[A-List] US economy: hedge funds push for evictions

["Michael Keaney" <michael011@xxxxxxxxxxx>]

Fears over helping hand for mortgage defaulters
By Saskia Scholtes in New York
Financial Times: June 1 2007

A generation ago, a mortgage was still a simple contract negotiated
face-to-face between a borrower and a local bank manager. But the
business of home lending has changed dramatically.

The crisis in the US subprime mortgage market has revealed a tangled web
of relationships and competing interests between lenders and mortgage
brokers, investment bankers and bond investors, and bank trading desks
and hedge funds.

One particularly knotty problem has emerged in the derivatives market
that tracks bonds backed by subprime mortgages. A key benchmark for this
market is the ABX index. Hedge funds that bet on a fall in the ABX have
profited handsomely as the index has fallen in value this year.

But a group of more than 25 hedge funds is anxious that investment banks
could use their influence in mortgage markets to manipulate the value of
the derivatives.

The debate has set powerful hedge funds against a practice favoured by
regulators and politicians as a way to keep struggling borrowers in
their homes.

The hedge funds are worried about modifications that mortgage
administrators, or servicers, sometimes make to home loans for troubled
subprime borrowers ? for example, changing the interest rate, or
extending the repayment term.

Some investment banks are active in the mortgage servicing business as
well as being mortgage lenders, underwriters for mortgage-backed
securities and derivatives traders.

The hedge funds claim that the banks? ability to modify the terms of
individual mortgage loans could go beyond helping borrowers and enable
them to profit ? or avoid losses ? on the derivatives contracts sold to
the hedge funds.

?Manipulation is a charged term, but there are concerns that the
potential for manipulation is there,? said Karen Weaver, global head of
securitisation research at Deutsche Bank.

This is because, in contrast to other strategies for managing troubled
mortgages, these loan modifications show up in performance reports as no
longer in arrears. Loans modified in this way would not trigger
writedowns of bonds backed by such mortgages, and in turn, this could
mean an investment bank would not have to pay out on derivatives
contracts tracking those bonds.

Robert Lacoursiere, research analyst at Bank of America said: ?True
credit exposure will be masked because worked out loans are considered
performing and will no longer be disclosed once they are disseminated
into the performing loan pools.?

The dealers, meanwhile, argue that the terms of the underlying
mortgage-backed securities explicitly permit such loan modifications for
the underlying mortgages, provided they are in the best interests of
borrowers and investors in the securities.

In recent weeks, Bear Stearns became so concerned that these terms were
poorly understood by some derivatives traders that the bank proposed new
legal language to the International Swaps and Derivatives Association to
clarify the situation. The bank later withdrew it, but stoked debate.

Tom Marano, global head of mortgages at Bear Stearns, said: ?We believed
that the original ISDA documentation adequately disclosed that investors
should look at the provisions in the underlying securities, and that the
ability to modify loans was adequately disclosed in the bond
documentation. When we saw the debate in the market, we thought it was
worthwhile to try to reiterate our position.?

Bear Stearns has been particularly active in mortgage servicing through
its subsidiary, EMC Mortgage Corporation, which recently launched the
?EMC Mod Squad? to help struggling borrowers modify their loans or
pursue other options. EMC says loan modifications have increased by more
than 300 per cent since February.

Mr Marano emphasises that there is no communication between the bank?s
derivatives traders and its mortgage servicing arm.

Nevertheless, the hedge funds remain concerned that some loan
modifications could mainly benefit the dealers? derivatives traders. One
of their arguments is that loan modifications are expensive and often
fail, with 40 per cent of borrowers in modified loans back in arrears
within a year.

However, Mr Marano argues that, in many cases, loan modification is
still the best option to minimise losses because foreclosures can cost
even more, with losses of up to 50 per cent of the loan balance in
markets with falling house prices. 

?We also require the borrower to stay on their repayment plan for three
payments before they are treated as current borrowers. If a borrower
falls off the plan in that period then we resume the normal foreclosure
process,? he said.

Ms Weaver at Deutsche Bank said: ?The bottom line is that when a
servicer modifies a loan, they have to represent that they believe they
can maximise the value of the loan by doing a modification as opposed to
choosing another option. There?s a fiduciary responsibility there.?

Moreover, whatever their motivation for modifying loans, dealers can
only make changes if borrowers agree.

?A lot of the most problematic mortgages were taken out in late 2005 and
2006, when many borrowers took on huge loans on the belief that house
prices were going up,? said Ms Weaver. ?That hasn?t happened and those
homes have become albatrosses, so a lot of borrowers may just walk
away.?

Part of the problem is a lack of specialist knowledge on the part of
some hedge funds, one dealer said. ?There are participants in the
derivatives market that don?t understand the servicing process and don?t
understand the mortgage process. They are great macro players that made
a great call on a sector that was going to underperform but they didn?t
take into account that servicers have options to modify the loans.?

Some investors, particularly those active in both the cash and
derivative markets, say that the solution is greater disclosure. Mani
Sabapathi, portfolio manager at Prudential said: ?It may be an
unintended consequence that the derivatives are affected, but I doubt
it?s malicious. What investors really want is better disclosure and
reporting of modifications to model how the securities will change, and
that?s not there yet.?


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