Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

19 September 2008

A Real Solution to Our Mortgage Crisis


[For a more recent post on solutions to the foreclosure crisis, with attention to legal mechanisms, click here.]

Introduction
How Big is Our Crisis?
Three Levels of Crisis
Three Domino Effects
Why a New RTC Won’t Work
A Real Solution
What this Solution Would Do
Conclusion
P.S. and Update (9/21/08)

Introduction

Like generals, financial experts often want to fight the last war. That’s why many are recommending something like the Resolution Trust Corp. (RTC) of the 1980s.

The RTC was the killer solution to our last big financial crisis: the savings-and-loan meltdown. It was a government-funded entity charged with buying up bad paper from struggling S & Ls, saving those that could be saved, and stabilizing financial markets. It worked well for that crisis, although it cost the taxpayers lots of money.

We don’t yet know how much our mortgage-and-derivatives meltdown ultimately will cost. It’s likely to cost at least twice what the S & L crisis did. Yet if we were sure we could solve the problem, even that kind of money might be well spent.

The problem is we can’t be sure. Our current crisis affects three distinct levels of our financial system, while the S & L crisis affected only one. It also creates domino effects at all three levels. This essay explains why the two crises are different, why the RTC solution won’t work, and why a more people-friendly (and far less costly) solution probably will.

How Big is Our Crisis?

As it ultimately turned out, we solved the S & L crisis for what today would be a pittance. It cost us about $160 billion over a period of ten years. The taxpayers footed $124 billion. Today we spend more than that on foreign oil in five months.

Several months ago, I estimated the size of our mortgage crisis as about the same amount. My calculation was simple and transparent. I took the estimated number of homeowners facing possible foreclosure (2 million). Then I multiplied that number by a rough estimate of the mean home price ($200,000), and by the predicted maximum loss in value of a typical home, namely 30% (the worst-case depreciation that economists then predicted). The result was $120 billion.

My numbers were rough, and they may have been understated. About 2 million homes are in or under threat of foreclosure now. There may be more as the crisis continues. The current median home price is about $231,000, and the mean is higher. We may have to increase that value by as much as 50% because many homes in now foreclosure are in more expensive markets like California and Florida. And we might have to increase the estimated loss in value by 50% (for total depreciation of 45%, almost half!). But even if we do all that, the product rises to just $310.5 billion.

Our federal government’s bailouts so far total more than that [subscription required]. We taxpayers have pledged up to $200 billion investment in Fannie Mae and Freddie Mac. We’ve bought 80% of AIG for $85 billion. And our own Fed, together with foreign central banks, has given international money markets a transfusion of $180 billion. The total of these bailouts is $465 billion—about 50% more than my conservative (higher) estimate of the problem.

So we’ve thrown 50% more money at the problem than the problem is worth. And that’s even before today’s announcement by Treasury Secretary Paulson that our government intends to provide federal insurance for money-market accounts, at a cost now completely unknown. After throwing all this money and expensive insurance at the problem, we should have solved it, right?

Wrong, for two reasons. First, even my higher number may be an underestimate. The financial press has published estimates of the mortgage crisis’ magnitude as high as the mid-$600 billion range—about twice my estimate. Since it didn’t disclose unnamed experts’ reasoning, I have no idea how their calculations differed from my simple estimates. Likely they had better raw data than I. They also may have considered the ripple effect of foreclosures on the rest of the economy.

The second reason is much more important, and it relates to those ripple effects. We can’t solve our current crisis by throwing money at financial institutions because that’s not where the crisis starts. It starts at the homeowner level. As loans go bad and people lose their homes, home values plummet and neighborhoods fall apart. Then the loans become further devalued, and the cycle begins again. If we let this vicious cycle go on much longer, no one can tell where it might end. We have to act quickly.

After the 1929 stock market crash, stocks eventually fell to about ten percent of their peak values, for a loss of about 90%. They took three years to reach their lows. If anything like that happens to even a fraction of our national housing market, we can kiss our economy goodbye.

Few expect house prices to fall that low, but no one knows how far they might fall. The longer we temporize, the harder the problem gets to solve.

That’s why Secretary Paulson also announced plans today for the federal government to buy up distressed mortgages. Vague as they still are, those plans are a step forward. They recognize that the mortgage crisis is the root of all the others and that nothing will be solved until it is.

But having the government buy up bad mortgages is too expensive, unfair to taxpayers, and unnecessary. There’s an easier, better and cheaper solution. Read on.


Three Levels of Crisis

The S & L crisis of the 1980s was a very different animal. Deregulation had allowed commercial banks and other financial institutions to enter financial territory (home loans) on which S & Ls had previously had a monopoly. The S & Ls tried to compete by raising the interest rates they paid depositors (to attract more money to lend) and lowering the rates they charged for home loans (to attract more borrowers to lend it to).

When you pay out more and take in less, your profit goes down. Eventually you incur losses. Apparently many savings-and-loan executives had trouble figuring that out. Or, like lemmings, they all followed the first idiot over the cliff. Whatever the reason, their “spreads” (between interest received on loans and interest paid on deposits) became negative (after their operating costs were figured in), and a whole bunch of them went belly up.

That was the entire crisis. There was nothing wrong with the underlying loans. In fact, the homeowners had gotten bargain rates because the S & Ls had priced their loans too low. So the RTC simply closed down the insolvent S & Ls, bought up their good loans, sold the loans at appropriate prices (often at a writedown) to healthy institutions, and paid the difference out of us taxpayers’ pockets. Problem solved.

The S & L crisis was simple because it had only one level: bad business decisions at the S & Ls themselves. What’s different about the current crisis is the underlying loans. They are bad because unscrupulous, unregulated mortgage lenders sold overpriced loans to people who couldn’t afford to pay them back. Worse yet, the lenders made so many of these bad loans that they helped create a housing “bubble,” inflating the prices of homes far beyond anything that economic fundamentals could justify.

As the housing bubble inflated, the principal amounts of mortgage loans rose with the prices of houses. When the bubble burst and the whole system collapsed, the lenders couldn’t recover the principal amount of their loans because the borrowers couldn’t pay, and the collateral (the homes) had fallen in value. Many lenders also had required no or only a small down payment, so they had no “cushion” against market-value declines.

The lenders (mostly unregulated mortgage brokers) didn’t care about any of this because they had already sold the loans to Wall Street, which packaged them in bundles known as “mortgage-backed securities.” Investors in those securities didn’t care about the risk of lending to people with little or no ability to repay because they insured against that risk by buying a “financial derivative” known as a “credit-default swap.” The ones left holding the bag were the issuers of these credit-default swaps, one of which was a subsidiary of AIG.

Why didn’t these insurance geniuses analyze the risk involved in the paper they were insuring (the mortgage-backed securities and their underlying mortgages)? Remember the S & L lemmings? When something sounds to good to be true, but enough people in a particular business believe it—and when they all talk to each other in a big echo chamber—the temptation to get something for nothing becomes too hard to resist. Even AIG, once one of the best-run insurance companies on the planet, bit hard and got sick.

So now, instead of one level of crisis (the S & Ls), we have three. We’ve got millions of homeowners who can’t afford to pay their loans and stay in their homes. We’ve got an unknown number of big firms on Wall Street left holding bags full of bad mortgage-backed securities based on bad loans. And we’ve got issuers of credit-default swaps like AIG’s subsidiary, left holding the ultimate bag of obligations to make good on all the losses, but without the capital to do so.

Three Domino Effects

Not only do we have three levels of crisis. We also have three domino effects.

The first domino effect occurs in Main Street, in neighborhoods with lots of bad home loans. As homes in the neighborhood go into foreclosure, the market value of all the homes there drops, including ones not in foreclosure. If foreclosed homes stay empty—as they often do in hard-hit neighborhoods—home values drop even faster. Ditto if so many homes become empty that crime, neglect and blight further tarnish the neighborhood.

The second domino effect occurs on Wall Street and in international financial markets, where the mortgage-backed securities come to roost. Buying and selling bad assets is not rocket science. It happens every day. Our marvelously diverse business community has people who specialize in buying and selling virtually every kind of bad asset.

But no one can buy or sell something whose value is utterly uncertain. That’s the case with the mortgage-backed securities. No one knows they’re worth because their worth depends on the value of the underlying loans. That value in turn depends upon the value of the collateral—the homes—because the borrowers can’t repay the loans (otherwise they wouldn’t be in foreclosure). But no one knows how much the homes are worth because their values are still falling, due both to declining general economic conditions and to the first domino effect—the chain reactions of foreclosures in many neighborhoods.

The final domino effect begins with the credit-default swaps. Because these financial instruments were completely unregulated, no one knows how many there are, what their aggregate value is, and who issued them. If companies like AIG issued them, then forcing them to pay up could hurt businesses as far afield from mortgage lending as car and life insurance. Who knows? A payup might even affect manufacturing firms, which may have used the swaps for hedging or other sophisticated financial strategies. This is the third and final potential domino effect, whose nature and magnitude are totally unknown.

Why a New RTC Won’t Work

At this point, it should be clear why a new RTC won’t work. The old RTC could collect and sell the loans held by insolvent S & L’s because those loans were good loans, and there was no crisis in the housing market. The interest rates were known and fixed, and virtually all of the borrowers could pay the loans. Even if they couldn’t, the prudent lending practices of that time required large enough down payments to protect lenders: the value of the home, plus the homeowner’s down payment, was almost always more than the outstanding balance on the loan.

This crisis is different in two respects. First, the loans at issue are not good; they’re bad. Most of them are “under water,” i.e., the value of the home used as collateral is less than the outstanding balance on the loan, and there is no or just a small down payment—too small to make up the difference. Second, since home values are in free fall, lenders and mortgage securitizers can’t even guess what the loans and the securities that bundle them are worth. Everything is uncertain, so nothing can be bought or sold.

Under these circumstances, neither the government nor anyone else can solve the problem by buying bad assets and selling them to willing buyers. There are no willing buyers because no one knows what the assets are worth until the values of the homes ultimately securing them stop falling. You can build an RTC-like entity; but if you build it, they won’t come.

A Real Solution

Any real solution to this crisis requires understanding and dealing with the housing bubble and its bursting. That’s the origin of the crisis. That’s where all the domino effects begin.

The housing bubble had two sources. The first was increasing general affluence and general irrational exuberance. No one should be held responsible for those general economic effects because no one’s identifiably bad business decisions caused them.

But bad business decisions by people who should have known better—mortgage lenders, mortgage securities bundlers, and credit-default swap issuers—contributed to the bubble. They probably caused the lion’s share of the problem. Suppose we could retroactively reverse those bad decisions and correct at least that part of the mortgage meltdown. Here’s how we might do just that:

Step 1. Declare a moratorium on foreclosures, including ones now in progress, for as long as the following steps take (rough estimate: six months to a year). Allow every homeowner (single or couple) who still holds the same jobs they held on taking their home loan to participate in the moratorium. Give already-evicted homeowners the option of returning to their homes, if still unsold and empty. (Those who lost or will lose their jobs due to general economic conditions would be out of luck. We don’t want to put people back in homes who can’t pay anything at all.)

Step 2. Forget about the home’s value, as no one knows what it is. Allow the homeowners to resume residence—and payments—as if the lender had made a prudent loan to begin with. Before the subprime madness began, standard lending practice limited monthly mortgage payments to one-third of the borrower’s take-home pay. It also required a 10% down payment. So allow homeowners subject to foreclosure to get back in theirs homes by agreeing to make payments of one-third of their take-home pay from the same jobs that they held when they took the loans.

Step 3. Calculate the home’s present value based on the discounted sum of thirty years of those payments using the current interest rate for thirty-year loans in the private market. Then increase that value by ten percent (for the presumed down payment that a prudent lender would have required). If the homeowner sells the home at a price higher than this calculated value, let the lender keep the excess (up to the down payment) off the top. Then let borrower and lender split any additional appreciation fifty-fifty.

Step 4. Continue with Steps 1 through 3 until the foreclosure rate subsides to the “background” rate in effect before the mortgage meltdown, say in 2005.

Step 5. Set up a temporary, emergency system of local federal courts to resolve disputes over the only two variables that might be in dispute: (1) whether the borrowers still hold the same jobs as they did when the loan was made and (2) the current salaries in those jobs.

What this Solution Would Do

This solution would do a number of things. First, it would immediately halt further deterioration of neighborhoods resulting from the mortgage crisis (although not decay resulting from a general economic downturn). Second, it would keep people now under (or threatened with) foreclosure in their homes. Third, it would allow some people evicted after foreclosure to return to their homes (if still empty) and to help restore their neighborhoods and the values of homes in them. Fourth, it would give lenders the very same income stream from the loan that they would have if they had lent prudently, updated to reflect borrowers’ current income. Fifth, upon sale of the home at a profit, it would give the lender the benefit of a presumed ten percent down payment, even though the lender had been too imprudent to require it. Finally, it would help reduce the lender’s ultimate loss by giving the lender an additional 50% share of any profit on sale above this presumed down payment.

Most of all, this sort of solution would solve the present financial crisis by removing the uncertainty in asset values. By prescribing a precise level of payments and terms, it would give each loan a precise economic value, depending only on the prevailing mortgage interest rate and the borrowers’ current income. By giving each loan a precise value, it would give each mortgage-backed security a precise value. Holders of those securities could calculate what they’re worth, with no more uncertainty than mortgage lenders face every day (e.g., the risk that a borrower would lose a job or suffer some other unforeseen setback).

Lenders would know what their loans are worth. Holders of mortgage-backed securities would know what their securities are worth. And issuers of credit-default swaps would know precisely what their obligations are. Financial markets could function again. The logjam of mortgage-backed securities and derivatives could clear without further federal intervention. Best of all, this solution would require no further taxpayer subsidies at all.

Conclusion

This solution works because it recognizes the origin and essential nature of our crisis. It is first and foremost a mortgage crisis. It begins and has its worst effects in our consumer housing market.

As the last few weeks have shown, we can get along without the likes of Bear, Stearns and Lehman Brothers. We can’t get along without a robust and smoothly functioning housing market, let alone if housing prices drop 90%, as stocks did in the Great Depression. Fixing Main Street is far more important to our people and our economy than fixing Wall Street. We’ve got to do it as quickly as possible, before we risk further unintended consequences like the untimely demise of another AIG.

With his superb understanding of economics, Barack Obama recognizes these points. Already he has proposed a solution similar to this one, in which stressed homeowners could modify their bad loans by filing for bankruptcy and putting judges to work. Obama knows that saving Main Street is the best, fairest and least expensive way to save Wall Street.

But the plan proposed here has decisive advantages over the bankruptcy-based plan. The first and most important is speed. If we are to save Main Street and our economy, we have to stop the financial destruction of our neighborhoods and stabilize home prices as quickly as possible. Individual bankruptcy is a slow process that can take years. By the time millions of bankruptcy proceedings have run their course, it may be too late.

The simple principle proposed here—giving defaulting homeowners the loans they would have had had their lenders been prudent—provides that speed. It involves only two variables for a court or anyone else to determine: the homeowners’ income when the loan is reconfigured and whether the homeowners still have the same jobs. In nearly all cases, the homeowners will have the best evidence: pay stubs or letters from employers. The lender or loan servicer will have to accept that evidence unless it has contrary evidence available in its files or on the Internet. Hiring a private detective for each loan simply won’t be cost effective. So even if these issues go to court, a good, well-trained temporary emergency judge ought to be able to resolve them in minutes or hours, not even days.

As for moral hazard, you can argue that the homeowner will suffer less. He or she will get the loan that should have been made by a prudent lender and will pay less. In some cases the calculated value of the loan, based on the new level payments, will be less than the market value of the house, so this plan will miraculously pull the homeowner out from under water, leaving the lender short.

But none of this will happen unless and until the plan achieves its larger economic goal of stabilizing the housing market. And on sale the homeowner will have to share any appreciation above the loan value with the lender, to the tune of a presumed (fictitious) 10% down payment and half of any excess. The lender or servicer would also gain by avoiding the expense of carrying costs (for an unknown period) and the legal and administrative expenses of foreclosure.

So borrower and lender both would gain a lot, perhaps more than each deserves. As between the two, who deserves more indulgence, a borrower who didn’t understand what he or she was signing, or a lender who should have? And if anyone is worried about speculation and a quick turnaround of properties financed by these new loans, they could be written to impose a steep financial penalty on the borrower for any quick sale (such as one in less than five years), except in hardship cases.

We are on the brink of a financial and social precipice. The only way to fix our crisis is to stabilize the housing market as quickly as possible. The best way to do that is to put people who still have their jobs back in their homes, with mortgages they can pay, as quickly as possible. This plan can do that.

Our labor movement saved our nation from Communism by putting workers first. FDR’s public-works programs fought the Great Depression by giving ordinary people honest work. Lest we forget, a “bank holiday” was part of the way he avoided another crash in 1933. That’s not much different than a foreclosure moratorium.

Just so, we can solve our mortgage meltdown cum financial crisis by putting people first. All it takes is understanding the real secret of America: take care of Main Street, and Wall Street will take care of itself.

P.S. and Update (9/21/08)


Yesterday Treasury Secretary Paulson and Fed Chief Bernanke announced a plan for a $700 billion fund to buy up distressed mortgage loans. Congress and the rest of the executive branch undoubtedly will approve it, and quickly, because they have no other ideas and know how dangerous temporizing would be. When ideology and all else fails, and just before the train wreck, we rely on the experts.

The proposed $700 billion bailout fund could dovetail nicely with the more specific proposal made above. The secret is price.

Bad mortgage loans have clogged up our financial system because they have utterly uncertain value. As yet, no one has determined at what price the bailout fund will buy them. But suppose the fund publicly set its buyup price at the value the bad loans would have had if lenders had observed prudent lending practices, as suggested above.

Then the Calculated Value of each loan, as proposed above, would be thirty years of level payments equal to one-third the borrower’s take-home pay (at the time the bailout fund purchased the loan), computed at the prevailing free-market mortgage interest rate at the time of the loan buyup. That Calculated Value would be a floor for the actual value, because there would be some chance of recouping, on any future sale of the home, the additional 10% presumed down payment, as well as sharing any additional appreciation.

Here’s how this plan might work. The bailout fund would require, as a condition of purchase, that the loan’s holder or servicer renegotiate it with the borrower under the suggested terms. The fund would then promise to buy the loan at the Calculated Value as soon as renegotiated. The bailout fund could draft and provide standard forms to speed renegotiation. The only variables would be the level payment, based on the borrower’s current take-home pay, and the current free-market mortgage interest rate.

Once the loan had been renegotiated and the borrower was living in the home and making sustainable payments, the loan would be worth more than the bailout fund’s offered price. So likely private buyers would step in and buy it, seeking to capture the additional value. In this way, the fund might start a robust private market without spending much money, while encouraging (but not coercing) loan holders and servicers to renegotiate the loans under sustainable terms and stop the destruction of Main Street.

The details suggested above are just one possible variant. They are not particularly important. The important points are to establish floor prices for loans based on rough justice: a calculated buyup price that the loan would have had if prudently made. Then that value can serve as the basis for actual renegotiation of the loan, giving the loan a real floor value. If the renegotiated loan includes a potential upside for the lender, such as the presumed down payment or appreciation-sharing proposed, the chance of capturing that upside would motivate an independent private market to form.

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