A Note on the Treasury Regulatory Plan and Images of a Fool In Action
By Monday’s close, it looks like the sharp upward move in rates that began in earnest after Memorial Day has run its course. A combination of factors has acted to hold 10-year yields under the 4% level; in addition to a re-assessment of economic prospects going forward, the inflation data (Producer and Consumer prices) has remained friendly toward bonds, and equities have come off their recent highs. (The S&P 500 index has dropped 5.5% from its recent peak, which was recorded on June 12th.)
MBS have put in a pretty fair performance over the last week. The Fannie Mae current coupon spread tightened to the 5-10 interpolated Treasury (a widely-used proxy for Treasury yields) by six basis points last week, and most coupons outperformed Treasuries on a duration-adjusted basis. (This is not a complex concept, but does require some explaining. If the duration of a 10-year Treasury is 8 and the duration of an MBS is 4, the price change of the MBS should be half as much as the Treasury—i.e., if the Treasury rises by 8/32s, the MBS should increase in price by 4/32s. If the MBS only rises 2/32s, it has underperformed the Treasury on a duration-adjusted or “duration-neutral” basis. The tricky part is that MBS durations are not constant, but are a function of the bonds’ note rate relative to market rates—negative convexity in action.)
The big news last week was the release of the Obama Administration’s comprehensive plan for regulatory overhaul. While the proposal’s final form remains to be seen (and will be subject to the vagaries of the legislative process), there is clearly broad support for revamping and modernizing the rules governing the national and international financial system.
I’m still in the process of digesting the proposal, since the original document runs 88 pages; it can be accessed on the home page of www.fixedincomecolor.com. There are things to like and dislike about the proposal. For this audience, the most germane part is the proposal for a Consumer Finance Protection Agency (CFPA). The CFPA will have the authority to regulate both product offerings and the providers of consumer products and services. Most observers expect this proposal to generate fierce opposition from the industry. My personal hope is that the guidance offered for mortgage products reflects the fact that lenders and consumers both have a degree of culpability for the financial crisis. In that case, regulators need to specify what lenders and brokers can offer in terms of products, and dictate specific underwriting guidelines (which will need to balance the need for careful underwriting with fair and equal access to credit). At the same time, the regulators should specify that borrowers making inaccurate, incomplete, or misleading statements (or providing inaccurate data as part of a loan application) are committing a form of financial fraud.
One other positive outgrowth of the CFPA will hopefully be the avoidance of ad-hoc “solutions” foisted on the market without legislative oversight. I particularly have the Home Valuation Code of Conduct (HVCC) in mind. This construct was created by the NY Attorney General with the help of the supine GSEs. It has hurt appraisers, lenders, and borrowers while unfairly targeting loan brokers.
In my view, HVCC is the solution to a fairly minor problem. I don’t think it’s credible to argue that bad appraisals had nearly the same degree of impact on the market as items such no-doc speculative lending, rating agency failures, and unhedged credit-default swap exposure. This is the kind of “solution” that the CFPA will hopefully be able to avoid.
Finally, I’d recommend that involved in mortgage finance read a recent article in the New York Times entitled “My Personal Credit Crisis.” The article was written a Times economic reporter named Edmund Andrews, and details his experience with alt-A loan products. It outlines how he was able to “play” the system in order to obtain a loan for a home he had no prayer of affording (once he took his alimony payments into account); when he got into financial trouble, he engaged in increasingly dubious and foolish practices. (The NY Times article can be accessed here.
There has been a lot of back-and-forth on the internet related to criticism of Andrews and his decisions. More than a voyeuristic look into the financial foibles of an economics reporter (for the NY Times, no less), the article’s value is in giving a sense of how easy it was for a borrower to move from “fudging” information on his application to engaging in practices which, by the above definition, were fraudulent. The article (and forthcoming book) gives a very good perspective on how both seemingly intelligent borrowers and competent lenders could delude themselves into making what were, in retrospect, a series of disastrous decisions.
Bill Berliner is a mortgage and capital-markets consultant based in Southern California. His web site is www.berlinerconsulting.net.