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siv0 Commentary


March 11, 2008

February 2008 was a busy month. The financial crisis has escalated on a number of fronts. Various solutions have been proposed, and some temporary stability in some sectors seems to be occuring, but overall, things appear to be getting worse. In a recent essay in John Maudlin's "Out of the Box" e-newsletter, Carolin Baum, who writes for Bloomberg had this to say:

"Let's face it: The Federal Reserve must be scared to death as it watches the financial system unravel.

Unravel would appear to be the operative word as leverage proves to be as toxic on the way down as it was intoxicating on the way up.

By late last week, events seemed to be spinning out of control. Credit spreads were blowing out, with tax-exempt municipal bonds out-yielding Treasuries by a record and the spread between Fannie Mae mortgage-backed securities and government bonds hitting a 22-year high. Treasury bill yields were collapsing (further). The U.S. dollar was sinking like a stone. And commodity prices, in their lofty ascent, had all the makings of a market unhinged from the fundamentals, which, after all, is the definition of a bubble.

Mortgage foreclosures hit an all-time high in the fourth quarter of last year while homeowners' equity, or the value of a home less the outstanding mortgage, sank to an all-time low of 47.9 percent.

This measure of owners' equity has been declining since the Fed started collecting data in 1945. (This isn't your father's housing market.) More unusual was the drop in the value of household real estate in the fourth quarter, one of a handful of declines in the half-century life of the series.

Margin calls are causing forced selling of assets (often what investors can sell, not what they'd like to sell), which makes them cheaper, which triggers additional margin calls and more forced selling. No wonder the Fed announced two initiatives early Friday before the New York Stock Exchange opened to address "heightened liquidity pressures." ...

This sums up what has happened this month, and actually since January pretty well. In February (and beginning of March) we saw Gold skim $1000/ounce. We saw oil hit $106/barrel. The Euro is trading at above $1.53. In fact I am in Europe, and the airports and hotels are trading the Euro at $1.71. Normally these sources are a bit higher, but normally not this much. Clearly they are hedging their bets. Add to this that February saw the highest forclosre rate on record plus saw home equities drop to the lowest level ever. The subprime crisis was one of the triggers of the current situation, and it is spreading into Alt-A and prime mortgages and home equities in general. On the other side of the pond, the UK had to nationalize Northern Rock, a UK based home lending institution- the bank with the honor of having the first public run in UK history.

As a result of this, there has been a lot of news regarding Fannie Mac and Fannie Mae. These funds are the bedrock of the US mortgage industry, and they are getting deepr into trouble. siv0 will continue to monitor them. In an attempt to get the government to help more on mortgages, the FHA has upped limits on conforming mortgages. In some cases, the limit is $729,000.

The US treasury and the Federal Reserve Bank have stepped in to try and impact the problem. The Treasury mainly through suggesting that lenders help out mortgage holders more, and the Fed by first injecting $50 billion through the TAF, then just last week making an additional $200 billion available! All this on top of recent slashing of the Fed funds rate. The Federal government (FBI and SEC) are also opening new investigations into wrongdoing at financial institutions, includng Bank of America, Countrywide, UBS, etc.

The auction rate market, a market for municipal bonds took serious hits in February due to the problems with the monoline insurers (i.e., Ambac and MBIA, especially). Some Municipal agencies (such as the NY Port Authority) had to pay up to 20% on bonds to raise cash! Many more took lesser, but substantial hits. The monoline bond insurer problems got worse as they tried to raise capital, but ended up substantially losing value, as the plans were not well received. The rating agencies (i.e., Moody's, S&P, Fitch, etc.) who rated the insurers garnered a further loss of confidence as the auction rate market froze up.

In February, the structured investment vehicle (SIV) was declared "dead", and Moody's said they do not see any imporvement on collateralized debt obligations (CDO) in 2008. These vehicles are at the core of the current credt crunch. In February Standard Chartered withdrew support for the Whistlejacket SIV, leaving Orange County California shorter of cash and wondering if there is any chance of recovering principal ($ 80 million). Dresdner did promise to support the K2 fund, and Sigma did succesfully mature a $50 million issue held by Orange County in February. The biggest worry for Orange County are future issues extending well into the third quarter of 2009. They still have $100's of millions of dollars on the line, and the problems are getting worse, not better.

Hedge funds and financial institutions were liquidating, defaulting, and otherwise going into default during February and this last week. The banks have been making margin calls on hedge funds due to uncertainty in valuations. This is causing massive deleveraging. In some cases funds that were leveraged 30:1 last year in March, after the margin calls are leveraged at 8.3:1. This means a lot of assets sold, likely at below book values. This could lead to a new lower valued market for various asset backed securites, causing yet more writedowns, deleveraging, defaults, etc. Recently we learned that Peloton partners is liquidating, Thornburg mortgage is at or near default, and the Carlyle Group and Bear Stearns are following suit. Some hedgefunds are claiming huge profits at the same time.

Many opinions abound about what to do. Some claim that it is natural for housing prices to fall. The market is overpriced, and this makes sense. But the problem is if there is no credit for people to buy the lower priced homes, and additionally, they do not have jobs to gain the credit (that is not available anyway), then it means very little that such an action is natural. The problem clearly goes beyond a normal cyclical "correction". Some voices are telling us that the government needs to get out of the way and allow the "market" to solve this problem. While I agree that the government has not done an astounding job managing the financial system as the problems occured under their noses, nor have they found a good solution, I am afraid that ultimately the governments of the world may be the only institutions capable of solving the problem. And unfortunately the solution may be more radical than Wall Street and London would like to see, or could even imagine today. I hope it does not come to this, but things seem to be accelerating, not stabilizing. I think by the time of the 2008 second quarter disclosures we should have a clearer picture of the situation. It is unfortunate, but the financial crisis appears to be impacting the broader economy. This is becoming much more than a credit crunch. Hang on, do not panic, but keep a watchful eye on the situation. I think that is the best any of us can do at this time.

I will end with this quip. On February 15th, Treasurey Secretary Paulson was asked "...is the worst over yet...?". His answer was (all hand waving removed) "...the worst is just beginning..."

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