“Color-Blind In A Sea Of Red Flags”


Floyd Norris, in his May 16, 2008 New York Times column with the great title “Color-Blind in a Sea of Red Flags,” asked whether any investor would want to invest money at a low interest rate to finance mortgages for risky borrowers who put no money down. Add to that scenario the further information that the lender had gone bankrupt because so many of these loans turned bad so quickly.

Unfortunately, this scenario is no mere hypothetical. Last year, Merrill Lynch put together a securitization exactly like that involving so-called piggyback loans.

In a typical piggyback loan, buyers take out two mortgages, one for 80 percent of the purchase price, and another for the remaining 20 percent. Fewer than 30 percent of such loans made prior to mid-2007 were made to borrowers who provided full documentation of their income and assets. It is believed that many of these borrowers lied about their income. Since nearly all had borrowed the full appraised value of their home, it is possible that some of these appraisals were also suspect. With falling home prices, even the honest appraisals are now too high.

Piggyback loans become vulnerable because of homeowners who walk away when property values fall. Moody’s has said, “In light of the pressure on home prices and limited or negative borrower equity in their homes, many second liens were simply written off” after only several months of missed payments. Merrill’s securitization, and others like it, now own the written-off portion of those second home loans. Foreclosure is seldom worth the effort especially since any money collected goes to the first mortgage holder.

Although market interest rates were low when these mortgages were written, the average mortgage rate was 11.2 percent. Still, investors who put up most of the money were willing to accept a floating rate of .3 percent over the LIBOR yield. This gives investors a yield of 3.2 percent.

Moody’s forecasts that so many of the mortgages will have defaulted that 60 percent of the money lent will not be paid back. If Moody’s assumption is right, investors will suffer capital losses on a security that delivered low yield and high risk.

Moody’s lists three other similar deals from 2006 that are likely to have comparable losses, including one underwritten by Goldman Sachs.