dwot (31.01)

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January 06, 2008 – Comments (6)

In Six Degrees of Leverage Part I I showed how a modest change of interest rate changes the effective yield on a hypothetical 10 utility bond.  Because rates declined from 6% to 4.5%, the bond was priced up so the yield would be 4.5% and because of selling early the yield ended up being 8.3%.

One thing that I don't remember looking at in that series is the leverage if a mortgage if the price of a mortgage is priced to reflect current rates, or just different rates.  I  was reading John Mauldin 2008 forecast and he said something about some derivatives having 3 times the face value.  I am not going to profess to understand the complexity of the things the financial industry has done, but I suspect that some of this bad mortgage debt has also been repriced somewhere along the line to reflect current yields, and this post is calculating the principal some of those terrible mortgages may have been sold for somewhere in this mess.

My reading on the municipal funds that got into trouble with CDOs was that their yield was about 5.5%, so this is the rate that I will use to re-price these 30 year mortgages.  There is some of this crazy stuff that was priced at 1 and 2%, but my reading shows that these were not that common, and a rate around 6% was more common.  Some of it is being repriced to as much as 12% for the last 25 years.

On a 30 year mortgage, especially if the starting rate was low, there would be very, very little principal paid back during the first 5 years.  Say you had \$100k at 6% for 30 years.  The monthly payment would be about \$600.  At the end of 5 years you would still owe about 92,900.  If it reset to 12% your payments would increase to about \$952/month.  Even though the payment started at \$593, the average payment over the mortgage would end up being \$892.  To have a constant payment for 30 years the rate would have been 10.4%, so the effective rate tends to be closer to the reset rate than the starting rate.

For simplicity I am just going to use a constant rate over the life of a 30 year mortgage and calculate a purchasing price for the debt to re-price the yield to 5.5% for a \$100k mortgage.

 Rate (%) Total Payment(for \$100k Mortgage) Priced at 5.5% yield 3 151,000 74,700 3.5 161,000 79,500 4 171,000 84,500 4.5 181,000 89,500 5 191,000 94,700 5.5 202,000 100,000 6 213,000 105,500 6.5 224,000 111,100 7 236,000 116,700 7.5 248,000 122,500 8 260,000 128,300 8.5 272,000 134,400 9 284,000 140,300 9.5 296,000 146,400 10 309,000 152,600

What I understand in this mess is that even prime loans are resetting at higher rates, so they may not be resetting to 12% like a subprime loan, but they maybe resetting to 8 or 9 percent.  A reset to 8% gives an effective rate over the life of the mortgage of about 7.5% and if that prime mortgage was repriced to yield 5.5%, well there is about 22% extra being charged to an investor than what the borrower got.

Without making a new table, say it had a teaser rate of 3% and was resetting to 12%.  These things were rated AAA so there would have been the ability to reprice them to yield 5.5%.  In this case the difference is 104%.

The incentives to keep homeowners in their homes and to work out new financing arrangements to prevent foreclosures resets the effective rate down.  Reducing the effective rate by 2% re-prices the principal down by about 20%.

It does make me question just what was it that hedge funds were doing that enabled them to make those insane rates of return.  Would anyone reading this actually pay \$122k for \$100k of debt and give the bank \$22k for their services and then hope to collect over the next 30 years?

But somehow with their financial scythe they've managed to create something valued at 3 times the face value.  It does explain how it is that some of these things have gone to zero value...

#1) On January 06, 2008 at 4:47 PM, dwot (31.01) wrote:

I wish there was a place to post a reading list.  I don't want to start another blog.

Mish had a post about how interest rates are repricing themselves.  Well, it is also about housing around the world.

What got my attention in it is that Fannie has only \$42 billion of capital for 2.4 trillion of debt.  That's a leverage of about 62.

Seriously, I get a new shock every time I do a freaking calculation...  Historically loans to reserves was about 12 to 1.  This reserve ratio is about 1/5th the historical standard, and that's in a housing bubble?  If anything, you want a more conservative reserve ratio in these kinds of market conditions.

I predict that what we are reading here is a conservative future taxpayer bailout of about \$250 billion dollars.  When you consider the liar loans, interest only, subprime and high loan to value mortgages make up about 40% of the portfolio the bailout could end up as high as a trillion.

The other thing that got my attention is the increasing price of loans without the bank rate increasing.  I guess Australia has increase floating and other rates 1/8th to 1/4 percent.

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#2) On January 06, 2008 at 4:52 PM, dwot (31.01) wrote:

More reading, lenders are being sued to maintain houses they can't sell.

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#3) On January 06, 2008 at 5:29 PM, DemonDoug (31.61) wrote:

dwot, it amazes me that in the face of all this information, that anyone would believe that RE is a good business right now, or that buying a house would be a good idea.  The punchbowl has been taken away, but i think people are still drunk from the kool aid that's already been served.

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#4) On January 06, 2008 at 6:05 PM, Imperial1964 (96.73) wrote:

As quoted in John Mauldin's forecast,

"UBS Investment Research estimates that CEOs sold credit protection on around three times the actual face value off triple-B-rated subprime bonds." (emphasis mine)

I think you misread that to say that they sold it for three times face value.  As I read it, it means they sold more bond insurance (in the form of CDSs) than there were actual bonds, not that they sold the insurance for more money than the value of the bonds insured.  That would be silly.

The implication of the statement about 3x the face value is that there is potentially more money at stake in CDSs related to CDOs than there is in the actual CDOs in the first place!  CDS buyers don't actually have to hold the bond the CDS is derived from.

Of course, buyers of CDS (credit default swap) insurance didn't pay the face value of the coverage any more than you pay the coverage limit on your homeowner's insurance policy.  They paid a small premium, like 2% per anum.

As you can probably see by now, given that there is 3x as much insurance on BBB rated subprime debt than BBB rated subprime debt, the bond insurers will be facing really hard times.  Furthermore, some banks have agreed to backstop losses from the bond insurers.  Sometimes the insurance end of the CDS has been sold to other counterparties.  By "insurance end" I mean the end that pays in the event of a default.  As John briefly touched on, they have even been securitized, rated, and sold to investors.

I haven't done it yet, but hopefully tomorrow I'll get around to posting another blog on the topic of CDSs.  I think you've already seen my last CDS blog.

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#5) On January 06, 2008 at 7:00 PM, dwot (31.01) wrote:

DemonDoug, in Vancouver people still believe that housing is a solid investment.  They believe the Olympics will make prices go up even further.  When I bought my home that I just sold I thought I was paying a high price and that it would be flat for years.  But it went up an average of 11% per year over the 4.5 years we owned it.  I talk about the housing market, but for example, Friday evening my waiter was saying he thought \$250k for 750 sq ft was a fair price and a floor price for support.  He was also saying a 400 sq ft bachelor apartment cost \$600/month to rent.

Imperial, I read that several times as well.  What I find confusing about these things is if you look at the places that have had massive losses from them they were only getting a 5 point something rate of return.  Most of these things are at 6 and 7 percent and have reset rates.  So, what has happened to that difference?

Somewhere I read insurance paid was something like 0.5%.  I have no idea hour Canadian laws have changed, I was most displeased to realise they had changed to our detriment in the past year, however, our 5% mortgages required 2.5% insurance.  Until this past year you couldn't get a zero down mortgage.  I was most displeased when I saw on the web site where I have banked for over 20 years that they were offering 0 down mortgages.

What is it with the insanity of bubbles?

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#6) On January 06, 2008 at 10:10 PM, abitare (69.68) wrote:

FYI - Canada News - Toronto's teeniest house back on the market - a strange property to try and flip?

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