poorhouse if you asked me. Novastar also got PMI to ensure mortgages but quite quickly PMI realised what Novastar was it stopped doing business with them. Herb Greenberg also wrote about that.

Anyway Magic were the ugliest of the ugly in subprime securitisation. They insured pure crap. I couldn’t imagine how they would wind up solvent.

They then pretended it was OK by using the most absurd definition of subprime, Alt-A and prime I have ever seen. I blogged about that here. Their definition of subprime was so weak that it was possible to not be considered subprime if you had:

• A 95 percent loan to valuation in a low-end housing estate
• Where the valuation was taken by a broker-friendly appraiser at the third cash-out refinance
• Where there was no evidence that the person was able to repay principal and – to the contrary where they needed to refinance their mortgage every few years to make it current, and
• Where the customer had in the past seven years defaulted on a credit card costing the issuer money

And that was the guts of the reason why I hated Magic. It was the company with the most subprime book – but they pretended it was mostly not subprime by defining subprime in such a way that only serial credit card fraudsters seemed to meet the definition.

They also owned half of CBASS – which owned a very nasty loan servicing business (Litton). You can find out just how nasty Litton is here. I blogged about it here.

Magic were the scum of the mortgage boom.

And if you had asked me if there was any realistic proposition of magic surviving a proper crisis I would have answered no. I always said it was a $5 stock – which was just so I didn’t sound nutty saying it was a zip. [I was considered a hyper-bear in those days…]

Anyway I was wrong. Magic is sort of surviving. It is not an easy situation – but it is not completely diabolical. And sometimes I am stunned when institutions with OK management (Fifth Third) or really rich institutions (Natixis) get into trouble. But this stuns me the other way – these guys are haven’t filed the Chapter 11 they so richly deserve.

Do I have to add that they compounded these errors by repurchasing billions of dollars worth of their shares at absurd prices? No – I can thank them for it – their repurchases provided a counterparty to my short sales!

So where is Magic today?

Well – obviously they have given up doing the real dumb business. CBASS has been written off and the company has retreated to doing the traditional business of first home buyers…

I doubt I can say it any better than the Management discussion in the last annual report:

Premium Deficiency

Historically a significant portion of the mortgage insurance we provided through the bulk channel was used as a credit enhancement for mortgage loans included in home equity (or “private label”) securitizations, which are the terms the market uses to refer to securitizations sponsored by firms besides the GSEs or Ginnie Mae, such as Wall Street investment banks. We refer to the portfolios of loans we insured through the bulk channel that we knew would serve as collateral in a home equity securitization as “Wall Street bulk transactions”. During the fourth quarter of 2007, the performance of loans included in Wall Street bulk transactions deteriorated materially and this deterioration was materially worse than we experienced for loans insured through the flow channel or loans insured through the remainder of our bulk channel. Therefore, during the fourth quarter, we decided to stop writing insurance on Wall Street bulk transactions. In general, loans included in Wall Street bulk transactions had lower average FICO scores and a higher percentage of ARMs, compared to our remaining business.

In the fourth quarter of 2007, we recorded premium deficiency reserves of $1,211 million relating to Wall Street bulk transactions remaining in our insurance in force. This amount is the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves on these bulk transactions. See further discussion under “— Results of Operations —Losses— Premium Deficiency.”

C-BASS Impairment

C-BASS, a limited liability company, is an unconsolidated, less than 50%-owned joint venture investment of ours that is not controlled by us. Historically, C-BASS was principally engaged in the business of investing in the credit risk of subprime single-family residential mortgages. Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. As a result of margin calls from lenders that C-BASS was unable to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased. On July 30, 2007, we announced that we had concluded that the value of our investment in C-BASS had been materially impaired and that the amount of the impairment could be our entire investment.

In connection with the determination of our results of operations for the quarter ended September 30, 2007, we wrote down our entire equity investment in C-BASS through an impairment charge of $466 million. This impairment charge is reflected in our results of operations for 2007. For additional information about this impairment charge, see Note 8 to our consolidated financial statements. In mid-July 2007 we lent C-BASS $50 million under an unsecured credit facility. At September 30, 2007 this note was carried at face value on our consolidated balance sheet. During the fourth quarter of 2007 C-BASS incurred additional losses that caused us to reduce the carrying value of the note to zero under equity method accounting. The equity method reduction in carrying value is not necessarily indicative of a change in our view of collectability.

Well apart from not disclosing just how scummy C-BASS was all along this seems a fair disclosure. But here are the critical things for the future:

• That the excess of future claims over revenue (a premium deficiency reserve) was a bit over a billion dollars.
• That the flow business – the traditional first home business – was not showing undesirable credit characteristics as of year end.

Now, as you imagine, I never thought this company had much credibility (they continued to lie about the nature of C-BASS) and they were as close to scum as anyone I have come across in this industry. (Surprisingly the CEO has not changed.) But if the losses on the closed block of business are larger than this or the traditional business of first home buyers goes pear shaped then there is not going to be much left.

So here is the sticky question: do you believe in Magic?

The company gave us one marker that I guess you could use to test whether you believe… that marker is that they predicted paid losses this year to be just under two billion dollars.

And if you want a bull case – the margins are very much improved

Premium revenue is going up massively and they are no longer having to write business for Novastar to get that premium. Net premium written in the second quarter were 372 million compared to 321 million last year – and the total par insured has fallen from 19 billion to 14 billion.

372 million for accepting credit risk on 14 billion of mortgages is still not stunning business – it is still less than 3 percent. But it is an awful lot better than it was. However with this premium the company is still going to get into diabolical trouble if the conventional first-home owner/Fannie insured mortgage market goes pear shaped.

But current margins are not the story – the back-book and the quality of the new business is

Magic gave us a criteria by which we can judge - they told us that premium income was going to be rising and claims paid would be under 2 billion dollars this year. Surprisingly they are beating this by a very comfortable margin.

The claims paid are running at 385 million for the last quarter – about what the written premium is. The company is barely bleeding cash at all. If you had asked me whether it was possible that this – the most scuzzy of mortgage companies – could be essentially cash-flow neutral this far into a mortgage crisis this big I would have laughed and not answered. But they are essentially cash flow neutral (with a caveat that I will explain below about statutory capital). Still it is pretty hard for a company that is not bleeding cash to go insolvent. It is not impossible – but on these numbers you would have to say that you do believe in magic.

The problem with this analysis is that there is a bad reason claims paid are running below projections. It is just that the courts are jammed up, the servicers of the mortgages totally swamped and foreclosure is running much slower than anticipated.

You can see that. The delinquency on their super-scummy subprime loans is over 36 percent and rising very fast. This is serious delinquency – the company does not bother reporting 30 day delinquency (probably because its servicers do not tell it).

The company’s reserves smell very light if you adjust for this problem. They have insurance over 34 billion of bulk loans in force and they have serious delinquency on the bulk loans of is over 25 percent. They are coming in at a few billion of losses – not just the billion or so in the reserve kitty. This company looks and smells under-reserved still. And given that I probably wouldn’t buy insurance from it. Whether it is solvent or not – that is another question.

But people do buy insurance from it and in quantity – and if that insurance doesn’t blow up in their face then the company will be just fine.

Is the new business any good?

This whole thing is contingent on the new business being OK. This is a company keeping up with old losses by writing lots of new business – and to date it is working.

The new business is mostly flow business being written for Fannie Mae and Freddie Mac. It may be good business (the jury is out). But it is pretty clear why Fannie and Freddie want to support Magic. It is in the interest of Fannie and Freddie to keep this company alive. If it dies then Fannie and Freddie are on the hock for the insured business. And if Fannie and Freddie stop trusting it for insurance then the company will die.

This is a bad dynamic. Magic gets to write lots of business at today’s much improved margins at terms which might keep it alive – and it gets to do it because Fannie and Freddie refuse to face reality.

But here I think the magic is very black indeed.

Look at the delinquency rate on the flow business. It has doubled and it is running I the table above just over 6 percent. That number has me really puzzled. Indeed I needed a good lie down and think.

Why is six percent so high? Well Fannie Mae publishes the delinquency on its credit enhanced book every month – you can find it in the monthly statistics. It’s a pretty good indication of the average of the mortgage insurance industry. You can find the table in the bottom right corner of the second page of this pdf.

The Fannie Mae number is running at 3.56 percent. The Magic number is almost twice as high. Come to think of it – the Magic number is almost twice as high as the delinquencies on the 100 odd billion of Alt-A stuff at Freddie Mac which makes everyone sure that Freddie is going to fold.

This suggests to me that Magic is doing something considerably riskier than the Fannie Mae average to get the higher delinquency.

We are meant to believe that this is good business – but it doesn’t look like America. Fannie Mae’ average delinquency of under 1.5 percent looks like America. I do not get it and I have fast come to the conclusion that Magic are just unreformed and unrepentant river-boat gamblers who still operate in the risky end of what is left of the mortgage market.

It might be just the general trend that I have blogged about – that 2007 business just looks sick (see here and here). But if it is the oncoming train of 2007 business then I wouldn’t want to stand in front of it.

So in summary: I do not believe in Magic. I have covered my short – unfortunately several dollars higher than this. But something remains not quite right here.

John

Postscript: Can you go bust whilst being cash flow positive?

I asserted in my post that it was pretty difficult for Magic to go bust whilst being cash flow positive. That assertion was a gross simplification.

Magic is a holding company with considerable debt holding a regulated insurance company. When the insurance company writes premium it needs to make reserves (the so-called contingency reserve). These reserves reduce distributable capital. The losses also reserve distributable capital. The cash flow and the ability to distribute from the regulated insurance company to the holding company are not correlated.

The holding company needs to receive distribution as it has debt – and if it fails to pay that debt it will fold.

In other words it is possible for the holding company to go bust whilst the whole entity is cash flow positive. [Holders of Conseco once found that out.]

I would love it if someone has modelled the statutory accounts of this company – or could help me with that task.

John

Note: I put my MTG:NYSE short back on "last night". This is unusual for me - I originally shorted this stock above 50 and covered at 20 and 12. I put it back on below 8. For those that don't know I am in Australia - so it really was last night.

Covered bonds as a panacea – or a recipe for the FDIC to kick in more taxpayer money

I am getting jaundiced in the banks pushing covered bonds as the panacea for the housing market and the journalists who buy it. This story really got my goat because it is so one-sided.

All a covered bond is is a guaranteed securitisation.

• Currently a bank can borrow money unsecured or subordinated to buy mortgages. In which case the borrowed money carries a bank guarantee, is generally subordinate to depositors, and hits the bank’s capital ratios. In insolvency the assets are there and that helps pay depositors.
• Alternatively a bank can securitize, in which case the funding is secured, but there is no bank guarantee and hence there is no impact on the bank’s capital ratios. Ideally there is no effective guarantee at all on the assets in which case problems with those assets cannot hurt depositors.

What the investment banks want to sell is funding which is secured and carries a bank guarantee.

When a bank sells covered bonds problems with the assets hurt depositors but the assets are not available to help pay off depositors if the bank gets into trouble.

In other words it downgrades the claim of the depositors whilst not reducing the risk to deposits.

Deposits generally carry a Federal Government guarantee. Covered bonds will increase the cost of honouring those guarantees and hence increase the cost to tax payers of bank bail outs.

Paulson wants to allow this. Advice to the Senate: you will be there in 12 months. Paulson will not. Think of it that way.

J

Update

A couple of people (notably Mish) have pointed out the limitations on covered bonds will make them less useful than they might otherwise be and hence reduce the systematic risk. The Aleph Blog also made that point here.

I still think this is very dangerous. Imagine a bank in some trouble selling covered bonds. When the loans go bad they need to replace them. When the insolvency happens the bond holders wind up owning the good assets and the bad assets get left preferentially to the depositors (read the taxpayers). But the limitations which are extensive both reduce this risk and reduce the effectiveness of the bonds as a capital raising tool...

From the comments:

Paul left a comment on my “what if it was fraud” post:

I live in California and work in finance. I took on a pro-bono "client" recently who was up against the wall thanks to mortgage/housing costs that were extremely large: 90% of his gross wages - before the ARM reset. His poor decision to buy near the peak was based on speculation, but the surprising thing I discovered when I looked at the paperwork is that he did not have to commit fraud to obtain the mortgage. Countrywide originated the 0% down ARM loan with full knowledge of my client's financial status.

My client is an immigrant, and Countrywide had reps fluent in spanish who penetrated this community.

I have a retired friend who works full time with a non-profit group focusing on individuals with high debt loads. He has had over 200 "clients" in recent years who got themselves into a very similar situation to my client. Zero money down mortgages, rising house prices, and financially unsophisticated clients all contributed to the situation.

I hear variants on this story regularly. There was a fraud committed. It may not have been by the borrower – it was probably committed by Countrywide (and my guess is that Countrywide offered representations when they securitised the loan and so Countrywide will need to make good). That could be unpleasant for Bank of America.

But the issue I have is about working out what is going on in the market as a whole. Losses like the one you describe are (a) not redeemable by forbearance, (b) large and rapid. They fit the “pig through the python”.

I wish I knew how much of the market was “pig through the python” and how much was ordinary mortgage stress. If it is pig through the python there are plenty of stocks to buy right now. If the “fraud” cases are the first wave of a much broader mortgage stress then there are stocks to short right now.

The thing about the case Paul describes is that there will be no more losses from such cases in a few years. They will have all been incurred.

I would love a way to quantify this. It’s the trillion dollar question.

John

PS. Paul – thanks – can you send me an email. Much appreciated.

A correction on mortgage trends

I posted the general view that the worse your credit the faster it is improving and the better it is the faster it is deteriorating. (See this post in response to Felix Salmon.)

Again there is a gross simplication. This is true for business written in 2006 and prior. 2007 business just looks sick everywhere. I also blogged about that here where I noted that if you did 2005 and 2006 non-prime business you are seeing light at the end of the tunnel. If you did 2007 business that light is an oncoming train.

J

Jamie Dimon – it is time to pay up

Yesterday I wrote about fraud in the mortgage market.

Today I will write about a single deal – the Bear Stearns 2007-1 closed end second deal insured by Ambac.

This deal is a stinker. Ambac has provisioned for an 82 percent cumulative loss rate on this deal. I have looked at the raw securitisation data and I don’t think it will be quite that bad – but it is awful.

For this to happen 85 plus percent of the loans in the deal need to default.

That doesn’t happen to normal loans. Even in the worst of crises diversified and honestly assembled pools of loans don’t default at that rate.

It only happens when there is mass fraud involved.

Bear Stearns assembled those loans fraudulently or knew the loans were fraudulent when assembled.

But it is worse. They warranted the loans would be OK.

You will find the serving agreement here. I am not a total masochist so I haven’t read all of it… however the document contains the usual clause requiring Bear Stearns to buy back and replace loans that breached the mortgage loan purchase agreement…

Jamie Dimon didn’t create this problem. Them lying scoundrels at Bear Stearns did. They misrepresented the loans – not Jamie Dimon.

But Jamie bought this problem and it is now his.

Jamie – it is time to pay up. Hope you have provisioned for it.

John

PS. Not to be too hard on Mr Dimon I have spent some time looking at securitisation created by JPM. They perform better than average at least in the areas I have looked.

Post script: I have just listed to Ambac's conference call. I said in this post that my estimate for loss on this deal is somewhat less than Ambac's estimate. In the quarter Ambac reversed some of their reserve and the reserves look much closer to my estimate. So Jamie doesn't have to pay quite as much. But he is going to have to pay...