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ECONOMIC ANALYSIS:

Thinking Upside Down

What will a surge in defaults and foreclosures do to the paper valuations of mortgage-backed securities?

by Fred Cederholm
Investments were traditionally assets having intrinsic value that were expected to grow in worth, or at least hold their own. Lending was secured by collateral that had a liquidation value in excess of the outstanding balance. But not any more!
I’ve been thinking about “upside down.” Actually I’ve been thinking about situations, motor vehicles, the Resolution Trust Corporation (RTC), housing, unwindings, CDOs/CMOs/MBSs, insurance, and financial counselor/advocates. What a strange world we find ourselves in this Twenty-first Century! Like the Cole Porter lyrics: “The world has gone mad today and good’s bad today and day’s night today and black’s white today... heaven knows anything goes.”

You see, things are now hardly what they seem. This is not just because of the spin, hype, and marketing propaganda used in attempting to make us believe things are better than they actually are. Words/expressions have come to mean their direct opposites. We are numbed into complacency by thinking things are what they really are not. Investments were traditionally assets having intrinsic value that were expected to grow in worth, or at least hold their own. Lending was secured by collateral that had a liquidation value in excess of the outstanding balance. But not any more!

I first encountered the concept of being “upside down” when I began in public accounting in the late 1970’s. In reviewing consumer credits at banks I was auditing, I found there were increasing numbers of motor vehicle loans that were for larger amounts than the costs of the new vehicles that borrowers had purchased. I was told that the borrowers hadn’t fully paid off the residual balances on their prior vehicles when they got the new ones, so the unpaid amount was rolled into the new loan: they were thus “upside down” the minute they drove off the lot. This situation was further compounded by any initial depreciation the instant that “new” vehicle” became a “used” one. That seemed risky, but I was assured it was a fact of life—no problem. This vehicle financing program continues to the present.

When I began working as an investigative/forensic accountant for the RTC, I encountered the phrase again in the context of foreclosed commercial and residential properties. When the developers found themselves under water—that is, owing more than a property was worth, or they lacked the cash flow to service the debt, they walked—thus leaving the already troubled Savings and Loans with an OREO ("other real estate owned"). This more than likely had to be liquidated at a loss to the institution—and ultimately the taxpayers. In many cases there were no recourse or “deep pockets” to pursue in any recovery. And...the attorney and accountant fees were added to the liquidation costs because unwinding/untangling the mess was time-consuming and expensive.

This current real estate bubble will take the devastating concept of being “upside down” to a much greater and more pervasive negative impact on our whole economy.
This current real estate bubble will take the devastating concept of being “upside down” to a much greater and more pervasive negative impact on our whole economy. Any prior prudent rules of thumb in residential lending went out the window. Down payments were not required, or were just disregarded. Required income levels for a loan fell victim to the concept of “don’t ask, don’t tell.” Fixed-rate conventional mortgages were eclipsed by adjustable rate mortgages with below-market teaser rates—many requiring payments based upon “paying” the interest only. To this toxic stew were added negative amortization loans that funded 100% to 120% of the so-called purchase price.

Rates were arbitrarily below real inflation rates and equity was built up—not by paying on the outstanding principal, but by any illusory gains from inflation. It was a formula for disaster if owners continued to borrow against that paper equity, teaser rates expired, interest rates rose, the economy stalls, borrowers lost jobs, or real estate stopped moving at ever-higher prices. Well guess what? All such negatives have come to be, and the real estate bubble/ spiral is bursting/unwinding big time.

If the “buyers” acknowledge they are now “upside down” and stuck with an asset that is a net liability, will they try to walk, like what happened in the earlier S&L crisis? Will they even be able to walk this time? What will a surge in defaults and foreclosures do to the paper valuations of mortgage-backed securities (CDO’s/CMO’s/MBS’s) now held/hedged by so many investors? How big a bath will mortgage insurance underwriters be forced to take by all the collateral deficiency claims? The attorneys and accountants should once again find themselves doing very well.

I’m Fred Cederholm (a CPA, CFE, and forensic accountant) and I’ve been thinking. You should be thinking, too.
Copyright 2007 Questions, Inc. All rights reserved. Fred Cederholm is a CPA/CFE, a forensic accountant, and writer. He is a graduate of the University of Illinois (B.A., M.A. and M.A.S.). He can be reached at asklet@rochelle.net.


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This story was published on July 2, 2007.