Banks behaving badly: Evictions of Military Families

The New York Times today ran an article about banks foreclosing on the homes of deployed military families.  See, Banks Find More Wrongful Foreclosures Among Military Families.  The Servicemembers' Civil Relief Act provides protections to military service members on important financial issues, including evictions and mortgage foreclosures, which should have prevented many of the reported cases.  The SCRA is a key protection that perhaps needs further promotion to ensure that banks comply.

- JSM

Are Larger Down Payment Requirements for Homes Needed?

This week's news reported another 4% drop in home prices in 20 U.S. cities from the prior year (See Bloomberg). With prices lower than we've seen in some time, shouldn't that necessarily translate into home purchases? Not necessarily so. Of course, even if homes are less expensive, one's ability to buy is not just tied to a credit score. It is tied to cash. Right now, cash buyers are the kings in the weak housing market (See USA Today). These cash buyers are primarily investors who account for about 30% of home purchases in the current market.

So, what is happening to the regular people? Well, credit is still tight. According to the Center of Responsible Lending, high down-payment requirements (20% generally) is enough to keep many who might be good bets on home mortgage repayment from buying a home. First time home buyers and minority home-buyers could be hardest hit At the root of some concern about down payment requirements are portions of D0dd-Frank that require lenders to retain a portion of mortgages they sell, but Qualified Residential Mortgages (QRM) are exempt from this rule. To the extent Congress sets the QRM at 20% down payment for residential mortgages, this rate would be expected to have an impact on how the market views risk on residential mortgages (See, Wall Street Journal). This could in turn affect what mortgages are available to home buyers and the cost of those mortgages.

Currently, the regulators have extended the comment period on QRMs until August 1, 2011 (See Federal Reserve). So, if you have an opinion . . .

- JSM

Finally a Homeowner in Florida

Yes, I finally closed on a home in South Florida. Now that the boxes are unpacked (well, mostly), some thoughts on the process. Not to deter any wanting to purchase a home, the real estate market in South Florida is particularly daunting if you are wanting a mortgage (See, South Florida Mortgage Rates At Record Lows, but Who Can Get Them?). And, I was moving to a new area to start new employment adding complication to any mortgage application. The loan approval came less than a week before closing, and I breathed a great sigh of relief that the worst part was over (the tax returns, w-2s, document requests, interviews, etc.).

By the time I closed, though, new lending requirements meant a change in lending product and another round of documents! The closing was also delayed a few days. Since our family's belongings were already en route from two far reaching parts of the country (Oregon and Massachusetts), we were faced with the prospect of furniture arriving before the home closed. While it all worked out well in the end, there was much stress and the specter that it might not close at all. The lender's agent seemed unprepared for the changes in requirements for home mortgages that are ever changing, so that the lender was working last minute on details that should have been addressed much earlier in the process (i.e., calling for employment verifications for all employers for the last 5 years the day before closing). I thought to myself, with all this headache, who would actually want to buy a home in South Florida!

So, what does this all say? It seems to me a sign that changing, strict credit standards will impede the real estate market. (See, Borrowers Hit New Home-Loan Hurdles). While credit standards for home loans may have been too easy, they might now be too hard. Of course, the Florida market still has signs of distress, so it may be one of the last markets to see easing of credit standards in real estate. An excess of care and caution of lenders, though, impedes their own business and the real estate market as a whole, making recovery further off. When I listen to NPR on the drive to the office in the morning and hear reports of the sluggish real estate market, I am not surprised. The core of the problem is confidence in borrowers and the real estate market as a whole. While those in the real estate industry attempt to be optimistic, more marked recovery would seem to require a level of confidence that does not permeate South Florida at this time.

As for me, I'll be finishing off the last of my boxes for another week or so . . . glad that I can now send in that first mortgage payment next month!

- JSM

Lenders Modifying Home Mortgages

Today's news included a Treasury report that lenders have modified 500,000 home loans to keep home owners in the homes under a trial loan modification program. I applaud the government for encouraging such modifications which would hopefully increase the value to both the mortgage holders and homeowners alike by protecting the asset and obtaining payment on the loan. Yet, I am reluctant to find joy in the number of loans so modified or the ease for consumers seeking loan modifications.

The Making Home Affordable modification program originally advertised that it would help 4 million homeowners retain their homes. (See, Foreclosures, New York Times). Mortgage foreclosures during the second quarter of 2009 were up 16%, reflecting falling housing values and rising unemployment. New Treasury plans include incentives for "short sales," which allow homes to be sold at less than loan value (i.e. market value) to head off foreclosures that are coming in the future (Short Sales Plan).

Two of the biggest impediments to modifications or short sales seems to be time and difficulty. While keeping homes out of foreclosure appears a good idea, lenders are likely earning default fees on the loan. Lenders may also be reluctant to modify loans too early, hoping owners will bring the loans current. Yet, waiting too long can allow the home to slip into foreclosure. Buyers interested in a short sale may also bolt if the bank takes too long or does not approve the home price, which is likely to be substantially below the loan value on the property. The difficulty of obtaining loan modifications and conflicting information received from lenders discourages eligible modifications under the federal plan.

While our home thankfully is not in foreclosure, I can report on our in process home refinancing that probably represents much of the frustrations that home owners face. For instance, in shopping for rates and costs, we found that some of the lending representatives did not return calls. Others had voice-mail boxes that were full so that messages could not be left. One Citi Mortgage representative gave us refinancing numbers, but then later we were never able to reach her. A second Citi Mortgage representative told us the initial numbers were actually wrong. Hardly inspiring. In the end, Wells Fargo actually negotiated rates that beat the competitors, so we are now working on reviewing paperwork with them. We're not done, but at least the refinance is locked in at a favorable rate. Yet, I can see from our own experience for an uncomplicated refi the frustrations that homeowners are reporting, particularly when the situation is complicated by a delinquency or foreclosure.

So, is the 500,000 milestone a reason to celebrate? Probably. But my enthusiasm is lessened by the amount of transactions that remain.

-JSM

Falling Behind on Your Mortgage?

For those wondering how exactly did all these people fall behind on their mortgages, take a look at a pretty honest personal story in the New York Times. The author, like many, bought a home he couldn't afford, tried to compensate with credit cards and refinancing and had a spouse lose a job. There are tough times for many who bought into the traditional model of rapid real estate value increases and living beyond their means. Reading the piece, it is easy to see how people fall into the trap.

A surprising little aside is that the banks have not had time to foreclose on his home or do a loan modification even though his last payment was eight months ago!
- JSM

Banks Extending the Crisis pt. II

Photo by rjones0856
Someone needs to send these bankers to the principal's office and not let them out for recess any more--or perhaps expel them altogether. First the AIG bonus scandal, now we hear (yet again) that banks are deepening and extending the current crisis, despite Herculian federal efforts to pump them up with liquidity to solve the problem. Banks and their overly finicky underwriters are now making it difficult for even the most creditworthy borrowers to get loans. If the theory behind the stimulus moves is prop up the housing market by pumping liquidity into the mortgage finance market through the banks, it isn't working.

Tell me again why nationalizing these banks would be a bad idea . . . Does anyone reasonably believe that the feds would do a worse job of managing lending???

Problems for Secondary Lenders?

I received a call today asking whether a local company in Louisville should be worried that its secondary lender on its real estate filed a lawsuit to foreclosure due to default. In some ways an odd question, but perhaps not. Imagine this, Company X owns real property worth $750,000 at the time of financing. First Bank holds a mortgage for $500,000 and Second Bank holds a mortgage for $225,000. If both banks have properly recorded their mortgages, all would seem to be in order. But, in a declining real estate market, we could imagine the property now being worth about 20% less (here, just $600,000). First Bank is still secured, but Second Bank is now undersecured. If Company X stops paying Second Bank, but is in good standing with First Bank, then what are Second Bank's options? Foreclosing on the real estate might ordinarily be a good call, but what happens in a declining market if the real estate has to be sold at auction?

Second Bank seems now to be undersecured. If real estate values have fallen dramatically, Second Bank could be in even worse shape. Its options? Perhaps Second Bank might try to renegotiate the terms of the mortgage to get Company X back on track. Alternatively, the loan might be sold to First Bank at a deep discount if First Bank is interested. If Second Bank obtained any guarantys from the owners of Company X when it issued the loan, that might help . . . if the individuals have enough assets to cover the loan. Forcing Company X into bankruptcy also might not work out so well if there are not sufficient assets to pay the creditors.

In the end, should Company X be worried about any lawsuit by Second Bank? It is a tough market out there. Secondary lenders on real estate may as a group be finding themselves with less bargaining power than in the past. If Company X is not worried about the situation about Second Bank it could be that good corporate news is around the corner that will allow them to pay the lender. In this market, though, Company X might know that Second Bank has rights, but little to enforce them against.

— JSM

Update on Home Mortgages

Thanks to the Federal Reserve, the benchmark interest rate will remain near zero. LIBOR remains around 1.17 percent. Home prices in twenty American cities dropped 18.2% in November from the prior year (this rate is lower for areas below the conforming mortgage rate of $417,000). Mortgage rates are at about 5.48% in the last week. What does this mean for home buyers? For mortgages? As we've said here before, the indicators suggest mortage rates should be lower than ever leading to more people buying homes and refinancing (see More Trouble For Home Refinancing; Refi No Good --- A Lesson in "LTValuation").

So, what does the mortgage news really mean? There is talk that the Senate will include housing relief in the economic stimulus plan. The discussion includes: (1) making available to home owners a 4% 30 year mortgage, either for buyers or refinancers; (2) increasing the first time home buyer credit; and (3) a ninety (90) day moratorium on foreclosures. Yippee! At least for my home, lenders cannot do too much better than the mortage we already have. So, the strategy for some home owners is shop around for better rates and wait. As much as I might like to see a 4% mortgage rate, though, the cost of this housing relief may become quite expensive. The cost for such a government program hasn't yet been publicized, but is likely to be the impediment to my dreams of a 4% mortgage rate.

Home purchase credits might help to encourage those who have been staying out of the market to buy a home. The structure of the credit needs to have the effect of home purchases by those who would not purchase otherwise. Timing and limits on eligible purchasers are also issues. Moreover, the word of caution with encouraging home purchases is avoiding the same problems that led us to the current crash. That is, to what extent should we encourage purchases of homes if some purchasers would not have their downpayment but for the credit? The same concerns about lenders repeating policies that created the housing crisis apply to home buyers. Throwing money at the housing crisis may well help in the short to medium term, but the stimulus plan should not forget the lending and borrowing implications for the longer term.

As to moratoriums on foreclosures? There are many open questions on the housing crisis. A little more time is probably warranted.

— JSM

More trouble for home refinancing?

Thanks to the Federal Reserve, interest rates are lower than ever. That would normally lead to home owners refinancing home mortgages in order to lock in lower rates, lower payments and (for some) to keep their homes. A good thing for a troubled economy with some homeowners in trouble. But, as Jason Kilborn has warned us, not so quick (see Refi No Good --- A Lesson in "LTValuation"). Home prices in twenty American cities dropped 18% in October from the last year according to the S&P/Case-Shiller index . Unfortunately, the twenty city index has been dropping since January 2007. All of this means bad news for homeowners who are seeing the value of their home drop each and every month.

So, what does this really mean? Well, we are considering refinancing our home in Boston where the new October 2008 index is 159.17. The last time the Boston index was about the same level was February 2004. As it turns out, this was when we purchased our home. In September 2005, the highest index was reached in the Boston Metro area at 182.45. The current level is almost 13% off the highest point reached on the index. But, we might also expect the numbers will continue to decline for some additional time, representing further erosion of home values. How bad the news is depends on where you live and when you bought your home. Some cities like Miami, Phoenix and Las Vegas have suffered the largest declines on the index, whereas cities like Charlotte, Dallas, Cleveland and others have only felt modest changes.

For us, who knows? Our Boston home is not worth what it was in 2005, but the drop is not as bad as some cities. Like Jason's refi gone wrong, the discretion of appraisers will dictate whether refinancing makes sense. The problem for homeowners is that they may not be able to take advantage of lower rates. For more on this, Urban Deveopment Secretary Steve Preston recently spoke on the Future of the Housing Market.

— JSM

Hurray for Fannie!

Fannie Mae has announced that tenants will be permitted to stay in foreclosed homes. A nice touch during the holiday season for sure. Imagine being a paying tenant who gets an eviction notice at the holidays. The hassles of moving makes me shudder. Moving also adds moving costs, new security deposits and perhaps increased rent to the budgets of many families in low-income apartment complexes that are foreclosed.

Here enters Fannie Mae the landlord. Fannie Mae will execute new leases with the paying tenants in foreclosed properties, who would otherwise face eviction. Perhaps I am missing something here, but in light of the current market, this is long overdue. Normally, the government having all the headaches of a landlord (maintenance, rent collection, etc.) of these properties would not be ideal. Let's hope this isn't a long term solution. With plenty of vacant properties around, however, evicting paying tenants would seem to increase the losses that Fannie Mae would face. In many cases, these properties will be worth more with paying tenants than sitting vacant.

For now, at least the government should collect rent. Now I just wonder what kind of landlord will Fannie Mae be? Now, a bit of humor during these hard times is a good thing. Will Farrell's short on the "Landlord" comes to mind. For those of you with sensitive ears, don't push play.

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— JSM

Refi No Good--A Lesson in "LTValuation"

Photo by jurek d.

Following up on my refi post, I share a lesson I learned today (when my own refi deal tanked) that suggests one reason why efforts to stabilize the housing market are foundering.

I still recall the point in my first home purchase deal when I looked at the contract and asked my realtor what it meant that a condition of the deal was my ability to obtain financing at [blank], and she had filled in the blank with "80% LTV." She couldn't explain it to me--she just always put that in the blank (!). I now know all too well what that means, and it killed my refi attempt. LTV stands for "loan to value," and it represents the ratio of the loan amount to the value of the property; e.g., an $80,000 loan secured by a mortgage on a $100,000 home is "80% LTV," while a $90,000 loan on that same home is 90% LTV, the wrong direction if you're the mortgage banker considering making the loan. The bank (mortgagee) wants an "equity cushion" (value in excess of the mortgage-secured loan) to protect the bank in the event that the loan defaults and the bank decides to enforce the mortgage ("foreclosure"). Indeed, borrowers who need to borrow more than 80% of the home's value (that is, can't afford a 20% down-payment) often have to pay "private mortgage insurance" (or "PMI") to protect the bank in case a foreclosure sale's proceeds don't cover the defaulted "more than 80% LTV" outstanding loan.

As in many other aspects of commercial law and practice, valuation thus becomes the key to the deal. Entire courses (probably series of courses) in business departments are dedicated to the variety of methods of valuing things, including real (immovable) property. The appraiser who tried to value my home for the refi (to establish at least 80% LTV) decided that the identical townhome behind mine that sold a few months ago for a depressed price represented an inflated comparable value for my home--since it sat on the market for a few months, he decided that the purchase price should be further depressed by more than 10% to represent its true "value." Good grief! I can imagine discounting a recent sale price if there were evidence that the local market had softened in the intervening period (my appraisal didn't suggest anything like this). But otherwise, if someone just paid $X for an identical home a few months ago, I would think $X would be a pretty good comparable for the value of my home, regardless of how long that other home sat on the market. Indeed, it's perfectly obvious that the other place sat on the market so long because the original asking price (which was nearly $30,000 over $X!) was too high, and when the right price was asked, it sold. That's how the market works. Now two townhomes in my association have sold for exactly $X, but the appraiser thinks my place is worth $X minus 10% because it took so long to sell one of the other places? Please!

JPMorganChase (and other banks whose appraisers operate in this foolish way) are losing good business and failing to embrace the economic stimulus that federal authorties are bending over backwards to offer. Banks and especially mortgage servicers seem to be stubbornly struggling against the stream of federal efforts to solve the housing/financial/economic crisis.

I'm now convinced that throwing more money at banks is not the solution--they have proven that they lack the resolve, willpower, or whatever to deal responsibly with this crisis. I hereby nominate Sheila Bair (FDIC Chairperson) as the new tsar of a nationalized housing lending industry. O.K., I'm kidding . . . but only a little.

Time to Refinance?

Photo by woodleywonderworks

Exams have me sidelined recently, but I wanted to be sure to point out one very nice effect of the Fed's most recent efforts at loosening up lending markets. Mortgage rates have fallen precipitously in the past two weeks. My lender, JPMorgan Chase, is offering 5.25% today, though this lowest rate requires payment of a point. Even for no points, many qualified borrowers can likely reduce their interest rates and monthly payments substantially in this new mortgage climate. Caveat: "qualified borrower" is a much more restrictive term today than in recent years. High credit ratings, substantial equity (at least 80% LTV), and documentable income are back in vogue. Indeed, the W$J reported this morning that self-employed professionals, even those with substantial equity, liquid assets, and reported incomes are having a hard time obtaining loans due to difficulty in documenting their pre-income-tax-deduction incomes.

If you qualify, look into refinancing. At current rates, it may well be worth it.

Bernanke on the Mortgage Meltdown

Federal Reserve Chairman Ben Bernanke spoke recently at the UC Berkeley/UCLA Symposium: The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, California. Although Bernanke spoke in general terms about the importance of mortgage securitization, he did not say much about short term initiatives or what should really become of Freddie Mac and Fannie Mae.

— JSM

Mandated Financial Counseling--Some Initial Empirical Results

In 2005, as a response to concerns over predatory lending, Illinois began to require financial counseling for a very limited number of high-risk mortgage applicants (generally those with a FICO score of less than 620) in a limited number of Chicago zip codes. Although the pilot program was quickly suspended, there was the opportunity to test the program's effect, as Sumit Agarwal et al. do in a new paper just released on SSRN, here.

The study concludes that counseled borrowers appeared to take on less risky mortgage obligations than non-counseled borrowers. Although counseling appeared to reduce the supply of credit and demand for credit among affected borrowers, property values increased and lower foreclosure rates were documented in affected areas. What is especially interesting to me is that, of the borrowers receiving counseling, "an overwhelming majority" of borrowers did not understand that their ARM rate, often a teaser rate, was not fixed over the period of the loan (p. 6) and that over half of applicants received a recommendation from the counselor that they could not afford the loan under consideration (p.7). Albeit limited, the results do illuminate the extreme informational deficit that likely characterized some high risk borrowing in the last few years, and the limits to disclosure as a consumer protection mechanism. While mandated counseling raises a host of other legal & policy concerns (paternalism, discrimination, costs of implementation, just to name a few), the study does present some data that it at least does lead to better-informed borrowers.

Comparative Mortgage Confusion

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Even very smart analysts seem to have a tough time understanding the most basic elements of the current crisis. The Economist for this week contains an "Economic Focus" section (Oct. 25th, p. 92) that discusses several plans for providing aid to homeowners to try to stem the tide of foreclosures and finally put an end to the basic problem at the heart of this financial mess. A key question is how to keep people in their homes and avoid mortgagees suffering 40% and higher losses on the increasingly depressed foreclosure market.

The premise of the introduction to the Economist's discussion is that declining house prices are getting in the way of this effort by undercutting mortgagors' (homeowners') incentive to work something out, keep making their payments, and stay put. While Alan White has convincingly and repeatedly pointed out that it is irrational resistance by lenders (and servicers) that is to blame here (see, e.g., here and here), not hesitancy by homeowners, the Economist perspective intrigued me . . . until I saw this catchy line: "Two features of housing finance make the crisis hard to resolve. The first is so-called 'no-recourse' home loans, which are standard in America (though not elsewhere)." [emphasis added] The second feature, by the way, is securitization and the problem of getting consensus from the pool investors for a workout, a problem that FDIC chairperson Sheila Bair seems to have largely disproved.

This observation from the non-U.S. Economist writers on American home finance seems to me patently false. Lesson for comparative researchers: if you discover that fundamental financing practices in a major region (like the U.S.) are different from "elsewhere," best check again. Non-recourse home mortgage loans (where the borrower is not legally indebted on the loan if the home value upon foreclosure does not retire the loan) are decidedly not standard in the U.S. (or anywhere else, so far as I know). While some states, like California and Arizona, make purchase-money loans for residential home mortgages non-recourse as a matter of law, these exceptional statutory impositions don't come close, it seems to me, to making non-recourse lending "standard" in the U.S.

Yes, many (but not all) U.S. home loans are secured by purchase-money residential mortgages, many (but not even most) of those loans are in California, and many (perhaps most) of the most troubled loans are in California, too, so the non-recourse issue has major relevance to the crisis. But let's not overdo it. Anecdotal evidence suggests that many of the troubled mortgages in California are investor properties--not residences--so these loans are most likely recourse in California, too. As for the practice of "jingle mail," where people just walk away from their hideously depressed-value homes and say "come get me" (or bettter yet, "ha, ha, you can't come get me") to the lender, I have yet to see any credible evidence that this is at all common, especially for residential mortgages (as opposed to investment units). It seems to me that, if the American Bankers' Association had hard, credible evidence of a high incidence of jingle mail, it would make serious political hay by sharing that evidence and decrying the sorry state of mortgagor morality in America. The fact that the ABA has remained mum on this issue (so far as I know) strongly suggests there's no "there" there.

So while ideas for getting folks to stay in their homes should be at the heart of a real solution to this crisis, such solutions should be neither explained in terms of nor based on the incorrect notion that most (or even many) home loans in the U.S. are non-recourse, and it's homeowners who need to be convinced to cooperate in workouts. If we can get lenders and servicers on board with the FDIC's IndyMac approach to mortgage modifications, we'll be moving in the right direction . . . and we don't need to worry about homeowners following.

Good News and Scary News on LIBOR

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The latest news about LIBOR seems to offer both hope for relief and, I'm afraid, a portent of impending doom. On the one hand, short-term credit markets seem to be coming back, thanks to the more-or-less coordinated efforts of major governments. The overnight dollar rate (the rate participating banks think they can borrow at overnight from each other in London) eased this morning to 2.14% down from 2.18% yesterday morning, and down from over 5% just last Thursday. Even the intermediate-term 3-month dollar LIBOR, the key rate for most observers, slid 9 basis points to 4.55% today, down from from 4.82% last Friday. All of this seems to suggest that the recovery effort has begun to succeed, though more water will have to flow under the bridge before we can announce a real recovery.

On the other hand, the key 3-month LIBOR rate has a long way to go back to normalcy. A month ago, it was only 2.82%. As I mentioned a few days ago, adjustable rate mortgages (ARMs), student loans, and many other types of private loans with floating interest rates are pegged to LIBOR, and those that are resetting these days may nearly double their interest rates for the remainder of the reset period. This strikes me as a perverse and unwarranted windfall for the banks holding these loans. I know, I know, those who play with adjustable rates must take the downs with the ups, but market fundamentals pushing rates higher makes sense to me; irrational panic pushing rates up--as an indirect result of these very banks' shenanigans years ago in the mortgage market--is just wrong.

My question is this: how often to most ARMs reset? If they reset quarterly, one quarter of pain might be bearable, but the reset will be dramatic (from about 2.8% to over 4.5%). If they reset annually, as I gather most student loans do, an entire year of astonomically hiked interest could produce yet another round of distress and anguish for the folks on Main Street--and, yet again, a windfall for those on Wall Street. That being said, 3-month LIBOR one year ago was nearly 5.25%, so maybe this won't be a catastrophe after all.

Update: See this fascinating chart that shows (1) 3-month LIBOR was quite high (in the 4.5-5.5% range) 1, 2, and 3 years ago, but (2) it stopped running parallel to the benchmark federal funds rate earlier this year, unexpectedly darting upward to join the Prime Rate recently, as we've discussed earlier. This seems to suggest that we'll know when something approaching "normal" credit market conditions have returned when 3-month LIBOR returns to a few basis points above the fed funds rate (now 1.5%, so 3-month LIBOR of, say, 1.75%).

I'm more and more pleased that I have a fixed rate mortgage these days.

How Will We Know If a Bailout Has Succeeded?

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I've been looking in the wrong places for indications of improvements in our current financial mess. The Dow is not a good indicator because it only indirectly reflects the real problem: uncertainty as to the value of mortgages and MBS held by banks and other investors, and the effect of that uncertainty on lending markets. What we should be looking for is a sustained improvement at the source--lending markets themselves. When liqudity begins to flow again, beginning with bank-to-bank lending, then prime corporate lending, then small business and consumer lending, hopefully on more realistic and careful terms than before, we'll have a good indicator that we've succeeded (it seems to me).

These markets get much less press than the simple Dow Jones Industrial Average and are generally more difficult to understand, particularly with all the high-flying jargon that bond and money market traders use to express their ultra-cool and sophisticated understanding of finance. John Jansen's bond market blog is a great example of an extremely insightful and helpful source for this info that uses language so opaque as to barely qualify as communication (at least for non-cognoscenti like me). Thanks to a mention from Jonah Gelbach on Prawfsblawg, which led to a comment by Felix Salmon on Portfolio.com, I found Jansen's cut-to-the-quick blog, which despite its difficult language offers the info we really need to gauge a recovery/success.

Contrary to the comforting news on the Dow from Wall Street yesterday, lending markets are still seized up, and things don't appear to be getting much better. We should care that equity traders believe the bailout will succeed, but only because this indirectly suggests that they believe that lending will loosen up, financing for business will return, and the economy will get back on track rather than grinding to a painful halt with repercussions all the way down to Main Street.

Better to go to the source, it seems to me. What do banks (lenders) think? The news on that front yesterday was nothing short of terrifying. The London Interbank Offered Rate (LIBOR) for overnight dollar loans climbed on Tuesday to a record 6.88%. This is the rate that banks charge each other to lend money (overnight)--if a bank has to pay nearly 7% to get a loan, imagine what a corporation, let alone an individual would have to pay to cajole a loan out of these banks! Luckily, the huge spike on Tuesday (the last day of the third quarter) was largely a result of artificial funding constraints caused by the final day of the quarter, and the rate fell over 3% (!) the next day to 3.79%. This is stomach-churning volatility! Money markets that normally hover within half a point of the Federal Funds rate (2.0%) opened at more than triple that figure, between 6.5% and 7% on Tuesday. The lending markets are not as sanguine about the proposed bailout or economic fundamentals as Wall Street traders apparently are.

When the volatility and scary inflated rates in these markets settle down, we'll be able to breathe more easily. The Dow's ups and downs are not a great gauge, it seems, when the real problem is a lack of liquidity (caused in large part by a lack of certainty with respect to mortgage and MBS value). Find the source of the liquid, and see if the faucet has turned on. Only when banks get comfortable lending to each other again can we have any hope of a sustained recovery. What John Q Public needs to understand in evaluating the "bailout" is that its purpose (I believe and hope) is to offer banks certainty with respect to the value of mortgages and MBS, and therefore comfort to turn on the lending faucet. This is a liquidity recovery program--"bailout" is an inaccurate label and, it turns out, very poor choice of wording for political purposes!

I don't know if the Paulson plan will produce this result, but I now feel more comfortable about where to look to find out if it was successful.

If You Follow Only One Issue In This Bailout . . .

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Amid all the noise about limits on executive comp and other distractor issues, one central important issue stands out, in my view, as the most worthy of attention as Congress and the Fed wrestle over the terms of the proposed bailout: How much will Treasury pay for the mortgage-related assets/securities it proposes to unload from troubled banks? Put more pointedly, how much of a discount will the Fed impose on the supposed value of these asset to try to find a baseline from which the market can rebound? To (1) put the pain on the too-clever folks who caused this financial mess in the first place, (2) avoid the Fed taking on assets that will continue to fall in value and produce losses for all of us taxpayers, and (3) put the Feds in a position of maximum maneuverability to modify the mortgage assets they buy, we would like to see sales at a significant discount from "nominal" or "book" or whatever other misleading "value" the banks had previously put on these things. Of course, we don't want to exacerbate the crisis by forcing banks to destroy the asset side of their balance sheets and further seize up credit markets, either, but I don't get the sense that this is a significant danger (yet).

We haven't heard much on this big question, but early indications are mixed. Bernanke and Paulson today reiterated that some sort of reverse auction might be the best way to go; that is, have the banks compete to offer the lowest sales price, and the low bidder gets the toxic assets off its books, to be replaced by crisp, relatively-clear-value U.S. greenbacks. My sense is that this structure would serve the concerns mentioned above and produce an acceptable result for most reasonable-minded observers. On the other hand, another report out today suggest that Treasury is less sanguine about an auction, fearing that banks might compete too aggressively with each other to drive down prices to deeply depressed "fire sale" levels. This latter report interprets Paulson's comments as suggesting that Treasury intends to pay something closer to undiscounted long-term value ("hold-to-maturity") as opposed to current distressed value for the bad mortgage-related assets. This would, of course, raise the risk level for a big loss by Treasury and pose a serious threat to the value of the U.S. dollar.

We should all watch quite closely as Treasury reveals (one would hope soon) which of these valuation/auction methods it intends to pursue if the bailout proposal makes its way through Congress. In my view, the evaluation of the entire bailout rests on the resolution of this issue.

Long-Term Solutions, Deleveraging, and Mortgage Modification

Photo by Jonny Thirkill

So the Dow has bounced back over 400 points in the latest roller-coaster move. It's hard in these trampoline-like days to tell at any given moment whether we're still falling or bouncing back. Apparently, investors were heartened by rumors that the Feds are considering longer-term solutions to the credit crisis, including a "new government entity to help Wall Street unwind its disastrous credit bets" (a "bad bank" or latter-day Resolution Trust Corporation to take on the worst toxic mortgage-related securities and other investments). The basic idea seems to be that banks need to jettison once and for all the disastrous investments they have made, put the losses behind them, and go and sin no more.

Or banks could just get a reality check! That this crisis is of their creation is now clear. That they continue to foster the illusion that they need not act rationally to cooperate in its resolution is maddening. One of the most informed and engaging experts on the mess in the home mortgage market, Alan White at Valparaiso, has a fantastic new post today over at the Consumer Law & Policy Blog reminding us of just how irrational and stubbornly unwilling to accept reality the major mortgage banks are being. Though they claim to be on board with the notion of acknowledging reality and writing down mortgages to the (vastly lower) value of the collateral-homes, they are backing up these words with action in only a small fraction of cases. Sure, they'll cut people a break on interest and maybe fees, but modify mortgages to reduce principle--Heaven forbid! White presented to Congress evidence that banks are taking the necessary bottom line action and writing down mortgage principle in only 2% of cases. As White explains, the half-hearted Hope for Homeowners program is a cruel joke, offering relief to those facing foreclosure only if their banks were willing to accept the reality of property values and forego some of the principle on their mortgage loans (which has, not suprisingly, not happened in most cases). The FDIC is doing the right thing and setting an example by aggressively modifying IndyMac mortgages (FDIC is now the conservator of IndyMac), so why can't this reality check be extended to the broader market?

When asked about their willingness to take decisive action along the lines of the FDIC-IndyMac program, major commercial bank representatives explained, according to White, "take 10% off the loan balance, rather than foreclose at a 40% loss? This was described as the least-preferred option, and none were willing to answer what percentage of their loan mods involved any principal write-down." Ridiculous, even reckless in this era when the bottom line--the point at which the financial crisis will hit bottom and truly bounce back--depends on establishing that mortgage collateral is fairly valued at levels that allow folks to stay in their homes or allow the banks to recoup real value in foreclosure sales (rather than evicting people, taking huge losses, externalizing even further losses onto communities and the entire housing market, and then asking for redemption from the Feds in the form of a new RTC . . . revolting!). Entertaining the fantasy that the housing market will bring back the losses that are causing this spiraling financial crisis (the root of all the ills from sub-prime bond investments and credit-default swaps, etc.) is, in a word, irresponsible.

So what's the Fed to do? Well, the Fed can't do much, judging by yesterday's stock dive (Dow up 140 points on Tuesday on rumors that the Fed wills save AIG; Dow down 450 points on Wednesday because the Fed saved AIG!!??). A higher authority should step in and do at least one simple thing: amend § 1322(b)(2) of the Bankruptcy Code to treat claims secured by home mortgages just like most other secured claims; that is, allow the claim to be written down to the value of the collateral (the home), rather than forcing the law to continue to entertain the fantasy that the claim and the home are worth the inflated price originally paid. Better yet, allow mortgages to be forcibly written down to the value of the home without bankruptcy, but in any event, the special-interest gift to mortgage lenders and MBS investors in § 1322(b)(2) seems increasingly unwarranted. The notion that subjecting mortgages to "lien stripping" in this way would drive up rates was refuted, in my view quite convincingly, by a clever analysis presented in a recent paper (versions one and two) by Adam Levitin and Joshua Goodman, in which they explain that allowing forcible modification of mortgages in bankruptcy would likely result in an interest rate increase of at most 15 basis points (0.15%)!

Rather than waiting for Treasury and the Fed to turn the financial system upside-down based on questionable regulatory authority, the real regulatory power center of our political system, Congress, should introduce law(s) based on a new policy for mortgage bankers and investors in mortgage-backed securities: GET REAL!