Mortgage Misrepresentation Explained

This is a little complicated but stick with it - I find it very enlightening and depressing at the same time - I feel I have no say in it or many other things that are going on behind the scenes that effect me directly - I'm not involved in this mortgage mess but I still feel angered by the panic and ignorance of the financial world by most of the general public.

It's not possible to know everything nor do it care to, but I want to feel secure in that those in charge have my best interests foremost. Yeah right! How does the saying go, "trust but verify".

Read on and keep the faith.


*“A very significant misrepresentation*.

The bond insurers that put their AAA ratings behind the least risky pieces of the CDOs have not defaulted. Nor have they been asked to make any principal or interest payments at this point in time. The village in Norway hasn't lost a penny and is still receiving all its principal and interest payments if it holds the AAA rated CDO.

““The presentation is playing out the worst case scenario, where mortgage defaults in the CDOs are so high that they actually threaten to bankrupt the bond insurers (Ambac, FSA, MBIA and FGIC are the names of the major bond insurance companies). This has not happened. The default rate and resulting losses due to foreclosure on the underlying mortgages would need to exceed 20% or more before the bond house were required to start paying the village in Norway. Even then they are not obligated to pay off the securities holders' balances.”“

All they are obligated to do is make principal and interest payments as they come due according to the repayment schedule in the notes. In return they get the collateral and that means they own the mortgages and ultimately the houses. They may not be able to liquidate the houses for all of the value that was advanced, but the mortgages and houses are not worthless. Over time the bond insurers are likely to realize most of the amount they guaranteed.

Their problem is one of cash flow in the short run if default and loss rates in the underlying mortgages are too high.”“In effect, the bond insurers have advanced 80% of the value of the house and taken the entire house as collateral. The "BBB" and "ugly" pieces of the CDOs advanced the first 20% and will absorb the first losses, just like your equity would be wiped out if you defaulted on your home mortgage with a 20% down payment and an 80% bank loan. This means that if the proceeds of sale from foreclosure are up to 80% of the original loan amount, the risky tranches are wiped out and the bond insurer (and thus the village in Norway) is whole.”

“Citigroup, Merrill Lynch and the other domestic and foreign banks that took the risky tranches of these securities had the first 20% of the risk and had to take huge write offs when default rates in the underlying mortgages started to spike. The default rates on these loans are running above projections so their tranches of securities are worth less. When the market panicked, the trading values of these securities plummeted. Accounting rules require that these securities be marked to market, thus the write downs when the values dropped. It's important to note that these are book write downs, not cash losses.”

“Only when the mortgages are actually charged off and the properties sold will the banks take the cash loss. They may very well end up with recoveries if the rates of default and losses don't reach the levels on which the market is now based. In fact, there is a buying opportunity for investors willing to bet that default rates will not be as high as expected and want to pick up these securities at fire sale prices.”

“The problem for the village in Norway is also one based on accounting and securities rules. Typically, these agencies are not allowed to hold securities that are rated less than A or AA. For now, the ratings on the CDOs the village holds are AAA. That will only change if the ratings agencies (Moody's or S&P or Fitch) downgrade the bond insurers. They have threatened to do this unless the bond insurers raise additional equity and thus contributed to the panic.”

“The panic that has gripped the market, much of it fostered by short sellers and opportunists (Warren Buffet's offer to buy the bond insurers at pennies on the dollar is a classic example of an opportunist who knows the risks are low and hopes to capitalize on the panic.), will pass.

Defaults will not reach the projected levels, but those who panic and sell now (or those who are forced to sell due to inflexible investment rules) will take huge losses and will look pretty stupid when the market recovers. What the village should do is suspend its rules temporarily and continue to hold the securities. But that's unlikely since it requires a level of financial sophistication and nerve that is sadly lacking in the advisors to most of these agencies.”