A Modest Proposal: The housing crisis worsened over the summer of 2008, prompting Congress to debate various bailout proposals. But the housing market worsened, raising the default rate on mortgages. The entire inverted pyramid of derivatives built on top of the mortgage market further worsened, adding yet more pressure to the credit crisis. The bankruptcy of Lehman Brothers and the nationalization of AIG were the results.
The response to this financial crisis from the Treasury Secretary Hank Paulson borders on Insanity: An outrageous trillion dollar plus bailout, with the potential for unlimited expenditures at the behest of the Treasury Secretary. It is a terribly expensive plan, one that prevents judicial or administrative or budgetary review. It is fraught with moral hazard, rewarding bad judgment and excessive risk taking. It punishes the prudent and rewards the profligate.It focuses on all the wrong issues.
Worst of all, it is unlikely to work.
Most of the current solutions under discussion amount to throwing obscene amounts of money at the problem, rather than recognizing what the key issues are.
These approaches have several fundamental problems. The goals are less than desirable: 1) they attempt to keep people in homes they cannot afford; 2) The Paulson plan takes bad loans off of the books of poor lenders, and dumps them onto taxpayers; 3) They maintain price supports for homes that remain significantly over-priced.
At the heart of the
$700 billion dollar unlimited finance Paulson bailout is the desire to move weak performing or poorly made loans off of the books of the lenders who made them and onto the taxpayers back (likely via the FHA). To understand the folly of the this housing bailout, one must grasp the magnitude of the prior housing boom, as well as the historical norms that exists in the American housing market.
The current proposal moves bad mortgages from the irresponsible lenders to the innocent. It punishes every taxpayer who was prudent, and every homeowner that behaved in a responsible manner. It eliminates the sanctity of contracts, and allows judges to “cram down” mortgages.
These may be desperate times, but they do not call for ill thought out, desperate measures. Rather than merely criticize the
$700 billion dollar unlimited finance Paulson plan, I would instead like to propose an alternative approach, one that costs much, much less, and is more likely to be effective: The 30/20/10 Proposal.
A MODEST PROPOSAL: A MORE REASONABLE WORKOUT FOR LENDERS AND BORROWERS THAN THE TAXPAYER FUNDED BAILOUT . . .
To understand pricing of homes prices in a historical context, we need to consider several different metrics. Economists traditionally employ a variety of ratios to compare where housing prices are relative to traditional pricing and affordability measures. The most reliable of these look at the ability of a purchaser to service a mortgage via salary, forming a ratio of annual median income to median home prices. This can be analyzed nationally, or on a region by region basis.
Yet another methodology compares the cost of purchasing a house versus the cost of renting a similar house. Numerous other measures involve factors such as mortgage rates, inflation, housing supply, new home construction, etc. For our purposes, we will use the two metrics above, as they provide the greatest insight into price and value.
A simple comparison of the median US income versus the median home price nationally is quite insightful. As we have shown previously, as home prices rose in response to ultra-low rates, the median US income failed to keep up. As prices began to slide downwards – they are off 16% from the 2006 peak as of September 2008 – they still remain significantly higher than had been historically relative to income.
Houses may be cheaper than they were two years ago, but they are by no means “cheap” on a historical basis.Indeed, prices remain quite elevated, which is one of the reasons sales are off 30-40% from the 2005-06 peak.
The current bailout proposal would have the FHA refinance mortgages at 85% of their present value, or would simply have Uncle Sam overpay for them, taking them off of the books of the lenders or speculators who currently own them. This effectively rewards lenders who made irresponsible loans, as well as rewarding the buyers of homes who could not afford them. It effectively punishes every taxpayer who was prudent, every American who tried to live within their means, and any homeowner who behaved in a fiscally responsible manner. It is the very definition of mortal hazard, and is very likely to have negative consequences for decades to come.
One of the problem that taxpayer-funded bailouts create is that it eliminates any incentive for industry to fashion solutions on their own. Far too many banks, brokers, insurers, and investment pools believe it is easier and cheaper to lobby Congress than suffer the consequences of their own poor decision-making.
Despite the lack of self-reliance on the part of the banking industry, it’s really not that complicated to develop potential solutions to the ongoing crisis. With a little creativity, we can craft an alternative solution. In doing so, let’s recognize several truths regarding the current housing situation:
• Home prices remain elevated;
• Artificially propping up home prices is counter-productive;
• Home owers (No equity, 100%+ debt) who are in houses they cannot now, and never could afford, are going to have to move to homes or apartments they can afford;
• The banks that made these bad loans to unqualified borrowers should suffer writedowns;
• Taxpayers should not have to bailout borrowers who are in over their heads, or lenders that made these bad loans.
If we use these as our preliminary facts and assumptions, we can craft a response that is rational, effective, efficient and requires very little taxpayer money. This means, however, that there are still several million people that are in the process of moving from living in a mortgaged home to moving to a rental property or a purchased property they cannot afford.
This is what is required to help normalize prices and supply.
Instead of the massive Paulson bailout plan, let’s consider a different type of solution, one that can be effectuated by a combination of policies and actions via Congress, banks, and private equity, with the loan servicing industry participating.
I call it the "30/20/10" solution to the credit crisis:
30: Takes up to 30% of any current delinquent mortgage and separates it from the “main” mortgage; it goes into a 2nd, interest free-balloon mortgage, and stays on the books of the present mortgage holder;
20: The plan’s goal should be saving at least 20% or so of the current delinquent and potential foreclosure properties; Of the 5 million homes that may be late in making payments, (the first step along the road to delinquency, default and foreclosure) the process should make 20%, or 1 million homes eligible;
10: The Balloon payment comes due in 10 years, and will be treated as a 2nd mortgage, with interest charges only accruing as of October 1, 2018; it can be refinanced or paid off in full.
The 30/20/10 option allows the lending entity (or its equivalent) to pull aside up to 30% of the mortgage as a separate interest-free balloon payment. The remaining mortgage is refinanced at a fixed rate for 30 years. The balloon payment will "restart" fresh in 10 years. Between now and then, there will be no interest costs or penalties for this separate loan.
Consider the advantages of this plan: It would prevent a significant number of foreclosures from further roiling the markets; it takes bad loans and avoids the write down so long as thy are performing; and it allows many people to stay in homes they can afford. Moral Hazard poses no problem in this plan.
Here are additional specifics: At least 70% of the existing mortgage becomes a new, refinanced, fixed rate, 30 year traditional mortgage. And, a loan payment for up to 30% of the original mortgage, not accruing interest, with repayment of principal and interest due beginning 10 years hence, makes the present house affordable. In other words, this would look like an ordinary mortgage plus a
balloon payment, one that would not begin accruing interest until year 10.
Congressional action is required to exempt the balloon payment from causing a tax issue, as this is essentially an interest free loan might be a taxable event.
The securitization of mortgages creates its own additional difficulties in attempting to resolve defaults and delinquencies. Residential mortgages get bundled into RMBS, which were then sold and resold to various Wall Street purchasers. One of the current problems in resolving the situation is identifying who is the actual owner of the mortgage in question. This can be resolved with a clever little act changing notification provisions, requiring further Congressional approval.
Any entity that identifies a potentially problematic mortgage, i.e., delinquent and in risk of default, can start the process by evaluating the property value and the borrower’s ability to repay the loan. If they believe a mortgage would be suitable for a 30/20/10 workout, they would then send notice to the current recipients of the mortgages interest and principal payment. This entity would have 30 days to reject the workout, and failing to do so in that time Is deemed to be an approval.
In our solution, it is the financing party – a private equity firm, a real estate fund, or even a US capital pool created for this purpose – that can make this request for a 30/20/10 solution. Notice is sent by to the current loan servicer, i.e., the firm processing the mortgage payments, and forwarding them to the mortgage owner. The servicer is in the best situation to send the 30 day notice, and if no written objection is received, from the whoever currently owns the mortgage – be it bank, mortgage pool, or other securitized owner – the refinancing process begins.
Instead of a foreclosed property, the former mortgage holder is left with an interest free, 10 year balloon on up to 30% of the mortgage. They also have a lien on the property, and no writedown on the delinquent mortgage for at least 10 years.
There are other details that need to be worked out — the priority in case of sales, what happens if there is an eventual default, how to avoid fraud, etc.
The end result of the 30/20/10 workout would be the following: Homeowners who can afford to make payments on the refinance home get to continue living in them. Neighborhoods are spared the negative impacts that Foreclosure has on property values and the blight of abandoned houses. Lenders get to avoid writing down up to 30% of suitable but problematic mortgages. The balloon payment stays on the books as a liability, but it is not written down until, if and when it defaults 10 years later.
The upside of this proposal is that it serves a variety of interests with a minimum of congressional market interference. Those homeowners that can afford to stay in their house with a little bit of help avoid foreclosure. Banks and mortgage holders get to avoid writing down delinquencies that could be avoided. Neighborhoods are spared the negative impacts that Foreclosure is known to have. Loan servicers can expand their business to process saying the 30/20/10 workout papers. I would expect a variety of private equity funds will leap into the void and begin looking for mortgages to rewrite as 30/20/10s.
Congressional action required would be to 1) Eliminate the tax issue for the interest-free portion of these loan; 2) Create a Legal standing and guidelines for this notification and waiver policy. The goal here is to insure that the complexities of determining who actually owns a a mortgage dozen not interfere in its work out; 3) Create any required exemption for banks and lending entities to avoid taking a write-down during the period of the 10 year in balloon forbearance.
Weaknesses and criticism: I would expect several objections to be raised to this proposal. From those representing homeowners who face potential foreclosure, the complaint will be that this plan fails to save more than 20-30% of those who might lose their homes. For the various funds and investors that own the underlying mortgages, there will be a complaint that notification provisions are insufficient. Lastly, given the enormous size of the Federal free lunch proferred by the Treasury Secretary, the banking industry will be reluctant to embrace any such workout that might be perceived as interfering with their ability to feast at the public trough to the tune of a trillion dollars.
No matter – this is a much more workable plan than the Trillion dollar Paulson giveaway. And, it restore responsibility and consequences to both lenders and borrowers who engaged in reckless behavior. We should consider a private sector solution to the currently mess we find ourselves in.
NAR Housing Affordability Index is Worthless