The Sub Prime and Alt-A Crisis is a crisis and we all have to deal with it. It will continue to be in the news. Every special interest group will have a solution, one that benefits their objectives. Appraisers should be one of those groups, but as yet they appear not to be.
In these next two Runt Rants I’ll try to make the case that the special interests of the Appraisal Profession is at the root of the solution for the current crisis, and would be one of the foundation blocks for preventing it’s re-occurrence.
Let's Define The Problem
A couple of weeks ago Ben Bernanke, Chairman of the Federal Reserve testified before the Joint Economic Committee and said in part;
“At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit-rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products. Because many investors had not developed the capacity to perform independent evaluations of these often-complex instruments, the loss of confidence in the credit ratings, together with uncertainty about developments in the housing market, led to a sharp decline in demand for these products. Since July, few securities backed by sub prime mortgages have been issued.”
A few weeks earlier on August 31st Mr. Bernake delivered a speech saying;
“Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk”
But the very best quote by Ben Bernake is this one….October 16, 2007;
"According to the New York Times, at a speech in New York last night Bernanke said, "I'd like to know what those damn things are worth. Until investors are confident in their evaluations, they are not going to be willing to fund these vehicles."
That’s it in a nutshell Uncle Ben! You don’t know, I don’t know, investors don’t know “what those damn things” are worth!
MBS are more like bonds than stocks. In fact, they are just another bond. The value of a bond is often different than it's market price.
The value of a bond is based on the coupon rate and two elements of risk; the ability of the bond issuer to pay the interest, and the ability of the bond issuer to return the principal on the stated date.
The price of a bond is based upon the risk rating of that bond by some financial geeks who know next to nothing about the underlying risks...they say they do, they sell that presumed knowledge, but generally they don't have a clue.
The Financial Analysts (geeks) in Investment Banks set the price of a bond, turn it over to the bond salesmen and bond traders, and those snake oil salesmen convince their cutomers to buy the stuff.
Mortgage Backed Securities (MBS) aren’t new. They’ve been around for decades. They are simply a group of individual home mortgages grouped together to create a portfolio of loans.
The big obstacle in creating MBS was the uncertain pay back date. That uncertainty blew up the calculators...yields couldn't be determined. The geeks solved that by applying historical trends to groups of mortgages....one third would pay off within 5 years, one third within 5-15 years, the rest in 16+ years.
The geeks then split the mortgage portfolio into fictitious creations...three Tranches to represent the three pay off groups. Later they divided them by Interest Only and Principal Only cash flows (IOs and POs). All based on an analysis of the historical experience in mortgage payment histories.
Now, that historical analysis is further broken down by geographic location, by size of the loan, by age of the borrowers....you name it....each sample performed a little differently...so the original three tranches which became six, now could be sliced and diced by these other factors.
Each of those types, and each of the six tranches (actually many more) had a price fixed to it. A price set by a financial geek who knew only about those historical experiences in the form of probabilities of repayment. A price set for each of the tranches based upon the geeks analysis. Think "bundle of rights" in real estate.
Finally, all of that fine tuning and slicing and dicing was based upon assumptions regarding the exogenous variables that cause folks to decide to pay off mortgages...interest rates, unemployment, inflation, out and in migration, boom times, down times....you get the idea.
Change any of those variables and the underlying assumptions about the mortgages change...the biggest being when the mortgages will be paid off, and what amount of principal will be received. This is where the geek’s models blow up again. The value of those MBS is then indeterminate, and a market price cannot be set. That's where we are now.
Investors need to know the value of what they are buying. But in the case of Mortgage Backed Securities, particularly the Sub Prime and Alt-A brands, they don’t know, and therefore they are not buying.
That's why Uncle Ben was quoted a few weeks ago saying he wished someone could tell him the value of those MBS that are Sub Prime and Alt-A. He doesn't know, nobody knows, because they don't know the amount of principal that those loans are likely to produce.
That's the Sub Prime Crisis.
The investors lost faith in the rating agencies ability to properly judge the risk of those suckers....the probability of interest and principal payments being made....The investors lost faith in the snake oil salesmen (Investment Bankers) who sold them those MBS which blew up in their faces, and they stopped buying until they can figure out what they are buying.
To solve the problem somebody is going to have to appraise each of the properties that are the underlying collateral that make up those troubled MBS. They are going to have to be appraised to establish a starting point to estimate just how much cash is going to be left after the foreclosure that will be available to pay toward the principal. Will it be 80 percent of the face value of the mortgage, 70 percent, 50 percent?...What?
Once that's estimated, the geeks can run their models again with a new set of assumptions and a price point can be set for each MBS and each of the twenty or thirty or fifty tranches within the portfolio.
Once that’s done, investors will be willing to invest, liquidity will return to the Mortgage Backed Securities market, and we’ll all be back in business.
Despite what the geeks and the snake oil salesmen tried to promote, the price of those bonds are indeed tied to the value of the underlying real estate. The rest was just a house of cards they created in their own minds.
So, how do we determine the value of those Sub Prime and Alt-A Mortgage Backed Securities? That’s the subject of the next Runt Rant!
The author is the owner of Acorn Appraisal Associates, a 22 year old firm offering a wide range of quality appraisal services to the Financial and Business Communities. [email protected]
I have the right to remain silent. Anything I say will be misquoted and used against me
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