Combating Risk in Today's New Mortgage World

Investors need to know how to properly evaluate MBS credit and fraud risks

Investment Dealers Digest
January 7, 2008
BYLINE: Andrea L. Felesky and Jeffrey B. Locke

As the value of mortgage-backed securities (MBS) continues to deteriorate, investors must now shift their focus from investing in these types of securities to minimizing earnings exposure, the magnitude of write-downs and mitigation of future losses from current investment vehicles. The key is to assess the risk of your secured investments in today's market.

The once lucrative process of providing subprime loans to potentially risky home buyers, then securitizing assets backed by these loans, has lost its luster and is now taking a major toll on many institutions and their senior management. In the past few months financial institutions have announced losses linked to MBS investments totaling over $50 billion, which continue to grow each day.

Investors have been unable to adequately evaluate the risks associated with MBS. Purely financial metrics to valuate the risks are no longer valid because much of the underlying collateral, the individual loans, were products of fraudulent conduct. A customer of the Mortgage Asset Research Institute studied its stated income loans and determined almost 60% of those loans were exaggerated by more than 50%. Whether the fraudulent conduct is the result of organized crime or individual greed, federal and local prosecutors have indicted a multitude of people who have allegedly committed mortgage fraud.

Based on their inability to properly assess risk in MBS and the rampant fraud in the underlying loans, investors will need new methods and metrics to analyze the current and future risks associated with these securities that are quick, efficient and reliable. We are at the beginning of a financial crisis and no one appears to know how long it will last, or the long term impact it will have on the financial institutions that were heavily invested in MBS and the financial markets as a whole. The question becomes more of how to begin to measure the risk exposure and develop a programmatic approach that mitigates or at least quantifies it so that informed decisions can be made.

To accomplish this goal, investors will need help. Determination of the overall magnitude of exposure in a pool of assets will be critical. Institutional investors will first need an efficient process to analyze the individual loans comprising the MBS before entire portfolios can be appropriately risk-assessed. Second, individual loans within the pool should be searched for the risk factors that tend to drive non-performance and fraud. Third, investors should be able to undertake a detailed analysis of the loans exhibiting those risk factors.

Hunting for Risk

A loan may have one or more risk-factor characteristics that indicate potential exposure for non-performance. Some examples of characteristics to examine are:

1. Payments: History of late payments or no longer making payments.

2. New Term Negotiation: Interest-only payments after a history of delinquent payments.

3. Loan Type: The type of loan can be a valuable indicator when evaluating and forecasting future risk and potential default. A portfolio can include subprime loans that are either fixed-rate mortgage or adjustable rate mortgage, Alt A, interest-only mortgage and negatively amortizing loans.

4. FICO Score: The FICO score used to gain loan approval can be misleading. For example, a married couple completing a loan application may be allowed to use only one FICO score for approval. There is a strong possibility that the spouse's FICO score, not used in the application process, is substantially lower.

5. Documentation: Lack of supporting documents in support of key factors used for the approval process.

6. Location of Homes: Certain areas of the country experience higher rates of foreclosures and have a higher inventory of homes with little or no equity built up in the homes.

7. Mortgage Bank: Many of the institutions that originated the loans are either in a dire financial situation or already bankrupt.

8. Investigations: The bank, broker or appraiser may be currently under investigation.

9. Loan-to-Property Value: The money needed to purchase the home by the borrower may provide an indicator of ability to pay in the future. Minimal equity in a financed property sometimes provides an outlet for the defaulted borrower to walk away from the loan agreement with minimal loss.

10. Refinance: The frequency and magnitude of a home refinanced in the last five years by the same borrower may shed light on future cash flow problems.

Using the foregoing risk factors (and possibly others that are learned over the course of having analyzed the non-performing loans) to perform a risk-based assessment of the loan portfolio will allow you to identify and segregate those loans that represent heightened risk for non-performance and fraud and require further analysis. These heightened risk loans may exhibit multiple or singular risk factors. Based upon the risk factors present, a risk scoring technique can be applied to efficiently prioritize the analysis of those loans with the greatest potential to default and negatively impact the performance of the investment. Investors must then begin the task of performing an in-depth analysis of those loans scoring above an established risk threshold.

Reviewing the loans

The in-depth analysis of the identified high-risk loans may uncover concerns that are usually not otherwise exposed during the approval and packing process. Below are some important points to remember.

1. Risk characteristics discussed above may be in multiples in a given loan or individually.

2. Insufficient controls during the underwriting process may continue to follow that loan once packaged, including lack of validated and adequate documentation.

3. Keep an eye out for fraud committed with falsified records or lack of documents. Look over the loan application and supporting documentation, HUD and appraisal records and public information. Also investigate the potential existence of a "straw buyer."

4. Transactions that were not "arms length" have a stronger likelihood of elements of fraud.

5. Review the repackaging of the MBS for fraudulent activity.

These above conditions are just a few of the common denominators found in pools of loans that are considered high risk and may warrant reserves and write-downs. Many of the issues pertaining to an individual borrower will not be identified in the consumer credit report that accompanied the loan application. Credit reports reflect a certain point in time and do not provide a real-time or accurate representation of the borrower. Additionally, the underlying fraud can often go undetected through the approval and packaging process.

To make an informed decision about the risks associated with MBS, investors need to evaluate the underlying collateral, the individual loans, of the MBS. This risk-based approach will help investors identify where the greatest exposure to current and future earnings lie and focus their time and attention where it is needed most.

Consumer loans increase by 23%

BusinessWorld
December 27, 2007 Thursday
BYLINE: Ma. Eloisa I. Calderon

SECTION: Pg. S2/2

Banks' consumer loan portfolios went up by more than 22% in September from a year ago, as the low interest rate environment encouraged spending.

Data from the Bangko Sentral ng Pilipinas (BSP) showed credit card receivables of the banking industry stood at P106 billion, up by 22.6% from P86.5 billion a year ago.

Automobile loans also went up by 22.2% to 83 billion from a year ago.

The September consumer loan data reflected increasing domestic demand for credit in the wake of the central bank's easing of borrowing costs.

The BSP's key policy rate, which governs bank lending charges, now stands at 5.25% after four rate cuts since July.

Purchases using credit cards accounted for 5.5% of the banking industry's P1.9-trillion loan book, a significant improvement from last year's 4.7%.

Commercial banks took up the biggest chunk of total credit card receivables at 79.9%, while the rest were held by credit card firms and thrift banks.

Delinquency ratio, which is the proportion of past due credit card receivables to the total, stood at 14.3%, better than last year's 19.3%. These past due receivables worth P15.2 billion accounted for 10.4% of the industry's P145 billion worth of bad loans.

Auto loans, meanwhile, made up for 4.3% of the banking industry's total loan portfolio.

Thrift banks cornered a 63.9% share of these auto loans, while commercial banks got the remaining 36.1%.

Past due auto loans, as a ratio of the total auto loan book, settled at 5.1%, higher than last year's 5%.

These accounted for 2.9% of the industry's total nonperforming loans, or those that remain unpaid 90 days after they fall due.

Citi and Chase boost SBA lending

Target a cross section of city businesses, including retailers, auto shops, manufacturers

Crain's New York Business

January 14, 2008
BYLINE: Stan Luxenberg
SECTION: SMALL BUSINESS; Pg. 18

Each year, thousands of New York area entrepreneurs with perfectly good companies have their loan applications rejected. Last year, Maribel Lieberman was among them.

Sales at MarieBelle New York, her luxury chocolate purveyor, were growing, but the company had only recently broken into the black.

``To qualify under normal terms, I needed to show another year or two of good performance,'' she says.

Rather than rejecting Ms. Lieberman outright, J.P. Morgan Chase gave her a $350,000 loan partially guaranteed by the U.S. Small Business Administration. In November, she opened her second store, on the Upper East Side.

Reversing course hundreds of other small business owners also got lucky last year as the city's two largest banks--J.P. Morgan Chase and Citibank--hugely expanded the volume of their SBA lending. In the fiscal year ended Sept. 30, Chase boosted the number of loans it made under the program by 82%, to 1,868--twice as many as second-place Bank of America. Meanwhile, Citibank, after years of reducing SBA lending, grew its loan numbers by 139%, to place fourth.

``We have made SBA lending a priority,'' says Hugh Donlon, Citi's Queens-based managing director of U.S. business banking.

Among other things, Citibank increased its small-business sales force and ramped up the number of sales calls it makes on potential customers, seeking to establish relationships that include SBA loans.

Chase took a similar route, not simply increasing the number of its business bankers but putting an emphasis squarely on SBA lending.

``We have been training our sales force in how to structure SBA loans,'' says Thomas Seery, vice president and SBA manager for the New York region.

Both banks' SBA loans have gone to a cross section of New York businesses, including retailers, auto repair shops and manufacturers.

New system in an era when all banks rely on computers and credit scores in assaying potential borrowers, the two banks have also adjusted their loan software.

Typically, high-volume lenders score potential borrowers according to their cash flow, collateral and other factors. In the past, when a business borrower came up short, the system would automatically reject the loan application.

``Now, if a borrower misses the mark by a few points, the system flips over to review whether an SBA guarantee can make the loan possible,'' says Ronald Goldstein, the SBA's assistant district director for economic development in New York.

By making more SBA loans, Chase and Citi were able to extend their reach in the market and to cultivate relations with companies that could qualify in the future for standard loans--as well as using a host of other banking services. The SBA guarantees cover from 50% to as much as 85% of loan values, increasing the attractiveness of those loans by reducing the risk of losses for the banks. In addition, those guaranteed loans typically carry interest rates about half a percentage point higher than those on conventional loans.

``You may have a bit of extra delinquency with the SBA loans because the credits are weaker,'' says Chase's Mr. Seery. ``But the interest rates are a bit higher on the SBA loans, and the business ends up being about as profitable for the bank as conventional loans are.''

Turn to Commercial Loans

American Banker
February 21, 2008 Thursday
Hurt by Mortgages, Some Turn (Cautiously) to Commercial Real Estate (CRE)

BYLINE: Jennifer Gordon

SECTION: MARKETS; Pg. 20 Vol. 173 No. 35

Aiming to diversify as losses on residential mortgages mount, some companies are banking on commercial real estate, despite concerns that the business could be the industry's next trouble spot.

Executives at BankUnited Financial Corp. Webster Financial Corp. of Waterbury, Conn., and South Financial Group Inc. of Greenville, S.C., all say the gambit is worth the risk.

"We are significantly deemphasizing our wholesale mortgage channel, and it's back to a significant focus on the commercial bank entity," said Ramiro Ortiz, the $14.4 billion-asset BankUnited's president and chief operating officer. "We think that sector will do very well for us."

H. Lynn Harton, South Financial's chief risk and credit officer, said it is also looking to "balance our portfolio out a little more."

And James C. Smith, Webster's chairman and chief executive, said it has "ample commercial real estate capacity" as it seeks to compete as "a pure-play regional commercial bank in our southern New England market."

Of the three, BankUnited is much more heavily weighted in residential lending. At yearend commercial loans, including real estate ones, made slightly more than 10% of its $12.6 billion loan portfolio, while residential loans made up 85%. Seventy percent of its residential loans were option adjustable-rate mortgages.

Commercial real estate loans made up nearly 17% of the $17.2 billion-asset Webster's $12.5 billion portfolio, while residential loans made up 30%.

At the $13.9 billion-asset South Financial, commercial real estate loans made up 40% of the $10.2 billion portfolio. The company did not break out the amount of residential loans on its books at Dec. 31.

Both BankUnited and Webster are exiting wholesale mortgage lending and said they may hire bankers as they look to make more commercial real estate loans.

This month South Financial hired Andy Morris, a commercial real estate executive at Regions Financial Corp. of Birmingham, Ala., to lead an effort to increase income-producing loan volume, including loans funding apartment buildings and other rental property.

However, analysts say that companies looking to replace troubled residential mortgages with commercial real estate may face issues, since a growing number of companies have cited deteriorating loan quality in the sector.

"The problems within the residential market are spreading to the commercial real estate market," said Mark Fitzgibbon, director of research at Sandler O'Neill & Partners LP. This year he expects most of the industry's growth to come from commercial and industrial loans.

The Federal Reserve Board's January Senior Loan Officer Opinion Survey showed that about 15% of U.S. respondents and 20% of foreign respondents expect a substantial deterioration this year in commercial real estate. Meanwhile, 80% of U.S. bankers reported tightened commercial real estate lending standards, the highest percentage since 1990.

Roughly 45% of U.S. and foreign bankers said demand for commercial real estate loans had weakened during the previous three months.

"If you're about to jump into a business that is seeing an overall weakening in demand and an increase in credit costs, I think you'd have to seriously question why now is the time to go into it," said Terry McEvoy, an analyst at Oppenheimer & Co.

All three companies reported deteriorating credit quality in the fourth quarter. But with the exception of South Financial, which cited an alleged loan scheme involving a Spruce Pine, N.C., development that affected several banks, the deterioration was concentrated in the residential sector.

Executives at the three companies said they are mindful of the environment as they put more emphasis on making commercial real estate loans.

"We think that modest growth is the right way to go about it," Mr. Ortiz said. He would like BankUnited to expand its commercial portfolio by less than 10% this year.

Alfred Camner, the company's chairman and CEO, said that the south Florida market remains strong, particularly for infrastructure projects such as hospitals, schools, and municipal expansions.

Also, BankUnited will look to sell fee-generating products and services, such as wealth management, to commercial real estate clients, "so we can ultimately end up with a more profitable relationship for us and a greater service for customers," he said. With cross-selling, underwriting is "driven by not only the spread on the loans."

Mr. Smith said he expects commercial real estate loan growth in the low or mid-single digits this year at Webster, because of softening in the sector.

"We are not expecting significant growth in 2008, due to the fact that we're in a down leg in the economic cycle and in the credit cycle," he said.

Webster's tight underwriting standards in commercial real estate have helped keep its commercial real estate portfolio on track and without a loss in a decade, Mr. Smith said.

Mr. Harton has not said how much he would like to expand South Financial's commercial real estate portfolio. However, he said in an interview last week that he is comfortable with its risk profile, despite concerns about credit deterioration.

"In that environment, we think really the winners will be people that have the best relationships and best contacts and are dealing with the best developments," Mr. Harton said. "Those are the relationships that we want to grow with."