(Article changed on July 29, 2013 at 22:58)
(Article changed on July 29, 2013 at 22:50)
Much of the brouhaha concerning the fate of the Federal Housing Administration can be traced to the actions of one dishonest man, a crackpot who is treated with utmost deference by the current Chair of the House Financial Services Committee and by friends in the media.
Genesis of the Disinformation Campaign
As recently as last September, the House was capable of passing a piece of legislation, known as the FHA Emergency Fiscal Solvency Act of 2012, with a lopsided bipartisan vote of 402 to 7. The Senate version of the bill, sponsored by Pat Toomey, was co-sponsored by Richard Burr, Kay Hagan and Mark Warner. It seemed likely to pass in the Senate as well, until December 13, 2012, one day after The New York Times published a favorable story on the crackpot research of Edward Pinto of the American Enterprise Institute. On that date, the bill was sent back to Committee to die.
According to two knowledgeable sources, neither of whom are Democrats, Pinto was lobbying in the Senate to kill the bill, and he persuaded Sen. David Vitter and two other GOP senators to do just that.
Whether or not he had a hand in killing the legislation, one fact is indisputable. The only reason why anyone pays attention to Pinto's disinformation campaign is because last year's bipartisan bill died. And the only reason why anyone would take Pinto's work seriously is if that person were ignorant of the subject matter, or shared Pinto's contempt for the truth. His campaign went into overdrive on November 16, 2012, the day HUD released the latest annual actuarial study of FHA's mortgage insurance portfolio. Right away, Pinto reveals his duplicity.
A Profound Misunderstanding of an NPV
FHA's annual actuarial study is primarily a net present value calculation, prepared by an outside consultant, of the insurance in place as of July of the current year. The NPV, the 2012 portfolio had an NPV of negative $13.5 billion, a considerable downward slide from the 2011 portfolio, which was valued at $1.19 billion. The primary reasons for the slide were traceable to revised assumptions, which pertain to cash flows extending more than 30 years, and to a different methodology for calculating the NPV, used by a newly hired consultant.
The NPV number refers to a static portfolio in liquidation, as opposed to the economic value of an ongoing enterprise. Pinto demonstrates an inability to differentiate between the two concepts, which is a pretty big deal. Because, notwithstanding all the controversy surrounding the mortgage crisis, there remains one universally accepted truism: If you don't understand the difference between a static loan portfolio and an ongoing lending enterprise, you don't know WTF you are talking about.
So, upfront, excuse me for belaboring some obvious points, which seem to escape Pinto. An NPV is a way to count your chickens before they hatch; it involves a number of forward-looking assumptions. As any kid who ever took a course in finance knows, if you tweak the assumptions, you can change the NPV dramatically. Similarly, there are different methods for calculating an NPV. Change the method, and you change the outcome.
(Many, including myself, would take issue with the consultant's change from a stochastic analysis to a Monte Carlo simulation for 30-year projections, but that's beyond the scope of this piece.)
Also, given the way that discounted cash flows work, changes that occur sooner in time have a bigger impact than changes that occur further out in the future. So, when loans perform better or worse than expected in the first year, the updated NPV of the same portfolio can change dramatically.
I know, you're thinking, "Duh." But lot's of people miss this point, which is the dirty little secret of credit ratings for private label mortgage-backed securitizations. A synonym for NPV is "credit enhancement," which, for the rating agencies, represents the margin for error, or safety cushion. Credit ratings are supposed to be stable over time, whereas NPVs for RMBS can be wiped out very quickly.
Static Loan Portfolios Versus Ongoing Enterprises
The NPV of any static loan portfolio is an estimate the projected future income from performing loans, used to offset the projected future credit losses from defaulting loans. In FHA's case, the static pool consists of insurance policies on mortgages, but the same concept still applies. If loans in a static portfolio prepay at a faster-than-expected rate, that shortfall in income is lost forever. The NPV goes down and the balance between good loans and bad loans irrevocably shifts for the worse. This is one of the key risks assumed by investors in any private label residential mortgage backed securitization.
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