December 07, 2007
Some questions about the new mortgage plan
Part of this plan sounds like an unambiguously good idea. But most of the coverage I've seen is ignoring what should be the key questions.
Yesterday President George Bush and Treasury Secretary Henry Paulson announced a plan to prevent the interest rate from rising on adjustable-rate mortgages for a particular class of borrowers. The first question I had was the same as Yves Smith: by what authority could a declaration of the President, or even act of Congress, alter or rescind the terms of existing mortgage contracts?
The Wall Street Journal's answer to this question appears to be that the President and Treasury Secretary were in fact announcing a voluntary agreement on the part of some lenders:
Under the deal, formally released yesterday, the industry would voluntarily help as many as 1.2 million homeowners who are heading for trouble paying their subprime mortgages but aren't yet lost causes. For some homeowners, loan-servicing companies will agree to freeze mortgages at their low introductory rates. In other cases, credit counselors or loan servicers will walk mortgage holders through refinancing processes.
The natural question is then, Why did lenders volunteer to receive a lower interest rate than that to which borrowers had previously committed? And why was the announcement coming from the government rather than the creditors themselves? There unquestionably can be a benefit to the lender to renegotiating the terms of a problem loan-- better half a loaf than none. And there is a profound problem coordinating such renegotiation in the modern world of mortgage-backed securities, as Paul Krugman explained last August:
Consider a borrower who can't meet his or her mortgage payments and is facing foreclosure. In the past... the bank that made the loan would often have been willing to offer a workout, modifying the loan's terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home....
Today, however, ... the mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody's or Standard & Poor's were willing to classify as AAA. And the result is that there's nobody to deal with.
In such a setting, there may be a very useful role for someone-- perhaps the Treasury Secretary-- to coordinate this process, and help arrive at an arrangement that collectively is in everyone's interest, but nobody could have implemented on their own. To the extent that this is what has happened, surely no one could object to the plan.
Tanta has an interesting alternative explanation of the role of the government in facilitating this coordination, noting that certain details of the tax treatment of real estate mortgage investment conduits invite clarification from the U.S. Treasury on the conditions under which the terms of a mortgage could be altered and still qualify as not being "actively managed" by the trust. Again, to the extent this is the story, such clarification from the government is surely most welcome.
But I wonder if the Secretary did more than just clarify and help coordinate. Bloomberg provided this curious detail:
The agreement addresses homeowners unable to afford higher interest rates once starter rates increase, and offers help in one of three ways, a White House official said. The options are freezing rates or refinancing into either a new private mortgage or a Federal Housing Administration-backed loan, he said on condition of anonymity.
We announce with great fanfare that we're "doing something", though details of that something can only be described by an official insisting on anonymity? It's that third option mentioned by the anonymous official that could be the potential stinker here. To what extent did lenders perceive this agreement to be in their interest because the government is offering to absorb some of their capital loss?
And this gets to the heart of the policy discussion that we need to have, but have not yet engaged in. My reading is that there are substantial capital losses that must be absorbed by somebody-- some creditors must take a loss on their investments, some borrowers must lose their homes, and all home-owners must see a decline in the value of their asset. The worry that these events could become so large as to cause huge problems for all of us is in my mind very real, and it might be that some commitment from the taxpayers could help mitigate some of these problems. But I'd prefer that we discuss openly and up front how much we're willing to spend, and how much we realistically expect those expenditures to accomplish.
This is too big a problem for us to pretend to have found an easy and painless fix.
Posted by James Hamilton at December 7, 2007 09:00 AMdigg this | reddit
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The Internet is alive with discussion of the sub-prime bail-out announced by George Bush yesterday: Representatives of HOPE NOW just briefed me on their plan to help homeowners who will not be able to make the higher payments on their sub-prime loan on... [Read More]
Tracked on December 7, 2007 07:00 PM
The article in the NY Post:
seems to think that the proposal will let states and local governments issue bonds to buy the marginal mortgages within their jurisdictions.
Politically, this seems a stroke of genius. It will let the bleeding heart liberals act on their emotions through local bonding without hurting the more prudently governed localities or the federal government.
Federalism at work!
The one hit is if the local bonds are tax-free municipals. That will mean some diverted tax revenue to the feds - but this is a second order effect.
Posted by: Joseph Somsel at December 7, 2007 09:28 AM
I doubt that the plan will help much at all. The only borrowers eligible for the freeze are those that have never missed a payment and who have positive equity in their home. Since most of the sub-prime loans had very small down payments, with the decline in house prices, very few will have positive equity. Only a small percentage of borrows will qualify.
As Dean Baker continues to point out, resets aren't the basis of the problem. About 10% of loans issued in 2006 are already in default, years before their resets even take place. The root of the problem is the decline in bubble housing prices. People with negative equity are just abandoning their loans because it no longer makes sense to pay them off. The Bush plan does nothing to fix this.
Posted by: Joseph at December 7, 2007 09:39 AM
Based on some quick research, CMOs seem to have been around since the early 80's. How have CMO investors handled defaults in the past? What is different now, beside the expected volume of defaults?
Posted by: Rich Berger at December 7, 2007 10:15 AM
This is probably a point that you have made before, Jim, but the participation of the FHA (taking a government-sanctioned workout plan as a given) makes some sense. The growth of sub-prime loans has come at the "expense" of FHA and VA loans. This is shown pretty clearly in Chart 10 on page 3 of this:
The FHA is probably the best-equipped agency to handle any credit evaluation issues, structuring, etc. This is especially true when you think about the shape that Ginnie and Fannie are in right now.
Posted by: KevinT at December 7, 2007 10:20 AM
FHA is best equipped to do credit evaluations???? Then god help us. Their automated underwriting is based on data from 1992.
see p. 9 of GAO's 2006 report on FHA at the URL above.
Posted by: tickets at December 7, 2007 11:18 AM
"It's that third option mentioned by the anonymous official that could be the potential stinker here. To what extent did lenders perceive this agreement to be in their interest because the government is offering to absorb some of their capital loss?
And this gets to the heart of the policy discussion that we need to have, but have not yet engaged in. My reading is that there are substantial capital losses that must be absorbed by somebody-- some creditors must take a loss on their investments, some borrowers must lose their homes, and all home-owners must see a decline in the value of their asset."
This is the question no one seems to have the answer for.
What have lenders/investors agreed to? And what is different from the status quo? If the "bailout" is simply a workaround within the structure of the existing mortgage, why would lenders/investors agree to more of this type of workaround (assuming they have agreed to something and not nothing)? And if they have agreed to something, why is it more in their interest to do this now, than it was 3 days ago?
Some mortgageholders are going to be paying less for quite some time. Who pays for that? Either the unpaid interest get tacked on their principal, which would simply put more mortgageholders underwater, or the holders of the debt eat the unpaid interest. Or someone (ahem) pays or at least partially offsets the investors' loss somehow. Which is it?
Posted by: benny lava at December 7, 2007 11:32 AM
The key player in the Paulson plan, the American Securitization Forum, does not represent investors in MBS. It represents companies that earn fees from securitization--investment banks, servicers, etc. What AFS did yesterday was redefine `standard industry practice' for servicers, thereby rewriting thousands of private contracts in one fell swoop, with varying and uncertain impacts on investors. The result is going to be tighter credit for mortgages across the board, because this plan has introduced a new source of uncertainty into investing in U.S. mortgage paper. Now the change that AFS made is relatively minor; but the worry will be that continuing high foreclosure rates will spur further political interference with contracts. Someone should point out that the servicers who belong to AFS are the beneficiaries of this plan, as they can now evade the expensive loan-by-loan analysis required by their contracts and some of their unreimbursable costs with foreclosures. Banks such as Countrywide that belong to AFS will benefit because they own many whole loans (non-securitized loans) that they can now modify without recognizing an impairment.
Posted by: Steve at December 7, 2007 12:38 PM
"with varying and uncertain impacts on investors."
...making the values of existing asset backed paper even more dubious and uncertain? So does this put more turds in the bathwater?
Posted by: benny lava at December 7, 2007 02:51 PM
Please check the following Reuters link for some background about how the Bush administration has responded to complaints from the Bond market about the FHA Secure Program: The new vehicle to assist defaulting mortgage holders to refinance.
Also see the following relative to recent Federal Agency mortgage losses:
Its interesting that most of the discussions posted recently in the Econobrowser have avoided three major contributors to the current mortgage crisis:
- Inflationary monetary expansion by the FED. Price rises have shown up in commodities, securities and real estate. Fortunately for the CPI, excessive home construction has depressed rents (the CPI housing price factor), and globalization has depressed manufactured consumer goods prices via artificially low tax, exchange and labor rates in third-world countries.
- Deregulation in banking and mortgage markets. Its interesting that reduced regulatory oversight contributed to the S&L crises in the 1980s. At that time, Deposit Brokerage services to S&Ls were paid by kick-backs involving CDOs on junk-bonds. The failure of those CDOs ultimately contributed to the failure of many S&Ls. A similar scam has occurred since 1995, with increased securitization of mortgage debt via SIVs and CDOs, exacerbating inflationary pressure by allowing banks to free up more of their reserves to increasingly risky loans continually flushed downstream to more derivative instruments. (The multiplier effect in action).
- Lax or non-existing regulation of the securities and mortgage markets. The SEC and the FED have ignored the exponential growth of the mortgage derivative market for years. This has facilitated the ability to leverage derivative instruments as collateral in the short-term commercial money market. Inappropriate securitization of mortgages has thus been used as a means of financing commercial LBOs by private equity firms. (The next shoe to drop).
At the end of day, the Paulson announced plan appears to me to be mere window dressing. Ultimately, the class of borrowers covered by the terms outlined, will be able to refinance in more affordable fixed rate vehicle or negotiate a work-out with the mortgage agent without any announcements by the Treasury.
Real government action will be more believable when the SEC, FED and Treasury coordinate controls on banking and securities. Prosecution of the frauds involved in the mortgage and derivative markets would also go a long way in restoring some integrity to the process. The day we rue the dismantling of the Glass-Steagall Act is fast approaching.
Posted by: Mark S at December 7, 2007 02:57 PM
re: varying and uncertain impacts on investors.
That's pretty much what Fitch came out with today, owing to the range and complexity of structures holding MBS.
It's certain that I/O (interest only) investors will be walloped but assumptions and structures vary enough that some senior debt might come out ahead and some might lose.
Posted by: Steve at December 7, 2007 03:20 PM
Thanks for your comments... You're right, the ASF is the key player here. Their main interest is to maintain the status quo relative to liability and contract clauses.
Readers might find it interesting to see...
...for a quick thumb-nail description of how the ASF (Paulson) plan is really going to work ...
Posted by: Mark S at December 7, 2007 04:19 PM
Mark S. Thanks. That first link shows that traders are certainly expecting some heavy defaults on these FHA Secure loans. The regular FHA business has projected lifetime default rates over 10%. I wonder what they are anticipating for these 'rescue' loans.
The second link was something of a blast from the past, wasn't it?
Posted by: tickets at December 7, 2007 05:17 PM
"There unquestionably can be a benefit to the lender to renegotiating the terms of a problem loan-- better half a loaf than none"
But better a full loan than half a loan.
Thats the problem with "freeze," which uses broad criteria to lump thousands of diverse situations as potential bankruptcies. Invariably, some people that could have struggled to pay the full loan can now relax their efforts in order to freeze in a teaser rate. You can argue that by and large the majority of those applying for rate freezes would have defaulted, but thats plays into the problem. A case by case basis is much more suitable for an investor to greater scrutinize which loans should be modified. The greater detail would weed out those that might be able to step it up a notch, or even get other funds, while modifying loans for those whom would certainly default.
I feel your trying to characterize as something investors (and mortgage servicers)would do themselves if they only had the means of coordination. I generate that sentiment from:
"In such a setting, there may be a very useful role for someone-- perhaps the Treasury Secretary-- to coordinate this process, and help arrive at an arrangement that collectively is in everyone's interest, but nobody could have implemented on their own."
This ignores the diversity of opinions that comes with any constituency, including MBS. There will be some investors that want a case by case basis, as I described above. Others might not want a freeze at all.
The only thing holding them back from litigation, currently, are the allowances for mortgage servicers to alter loans when "in the best interest of investors." From CNN money:
""Modifications are proceeding," said Mason, "and servicers are using the 'best interest' clause. It's not clear if that opens them up to investor lawsuits. It will be up to the courts to decide which clause wins.""
I'm not a lawyer, but its seems to me that all an investor would have to do is claim that servicers are not acting in the best interest of investors by creating a broad, ill-defined freeze. The following legal injunction would probably put the whole thing on ice for awhile (Though each servicer would have to get sued for that to happen, I suppose).
Thats why its not surprising servicers are asking for legal protection from Congress. I've read Tanta's post, but the whole thing still seems to me like its on some shaky legal legs.
Posted by: Kevin Adolph at December 7, 2007 11:26 PM
Remarks have been made that the small portion of mortgages that will be frozen only extends their default a few years...the declining house prices and the mismatch between the house price and the salary paying the mortgage do them in...so this is a toothless political gesture...so far.
But the gesture might be stage I of a multi-stage rescue (More Hope Now Aligned) --to prevent those house prices from falling. So further erosion in the dollar from more rate cuts looks like a real possibility to me.
Posted by: calmo at December 8, 2007 03:54 AM
The American Securitization Forum wrote the rate freeze presented to the public by the President and the Treasury Secretary.
It can be found it at americansecuritization.com
The framework allows servicers to modify loans without borrower signatures.
Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 13, third paragraph from bottom of page
Counseling and modification expenses are to be charged to securitized trust cash flows, so service providers, like Countrywide, which has a representative on the board of the American Securitization Forum, will profit from the process.
Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 7, first full paragraph
Appraised value for modifications are based on the date of origination, even if the current value is much less.
Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 2, second bullet
According to the American Securitization Forum's Framework for the rate freeze, borrowers will not have to document current income to be eligible for refinancing, even if they received initial loans with embellished incomes
Source: American Securitization Forum, Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, Executive Summary, December 6, 2007, page 3, FICO test
Some of the firms that may profit from the rate freeze are members of the industry group that authored the plan.
Posted by: harlynman at December 8, 2007 06:15 AM
Steve and others, the list of ASF members can be found here. While it is true that the pure holders of the securities might not be on the list, it sure seems to include everybody that I would have thought of as a player here, and collectively would in my guess include a very big fraction of the final lost capital in the event of a complete mortgage default crisis.
Posted by: JDH at December 8, 2007 07:33 AM
But James, does this,
it sure seems to include everybody that I would have thought of as a player here, and collectively would in my guess include a very big fraction of the final lost capital in the event of a complete mortgage default crisis
exclude the providers of that drying stream of mortgage income, the unfortunate ("poor"? "gulible"? "marked"?) players who mis-timed their entrance to the market?
The cost of treating (re-setting, re-mortgaging, fixing) each case individually was deemed un-economic (despite the decline in recent mortgage applications, despite the abundance of trainable RE agents twiddling their thumbs) by the vested "capital" interests who, until recently, thought the former treatment (that practice which now appears reckless, predatory, and a danger to the entire economy) was just fine, yes?
That difficulty of representing the players who are the victims, reminds me of that very concerned elderly gentleman who asked the President in one his televised stumps "Who will represent the rich?". Dang if smiling w did not pacify him with that somewhat awkward, "I will". All of a sudden Dean's Scream was just such an infinitesimal blip. But sadly, w's clip received less attention...way less.
Posted by: calmo at December 8, 2007 12:06 PM
Perhaps "this is too big a problem for us to pretend to have found an easy and painless fix." But it may not be nearly as big a macro problem as rent-seekers would have us believe. Calling something a "crisis" is an old tactic used to lobby for subsidies, tariffs, mandates and other favors.
In 1983, James Hamilton found the oil price spikes are followed by recessions. In 1997, Ben Bernanke added that the Fed usually hiked interest rates too. But central bank rates are now falling and oil might too.
Others have looked at yield curves and the paper-bill spread -- arguably proxies for Fed policy. But no serious research has found systematic evidence of housing-led or consumer-led recessions, per se, absent rising oil prices and/or interest rates.
I am ignoring most of the self-interested hype about mortgages and house prices, but prudently using ETFs to short real estate, oil, gold, the euro and financials. Regional and sectoral problems are not national or global crises.
Posted by: Alan Reynolds at December 18, 2007 09:06 AM