Reaction to the Recent Subprime Market Rate Freeze:
The housing market is generally David's corner, but I thought this article on the reaction to the recent agreement to freeze certain subprime loan interest rates was worth pointing out. An excerpt:
Politicians need to appeal not only to people at risk of losing their homes but also to those such as Ben Sullivan, who sees the agreement as a undeserved bailout. After the 2001 technology stock bust, many people lost significant value in their retirement plans, Sullivan said. "No one was offering to pay for their 401(k) losses. Why should they do it for their housing losses?" said the 28-year-old commercial banker.
Sullivan lived in the District for years and watched as his friends flipped condominiums and investment properties. "I think we shouldn't be bailing out the homeowners that got greedy buying homes they couldn't afford," said Sullivan, who moved to Atlanta nine months ago.
Understatement of the week. :)
Found out that the issue was farmers had bought land with as little collateral beyond the land as was possible. Once the value dropped, the collateral was less than the loan.
So we were doing benefits for land speculators. No wonder it was difficult to find out what was really happening. I've been suspicious of such subjects ever since.
My son has a friend who needed to move. Turned out his best likely sale price was about $100k less than he owed. So he walked away. Foreclosure. Problem was he had re-fied and re-fied until the thing squeaked and his collateral was practically invisible. Bad idea meets bad timing.
Not the same as a catastrophe for the usual folks doing the usual thing in the usual way.
In short, what the government proposes is to take money from some people (the investors) and give it to others (the defaulting borrowers). It's worse than a regular bailout because it doesn't even use the government's money. It just seizes the expected return from the investors.
I have serious doubts whether this plan could work even on its own terms. First, it's so narrowly targeted that it won't help many people. (And that's leaving aside the inherent unfairness of subsidizing those who would default but not those who, by carefully scrimping, would pay their bills on time.) Second, investors may well be able to bring suit in foreign jurisdictions where legislated immunity would have no effect. Third (and this is something I haven't seen mentioned in any of the news reports or blog discussions), isn't there a big contract clause issue here? The government would be acting indirectly (by immunizing the sellers of the mortgage securities) rather than directly (by changing the terms of contracts), but surely it can't be that easy to evade the contracts clause, can it?
The proposed five year freeze is repeatedly noted as: voluntary; not a government bailout; and industry sponsored.
My own view is that the proposed agreement, if implemented, would just extend the day of reckoning for subprime borrowers. Moreover, the agreement also creates a moral hazard: What prevents consumers whose interest payments are lowered by the freeze from buying other risky investments (during the five-year intervening period) with capital that could have been used to pay down their mortgage.
Isn’t it possible (even plausible) that consumers who purchased risky mortgage instruments with the hope of making a quick buck might use increased capital (from the freeze) to engage in other risky investments?
Barney Frank (from the NYT), being sensible: “Talk about moral hazard,” remarked Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee. “We’ve all told people, don’t go any more deeply into debt. Now we’re saying that people who go more deeply into debt will have an advantage over people who don’t go more deeply into debt.”
An investment banker (from the NYT): “Why would anybody in his right financial mind agree to a five-year price freeze, especially when we’re staring in the face of possible inflation?” asked Roger W. Kirby, managing partner at Kirby McInerney, which has represented investors in class-action lawsuits over securities. “Mr. Paulson has overestimated the generosity of people on Wall Street.”
Because by freezing the interest rate and accepting less income you may avoid losing 40 percent of your initial investment?
Actually the agreement does little that some banks weren't already doing on their own.
It only hurts the downstream investors if they would get a greater return on their investments if the foreclosures were allowed to go forward. I don't know the answer to that. My big question about this has been, why do the banks need any gov't assistance if it makes economic sense for them to not raise the rates in the first place.
I wasn't aware of the lawsuit immunity. I'm not sure, but I don't think that's something that Bush can just do on his own. If the immunity is passed, then there might be a good impairment of contract argument, or perhaps even a takings argument. But I doubt those problems (if they are real problems) would stop Bush. I don't think that he's ever seen an immunity from suit that he didn't like.
How will investors in mortgaged backed securities be compensated during the five-year freeze?
Some mortgage issuers (Countrywide) have already asked for and received loans to cover defaults, from companies that have an interest in seeing Countrywide stay alfloat. Such issuers may have been less likely to solicit or need such support if the five year freeze had been proposed earlier.
Other companies – Goldman-Sachs comes to mind – anticipated the subprime problems, and purchased insurance against subprime defaults. Such firms should be rewarded for making prudent decisions and having a clearer crystal ball than other firms.
In the old days, you could just go to the building and loan and explain to George Bailey that pa came down with gumption and you can’t make this payment, can he or Uncle Billy let you slide?
In the old days, you could just go to the building and loan and explain to George Bailey that pa came down with gumption and you can’t make this payment, can he or Uncle Billy let you slide?
If those loans are frozen at their teaser rates, who takes the loss?
If it's the current owner of the note, how likely is it that said owner will buy paper (or make loans) in the future?
When did the Republicans stop believing in limited government?
But what on earth is the excuse of the people who made the loans and created all the paper. They must have known they were blowing smoke and the run up was unsustainable. I'm not all that sophisticated, yet I predicted exactly this occurring in 2004. Even Allen Greenspan bought into this bullshit and encouraged it.
Republicans stopped believing in limited government at least as far back as Nixon (who pretty much invented the idea of tying federally imposed restrictions to highway funding). But I think the idea could probably be traced back to Lincoln, who did a better job of expanding federal government than any President before him. What the Republicans stood for before Lincoln?
If the government here was acting basically as a mediator, and convinced the banks to do what was already in the banks interest, would that bother you?
NRWO: Its been a while since I've read any impairments cases, but my gut sense is that its pretty easy for the gov't to slide around an impairment issue. So, yes, if I recall correctly, it pretty much is that easy.
I'm surprised there has been so little mention of this issue by policymakers.
Well, maybe I'm not surprised.
Look at the lender's track record. They never see the bust coming. Remember the S&L bailouts. Pretty much the same wolf with slightly different sheep's clothing.
How? The lenders must have known the loans were unsustainable. Are you saying the lenders are worse at managing money and predicting the real estate market than me, a civil engineer with absolutely no background in finance? That is freaking scary.
When they got elected, silly.
The banks are in favor of the administration taking the lead on this because it gives them political cover to say to their investors (and impatient stockholders only interested in next quarter's numbers), "hey, it's not our fault, Bush did it."
Scary, but not surprising.
The problem is not with the "lenders", per se, it's with the individual loan officers (and brokers) that get paid up front on commission, and have performance bonuses written into their contracts. Bad loan? Who cares? They've already been paid. Five years down the line when the borrower defaults it'll be someone else's problem.
It appears that Goldman Sachs did see the bust coming.
Too easy to blame the loan officers and the brokers. They were not fronting the money for the loans. Supposedly sophisticated investors and bankers were buying and trading the paper that backs these loans (actually to make matters worse, a lot of the money to back the paper was actually borrowed itself). Apparently, it was like a game of hot potato, they just prayed they weren't caught holding it when the music stopped.
I remember well the mid- to late-1970's, when the S&L's were holding portfolio's of 30 year fixed rate loans at rates as low as 4.5-5%, all funded by short term deposit accounts, on which the S&L industry was federally limited to paying no more than 5.25%. While the real cost of funds, driven by out of control inflation, approached 18-20%, and newly marketed Money Market Funds, which were paying near the short term market rate, bled all of the funds out of Bank and S&L savings accounts, Congress could either sit back and watch the S&L Industry die from a lack of liquidity (a politically unpalatable option), or put the industry on life support by allowing it to borrow funds to support those 4.5% and 5% 30 year mortgage portfolios at nearer the market rate. Yes, the S&L Industry avoided death from illiquidity, but only at the cost of offering 19% and 20% CDs. Now it doesn't take a financial wizard to figure out that if you borrow money at 19%-20% to fund long term loans at 5%, you will be bleeding losses. Congress once again stepped in to tell the S&L's to "grow" out of their otherwise inevitable death spiral by making riskier high rate loans - 100% or even 110% loan-to-value, high-rate loans to businesses (an area that the S&Ls had no experience with), like tax-driven limited partnerships building apartment complexes and shopping centers and office buildings in Dallas, Houston, Atlanta, Phoenix, LA, etc., etc.; many of these projects had no real economic prospects, but were funded and built because the limited partners could get a 5-1 or higher ratio of tax deductions on their investments, the General Partners took big development fees out up front, while the S&L's took big origination fees out up front (most of which were funded from their own loans), and paid big bonuses to loan officers to keep finding &closing these deals.
Lo and behold, the Tax Reform Act of 1985 comes along, doing away with the tax benefits of the no-at-risk partnership deals, and reducing the benefits of the deductions that remained by lowering top marginal rates. Meanwhile, rents and occupancies start falling from all the new tax-driven deals built in 1980-1985, the bottom falls out of the real estate market, and all of the S&Ls which were insolvent in 1979 are now much MORE insolvent, and the FSLIC bailout now costs the Federal Government $85-90 BILLION. Amid all of the sniping by politicians and the media about the losses caused by the "S&L Bandits", the dishonest S&L operators who looted and pillaged (and there certainly were some of these), what was totally lost in all of the noise is that the vast majority of the losses were caused by the S&Ls doing PRECISELY what Congress told them to do, and it was all started by Congress deciding that it couldn't let an industry die when market forces had already killed it.
God save me from Government that wants to "help" a situation created by market forces and short-sighted business people and consumers. I'll bet a large sum that the cure offered by Government is much more costly than the problem would be if left to the mkarket to resolve.
So would I. What's the right financial instrument to do so? If enough of us make the same bet, we can all share in the rewards if it works out, and demand a bailout otherwise.
I could be wrong, but isn't an accrued cause of action a property right? And doesn't immunizing the sellers from suit constitute a taking? Obviously there would be a difference as to causes of action not yet accrued by the time the law went into place.
True, and it's not clear how the second can be addressed. The fact is that people in some parts of the country (not mine) had to go way out on a limb to finance the purchase of their homes. Turns out there is an exception to the rule that owning is always economically preferred to renting.
Who knew?
Me. I am waiting to buy a repo at bargain price. I was smart enough to not buy when the prices started becoming over inflated. Now that prices are due to start plummeting, the government steps in and says that I'm screwed because I made good decisions.
Anyone with a modicum of common sense. Anyone who bothered to look at the historical record of appreciation in residential real estate over the last fifty years and ask themselves "why are the last three years so different from the prior 47 that would justify houses to appreciate at seven times the rate of inflation rather than pretty much just a little bit more than the inflation rate?"
Actually, by letting people stay in their homes, you are being helped because it will cause an orderly decline rather than a wholesale crash. Even if you can buy a house at bargain basement prices, you hardly want to live on a street with abandoned, unkempt and unsaleable properties.
Well, if the government can claim it's maximizing tax receipts from the lenders by preventing business losses, wouldn't that satisfy Kelo? Or some such argument: the government will blow smoke and do what it wants to, as usual.
There isn't really much wisdom in the market, just a lot of short-term cleverness. Every so often we get reminded of the fact. Then we get reminded that there's even less wisdom in government....
I have not read that there is anything in the plan that gives immunity to anyone. The companies servicing the loans on behalf of investors generally have the power to vary the terms of the mortgage within some limits--waive defaults, etc.,--if they believe it is in the best interests of the investors. In this environment, a good argument can be made that waiving the rate increases for some period of time for some borrowers is in the best interest of the investors, who are at risk of lose a lot of principal and therefore within the power of the loan servicing companies under the terms of the servicing agreements. If that is the case, then there would be no liability to investors for granting a moratorium.
I don't mean to say that this is in the best long-term interest of the economy, the housing market, the loan markets, etc. That, of course, remains to be seen.
Are there really that many more houses than there are people who want to live in them? Even if they rent, almost all of the houses that are now occupied will continue to be occupied, except in a few areas such as Detroit with special problems.
-dk
I sometimes wonder if the fact that most people do not deal in cash at some point in their lives they don't quite understand that each purchase made actually diminishes what you have in your hand. I don't think that just viewing numbers on your bank statement is sufficient to bring this point home.
Another point, of the homes that I have bought and sold some were bought on a downturn and others on the uptick, my goal was to have a place to live and build some equity. The one time I sold on the downturn I still made a profit, not much, but I got a great deal on another home in a better neighborhood. I'm not an economist or a financial guy but my experience has been that the economy grows and then pulls back, you can make slow but steady gains. When you gamble playing cards you can make good money and you can lose it too, you need to be focused on the game and not the pot and you'll do fine.
Well, it depends what happens to the people who are foreclosed upon. A lot of them are going to be upside down in their homes (which has probably never happened to a significant degree in the history of modern mortgages in this country). That means that they are going to have a significant debt hanging over their head when they go into the rental market. Who is going to have the money to rent these houses at a rent that someone is going to make money at? Who is going to manage the properties? Remember the "owners" of the mortgage are actually a bunch of investors who now own a bunch of worthless paper. Ten years ago a bank would have held the entire mortgage on the entire house and would have an interest in selling the house. The house actually had a value to the bank as an asset. Who knows how many people actually "own" the house once it goes into foreclosure. The mortgage has been carved up and bundled with thousands of others. The minute part of the instrument that is represented by one portion of foreclosed house is inconsequential (it's like a hyper-time share where you have bought a one-hour a year time share).
The problem is some people who are more culpable (like the CEO of Merrill Lynch) and help create this risk still get $200 million for their incompetence, while foolish people who listened to Alan Greenspan and bought into the American Dream lose their homes and have their credit destroyed.
Was the Texas oil bust in the 80s outside "this country" or before "modern mortgages"?
The few fools that can take this plan just keep paying on a depreciating asset. Prices need to come way down into affordability levels and anything else is just interference with the market cleaning the mess up. All that get the plan will lose their homes eventually anyway and the security holder his cut. Delaying the inevitable will just extend the housing bust for these folks who would be better off renting for 1/3 the cost and saving money to buy a new house when prices fall.
This is what used to happen: banks [S&L's, etc.] would loan their own deposits, so they had a big interest in making sure the borrower could repay. They required a hefty cash down payment, typically 20%, and their underwriters verified income and debts, usually accompanied by a letter from their employer stating their income and continued employment prospects.
That responsible scenario went by the wayside when mortgages started being bundled, first by Michael Milken at KKR, then by just about everyone else. Responsible home lending went away almost completely when those bundled mortgages were split up into numerous tranches, with each tranche rated and re-sold separately.
Banks that had carefully loaned out their assets didn't have to be so careful any more. As soon as a mortgage was made, it could be immediately re-sold for the same funds, which could then be loaned out again. The lender got a servicing fee for each loan originated, so making numerous loans without having to put its deposits at risk was a no-brainer; an S&L could get up to three-eighths of a percent in annual servicing fees on each re-sold loan, for the life of the loan [that's why even if your mortgage is sold, you still pay the original lender]. So why take the risk? Just write lots of loans, service them for a fee and get rich practically risk-free.
Now the chickens are coming home to roost. But the bundled loans aren't the real problem. As stated by others above, markets routinely sort out this type of crisis in short order -- if the government simply keeps its nose out of diddling with business, and sticks to regulation.
This is what caused today's problem: mortgage brokers began issuing "no doc" loans. In other words, if someone claimed that they earned $150,000 a year and had few debts -- but they really made only $50,000 a year, and had a few high balance credit cards and a hefty car payment -- they could simply fill out and sign a "no verification" [no-doc] mortgage application. [That's known as *ahem* "fraud."]
However, the gravy train was rolling and lenders who felt they were losing out by not providing the same no-doc loans jumped aboard. Everyone here has heard their ads. They were almost soliciting fraud, because they were never at risk; they would just sell that loan, and do it again. Over and over. Those 3/8% service fees add up fast when you're making hundreds of millions of dollars worth of loans every year.
Here's where you and I come in. The folks who signed a fraudulent loan app are the specific ones who will be bailed out [and make no mistake -- it is a bailout]. Lots of borrowers [no doubt helped by their various agents turning a blind eye -- or even encouraging them, with a wink and a nod, to lie on their loan applications] have signed entirely fraudulent loan applications. Yet, those are the very folks who would most benefit from a bailout.
And it is a bailout. Think about it for a moment. If a lender must, in effect, rebate interest payments to a borrower, that will be carried on the books as a loss against earnings. In other words, a tax deduction. And you and me -- the honest citizens who didn't lie on our loan apps -- will have to make up the difference.
There's a simple solution: require that any individual bailed out must first provide verifiable documentation that they were, in fact, making $150,000 [or whatever] a year, and had few debts. Because those who were honest are not the ones who are now giving taxpayers yet another headache. And no one who signed a fraudulent loan application is going to step up and try to verify it; who wants to be indicted for fraud?
How can they indict anyone for fraud? Doesn't Sarbanes remove all potential of fraud from the beginning?
In my company an individual can issue a purchase order, but they can not purchase the item. An individual can bill the client but they can not receive the check from the client. And so on. Don't you think the same applies to the mortgage industry? And without documentation anyone can say they misunderstood the question or the answer.
To me so much of this defies common sense.
But hey, I still pick up pennys.
So, we are supposed to feel sorry for bankers because they were forced to loan money to people with no documentation? In my book, the person who loans $150,000 to someone based on "trust me I make enough money to pay this back" is more culpable than the person who takes out the loan.
The government may do MANY things wrong, but they sure as hell we're forcing banks to offer liar loans. Banks were doing that out of sheer greed.
It was a pretty good trick, while it lasted -- the banks effectively got some poor schmuck to pay them for the privalge of watching the bank's house for a few years, while it appreciated in value.
I've got two words to say to your CEO friend: Bull Shit. Ask him where in the Community Reinvestment Act it requires lenders to lend to people with bad credit or without checking credit. He is simply full of shit.
The economy wide problem is that the entire economy has become dependent on the housing bubble. With most of the high paying manufacturing jobs going overseas the major influx of money into our economy has been from cash out refinances to pay off credit card debt. People who bought $150,000 homes in 1995 are working with 500,000 mortgages and are living in houses that are soon to be worth $165,000 is the true problem.
Let's get someone who knows to answer this. I also heard that banks were threatened with harsh penalties if they didn't loan in "all neighborhoods" and that means subprime loans.
Banning redlining doesn't mean forcing banks to make subprime loans. And you are getting close to blaming the crisis on lazy, shiftless black people without the slimmest shred of evidence to back up your claims. Do you have any evidence that the crisis is occurring predominately in urban, minority neighborhoods? Seems to me the focus has been on primarily suburban, middle to upper middle-class, white neighborhoods.
Essentially, so long as a belief in the continued growth in the housing market persisted with the vast majority of consumers, consumers would continue to take out risky loans, often attracted to them by the teaser ARM rates, on the assumption that the market would grow and they could refinance later into a better loan, etc. And, so long as the lenders could package these loans in pools that were securitized, sell the securities, and thereby raise more money to make more loans (and pay more commissions to brokers, keep more origination fees, etc), everything was great. But, once the bubble started to burst, the ugly truth about the risks of many of these loans (and thus securities) started to reveal itself.
Now, I don't mind a voluntary bailout, for the following reasons. First, it is infinitely better than a government-sponsored one that counts billions of taxpayer dollars. Second, it is essentially a decision for the banks to make: are they better off in worsening the crisis in this market, by forging ahead with foreclosures, in a depressed housing market, which may make the market worse, or are they better off restructuring some of these loans, to ride out the next 5 years. I would bet the latter scenario makes sense.
Third, I think there is a real sense on Wall Street that the big firms and banks, which are in up to their eyeballs with their own investments in mortgage backed securities and in peddling these investments to their institutional clients, that unless they do something, the situation will get MUCH MUCH worse. Think about the accounting for these securities, for a moment, and you will get it. Because these securities are not publicly-traded (I am not referring to REITS, which often are), the accounting is that you can value them at the acquisition cost unless you believe the underlying value is substantially impaired. I would guess that many of the write-offs taken to date of these investments (by Morgan Stanley, Merrill Lynch, Citigroup) have been of the worst of the worst of these securities, and that there are probably hundreds of billions of dollars of these investments still on the books at acquisition cost, not the impaired write-down value. This gives the bank a huge, immediate, short-term financial incentive to get the mortgage lenders (who typically fund the loans, and then use the banks to sell them, but keep the servicing rights) to ease up on the foreclosures.
In short, the mortgage lenders are worried that they won't get the continued access to capital that they need to survive, and the banks that provide that access are worried that they will have to take huge financial hits themselves if they don't do something to stop the bleeding. This bailout has nothing to do with helping the hapless consumer who took out an ARM and put no money down to buy a house that is now under water. It has to do with Wall Street saving itself from itself. That is why the Fed and the Treasury are behind it.
I don't believe that Michael Milken was ever with KKR or closely with any of the KKR principals; I believe that KKR has always been about LBOs and private equity deals, not about bundling or trading bundled home mortgages and derivates based on them; and I believe it was Fannie Mae and Freddie Mac, not any individual investor* or group of investors, KKR, hedge fund, or investment bank/brokerage that started packaging home mortages and using them as the collateral for bonds sold to investors. If I am wrong about any of this, someone should correct me.
*Lou Ranieri, not with KKR either, may get credit for taking the commoditization of home mortgages and other debt beyond where it was when Fannie and Freddie were most of the story.
The US is not the only place that has seen big run ups in the price of housing and faces problems now as the financial chickens come home to roost. If one owned a house in London, they might have seen a much greater run up in the price of that house over the past decade or so than homeowners in even the hottest markets here in the US have over the same number of years. And for Brits, a fixed rate mortgages fully amortizing over 15 to 30 years are virtually unknown, if indeedd they exist.
So my question - how did the Brits', Londoners in particular, housing market get so frothy with such huge run ups in prices, and are they standing with one foot on a banana peel right now, with it all about to crash down on their heads now? (I assume that the Royals own their properties free and clear, so they wouldn't be in imminent peril in any case.) Anyone know?
J.F. is correct that the CRA, 12 USC 2901 et seq, does not directly require lenders to make subprime loans. However, it does permit activists to severely retard the ability of a bank (or thrift) to merge or expand its business, or even open a new branch, by filing a "protest." As a result, major banks have been pressured to make fixed, multibillion dollar commitments to lend in underserved areas, regardless of whether the quantity of creditworthy borrowers in those areas can justify that level of capital infusion. In a brief search, I wasn't able to find anything quantifying the impact on subprime lending. Two claims point in opposite directions, however: (1) An activist group, the National Community Reinvestment Coalition, claims to track more than $1 trillion dollars in pledges, but (2) the NY FRB indicates that as of 2003, less than 30% of lending institutions were covered by the CRA. The NY FRB has a fairly good history here: http://www.ny.frb.org/research/epr/03v09n2/0306apga.pdf
If you haven't picked up on this in other threads, it's wise to call J.F.'s hand when he starts opining on what the law requires.
FWIW, loans carry interest for at least three reasons: The risk (amortized against all such loans, ideally adjusted for the level of risk), inflation (since they're denominated in nominal dollars), and opportunity cost (the lender could do something else with the money, like consume stuff, or buy capital or real estate and get wealth that way.)