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Wednesday, February 21, 2007

 

buying reo


with the popping of the real estate bubble a current fact but prices being sticky as forecast, i've been giving much more consideration to buying an reo property.

tanta at calculated risk outlines the decline of the loss mitigation aspects of mortgage loan servicing among other intersting points about that industry, further including this comment. one of the conclusions is that "nuclear waste" servicers are bidding very little on the dollar to take problem loans off of other people's balance sheets in part because they haven't enough staff to deal with the wave of bankruptcy. some are already adding staff as fast as possible in anticipation of the wave.

as usual, the comments are as informative as the post. here is as succinct an account as can be made of the danger that faces the entire economy over the collapse in housing.

I would add 'negative convexity' is easy.

Bonds go down in price when interest rates go up. The degree to which they do so is measured by 'Convexity' (strictly speaking: the partial derivative of the bond price with respect to the change in interest rates, is normally less than zero).

When interest rates go down, bond prices go up (for the same reason).

Mortgage Backed Securities do not, necessarily, go up when interest rates go down.

This is because when interest rates go down, mortgage holders refinance. And so the MBS holder gets back his or her capital, before he wants/expects it.

Hence negative convexity. An asymmetric response to interest rates.

Analytically, the holder of an MBS has granted the borrower a call option which they can exercise if the MBS starts to rise in value. That is how one normally models these things (can someone confirm this?).

To fight this, investment banks created Collateralized Debt Obligations (CDOs) where the repayment is broken off into 'tranches' of mortgages.

The top tranche is essentially triple A or near enough, typically. The borrowers are very unlikely to default, and to repay-- the tranche is usually protected against early repayment in some way (ie another tranche must be fully repaid, before the top tranche can be repaid).

The bottom tranche (there are normally several, packaged and sold by the investment banks to different investors with different risk-return requirements) is normally called 'the toxic waste'.

In a tough market, the bank has trouble moving that one, the toxic waste. It may have to take it on its own balance sheet. Although it will be 'marked to market' the reality is, if the market is illiquid, there is no market, and it cannot be sold or turned into cash at any price.

In today's wild and crazy markets, hedge funds have been borrowing money from banks to take on CDO tranches-- they are a key part of the market liquidity.

So you have levered holders of CDOs. If something goes wrong, the market could be flooded with low quality MBS/CDO, as the hedge funds (also 'marked to market') will be forced to sell, and effectively the new issue market for MBS will be shut down.

At which point, only banks that keep mortgages on their balance sheet will be lending.

And we will be back to a world of 20% cash down, first mortgages only. The remaining banks will only lend as first mortagors to prime residential real estate, because they will not be able to shift the mortgages off balance sheet and so free up reserves for more lending. This is called a 'credit crunch'.

The housing market will, accordingly, freeze up for some time.

That is the danger.


but more to the point of reo -- that is, homes that have been foreclosed on, passed through auction and are now owned by the bank -- there is much for me to learn here. but this may be an avenue to finding some protection against buying a house in the middle of what may be truly unprecedented price declines.

to housingtracker.net and realtytrac -- the first a monitor of local pricing, the second a monitor of foreclsoures -- one might add (via big picture) neighboroo, whose foreclosure may may be of some assistance.

UPDATE: a post at the housing bubble blog relays what is the beginning of some really frightening times in florida as desperate sellers of property overwhelm the potential buying pool.

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