Home Loans - Too Risky? Don't Ask, Don't Tell!

Should Banks be making mortgage loans? We take the answer for granted. Yet, I have been involved in an on-line discussion that started about gold’s value and price, that became about the wisdom of banks making loans for homes. And, if so, the circumstances under which loans are made. Financial and economic modeling does not take into account all of the variables, nor can any model accomplish that feat. My position is that, the contributors to the conversation should have the actual experience to deal with the issues, and even then they will end up with as many opinions as there are participants

The Philosophical debate of home ownership is one that has so many moving parts, IBM's “Jeopardy!” winning super-computer, WATSON, would have difficulty arriving at "an answer".Oh, and that assumes that we can identify all of those factors which should/must be considered. Part of the problem here is that lending for home purchase is tied to our (U.S.) culture and societal expectations. Further, politically, we have tied ourselves to a tax and income structure that counts on home ownership.

How to make successful loans? Easy - (1.) Take only Borrowers with perfect credit and lifetime employment with Life and Disability insurance naming the lender (2.) Variable rate (3.) changing DAILY (4.) at a rate fixed to the Fed Funds rate (5.) Plus whatever margin the institution needs to satisfy stockholders. (Oops! Nothing will satisfy stockholders so let's just call it a reasonable “ROI”-Return on Investment)

The issue is simply Home Ownership for the “99%” or Not! The mutual financial institutions, including credit uions, have an advantage, that they have squandered, as they have no stockholders and pay lower/no taxes. Mutual holding companies allow community banking to survive the onslaught of mega-banks. But as mutuality disappears, we will be left with the Savings & Loan “S&L” model. That worked real well. I ran several failed S&Ls for the State of MD with the FSLIC (now part of FDIC) right next to me. Commercial banks? How about Bank of New England - $32B "failure" in 1990 (translate that to 2012 dollars!). I know it well, because I "worked-out" a small part of the organization, me having moved from MD, where I was President of a new Federal Savings Bank, in January 1989 to run the Berkshire, MA region of BNE.

Lending is RISK. That is what banks are supposed to do: Take Risk! However, it is supposed to be managed. Shareholders, by demanding higher dividends and share prices, force unwarranted risk-taking. The two demands are somewhat diametrically opposed, yet sophisticated models will demonstrate that they follow one another, and lower the risk taking as the Board over-sees the "lending activities". GOOD LUCK!

Spend 10 or 20 years in banks and mortgage companies. thrifts and commercial banks. Then spend 10 years looking at changing regulations, but not just "real" banking, but so-called shadow-banking (Morgan Stanley, Goldman Sachs et al) as well. See what the SEC (Securities & Exchange Commission) has planned, versus what was on the books in 2006. Then look at enforcement or the lack thereof.

My long and drawn out point is that without field experience one cannot "model" the issue of "to lend or not to lend" and how much to charge if the decision is "YES". Then again, we are at the juncture of epistemology, philosophy, and economics. Answering the question of whether there is A God, many Gods, an Intelligent Designer" (ha ha - think about it), or just Chance, would be easier.

The price and value of gold - I guess that debate is over. It's worth something because we say so and because my grandson liked shiny stuff when he was little.

Author's Copyright by Richard I. Isacoff, Esq, September, 2012 rii@isacofflaw.com http://www.isacofflaw.com/

Stopping Foreclosure When the Lender Says "NO!"

(THIS IS A RE-POSTING FROM AUGUST 12, 2009)

Bankruptcy is a good option if you are facing foreclosure and cannot get the lender to accept reasonable terms for a modification; terms that will allow you to either catch up on back payments over time, or which will put the arrearage at the back of the loan.

The filing of any type of Bankruptcy, which is asking for protection from creditors, will stop ALL actions for money, foreclosures, repossessions etc, against you. BUT, for most consumers, only a Chapter 13 will give you the ability to spread out payments for the arrearage over a period of up to 60 months. So, assuming you are 6 months behind in payments of $1,500 each, and there are $3,00 in legal fees because you are in a foreclosure status, and you have $300 in late fees, and the lender has paid $1,200 in taxes for you because your escrow account (where the lender collects money to pay real estate taxes each month as part of the mortgage) is short because you haven't paid in 6 months - you owe the bank $13,500.

Most of us do not have that amount of pocket change, and if you did, you wouldn't be 6 months behind. Spreading that amount of money over 60 months adds only $225 per month to your expenses. Please understand that there is no misunderstanding about a desperate financial situation, but if the arrearage occurred because of a temporary drop in income, for whatever reason, you can get caught up. Too many people give up once they get that far behind because they know they cannot pay $13,000+/- all at once, and once the foreclosure starts, the lender is not inclined to "make a deal".

The Bankruptcy Laws were established so that people could get a "FRESH START". The whole concept is to give people who get into a financial bind a way out, without losing their home, car, retirement accounts etc. Details of the protections a Bankruptcy gives you are on my website www.isacofflaw.com . Once in a Chapter 13 Bankruptcy, the United States Bankruptcy Court controls what a creditor can do. If you make payments on time, including the $225/month in the above example, the lender can only sit by a wait until you finish the Plan of payments. If you make all of them, your loan is put back into "regular" good payment status.

Also, if you miss a payment due to a temporary problem (broken arm with no sick time available from your job or a seasonal drop in hours so the overtime you have been counting on isn't available) the lender CANNOT just foreclose. It must ask the Bankruptcy Court for permission and there will be a hearing on the request. There, your lawyer (don't try a Chapter 13 Bankruptcy on your own) can explain the situation to the Court and usually work some type of compromise with the lender. The Bankruptcy Court is there to protect Debtors, provided the Debtors do what they promise.

Further, if you have equity in your house of $30,000, and your payments are $1,000 per month, the Court normally will not allow a foreclosure even if you are 2 or 3 months behind. While that is not specified in the Bankruptcy Code, the concept, called "adequate protection", is clearly spelled out. In essence it states that if the lender is not at risk of losing anything by waiting and using some of your equity to guaranty the arrearage will be paid, then the Court WILL NOT allow the lender to foreclose. The lender has no risk in waiting so you get a chance to get caught up again.

The Bankruptcy laws are complex, but the concept is not. If you are behind in your mortgage payments, and the lender wants to foreclose, and the lender will not "make a deal" with you, and you do not have a lump sum to pay all of what you owe from payments not made, a Chapter 13 Bankruptcy filing can be used to save your home. You can find a qualified Bankruptcy attorney by going to the website of the National Association of Consumer Bankruptcy Attorneys www.nacba.org , www.abi.org, or by calling my office for a "no charge" referral.

Author's Copyright by Richard I. Isacoff, Esq, August 2009

www.isacofflaw.com

rii@isacofflaw.com

Foreclosures; Another Shoe is Dropping

Currently, in the City of Pittsfield, MA, there are 190 properties in some stage of foreclosure; 69 are currently in default, 30 are Bank owned, 16 are awaiting a foreclosure sale date, and the rest are in some part of the process (such as sale completed but deed not yet recorded or waiting for the sale with a date set).

For a city the size of Boston, or Atlanta, or even Springfield, MA, that number might not be worthy of note, but in a city of 40,000, to have 190 HOMES in some state of being taken from the homeowner is alarming. What is more concerning is the fact that there is no action on the part of the city to assist those homeowners in trouble. There are no meetings inviting homeowners to learn how to protect their home which is probably their biggest investment; the local community college, which offers courses and seminars in all types of subjects, has no offerings to educate homeowners about how to avoid the common pitfalls that lead to defaults and foreclosure. There isn't even a hotline that is well publicized, that a homeowner in trouble can call to get emergency legal assistance/counseling.

What is most disturbing is that the situation in Pittsfield is not the exception, but the rule. This issue pervades the country and, yet, because we have moved to a new news cycle, gets no attention anymore. The stock market is nearing 10,000 again; the dollar is low so exports are high; oil is over $70/barrel but not too much; gold is over $1,015 per ounce but that is because of the weak dollar; inflation is under control; and the Federal Reserve is continuing to give the banks cheap money to lend. The fact that it isn't being loaned to consumers or small businesses also goes undetected.

We are facing a real housing crisis. As has been commented on and explained in earlier postings, the next wave of adjustable rate increases is about to hit - the so-called Option-Arms, were "prime" borrowers could get a mortgage, and pick a payment for the month. Well, that period of pick as you may is starting to change. Most had that scheme for 3-5 years. The 3 year period is beginning to end (2006-2008) was most of the activity, so we will start to see loans that have to have PRINCIPAL & INTEREST PAID each month for the remainder of the loan term (27 years generally). That will be coupled by a rate increase of 2%-3%, based on the contract (mortgage documents).

So, will the better qualified borrowers start to default and hit the statistics as a "property in foreclosure"? Not all of them but YES, many will! Keep in mind that many of these borrowers no longer have the jobs they did when they got the loan, or hours have been cut, or the second job is gone, or there is no overtime. This will start another decline in home prices and cycle of panic.

Mortgage lending has already slowed to a trickle of what it was. That is not all bad, but when people cannot refinance or buy a new home, even when they have a steady job and decent income, but only a 670 credit score (680 being the line between prime/regular and the evil sub-prime borrower) we have a major problem.

In many areas, local banks and credit unions are trying to fill the void, but the demand is greater than the supply of loans. And, many institutions have new financial requirements to meet per FDIC, OTS, OCC and the rest of the alphabet; the locals have little to lend on anything but the best prime loans.

One hidden factor regarding the recovery of home prices and the market: banks that have foreclosed on homes, many homes, are NOT putting them on the market for sale, hoping for a recovery in pricing and not wanting to flood the market and further depress prices by increasing the supply of "existing" homes beyond the demand.

So much for the good news!

More On Modfications - The Borrowers' Hidden Costs

Mortgage Modification, as stated in earlier posts, can mean anything from allowing a late payment without a fee attached to it, or reducing interest and principal substantially. Unfortunately, most are closer to the deferred penalty than a true modification of terms which will allow the borrower to keep their home.

In today's USA Today, there is a brief analysis of the business of mortgage modifications. The article "Many mortgage modifications push payments higher" by Stephanie Armour, recites the history of 2 borrowers, but details the problems with the program. http://www.usatoday.com/money/economy/housing/2009-09-14-mortgage-modifications-not-helping_N.htm?csp=34

The MHA (Obama) program concentrates on lowering payments. This is accomplished by lowering the interest rate, and, if necessary, extending the term of the loan to 40 years, so that the payment of principal, interest, taxes and insurance, is no more than 31% of the borrowers gross income each month. HOWEVER, the amount of principal owed can actually increase substantially in the process. Per USA Today's quote of government studies "Of loans modified from Jan. 1, 2008, through March 31, 2009, monthly payments increased on 27 percent and were left unchanged on an additional 27.5 percent, according to a recent report by banking regulators." Dismal? Yes! The light might be that the new program, MHA, will do better.

For a borrower that has fallen 6 months behind with his/her $1,500/month payment, accumulated interest, penalties, late fees and other costs, such as legal and inspections, all get added to the amount ultimately owed by the homeowner. In this example, that translates to a minimum of $14,000 added to the amount owed. This in turn would normally increase the monthly payments so a balance has to be reached, generally by adjusting the rate.

NOTHING IS FREE as we all know. Many of these mods (common slang now for mortgage loan modifications) are fixed for only 5 years, and can then adjust. The mod itself creates a new Adjustable RateMortgage ("ARM"). Is this just postponing the inevitable foreclosure? Maybe so - but at least there is a chance for the borrower (who can find new/additional employment, and can clean up his/her credit score, and can make every payment on time) to keep the house by a refinance at the 5 year adjustment period.

Other issues with modifications. There are a number of agencies, well-intended, which help borrowers at risk for foreclosure, to get a modification. The thought there is that by postponing the foreclosure at least the borrower has an opportunity to keep the house. One of the problems here is that many of these agencies are ill-equipped to go toe-to-toe with a mortgage company, be it the servicer or the actual lender. To many of the agencies, any modification is better than none - right? MAYBE!! If the agency is funded by getting modifications done, it can turn into a numbers game. A modification completed is one towards the quota for funding. Keep in mind that a modification can be simply delaying 2 or 3 payments until the end of the loan, or even creating a balloon payment at the end of the term of the loan.

Well, some may say, at least the borrower kept the house for a few more years. Well, I say, "SO WHAT"? The modification should give the borrower a real shot at keeping her/his home for as long as she/he wants.

Recapping, we have a federal program that was put into place for loan mods - fixes - to allow homeowners, who are facing imminent foreclosure or who will be falling behind over the next several months because of a job cut or an UPWARD MORTGAGE INTEREST RATE ADJUSTMENT, to keep their homes. The program allows the mortgage industry, company by company to participate or not. There is only one standard program and that is the Making Home Affordable ("MHA") plan.

Lenders can opt to modify any way they would like to, and are doing so, especially to those borrowers who do not qualify for MHA. The modification may be detrimental to the borrower in the long term but who cares? CreditSights, which is a firm that tracks such matters, states that of the more than 1/2 million mods this year, 90% have resulted in higher principal balances. Good? Bad? It would seem that just adding back interest and fees to a delinquent loan is not good. It seems and is counter-intuitive, and counter to success. It is a short term fix - a band-aid.

HERESY but perhaps there are those who would be better-off losing the house that is a constant struggle to pay for, month after month, year after year. Maybe some homeowners would be better-off losing a house, regrouping and getting finances straight, renting for a few years and saving money each month for a down payment on a house that is affordable.

Author's Copyright by Richard I. Isacoff, Esq, September, 2009

rii@isacofflaw.com
http://www.isacofflaw.com/

Mortgage Modificiations To Get More Difficult?

Countrywide, now part of Bank of America was one of the major lenders to sub-prime borrowers (that only means a credit score below 680 (or 640 depending on the day). It also packaged and sold the loans it originated, as Mortgage-Backed Securities ("MBS"). It continued to service the loans (collect money and send bills from and to borrowers) and was paid by the owners of the MBS to do so. The owners were just investors - they bought $xxxxx of a bond, not any different than if they bought a corporate or municipal bond.

When the mortgage/housing crisis hit, in large part due to Adjustable Rate Mortgages ("ARM") there was tremendous pressure on the Servicers, of which Countrywide was one, to MODIFY loans so that they were affordable for the borrowers. Some servicers modified loans, which they may or may not have been permitted to do in their contract, called a Pooling and Servicing Agreement ("PSA"), with the "packager"/"owner" of the bond. Countrywide modified loans and then, ignoring its PSA, refused to re-purchase the loans that had been modified by lowering the interest rates or even putting payments at the back of the loan. In simpler terms, Countrywide altered the amount of interest the owners of the MBS would receive.

A federal court ruled that Countrywide's motion to dismiss the lawsuit brought against it by the investors would not succeed. The Court stated that the case was one which should be brought in State Court, the the modifications were not protected by the recent legislation and Congressional acts to force lenders and servicers to modify loans. Basically, the Court said that if there is a contract, Countrywide must observe it - any quarrels with that belong in a state court on a case by case basis. No "get out of jail card" was given to Countrywide.

WHY DO YOU CARE? Because Servicers, if they aren't protected when they make modification from the investors, who expect a certain percentage return, will refuse to modify citing the Court ruling but relying on the contract they made, and arguing that they cannot breach the contract! This means more difficulty getting Servicers, which are not participating in the Federal program to modify loans, now for fear of a lawsuit.

This issue was brought up months ago and detailed in my posts of 10/25/2008 and 11/9/2008 -
http://finance-for-us.blogspot.com/2008/10/foreclosure-crisis-how-to-stop-it.html and http://finance-for-us.blogspot.com/2008/11/who-is-bailout-helping-right-now.html.

This just points out the disconnect, the lack of communications and an efficient coherent policy to deal with the foreclosures. Maybe Congress would act if it the home of a member!!

Author's Copyright by Richard I. Isacoff, Esq, August 2009
http://www.isacofflaw.com/
rii@isacofflaw.com

Who To Trust - Federal Judges or Wall Street

THIS IS A RE-POSTING OF THE MARCH 18TH ENTRY DUE TO THE RECENT SENATE VOTE

The United States Senate has referred the one bill, S. 61, that could break the log jam of mortgages tied up in "TOXIC ASSETS" to "Committee" for review and reconciliation with the House version. The short version of the bill is that it would give Bankruptcy Court judges the power to modify residential home mortgages. The homeowner/debtor would have to prove that the loan was patently unfair, that the lender/broker/originator used Unfair and Deceptive Trade Practices, or that the borrower never received the proper documentation to know what product he/she was buying. The assignment to the committee will assure that there will be a delay in getting the bill to the full Senate for a vote. Keep in mind that the House of Representatives has already voted favorably on giving the judges the powers needed.

Unfairness? Didn't the borrower read the documents before signing them, and if he/she/they did not understand everything fully was the closing attorney asked for information or clarification? Unfortunately, many of the closings were done without any attorney present - representing the lender or the borrower. Just a notary was there to be certain the all of the right places were signed and that there was proof the the person(s) at the closing were in fact the person(s) borrowing the money. These are called "Witness Only Closings" and were commonplace during the boom years from 2004-early 2008.

Real Example: clients came into my office Monday ready to file a Chapter 13 Bankruptcy to save their home. The documents they brought, although unsigned, told the story of how a $1,326 monthly payment grew to nearly $2,300. They had contacted a broker who had helped them, in an earlier transaction, with a major lender. Because of the prior experience, the borrowers trusted that the closing would be okay. The entire transaction took less than 20 minute for a full mortgage refinance, and that was at a local sandwich and ice cream restaurant. Virtually nothing was explained despite questions from the borrowers.

I can state from doing hundreds of closings that an attorney cannot explain all of the documents, including mortgage, mortgage note, HUD-1 Statement, Truth-in Lending, Good Faith Estimate, and all of the other disclosure required by state and federal laws in an hour; not in 20 minutes less the time to be seated. This closing went so fast that no one even ordered a coffee. What is worse is that the loan was not a common loan.

The borrowers were told that they were getting a loan with a fixed payment for 2 years, and that after two years the rate would change periodically. They were not told that the loan was an "Interest Only" loan for the first five (5) years, so that none of the payments made during that time would be applied to principal - the amount borrowed. Further, they were not told nor were the papers explained to them, that the interest rate could move up as much as three percent (3%) at the end of the first two (2) years. It could not go down regardless of the market. Nor did they comprehend that after the first two (2) year period, the rate would be adjusted every six (6) months.

It was only after receiving the first bill from the lender that they found out that there would be a tax escrow in excess of $300 each month. They thought that the taxes were included in the $1,326 amount. Instead of paying $1,326 they paid $1,626. At the end of the two (2) years, though they had been promises that they could refinance as they were getting this great loan, the payments increased to $1,700+ without the $300 tax escrow. They were now paying $674 per month more than they had been led to believe they would pay.

The loan provisions, Fixed Rate for the first two (2) years and then variable/adjustable for the next twenty-eight (28),, is a common product. The interest only feature is rare for middle, middle class borrowers. Combining the 2/28 fixed/adjustable structure and coupling it with a five (5) year interest only provision, and NOT EXPLAINING it to the borrowers is why we have the mess we do.

The above real-life, in my office example, is the reason that the Judges have to be given the power to modify bad loans. They can eliminate the excuse/reason too often given that "it's not allowed in the contract... yeah, the one the Wall street guys made for us.

Author's Copyright by Richard I. Isacoff, Esq., March, 2009

http://www.isacofflaw.com/
rii@isacofflaw.com

Senate Votes Against Homeowners' Rights

Photo from Article by By Mike Lillis in the Washington Independant

What could have been the best and least costly way to fix the housing market and to save countless homes from foreclosure has been snatched away. A piece of legislation that had become known as "The Durbin Bill", actually Senate Bill 61 which was sponsored and championed by Sen. Richard Durbin, has all but been permanently defeated when only 45 Senators voted to end a filibuster on the bill this past Wednesday (Note: A filibuster is a procedural rule that allows the opposition to proposed legislation to prevent it from being voted upon, by continuing the debate forever. It takes 60 senators to end the filibuster and stop the delay).

The bill, following the House or Representatives' lead, would have given Federal Bankruptcy Judges the authority to modify unfair primary residence first mortgages. First, it must be stated that the Judges have the authority and use it every day on almost every other type of loan. Sometimes the Lender is happy because the Judge will not modify the loan, and sometimes the borrower is happy because needed relief is okayed by the Court. Why then has this proposal brought about such intense debate and one of the most "gloves off" lobbying effort in a long time?

The simple answer is greed, but that does not really explain the full picture. Having worked in the Banking industry, as a banker, regulatory enforcer, and part-time lobbyist, I can attest to the power of the banking and finance lobbies. Why would this sector of the economy which has received billions of dollars, in fact, a trillion dollars, oppose the ability of a Federal Bankruptcy Judge to modify an unfair home mortgage? The explanation lies in the nature of home mortgages in today's financial market and in the new definition of a "Bank". The "banking" industry includes companies like Goldman Sachs, which do not make consumer loans, do not take deposits, do not have checking accounts, do not have ATMs, do not have branches, and do not have customers/depositors, except those few customers who buy SECURITIES. These so-called banks are really securities firms which put pools of mortgages together and sell them to pension plans, large companies, mutual funds etc.

Earlier posts have discussed the securitization of home mortgages into a type of derivative called mortgage backed securities. This pooling of hundreds of millions of dollars of mortgages into packages has caused them to cease being a loan from a bank to a homeowner, and to become a source of income, each mortgage contributing its fair share, for investors who bought not the mortgages, but the right to receive income from the pool of mortgages, the Mortgage-Backed Security (we will refer to these as MBS for the rest of this post).

The argument runs like this: Because the rate of defaults has risen well above predictions, the flow of cash is threatened to a point where the investors may not get what they "were promised"when they paid for their fractional share/piece of the MBS. It is critical to keep in mind at all times when thinking about this issue that the MORTGAGE as we think about it HAS CEASED TO EXIST for the purposes of the investment MBS.

The investors in the securities called MBS,do not want to have the value of their investment decreased. If enough mortgages in the package have the terms changed to lower the payments, the entire package will pay less than expected/promised, and therefore the entire package will be worth less than the investors paid for it. Also, we are referring to a pooling of mortgages where each pool might be $500,000,000 (1/2 billion dollars) or more. The financial stakes are enormous. This in fact is why the term "toxic assets" sprung up - toxic because they would harm or kill the value of the MBS AND no one knew to what value. Therefore the assumption was that they were worth nothing, or close to it.

Okay. So what does that have to do with the Durbin Bill to allow Bankruptcy Judges to change terms? EVERYTHING! If a borrower obtained a loan that had an interest rate which was at the market rate of maybe a bit higher, and it was an Adjustable Rate Mortgage (ARM) where after two years the rate would go up and where the loan could never go down below the original rate, the mortgage could be sold at a premium even if, in reality, it cheated the borrower who never was told about the rate increases. By allowing a Judge to determine that the mortgage was sold to the borrower under false pretenses, and misrepresentations, and therefore permitting the Judge to CHANGE/LOWER the interest rate, the owners of the MBS that owned the loan would lose, as explained above.

Again, if a Judge can state that a loan was unfair, and that the lender cheated the borrower, and therefore the terms have to be changed to make the mortgage fair, the entire structure of the MBS falls apart. If that happens, the "banks" who own them or have sold them, lose millions of dollars. This is because no one knows what the end rates will be or the amount of income any loan will pay, because a Judge could change it. There is NO CONCERN about the family, losing its home and being evicted because they were tricked into taking a loan with a moderate interest rate, not realizing that it would go up after 2 years by 3%, and then adjust every 6 months thereafter. The variations on the theme of bad loans have been discussed in earlier posts ( see the following postings: 3/18, 3/7, 2/21, 1/29, 1/3)

The "banking industry" lobbied the Senate not to allow Judges to make the determination that the loan is unfair. The attitude is that a borrower should have known better; that once you make a deal you MUST live with it, even if you were misled, lied to, cheated etc. What is lobbying? In its nice form it is just talking to members of Congress and expressing the opinion of the lobbyists client. In it TRUE form, it is pressuring Congress on a member by member basis to vote the way the Lobbyist/persuader wants by some of the following: threatening to move a large banking operation to another state; threatening to make no more campaign contributions if the vote isn't the "right" vote; threatening to support the Senator's/Congressman's opponent; threatening to pay for ads like the "Swift Boat" ads that hurt Sen. Kerry's presidential campaign; AND flat out bribery - money, houses, trips to where ever etc.

There are other players as well, like the companies that "RATE" the MBS, in a sense "kick the tires" to see how solid the investment really is. The companies have huge amounts of liability if the rating of the MBS market has been a sham. The stakes are huge -Billions of dollars for the investors,"banks", and the rating agencies!. Motive? "YOU BETCHA!" (thank you Governor Palin for the words to use)

Author's Copyright by Richard I. Isacoff, Esq, May, 2009

http://www.isacofflaw.com/
rii@isacofflaw.com

The Real Toxic Assets - Derivatives (whatever they are)

This posting will begin a 3 part series, to be finished by week's end, where we try to make understandable the un-understandable. Obviously the topic continues to be the "Stimulus Package", TARP, TALF, and the latest entry into the lexicon of acronyms, the PPIFs. PPIF stands for "Public Private Investment Funds". These are going to be the repository of those evil and lurking "Toxic Assets".

(cartoon from The New York Times)

A short recap: - mortgages were sold that had the interest rate adjust ("ARMs"), on both prime and sub-prime borrowers, to the point that some homeowners could not pay the monthly payment. These, along with perfectly fine loans were then bundled together in $500,000,000 or larger pools, and sold to Wall Street firms which made them into saleable securities akin to a bond. They were then resold as investment quality bonds, in smaller pieces, to investors all over the Country and the world. After all, what could be safer than an investment, paying interest, that was backed by Home Mortgages. Everything was fine until the adjustments started to occur and delinquencies looked as if they would be greater than expected. The investments, Mortgage Backed Securities, "MBS", were no longer worth as much as everyone thought they were because of the fear of more defaults and foreclosures, so panic selling began, until no one would buy any of these MBSs. Because no one knew the exact value, IT WAS DECIDED, that the value would be ZERO, or something close to it and they became "Toxic Assets". (RECAP OVER)

The assets were no more toxic then than they were at the start. In reality, the true asset was the underlying collateral - home mortgages. How many would go to foreclosure and how much would be recovered was unknown, but there are a lot of percentages between 0% and 100% - none were used!! There were 2 hidden issues: 1. With the mortgages being bundled as MBSs and sold as bonds to investors (earlier posts please) no bank or lender or any one who sold them was at risk. The investors might lose some money, like they might on any corporate bond or a mutual fund, but the lenders were home free. 2. A little understood evil was waiting to steal the souls of all who succumbed to good interest rates - DERIVATIVES.

What is a "Derivative"? Simply put - a BET, a gamble that something will happen based on something else; like during the World Series, betting not on which team will win or lose but whether the score of both teams will be higher or lower than the number of strokes Tiger Woods takes in the first 3 holes of his current tournament. THIS STUFF REALLY HAPPENS!!! Here, it was a bet that mortgages would default in record numbers. It seemed like a safe bet to take, and had been for the past 50 years; mortgages had a more or less constant and predictable default/foreclosure rate.

Let's get an example that most of us understand more easily - LIFE INSURANCE. When you buy a life insurance policy, you are betting an insurance company that you will die before you have paid more in premiums than the policy will pay to your beneficiaries. The Insurance Company takes the BET, because they know that on average, very few policy holders dies before either paying in more than the death benefit, or simply let the policy lapse after many years of paying. The insurance company, having hundreds of thousands,or millions of other people buying and dying, have sophisticated mathematicians (actuaries they are called) who prepare statistics on the probability of someone dying.

For example, if you are healthy and 30 years old, and do not race cars, and want to buy a $25,000 policy, the company will say "fine" and charge you a modest monthly premium. They can do this because they have statistical proof that very few 30 year old healthy people die. If you are 70, the chances of death before paying a lot of premiums is far greater, so the payments are much higher.

REGARDLESS OF THE SITUATION, YOU ARE BETTING THE COMPANY YOU WILL DIE WHILE YOU ARE INSURED AND BEFORE YOU HAVE PAID A FORTUNE, AND THEY ARE BETTING THAT YOU WON'T. That is gambling/betting/buying chances... The company can do this because they sell hundreds of thousands of policies and the statistics prove them right enough of the time. Basically, you and hundreds of thousands of others pay premiums, and the Insurance Company pays relatively few claims. They get to keep the profit!

To be certain that the Company has guessed correctly, it will bet another and bigger insurance company to bet that the insurer might be wrong. The bigger company which has even more statistics takes the bet and collects easy money. It has bought a derivative - a bet not on the life of the insured, but a side bet on whether the first company will have to pay the claim. This second bet is DERIVED from the first bet -the insurance policy itself. It is equivalent to the bet on Tiger's golf game.

What would happen if a disease struck all of the 30-40 year olds and they died, leaving the older people only - the people who have less time to live (and pay premiums according to the math guys)? Easy - the company would not be able to pay all of the claims. The bigger company which had to pay the smaller company who issued the insurance policies might default. Both companies might go bankrupt. So, the bigger company bets with even bigger company etc. What happens is that there might be 7 bets that the 30-40 year olds will live long. If they don't, 7 companies have to pay and 7 companies might file bankruptcy.

Were any of the assumptions wrong? Yes and no. It was a first time event, all those young premium payers dying, but they did die. Would that make all policies bad no. It does point out that betting that a mortgage will go bad (OKAY CALL IT INSURING AGAINST IT GOING BAD) or any other such bet is fraught with potential disastrous problems. The biggest of these is the fact that there could be 5,6,7 or 100 bets on that 30 year old's life.

These DERIVATIVES, these side bets, are some of the main issues that "broke" A.I.G.

What happened in the financial markets that have left us with trillions in debt is next in this 3 part series.

Author's Copyright by Richard I. Isacoff, Esq., March 2009

rii@isacofflaw.com

http://www.isacofflaw.com/