Stabilize House Prices, Part 5

“Our plan would keep many more Americans in their homes, and put government money into local communities where it would make a difference. By clarifying the true value of each loan, it would also help clarify the value of securities associated with those mortgages, enabling investors to trade them again. Most important, our plan would help stabilize housing prices.” – John D. Geanakoplos and Susan P. Koniak.

I have written in previous posts about various proposals to stem the tide of mortgage foreclosures. Today’s New York Times Op-Ed piece Mortgage Justice Is Blind by John D. Geanakoplos and Susan P. Koniak is the latest entry.

They cover familiar territory, blaming subprime loans and securitization and quickly summarize the problem.

The current American economic crisis, which began with a housing collapse that had devastating consequences for our financial system, now threatens the global economy. But while we are rushing around trying to pick up all the other falling dominos, the housing crisis continues, and must be addressed.

We start with this simple fact: Too many families are being thrown out of their homes when it makes more sense to let them stay by “reworking” their mortgages — adjusting terms to make it possible for the homeowners to meet their responsibilities. In many cases, adjusting loans would help the homeowners and the lenders: the new mortgages would have lower monthly payments that homeowners could afford to pay, and would end up giving the lenders more money than the 50 cents on the dollar that many foreclosure sales are bringing these days.

To arrive at their solution, the authors first focus on the incentives of the “master servicer” which manages the pool of loans that are bundled together. In the old days when one banker lent money to one consumer each knew the other. If the borrower experienced financial difficulty, the lender had the ability and the incentive to renegotiate the mortgage.

With the advent of securitization, it is the “master servicer” who manages hundreds if not thousands of mortgages. They have very little incentive to rework the loans, fearing legal liability from investors. In addition, Geanakoplos and Koniak point out that the servicers will not be adequately compensated for the extra work.

As a result, “the master servicer now holds the power to rework the loans. And, as we have seen in the current crisis, these servicers aren’t doing that, as house after house goes into foreclosure.”
 
To solve this problem, we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make.

Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure. The government expense would be limited to paying for the trustees — no small amount of money, but much cheaper than first paying off the security holders by buying out the loans, which would then have to be reworked anyway. Our plan would also be far more efficient than having judges attempt this role. The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks.

Americans have repeatedly been told that the distressed loans cannot be reworked because these mortgages can no longer be “put back together.” But that is not true. Our plan does not require that the loans be reassembled from the securities in which they are now divided, nor does it require the buying up of any loans or securities. It does require the transfer of the servicers’ duty to rework loans to government trustees. It requires that restrictions in some servicing contracts, like those on how many loans can be reworked in each pool, be eliminated when the duty to rework is transferred to the trustees.

Under our plan, servicers would provide the homeowner’s name and other relevant information on each loan to a central government clearing house, which would in turn give trustees the data on homes in their local area. Once the trustees have examined the loans — leaving some unchanged, reworking others and recommending foreclosure on the rest — they would pass those decisions to the government clearing house for transmittal back to the appropriate servicers.

The servicers would then do exactly the same work they do now, passing on the payments they collect from the reworked mortgages to the securities’ owners in each pool. The servicers would also foreclose on those properties the trustees had decided did not qualify for reworking. For performing those tasks, the servicers would continue to receive the fees due under their existing contracts.

We need an innovative approach to overcome the gridlock that plagues our housing markets. Otherwise, we imperil millions of homeowners and — through the alchemy of derivatives — the American and global economy.

I think their solution to the problems of falling home prices, abandonment and foreclosure is very interesting. It adds to previous suggestions.

News reports have indicated that the Bush Administration will unveil their plan shortly. We’ll see what aspects of the various proposals they will recommend.

photo credit: TheTruthAbout…

Understanding the Financial Crisis, Part 2

Barry Ritholtz, who writes a very popular blog, The Big Picture, often discusses the causes of the financial crisis. How Lending Standard Changes Led to the Housing Boom/Bust, posted on October 21st, blames the problem squarely on the lax standards of lenders. I agree with his main point, which he makes persuasively. Maybe it is a question of emphasis, but I believe that there is enough blame to go around.

Many of us acted as if housing prices could only go in one direction – up. Individuals bought as much house as they could get approved for. Some investors/speculators bought several condos when they were under construction. They hoped to “flip” the apartments as they were completed, thereby making exceptional profits.

With the very low interest rates promoted by the Federal Reserve, there was a big demand for any investment that promised higher returns. Investment banks packaged questionable mortgages, and investors bought the complicated financial instruments without asking enough questions. Rating agencies blessed the securities with triple A ratings, never imagining that home prices could actually fall substantially.  Regulation did not keep up with the changing markets for securitized debt instruments.

This housing bubble or mania could not go on forever, and it did not.

Here is Ritholtz’s article.

There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust.

Let me take another shot at clarifying this:

Underlying EVERYTHING — housing boom and bust, derivative explosion, credit crisis — is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.

After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized — purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper.

In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.

So long as the mortgage did not default in that period of time, it could not be “put back” to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.

What do rational, profit-maximizers do? They put people in houses that would not default in 90 days — and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators — by then, it was Wall Street’s problem.

This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.

This was a simply unprecedented shift in lending standards.

And, it is why 293 mortgage lenders have imploded — all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussions of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm.

If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the “2″ of the 2/28) of these mortgages so attractive.

Contrary to the cliche, failure is not an orphan in the current crisis — it has 100s of fathers. But these four are the primary movers, the key to everything else. The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings — these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.

photo credit: eron_gpsfs