Congress has been considering a homeowner bailout plan that would allow bankruptcy judges to modify the terms of mortgages by reducing the principal amount owed. It’s hoped that these so called “cramdowns” would help homeowners stay in their homes and, perhaps, make defaults less likely by reducing the incentives for people to walk away from mortgages that are bigger than the value of their homes.
Because the cramdowns might reduce mortgage defaults, it’s often been argued that the cramdowns might actually provide relief to banks holding mortgage backed securities. Sure, they’ll take a hit when the principal is reduced on the underlying mortgages but the overall return on the bundle might be higher. Unfortunately, this may just be wishful thinking.
Paul Jackson at the always useful Housing Wire points out that bank analysts are raising red flags about the cramdowns. Here are the three big worries:
- Mortgage insurance is concealing risks that won’t get covered in a cramdown. In order to make highly leveraged mortgage backed securities more attractive to investors, bankers bolstered them with mortgage insurance. These mortgage backed securities based on bundles of mortgages that had a thin collateral margin were able to get higher ratings from credit agencies because of mortgage insurance. Banks could carry these on their books as less risky assets, and weren’t required to reserve much capital against them. They haven’t been written down as much as other MBS because the insurance was supposed to protect them from losses. But most mortgage insurance won’t cover bankruptcy modifications. That means that assets on the books of banks could have far higher loss risks than they appear to on balance sheets. When the losses kick in, banks will once again have to raise capital.
- Even the best, most highly rated paper will share in cramdown losses. Ordinarily, lower tier mortgage backed securities get whacked first by losses on the portfolio. High tier MBS with higher ratings can keep delivering revenues because they get the first claims on payments. But a good number of private-party MBS deals, pretty much every prime and Alt-A deal, have provisions that allow bankruptcy losses to be allocated among all investors. This means that highly rated paper, which has not been written down very much and is held on bank balance sheets at high levels could get hit. The capital reserved against these losses will be inadequate. You see where this is going, right?
- Federal Housing Administration insurance does not cover bankruptcy. If you were a conservative banker who only bought MBS backed by FHU insurance, you probably think you’re in good shape. Think again. The cramdown legislation will make those assets unsafe. “The reason is simple: FHA insurance does not reimburse servicers for losses on bankruptcy cramdowns on loans that are not in foreclosure. If servicers have been stretched thin already by this mess, the cram-down proposal currently being considered might serve as the final nail in the coffin for some,” Jackson writes.