Treating the disease, not the symptoms: a comparison of proposed solutions to the problems resulting from the bursting of the housing bubble.
By Sid Eschenbach / The Rag Blog / November 16, 2008
There have been a variety of proposals for this line of attack, including recently by Martin Feldstein in the WSJ. I have also proposed a plan, outlined below. Following my plan is a précis of Feldstein’s plan, followed by a comparison of both. There is great merit in a strategy of treating the disease and not the symptoms.
First, some pertinent data points:
- Number of families who now hold a subprime mortgage: 7.2 million
- Proportion of subprime mortgages in default: 14.44 percent
- Proportion of subprime mortgages made from 2004 to 2006 that come with “exploding” adjustable interest rates: 89-93%
- Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities: 93%
- Number of subprime mortgages set for an interest-rate reset in 2007 and 2008: 1.8 million Valued at: $450 billion
There are 7.2 million subprime mortgages out there worth 1.3 trillion, of which possibly 70% of them have exploding rate mortgages, which means about 5 million have exploding rates. Exploding rate mortgages account for 93% of the bad mortgages, which means that possibly 4.5 million of these will go bad, or 63% of the total, at a value of $820 billion and an average value of $180,000. If the ARMs reset from 7% to 12%, the increase in monthly payments is about $590 per month. $590 per month times the total of 5 million is about 3 billion dollars per month. Therefore, $700 billion would pay for 233 months, or nearly 20 years of payments… and this without renegotiating the loans so that maybe they just go to… say… 9% with the government picking up the difference. The holders of all the CDO’s would then be able to value them, mark them back to market, solve their balance sheet problems… financial problems solved.
From the housing markets point of view, it would relieve the pressure of the foreclosure spiral forcing down prices more than ‘normal’, and provide the time cushion necessary for the economy to recover and housing to rebound. Any homeowner who elected to avail himself of the help would give up all or a part of the appreciation of the property over time, penalizing them for getting jammed up, but not penalizing the guy who is paying his mortgage, playing by the rules, and betting that his home is indeed a good investment over the long term.
If the sub-prime ARMS were renegotiated down to 9%, the monthly payments the government would be liable for would be an average of $225 per house per month, or $1.1 billion annually. The $700 billion under those circumstances would be good for 636 months, or 53 years…
So in review, the proposal is to:
- Allow the Government to become an ‘investment partner’ in troubled mortgages:
- have the government guarantee payment of particular mortgages by
- taking over the portion of the payment of the amount above the ‘teaser’ rate, leaving the existing mortgagee paying the original rate while the government pays the increase,
- while simultaneously renegotiating that ARM rate down so the difference is smaller.
- In exchange for this help from their new ‘partner’, the original mortgagee gives up rights to future appreciation of the asset, penalizing him for a bad decision, not rewarding him for it.
Benefits of the action:
- Stabilization of the housing market by ending foreclosures
- Slows the fall in house values, shoring up all real estate assets both residential and commercial
- Small relative rescue price for the government, as the payments are monthly, not lump sum.
- No budget busting huge amounts of capital required in any one year, but rather very nominal amounts in any particular year.
- No bankruptcy interventions necessary.
- Homeowners who can’t pay are saved and penalized, while homeowners who can are not penalized.
- The market in all mortgage related securities will be reestablished, as payment is now guaranteed, allowing all holders of all financial products based on the mortgages to have confidence in their value.
- No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.
- Market liquidity and company balance sheets will be reestablished through the market itself.
- Allows Mark to Market rule to continue to be used
- Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.
This would be a much cheaper and more effective way to solve the problem… renegotiate the exploding rate, paying the difference and profiting from the increase in asset value over time.
The following is the proposal advanced by Feldstein in the WSJ:
The Problem Is Still Falling House Prices
By Martin Feldstein / October 4, 2008The bailout bill doesn’t get at the root of the credit crunch.
A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.
…
We need a firewall to break the downward spiral of house prices. Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%.
…
Consider a homeowner who has a mortgage equal to 90% of the value of his home. The 15% decline in the value of his house that may be needed to bring it back to its prebubble level would shift that homeowner into negative equity. Further price declines would make default attractive. But the 20% mortgage replacement loan would take the loan-to-value ratio to 72% from 90%, making it unlikely that prices would fall far enough to push him into negative equity. An interest saving that could be as large as $3,000 a year would provide a strong incentive to accept the mortgage-replacement loan, even if the individual thinks that he might temporarily have a moderate level of negative equity.
Below is a comparison of the advantages of the two plans point by point:
- No budget busting huge amounts of capital required in any one year, but rather nominal amounts in any particular year.
- Feldstein’s plan would require huge outlays of capital, a trillion dollars by his own estimate, in order to protect the 5,000,000 threatened mortgages, which is a totally unnecessary budget buster
- No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.
- A benefit of both plans.
- Slows the fall in house values, shoring up all real estate assets both residential and commercial
- A benefit of both plans
- Doesn’t penalize those who ‘play by the rules’
- The Feldstein plan rewards those who for what ever reason can’t make their payments by making them eligible for a very cheap very long term loan. This penalizes those who are paying and is unfair on its face.
- Allows Mark to Market rule to continue to be used
- A benefit of both plans
- By establishing a value for all the mortgage-related assets, the markets in them will restart, liquidity problem solved.
- This is less clear under Feldstein’s plan, as there still could be defaults. Payment is left to the original mortgagee, and what if they decided to take that $80,000 and pay off some other more pressing bill. Because of that threat, the trillions of dollars in derivatives would not be as secure and thus would not be as valuable. They may be as liquid, but at a risk induced lower price… not a good thing.
- Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.
- Feldstein’s plan does not recognize the need to lower the ARM (more appropriately an ERM – exploding rate mortgage) increases through a blanket one time renegotiation with all holders. This is equivalent to what happens when someone secures a better deal rescuing a company than the deal originally offered to the original stock holders… such is life.
- The program could be expanded to include anyone who was threatened with foreclosure due to ARMs… not just sub-prime, but Alt-A, etc.
- A benefit of both plans.
- No bankruptcy interventions necessary.
- A benefit of both plans.
The Subprime Crisis Index
Number of families who now hold a subprime mortgage: 7.2 million
Proportion of subprime mortgages in default: 14.44 percent
Dollar amount of subprime loans outstanding: $1.3 trillion
Dollar amount of subprime loans outstanding in 2003: $332 billion
Percentage increase from 2003: 292%
Number of subprime mortgages made in 2005-2006 projected to end in foreclosure: 1 in 5
Families with a subprime loan made from 1998 through 2006 who have or will lose their home to foreclosure in the next few years: 2.2 million
Projected maximum equity that will be lost through foreclosure by families holding subprime mortgages: $164 billion
Proportion of subprime mortgages made from 2004 to 2006 that come with “exploding” adjustable interest rates: 89-93%
Proportion approved without fully documented income: 43-50%
Proportion with no escrow for taxes and insurance: 75%
Proportion of subprime loans bundled into mortgage-backed securities made to speculators (those who own but don’t occupy a home) in 2006: 5%
Difference in delinquency rates between speculators and owner-occupants: 0.1 percentage points, or virtually no difference
Difference in delinquency rates between subprime adjustable-rate and fixed-rate mortgages: 14.7 percentage points
Proportion of completed foreclosures attributable to speculators among all adjustable rate loans made in 2006 and bundled in subprime mortgage backed securities: 7%
Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities: 93%
Percentage increase of interest rate on an “exploding” ARM resetting to 12% from 7%: 70%
Typical increase in monthly payment (3rd yr): 30% to 50%
Number of subprime mortgages set for an interest-rate reset in 2007 and 2008: 1.8 million, valued at: $450 billion
Proportion of 2006 home loans to African American families that were subprime: 52.44%
Proportion of 2006 home loans to Hispanic and Latino families that were subprime: 40.66%
Proportion of 2006 home loans to white non-Hispanic families that were subprime: 22.20%
Subprime vs. Prime Loans
Subprime share of all mortgage originations in 2006: 28%
Subprime share of all mortgage origination in 2003: 8%
Subprime share of all home loans outstanding: 14%
Subprime share of foreclosure filings in the 12 months ending June 30, 2007: 64%
Year-over-year increase in foreclosure filings on subprime loans with adjustable rates (2nd quarter 2006 to 2007): 90%
Increase in foreclosure files on prime fixed-rate loans during the same period: 23%
Proportion of subprime mortgages with prepayment penalties: 70%
Proportion of prime mortgages with prepayment penalties: 2%
Estimated proportion of subprime loans made by independent mortgage lenders not affiliated with a federally insured bank
- In 2004 51%
- In 2005 52%
- In 2006 46%
The negative effects of subprime foreclosures are spreading.
- Nearly 45 million homes NOT facing foreclosure will decline in value by an
estimated $223 billion, with most of the decline hitting in 2008 and 2009, as
subprime foreclosures lower the prices of surrounding homes. - Because of property devaluations caused by subprime foreclosures, 24 states and 42 counties will lose over $1 billion each in local house prices and tax bases.
- More than 90 subprime mortgage lenders have gone out of business as of July.
- Up to half of the 450,000 families whose subprime adjustable rate mortgages will reset in the next three months will lose their home in foreclosure.
- Foreclosures cost lenders an estimated $50,000 per home in processing fees, liquidation-sale price cuts and other costs. “In 2003 this translated into approximately $25 billion in foreclosure-related costs for lenders alone—well before the 2006 foreclosure spike.”
