A recent report in the St. Paul MN Pioneer Press discusses the mortgage industry in great detail. Specific focus is spent on the impact of various issues to the rising rate of foreclosure.

Foreclosure: the buck stops where?
The U.S. mortgage industry allows many actors down the mortgage chain to off-load much of the risk of defaults and foreclosures, insulating them from damage - so far.

When a home goes into foreclosure, homeowners aren't the only ones who lose. Each foreclosure costs the mortgage industry about $59,000, according to a recent estimate. That's a sizable chunk of change, about the cost of a midsize BMW or a year at Harvard Medical School.

But it's not breaking the bank. In the hugely profitable U.S. mortgage industry, where loan pools are measured in tens or hundreds of millions, $59,000 is a nick. Rising foreclosures around the Twin Cities may be slamming particular neighborhoods and rattling others, but the impact of those foreclosures on the folks who made the loans or who now hold them is negligible - so far.

Why that's the case goes to the heart of the workings of the U.S. mortgage industry, which allows many actors down the mortgage chain to off-load much of the risk of defaults and foreclosures, insulating them from damage. How bad would the national wave of foreclosures have to get before bond investors and other players down the chain feel real financial pain?

"I think we're about to find out," said Allen Fishbein, director of housing policy for the Consumer Federation of America.

HANDING OFF RISK

The transferring of risk starts almost as soon as a mortgage is written. Say a mortgage broker arranges a loan for a homebuyer. The lender might be a community bank or a national mortgage giant like Countrywide Financial. The broker probably pockets a commission of 1 percent of the total loan, or $2,000 on a loan of $200,000. Then the broker moves on to the next customer. The lender usually moves on too, selling the home loan to a bigger lender or mortgage-buying giant such as Fannie Mae, perhaps as soon as the ink dries at closing.

Lake Elmo State Bank, for example, sells nearly all the mortgages it makes on the secondary market, generating more cash to lend. The bank keeps only a few short-term mortgages on its books. It has no foreclosures, said bank chairman Don Raleigh.

Many lenders sell the loans but retain servicing rights, as Wells Fargo & Co. does. That means the homeowner writes Wells Fargo the monthly check and Wells Fargo will be the one calling if it's late even though it no longer owns the loan. Servicers typically make about 0.25 percent a year on the total amount owed on a prime mortgage or about $250 a year on a loan of $100,000, according to Grant Bailey, a director in rating agency Fitch Inc.'s residential mortgage group.

Most likely the loan itself ends up bundled with many other mortgages that are sold to companies that "resell" them to investors as mortgage-backed securities - basically IOUs backed by mortgages. About 60 percent of all outstanding residential mortgage debt is securitized. Loan bundles typically run in the tens of millions to hundreds of millions of dollars.

Ultimately, the buck stops here. A home loan first made in Eagan is likely parked in a bundle in one of the big companies issuing securities. If the loan goes belly up, either these companies who actually hold the loan, or the investors who bet on their securities, take the biggest hit.

Fannie Mae and Freddie Mac, the government-created mortgage giants, are big securitizers. But they have increasing competition from the so-called "private label" issuers, which include major lenders themselves such as Wells Fargo and Washington Mutual, as well as Wall Street investment banks such as JP Morgan Chase and Lehman Brothers.

The ability to distribute risk is the beauty of securitization, said Michael Decker, senior vice president for research and policy at the Bond Market Association.

"It's a way to parse risk and price it distinctly and sell the riskier parts to investors that want to bear the risk and potentially see higher returns," Decker said.

Investor demand for mortgage-backed securities remains hot despite the housing slowdown. After all, the IOUs have long offered higher payments than U.S. Treasuries and, since most are AAA rated, frequently are safer bets than corporate bonds.

The market for these investments is immense. There is now roughly $6.1 trillion of securitized residential mortgage debt outstanding - that's more than everything invested in the U.S. Treasury market. The investors include mutual funds, hedge funds, state and local pension funds, foreign banks (which hold about 11 percent of all mortgage-backed securities issued, according to one government estimate) and domestic banks such as Bank of America and Wachovia.

Fannie Mae and Freddie Mac shoulder more risk than private-label issuers, because they guarantee the securities they issue (the U.S. government does not back them). So when a mortgage in a Fannie Mae loan pool goes into foreclosure, Fannie Mae pays it off and prepays the bond investors.

Most of the private-label securitizers, such as the Wall Street investment banks, don't guarantee securities that way, according to the New York-based Bond Market Association. If mortgages go bad in a JP Morgan pool they crimp payments to bond investors.

Investors select the level of risk they want to bear. Mortgage-backed securities are typically sliced and diced into classes, called tranches, each carrying a credit rating from AAA to BBB- (one step above junk). Investors in the riskier lower classes get hit first if foreclosures rise, while investors in the senior classes are well insulated. Some securities are insured; some aren't.

To be sure, a loan servicer loses a valuable payment stream if a loan goes bad. And mortgage insurers feel the pain of foreclosures. But only about 35 percent of home loans are insured, either by the government or private insurance. And private insurance covers only about 20 to 30 percent of the loan's total.

LACK OF ACCOUNTABILITY?

The revved-up U.S. mortgage machine has been great for spinning off capital to make more loans to more people. Many consumers, particularly those with weaker credit, have gotten a crack at homeownership they might not otherwise have had.

But critics say the lack of direct accountability in the current system is contributing to a rise in foreclosures.

With little downside to lenders, standards got loose, and the surge of capital into the mortgage market fueled the aggressive marketing of high-risk mortgages to some vulnerable homeowners.

Mike Calhoun, president of the Center for Responsible Lending in Durham, N.C., argues the system has been close to a disaster for many consumers because they don't have the safeguards financial companies do.

No one has as much skin in the game as a homeowner. Homebuyers can't offload or dilute their risk when they take on a big mortgage. They don't have the same mathematical models that servicers, lenders and bond buyers do for gauging tolerable risks and protecting themselves. Bond investors may lose an income stream, but homeowners lose the roof over their head, neighborhood connections and, probably, their most significant financial investment. If that weren't enough, the word "foreclosed" will remain stamped on their damaged credit report for seven years.

"That's got to be more severe than an out-of-pocket financial loss for whoever the end party is," says Fishbein, of the Consumer Federation.

CRACKS APPEARING

For the industry, foreclosures haven't really turned painful yet. Foreclosures aren't swamping boats, although the swelling wave of adjustable-rate mortgages whose interest rates are resetting is under scrutiny. That wave is predicted to crest next year, when nearly $700 billion worth of adjustable rate mortgages will reset, causing monthly payments to jump, to the shock of some borrowers.

At Calabasas, Calif.-based Countrywide Financial, a mortgage giant servicing a portfolio of 7.9 million loans, the shocks haven't registered yet.

As of September, 4.5 percent of those were delinquent and just 0.52 percent were pending foreclosure. That's up from a year earlier when 4.03 percent were delinquent and 0.42 percent were pending foreclosure - but the increase really hasn't registered, a spokeswoman said.

But nationally, cracks are appearing. Foreclosures are clearly rising as more and more borrowers with subprime loans fall behind on payments.

Last month there were 63 percent more properties in some stage of foreclosure than one year ago, according to online foreclosure tracking service RealtyTrac in Irvine, Calif.

Most of the trouble so far has been in subprime loans to people with weaker credit histories. Nationally, the share of subprime loans at least 30 days past due rose to 11.63 percent in the second quarter, up from 10.41 percent a year earlier, according to the Mortgage Bankers Association's national delinquency survey.

More mortgage securitizers are yanking loans that went delinquent fast out of loan pools and shipping them right back to the lenders.

Lenders, meanwhile, have been beefing up reserves to handle buying back defective loans. Kansas City, Mo.-based H&R Block Inc. took a special pretax hit of $102.1 million in its most recent quarter because its mortgage unit, Option One Mortgage, had to repurchase loans.

Credit rating agencies are taking notice. Fitch Inc. in New York just started requiring bigger credit enhancements on securitized loan pools, such as shaving off more of the total dollar value to balance out greater expected losses.

"Mortgage performance is certainly deteriorating," said Fitch's Bailey. "The biggest challenges are probably still ahead of us."

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