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Friday, December 07, 2007

Another Teachable Moment - Squandered

On the same day, both George Bush (#1) and Hillary Clinton (#2) attempted to dash to the head of the parade in the effort to "help" sub-prime borrowers faced with the prospect of defaulting on their mortgages and "losing" their homes. If THESE two players agree that "something must be done," does anyone believe any sound economic principle lies behind this sudden "helpful" instinct? It's pretty easy to argue the negative, just by analyzing the mechanics of a mortgage freeze and its likely impacts.

Some Proposed Fixes

The Bush proposal (actually a joint effort between the Treasury and mortgage industry) calls for freezing mortgage interest rates for a period of five years for a particular category of borrowers who:

* took out a mortgage on a primary (occupied) residence
* between January 2005 and July 2007,
* have not yet defaulted on the loan
* and have not yet been hit with the interest rate adjustment on their loan

The Clinton plan (#3) calls for

* allowing state level bond programs to use funds for re-financing as well as original loan
* providing an extra $2.5 billion to fund those state bond programs (MRB)
* a freeze on sub-prime rates for 5 years or until "affordable" fixed-rate loans can be made
* a 90 day moratorium on foreclosures involving sub-prime loans
* better reporting from the mortgage industry on loans being renegotiated

So is either plan appropriate for the scale of the problem? First some basic statistics:

* nearly $2 trillion in mortgage debt faces rate resets in the next two years (#4)
* the average home price is $211,700 (#5)
* the average monthly home mortgage payment is $1672 (#6)
* estimates for the number of sub-prime mortgages at risk range from 1 to 2 million (#7)
* the current 30-year interest rate is about 6% (#8)

Ignoring for a moment the number of loans originated as interest-only loans or loans with ridiculous 1% rates, let's just assume the average reset increased the interest rate by three percent on a $190,530 loan (a 90% loan to value on an average home). Running the amortization on that loan in Excel shows a monthly payment of $803.28 for the first three years jumping to $1112.13, an increase of $308.85 per month.

Obviously, this implies the average home mortgage amount of current loans (regular and sub-prime) is significantly higher than the overall average home price. A monthly mortgage of $1672 assuming a fixed 30-year mortgage at 6 percent implies a mortgage amount of about $279,000. If a $279,000 loan amount is used in a 3/27 model jumping from 3% to 6%, the monthly payment would jump from $1176.28 to $1628.53 or $452.25. Let's go with that number.

A five year freeze on upward resets aimed at one million borrowers is aimed at deferring 60 months of incremental $452.25 payments the borrowers cannot afford, or a $27.1 billion shortfall. Clinton's proposal to add $2.5 billion in funding to a bond program aimed primarily at original mortgages instead of re-finances would appear woefully inadequate to make even a psychological improvement in the market. Using the above numbers for comparison, a $2.5 billion solution only addresses about 9.2 percent of the at-risk loans, or about 92,250 loans of the low-end one million loans estimated to be at risk.

The plan touted by President Bush involves no direct funding by the government but involves a voluntary agreement by lenders to alter lending terms under specific qualifying criteria. Critics have already raised concerns that the criteria not only narrow the eligible pool to a number far below the million at risk but that they perversely reward those who have the worst credit and closed their loans later in the cycle when presumably the risks should have been better understood. No cost is estimated for the Bush plan but clearly lenders won't voluntarily surrender the right to $27.1 billion in interest payments with all other variables unchanged. The obvious variable under their control is the amount of funds available for other loans. $27.1 billion fewer dollars coming in means $27.1 billion fewer dollars available to lend to ANYONE. The missing $27.1 billion could be used for an additional 160,014 loans for average priced $211,700 homes with an 80 percent LTV. See? This voluntary program would reduce the supply of funds to 160,014 qualified buyers able to produce a 20 percent down payment on an average priced home to allow unqualified sub-prime borrowers to stay in houses they never could afford in the first place for an additional five years. Other than that, it's "free."

It seems pretty evident that any of the current proposals involve dollar amounts or eligibility which are at least one order of magnitude beneath the scale of the dollars or numbers of loans at risk. Regardless of the scale, a quick analysis of the mechanics of any such freeze at the micro-economic (the homeowner) or macro-economic (the financial industry) levels makes the logic behind such proposals even more dubious

The Little Guys

Can a mortgage rate freeze actually protect current homeowners, either sub-prime borrowers or the rest of us? In a word, NO. First consider the borrowers nearing default. If our average borrower looking at a $452 dollar jump defaults the very first month after their mortgage adjusts, that literally means that borrower has no other liquid assets to tap to cover a $452 dollar expense. At any time. How many homeowners ignorant enough to sign a $279,000 loan without the financial cushion to absorb a $452 shock are also ignorant enough that they don't understand they have to make 6 percent on their home just to break even? Even if the borrower managed to sell the home to cover their loan, the borrower without $452 in spare cash also won't have the $16,740 to cover the real estate commission on a $279,000 sale. If a government program did nothing but pay the sales commission as defaulting borrowers sold their homes for the loan amount, it might take $16.7 billion just for that.

From the perspective of equity appreciation protection for other homeowners, the logic behind a mortgage rate freeze has equally fatal flaws. First, any arbitrary freeze period doesn't change the underlying economic reality that the sub-prime borrowers CANNOT AFFORD THEIR HOME. A Bloomberg news story (#9) indicates possibly half of the 450,000 sub-prime borrowers facing rate hikes in the next three months will lose their home. That trend is likely to continue for the next full year, putting 900,000 borrowers in the crosshairs. Are you aware of any looming economic boom in America that will produce average take-home pay increases of $452 dollars per month ($5424 a year) for a million workers? I'm not either. Are you aware of any looming economic boom in America that will produce one million new jobs in the next year to help borrowers avoid losing their home after a job loss? I'm not either.

If your home value shot up thirty percent in the past three years because you had a bunch of new neighbors move in with artificially cheap mortgage money that allowed them to get more home temporarily than they could afford permanently, shifting the pain out one year doesn't change reality. The cruel reality is that your home in fact did NOT go up thirty percent in value, unless you happened to luck out and sell your home before the bubble burst. Arguing it did makes no more sense than arguing Enron was ever worth $90 a share. Homeowners who acted upon that inflated valuation before the bubble burst by borrowing against it via a HELOC or by selling and buying an even bigger home are no smarter than the original sub-prime borrowers.

Freezing rates on existing sub-prime loans also hurts the market by freezing all of the current uncertainty in place as well. Protecting teaser rates on current loans won't ease the tighter (justified) lending standards required for new mortgages. As a result, the pool of potential new buyers who can afford an inflated home price is still smaller. Protecting the teaser rates allows borrowers to stay in their home longer, reducing the supply of homes that would otherwise be on sale. The combination of fewer eligible new borrowers and fewer sellers produces reduced sales volume, which makes it more difficult for the market to gauge new price levels and eliminate the uncertainty. A lack of liquidity paralyzes not only the home market but the job market as well. How many people have the nerves of steel required to accept a job in a new city without knowing if they can sell their current home in nine months and without having confidence home prices in their new community won't be tanking a month after they move in? How many employers will be willing to cover that risk as part of relocation benefits?

The Big Guys

Rate freezes , even if voluntary, will fail to help stabilize the broader financial markets for the same reasons they fail at the micro level for individual borrowers. Deferring the point where those who truly cannot afford their home get tossed out doesn't materially change the underlying problem. It simply shifts the timing of the missed payments and the ripples they cause on valuations of the underlying CDOs and similarly obtuse financial instruments built upon the original bad loans. It does nothing to clarify the actual value of the underlying assets. Until that happens, financial markets will continue to seize up any time two major parties to a transaction suffer a panic attack from trying to set a value on assets they give or get in a deal. The longer that goes on, the greater the volatility will be in stock markets as investors try to gauge the true book value of companies holding this debt.

What Should be Done?

The real fallacy about any proposal to "solve" the sub-prime problem starts with the very definition of the problem as limited to the sub-prime mortgage world. The sub-prime mortgage problem is a microcosm of the failure of American economic policy and American politics in general. People taking out a mortgage because they could afford the first three years of payments and "deserved" a nice house are no different than the American public at large, which has continually returned politicians to office who vote for prescription drug programs or wars with dubious near-term benefits using long-term borrowing. Long term borrowing lowers the near term cost of government spending and artificially increases demand.

The complexities of the sub-prime business and the damage done to the economy by its collapse are so great that the odds of a small group of politicians or industry heads devising an equitable and efficient solution are virtually zero. However, the odds of a small group of politicians and industry heads devising a solution that protects their interests (remaining in power and remaining wealthy despite their mistakes) at the expense of those not in the room are a near certainty.

The sub-prime crisis represents another in a series of "teachable moments" for the American public -- moments where the consequences of a decision become apparent in a way that can be inescapably correlated to the decision that produced them and cement a powerful lesson in the minds of the public about future decisions. The idea of one million families losing a home certainly isn't pleasant. There is a worse scenario, however. What if the government saves one million homeowners from default? What's more likely to happen? One million citizens walking away from the cliff saying "Wew, I'll never do something THAT dumb again." Or FIFTY million citizens saying "Hmmm, that worked out OK for them, I bet I can play even closer to the edge." Every teachable moment is a painful lesson. The problem is that every teachable moment squandered produces a much more painful teachable moment down the road. The American economy is running out of road.

The sad truth is that America has raised a generation of consumers and voters so ignorant about legal and financial matters that millions voluntarily entered into legal agreements involving hundreds of thousands of dollars without a clue about the true reality of their situation. They weren't sitting in a room signing closing papers surrounded by people eager to "help" them get into a home they "deserved," they were sitting in a room signing their own financial death warrant surrounded by real estate agents, builders and lenders who devised the perfect financial tool for separating fools from their money while providing a three-year head start in fleeing the scene of the crime.

The even sadder truth is that the same generation of Americans is also likely so financially and politically ignorant they cannot recognize the true cost and the true beneficiaries of the so-called solutions being proposed by the very players who contributed to the debacle in the first place. Hopefully, Americans will recognize the similarities between that sub-prime borrower closing his ill-fated loan and the larger situation we face as politicians promise to help now. It's up to us to realize the big guys in the room aren't really there to help us. They're looking to help themselves -- with our money.


#1) http://news.yahoo.com/s/ap/20071206/ap_on_bi_ge/mortgage_crisis

#2) http://www.cnbc.com/id/22116919

#3) http://www.hillaryclinton.com/news/release/view/?id=4496

#4) http://online.wsj.com/article/SB114204536747195612.html

#5) http://www.realestateabc.com/outlook/overall.htm

#6) http://wiki.answers.com/Q/How_much_is_the_average_mortgage

#7) http://www.npr.org/templates/story/story.php?storyId=16783072

#8) http://www.msnbc.msn.com/id/7148582/

#9) http://www.bloomberg.com/apps/news?pid=20601103&sid=akOEPec30TR4