PrintMarch 25, 2009
Time to Undo the Rescue?
President Obama recently delivered a speech where he identified the housing problem as one of foreclosures, citing a study that foreclosure signs depress prices by 9%. This is a lot like saying thermometers cause fevers.
To deal with this symptom, Congress is promising up to 9,000,000 mortgage defaulting homeowners relief from foreclosure under a new program H.R. 1106. The legislation is being driven through Congress by Speaker Pelosi and Senate Majority Leader Reid, whose two states account for one third of all mortgage defaults of the 50 states. The legislation has many facets, but its main points consist of giving taxpayer funds to borrowers and mortgage servicers and prospectively redistributing bank and bondholder collateral to borrowers.
On the positive incentive side, the mortgage servicer gets a new added fee for the modification of the loan and a legal safe harbor for effecting a write down of the collateral, and the homeowner may get various forms of debt relief, including a lower principal amount, a lower interest rate, and a bonus for doing what is in their self interest anyway. In concept, it is akin to paying kids to do their homework, as if gaining knowledge to compete and stay alive in a flat world is not incentive enough.
On the negative incentive side, the bank or bondholder is now subject to new law allowing a federal bankruptcy judge unilateral authority to write down the amount of principal on a mortgage in a consumer bankruptcy. The plan promises up to $75 billion in relief but potentially transfers several hundred billion dollars in collateral to defaulting borrowers.
Milton Friedman once said that legislation should be judged not on its intentions, but on its results. As pointed out in an article by Caroline Baum, the recent mortgage relief programs were introduced by the Bush administration with great fanfare and few results. The plan to save 240,000 sub-prime mortgage holders called FHASecure was actually only used by only 4,000 borrowers. The more recent HOPE for Homeowners was supposed to help 400,000 homeowners, but was used by only 25.
H.R.1106 may help a few more borrowers, but not likely in the fashion sold to the American public, and at a cost of dramatically changing the rules. Its overall impact will no doubt be bad. The official plan is that up to 9,000,000 newly defaulting mortgage borrowers will refinance applying guidelines that were popular before the government forced banks to increase loans to unqualified borrowers. Some will be able to refinance at lower interest rates if the mortgage is 105% or less than the value of the house. Others will be able to refinance using only 31% of their income to service debt while the government buys down interest payments.
The plan excludes many borrowers. It does not provide payouts for defaulters who (A) borrowed privately (i.e., not the government darling Fannie Mae or Freddie Mac loans); (B) borrowed over $729,000 essentially in New York or California, or $417,000 in most other states; (C) refinanced; (D) don't have a steady enough income to qualify under the new 31% guideline, or, most important, (E) lied about or exaggerated any part of their original application. According to a 2007 Fitch study, 45 out of 45 randomly selected mortgage applications in a typical loan pool were found to have engaged in fraud in the inducement to lend.
There are many problems with this plan. FDIC head Sheila Bair has acknowledged that the government cannot effectively do forensic analysis. Moreover, it is highly unlikely that many borrowers, already defaulted, will submit to go under an IRS audit like microscope while the government conducts a forensic analysis of their past mortgage applications. Because of this, relatively few borrowers will likely qualify or voluntarily use the official plan.
However, the change in the bankruptcy law completely changes the negotiating dynamic between all borrowers and all lenders, whether or not the government incentives are available. Up until now, banks and bondholders could foreclose without forcing borrowers into bankruptcy. Even so, in states like Florida where foreclosures are rampant, the foreclosure process is taking over a year from the day of the first 30 day default to the actual foreclosure sale. During that entire time the defaulted borrower can be living in the house free of charge and without paying down the mortgage.
It is not difficult to envision a scenario where this situation is exacerbated by H.R. 1106 and the corresponding proposed changes in the bankruptcy laws. By offering a fundamental right to renegotiate the principal of a primary home mortgage, the law could significantly lengthen the time of the property stays in the hands of the defaulting borrower. And who is to say that the costs of filing bankruptcy won't come down? In fact, by lengthening the procedural time of bankruptcy and foreclosure, the change could be seen as affecting a property seizure under the Constitution, and a denial of due process, since, under H.R.1106, every consumer would have the right to go through bankruptcy to determine their new/lower mortgage principal and interest before a foreclosure could even take place.
Now consider that we are told there are 9,000,000 homeowners in default, 368 federal bankruptcy judges, and that a typical consumer bankruptcy can take up to five court days. This gives each judge the capacity to fully try about 50 individual cases a year, or a total present national capacity of 18,400 cases a year. Last year 1,000,000 bankruptcies were filed, and thisyear 1,400,000 are expected, absent any changes in the law. But most of these cases are cleared quickly because the rules are well established and outcomes are predictable, and consumers are using Chapter 7 for liquidation.
With bankruptcy converted from a disgrace to a privilege, if even a modest portion of defaulters choose to file for a Chapter 13 bankruptcy and insist on a trial, the old expectations are gone. This will happen more if the costs of filing for such a bankruptcy are less than the additional costs of meeting all monthly obligations without relief from creditors. Just guessing, the backlog for clearing the bankruptcies will likely significantly lengthen as the stigma of changing a contract falls away and more people are upended. The furor over the AIG executive payments has come out as, "the government should have the right to retroactively change contracts." Surely, beleaguered consumers will embrace the government's amoral example.
Many defaulters are now looking at housing as a trading asset, and contemplating walking away if the debt exceeds the current value. 20% of houses meet this walk away threshold and the number is rising as housing prices continue to fall. In addition, the availability of credit card debt is imploding as FICO scores plunge and credit lines are withdrawn (in part because of falling housing prices), setting up a vicious cycle of credit card line reduction impacting the desperation house sale in a negative feedback loop. As recently pointed out by Meredith Whitney in the Wall Street Journal, banks are reducing $ 5 trillion in credit card lines to perhaps as little as $2.3 trillion by the end of 2010, with the result that for many consumers almost every new credit payment simply reduces the credit line, and does not create any new availability of credit.
So once a family finds itself underwater on its mortgage, and at its full credit card limits, the issue becomes which bill should it pay and when. Once upon a time the mortgage was among the first bills to be paid. But if the foreclosure docket is crowded, and a family may be able to live for a year without paying out any cash to the bank, defaulting becomes a more attractive option. Under H.R. 1106, that year could easily stretch out further, disincentivizing any deals with the bank.
As more and more families rationally conclude that bankruptcy is a superior option, discretionary defaults are starting to soar. These are defaults where mortgages could be paid first if desired, but strategically defaulted. Call it the Thelma & Louise approach to borrowing. And then there is the chance to re-default, as many do. Call it The Nightmare on Elm Street: Part 2.
Private banks and investors will respond by offering mortgage terms more similar to credit card loans for new mortgages: much higher interest rates, much bigger down payments, shorter terms, more hair triggers. This will shut the door on the homeownership dream for many of our children and depress the value of real estate today. Call it the Pawnbroker approach to lending privately.
So the government could soon be the only game in town for conventional mortgages with traditional terms. Call it the Godfather approach to government backed loans. They were all great movies, but they make for bad policy.
Finally, one cannot over estimate the impact of the moral injustice of imposing on the large majority of homeowners who have struggled in a worsening economy to meet their obligations, only to find that they will have to pay higher taxes to enable less prudent borrowers to receive a government bailout while they are forced to sacrifice in the face of a slowing economy, a hemorrhaging housing market, a complete rule change, and the unfairness of calling on thrifty states to bailout profligate ones.
Starting with the President's number of 9,000,000 defaulters, one can easily envision a scenario of unintended consequences where an additional 5,000,000 or more homeowners default, many using the change in the bankruptcy laws to buy more time. In the game of musical chairs, it is best to move first. H.R. 1106 has opened Pandora's Box by assuming people will not change their behavior.
Last year, over $11 trillion in American wealth was destroyed, the bulk of it by imprudent government action. This year, the government is outdoing itself. With one hand, it is shoveling money into banks; with the other hand, it is undermining the securities that often compose a big part of the banks' capital and implementing policies that ultimately hurt housing's value. And, while Congress may fancy itself to be Shiva, creating with 500 hands and destroying with 500 hands, it's not what they were hired to do.
Eric Singer is the Fund Manager to the Congressional Effect Fund that seeks to avoid political risk by investing in the equity market only when Congress is on recess, and primarily in interest bearing instruments when Congress is in session.
