"Instant Refi"? Watch The Consequences...

Karl Denninger
Market Ticker
Jul 30, 2010

There's a rumor going around that Fannie and Freddie (remember, government-owned GSEs? Yep) are cooking up a plan to provide "instant refis" to everyone with a Fan/Fred mortgage that is current, effectively refinancing them to current rates.

This sounds like a huge win for everyone.

But of course it's not - there is never any such thing as "win for everyone." Someone always loses.

Let's remember how a mortgage-backed bond works. You take a bunch of mortgages, then slice and dice 'em into bonds. The bonds are sold; the investor pays for the bond, and then gets an interest coupon until maturity, at which point the bond principal is paid back.

With mortgages there are a lot of games played because unlike a regular bond that has defined call provisions (if any) a mortgage can prepay at any time, removing it from the pool. This creates a duration problem for the seller which is accounted for in various ways.

One of the ugly little things I've been suspicious of for a couple of years now is that the capital accounts on these notes may be "silently" deficient. That is, let's say you have 100 mortgages with an aggregate "face" of $200,000 each (average.) You thus have a $20 million "face" bond there (all this ignores your "vig"; don't get all technical on me :-))

Let's say the aggregate coupon you owe on that bond is 5%. So you have to come up with $1 million a year to pay the interest to the holders. In theory, as each note prepays or pays off, the capital account has been stacking back those funds, so when the bond retires, you can hand the principal back.

But what if some of the notes aren't paying?

Well, at first blush, you're dead, because the coupon "inbox" from the mortgagees is short. But in fact some of them have prepaid - which means that if you're not being honest you could raid the capital "box" and make the interest payments with it. Who's the wiser, up until the bond matures and suddenly the money that's supposed to be there to return to the investors is missing?

I know, I know, this can't happen. Uh huh. Pull the other one folks. How many little games have been played over the last three years with accounting? Why not here?

Now here's the problem: If Fan/Fred were to implement such a "refinance/prepay" program, suddenly all the performing loans will immediately roll off. All that's left is the non-performing ones.

Now if, and I stress "if", that sort of deceptive game up above has been played, it suddenly becomes exposed, as the capital account is dramatically deficient, and it's "game over" for those holders.

It might also be fun trying to separate out the actual prepay risk and problem with the value of these notes and the results of this sort of game.

Now again - I can't tell you it's happened, because I have no access to the security-level books and flows from the homeowners through the servicers and then through Fan and Fred. But it would certainly explain why we have the sort of delinquency numbers we've seen and yet we haven't seen huge hits to the securities issued by Fan and Fred. Remember, these guys are informally insolvent (in "Conservatorship") and while their losses have been big, I am having trouble squaring the claimed loss amounts (about 2% of their book) and the amount of funding that Treasury claims it has provided to them.

If I'm right about this - and remember - this is speculation - then some of those note-holders are about to get a truly ugly surprise, and we're also about to be treated to whether Treasury's alleged "promise" to back them was worth the breath that Geithner spent to mouth it.

###

Jul 29, 2010
Karl Denninger

Karl Denninger's Market Ticker
Karl Denninger's Home on The Net

Looking for "The Best of Market Ticker"? Check out Ticker Classics.

321gold Ltd