Laurie S. Goodman

Interest Rate Swaps: An Alternative Explanation

n The interest rate swap market, first developed in 1982, had an estimated annual volume of more than

Negative Equity Trumps Unemployment in Predicting Defaults

360 billion in 1987.1 Various reasons have been given for the existence and growth of the market, ranging from comparative advantage arguments to agency cost explanations to tax and regulatory reasons. However, each of the explanations is in some way inadequate in explaining the phenomenal growth of the market. Prior to the introduction of swaps, the only instruments available to borrowers were long-term fixed rate, long-term floating rate, and short-term debt. The combinations that were possible with those instruments are shown in Exhibit 1. The introduction of swaps brought additional options to borrowers. When combined with short-term borrowing in the credit markets, swaps enable borrowers to fix the risk-free component of their interest costs while allowing the credit risk components to fluctuate. This ability to provide borrowers with previously unattainable alternatives is the characteristic that makes swaps a true, and probably enduring, financial innovation.

The Cost of Delay

In this article, the authors show that negative equity alone is a more important predictor of defaults than unemployment. They also establish that when the borrower is significantly underwater, high unemployment can act as a trigger, amplifying the level of defaults.

Empirical Evidence on CDO Performance

In this study, we make use of a massive database of mortgage defaults to estimate REO liquidation timelines and time-related costs resulting from the recent post-crisis interventions in the mortgage market and the freezing of foreclosures due to “robo-signing” revelations. The cost of delay, estimated by comparing today’s time-related costs to those before the start of the financial crisis, is eight percentage points, with enormous variation among states. While costs are estimated to be four percentage points higher in statutory foreclosure states, they are estimated to be 13 percentage points higher in judicial foreclosure states and 19 percentage points higher in the highest-cost state, New York. We discuss the policy implications of these extraordinary increases in time-related costs, including recent actions by the GSEs to raise their guarantee fees 15-30 basis points in five high-cost judicial states. Combined with evidence that foreclosure delays do not improve outcomes for borrowers and that increased delays can have large negative externalities in neighborhoods, the weight of the evidence is that current foreclosure practices merit the urgent attention of policymakers.

Modification Success—What Have We Learned?

Despite the recent infamy of collateralized debt obligations (CDOs), there is a dearth of literature quantifying the performance of this fixed-income product. While performance is usually measured in terms of return relative to a benchmark, lack of pricing information necessitates an alternative methodology for assessing CDO performance. In this article, we use rating changes (principally downgrades) to assess 10 types of CDOs across 11 vintages, analyzing 4,328 CDOs and 13,333 tranches in total. We find the following: Asset-backed CDOs have performed far worse than other CDOs issued 1999–2007. Market value CDOs are the second-worse performers. Collateralized loan obligations (CLOs) and CDOs backed by emerging market bonds, investment-grade bonds, and high-yield bonds have significantly outperformed other types of CDOs over the last four years of issuance.

Where Have All the Loans Gone? The Impact of Credit Availability on Mortgage Volume

In this review of modification activity, the authors show that the key ingredients of modification success are principal reduction, substantial pay relief, and modifying early in the delinquency cycle. When all three of these ingredients are present, a modification has a good chance of success. They also demonstrate that success rates on modifications generated by the market’s methods are overstated: These methods do not take into account loans that have liquidated or re-defaulted on an earlier modification.

The Case for Principal Reductions

The total number of purchase mortgages originated in 2012 is considerably less than half of peak levels and is down 44% from 2001 levels. The authors estimate that a large portion of the drop—as many as 1.2 million loans in 2012 alone—can be attributed to low credit availability and find that African-American and Hispanic borrowers have been disproportionately affected by the credit box tightening. An overly tight credit box means fewer individuals will become homeowners at exactly the point in the housing cycle when it is advantageous to do so, depriving these individuals of the chance to build wealth. It also means the housing market will recover more slowly, because there is a more limited pool of potential buyers for each home. Ultimately, it hinders the economy through fewer new home sales and less spending on furnishings, landscaping, renovations, and other consumer spending that goes along with home purchases.

Covered Bonds: A New Source of U.S. Mortgage Loan Funding?

Principal reduction modifications are a cornerstone of the preliminary term sheet released by the State Attorneys General in March 2011.As a result, there has been increased attention to the success of these modification programs and the attendant moral hazard issues. In this article, the authors make a case for principal reductions, arguing that because negative equity drives defaults, principal reduction is the most successful type of modification. They offer some suggestions on better aligning incentives to minimize the strategic default issue. They also present evidence that it is very dangerous to not do these modifications and hence exacerbate the vicious home price depreciation/negative equity cycle.

Mortgage Hedge Ratios: Which One Works Best?

One of the largest sectors of the European fixed-income market consists of covered bonds, a financing mechanism for bank originators of residential mortgages and other assets. The term “covered bonds” comes from the “cover pool” used as collateral. The loans remain on the bank’s balance sheet. In this article, the authors define covered bonds and briefly describe their markets in Europe and the United States. They go on to explain the significance of the July 2008 actions to jump-start the covered bond market in the United States by the FDIC, Treasury, and U.S. Rep. Scott Garrett (R-NJ). While it is unlikely that covered bonds will be a major source of funding for U.S. residential mortgages, they will undoubtedly find some place among alternative funding sources.

Mortgage Modification Activity—Recent Developments

JEFFREY HO is a first vice president in the Mortgage Strategy Group at Paine Webber, Inc. in New York. ortgage performance quality is, to a very large extent, in the eye of the beholder. The trickiest problem for many portfolio managers is to M determine the duration, or interest rate sensitivity, of their mortgage holdings and how this sensitivity changes over time. For example, an investor who owns