Auto-Refi Hysteria, Plus SEC

The mortgage REIT blue light sale is on this morning.  For any lucky (or foolhardy) shoppers in the aisles right now, there was yet another morning downdraft in stock prices this morning, and it was once again across the entire sector.  A scary sounding announcement from the SEC was probably today’s source of fear, but the bigger (real) issue is whether there will be relief for borrowers “trapped” in high-rate loans these past few years.

Since the auto-refi concept has gotten the most press and even a fair number of requests for my opinion, I’ll add my voice to the cacophony.  I don’t intend to scream bloody murder, but you can get that plenty of other places.

Here’s one take on it from a blogger who, like me, can’t seem to give up his fascination with the markets even while being technically “outside” the system these days.  Here’s another from a key player inside the system (President of GNMA) that speaks to the level of hype flying around the internet and the media.

For the refi issue, I’ll look at the economics of refinance and put the potential damage to amREIT investors in context with the biggest investor giveaway we’ve ever seen.

In some ways, I think the current round of complaining is like the freshman going off to college whose parents decide to give her the family’s second car, and her reaction is to complain that it doesn’t have a good enough stereo.

We have to bear in mind that Fannie”Freddie MBS holders did not have an explicit guarantee from the government when they bought the bonds (prior to late 2008), and that they have been enjoying years of subsidies from taxpayers shielding them from hundreds of billions in losses as borrowers defaulted.

Even now, if they own premium MBS with rates as high as 6%, they’re enjoying a taxpayer guarantee while the real losers are the responsible borrowers who keep paying that high rate because they can’t refinance after their homes lost an average (nationwide) of 32% in value from the 2006 peak.

If you’ll recall, the Fed pushed rates up in 2005 and 2006, so 6% to 6.5% was the rate charged for very good borrowers (FICO score 720 and higher) who put down 20% in a real down payment from savings and had good jobs that covered the mortgage easily.  After all, that’s the bread and butter of prime conventional mortgage lending and the vast majority of the Fannie/Freddie paper out there from that era was just this type.

So let’s look at what’s happened these past five years.  If that borrower has managed to stay employed, you can bet it’s without a raise, and probably with a decline in take-home pay as health insurance costs have been steadily shifted toward the employees.

Let’s say it was a $360,000 house bought with 20% down payment, financed with a 30-year fixed rate mortgage at 6.25%.  If that loan was closed in March of 2006, the monthly payment would be $1,847.  So here we are, five and a half years later, and that borrower who did all the right things has continued to do so.  In fact, they’ve paid their $1,847 a month like clockwork.

Unfortunately for them, the house is now only worth $270,000 (or less) in an appraisal, so they can’t refinance their mortgage without writing a big five-figure check to bring the balance down to $216,000 or less.  That’s not very likely, even though the balance has amortized down to $277,248 by
September of 2011.

But what if Fannie or Freddie (the likely guarantor of the existing loan) could offer that responsible borrower a new 30-year loan at 4%?  The monthly payment would drop to $1,324 a month on the $277,248 balance.  Somehow I think Fannie or Freddie would have less risk guaranteeing that $277K if the family paying the loan has an extra $523 a month.

But what about the risk of the lower rate, and the ongoing Fannie/Freddie guarantee?

The reason I chose a rate of 6.25% was (besides being near the first-half 2006 prime mortgage rate) was that I assumed Fannie or Freddie and the servicer took out a combined 25 basis points, making the resulting MBS a 6% fixed rate MBS.

In my refi/recast scenario, I would take the new 4% loan and put it into a new-issue 3.5% 30 year MBS, which happens to be selling for about 100.75% today.  That leaves the same 12.5 basis points for servicing and a whopping 37.5 basis points for the Agency guarantee.  When was the last time a company could take in three times the revenue while taking on a lower risk?  As de facto owners of that company, taxpayers should be really happy to get a deal like that.

And the market is willing to pay more than it costs to retire the old MBS.  Remember that 2006 vintage 6% MBS?  It gets paid off at par, while the new 3.5% MBS sells into the market three quarters of a percent above par.  That $2,000 should be more than sufficient to pay for administering the refinancing, getting new appraisals, verifying checking accounts and employment, etc.

But what about the poor investors who might have just bought the 6% MBS, or at least was enjoying seeing the 6% MBS they bought for 100 cents on the dollar valued at nearly 110 cents on the dollar?  They take a paper loss to be paid in full earlier than they planned.  It’s not like they haven’t been the beneficiaries of nearly 100 times the benefit from the credit losses at Fannie and Freddie that taxpayers covered.   They’ll still complain about “changing the rules” or “anti-business government” or any number of other ideological complaints.  Since they never complained when they were getting much, much larger benefits by government action, I will take their complaints with the same lack of sympathy I would feel for that college freshman heading off in the car she never earned, complaining about having only four speakers in the stereo.

When you look at the total MBS premium in the most common retail investor’s portfolio, you have to look at the amREITs (Agency mortgage REITs).  Several of them have an average cost basis for their holdings in the 103% neighborhood.   Once we take into account the fact that 15% to 20% of those MBS would pay off each year anyway, and that no more than half of them are likely to have the spotless payment record it would take for the (trial balloon) auto-refi program, the potential losses are really quite small.

Could this result in lower dividends because capital will be returned and have to be reinvested?  Sure.  Will the amount the dividends drop be comparable to the giant gift Bernanke and the Fed gave us by saying we would enjoy low repo financing rates for another two years?  Not even close.

Of course, we should look at the positive side of this trade, too.  Middle class, responsible people (who didn’t listen to Cramer when he told them to become squatters in their own homes and stop paying their mortgages) will have somewhere between $50 and $100 billion a year of additional spending money, nicely spread out over twelve monthly payments.  It’s as if the economy would get a boost with no corresponding uptick in government spending, unless you’re the sort who only believes that increasing corporate or investment profits helps the economy, while having working families with more money in their pockets doesn’t.

Now let’s look at the panic-du-jour, the SEC decision to look at mREITsIt’s only been 50 years, so they might have decided to look as if they’re paying attention to today’s market.

A cyber-friend is convinced that the real reason the SEC is calling it an investigation is that short sellers took large positions in the most leveraged things they could find — Agency mortgage REITs, and when the general market correction got going last month, the amREITs stubbornly refused to go down in price.  In fact, a bunch of them enjoyed counter-trend stock price rallies.  Nothing hurts a short seller more than being caught in a dumb trade, since a key part of the psychology of being a short seller is the supreme conviction that you are smarter than the rest of the world.

When looking for cancers, every wart is suspect.  That’s why it’s so easy for short sellers to get SEC staffers to look into companies the short sellers want to go down.

I’m sure it was easy to convince a few folks at the SEC that this formerly quiet little corner of the market deserved some inspection  After all, it is nearly the biggest taker of new issue cash the stock market has seen these past three years.  Nearly all the major brokerages have added analyst coverage, and some of the paydays for the handful of people running these leveraged bond funds have been multi-generation wealth level paydays.

Then there’s that business of swaps and options and futures and forward commitments as hedges, an evil “black box” to every earnest public servant law school graduate if there ever was one.

A “negative” outcome of the SEC’s stated question (Are mortgage REITs really investment companies subject to the ’40 Act?)  would result in a drastic decrease in Federal tax receipts, in my opinion.

How would that happen?  The REIT is not a creature of securities laws, but rather a creation of the tax code.  If  mREITs shrink to nothing, removing all that income from the individual income tax world, the MBS they hold would be sold (driving mortgage rates higher at the margin), and they would be bought by institutions or hedge funds who generally pay little or no tax when compared with individuals.

So imagine if you will, the SEC telling the IRS that it is taking a major stream of revenue away because it thinks investors don’t understand what they are buying when they invest in mREITs, and it wants to reclassify those companies as taxable (at the corporate level).  That should go over really well.

I expect that the result will be better disclosure of the assumptions behind amREIT book value calculations, and probably better disclosure of the hedging strategies and instruments used.  Several mREITs already do this.  Others avoid the analyst and investor questions in their conference calls and say their hedging is “proprietary.”

Not the end of the world for anyone, in other words, and certainly not worth cutting the price of these stocks as much as 10%, in my humble opinion.

That said, the companies that hold a ton of premium MBS and don’t hedge to protect against that loss of premium, those guys deserve to be valued a bit lower.  Looks to me like the market has already discounted them enough, and the ones who do hedge more robustly just got a bit too cheap.



5 Responses to Auto-Refi Hysteria, Plus SEC

  1. jivko says:

    Not sure I agree. You are talking like the working class and the investment class are completely separate things. They often are directly or indirectly the same thing. I for one am tired of being bitten on both the tax side and the investment side.

    • hhill51 says:

      Good point…. certainly the pension fund and insurance holdings of MBS matter to most of us, whether we know it or not.
      Since amREITs are really the only way for small investors to participate in the leveraged carry trade that the very rich use to get very much richer, I sympathize. Of course, our amREITs can’t go to Japan and borrow in yen to finance their MBS in the States, but it’s as close as we get. We also don’t get to say we’re “domiciled” in the Caymans like the hedgies, even though I can see the disappearing driveways to their houses in Greenwich, so we pay taxes on our earnings from our REITs at the full personal income tax rate. Hence my point about a likely net decline in tax revenues if they change the REIT status of mREITs.
      Still, even for amREIT holders, the benefits of government action these past few years (extending the US guarantee in spite of specific “private” treatment of Fannie/Freddie and the flood of cheap financing that peaked at over $15 trillion for every flavor and type of bond), complaining now about possibly losing a few points of market premium seems pretty petty, like complaining that the napkins weren’t luxurious enough at the free banquet.

  2. Dave Simkins says:

    Thanks for writing. I see no factual basis for current hysteria

  3. Tom Drake says:


    I do not know how many of these refi-eligible mortgages are actually held by the FED. But assuming it is a meaningful amount, this will provide a nice chunk of change to the Fed and lead to an “upgrade” of its balance sheet, even though these mortgages are likely among their best.

    To upgrade its balance sheet the FED will take the proceeds and, as promised long since, buy more Treasurys. Hence the beginning of a backdoor QE3 larger than expected by the re-investment of regular coupons and “normal” payoffs only.

    So the administration looks good, the FED is “recapitalized”, QE3 is born, and some honest and good middle income homeowners have have extra money for taxes and imported Chinese trinkets. It’s a win-win-win for everyone except Fannie, Freddie, and future taxpayers. But that’s the way everything is always done.

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