Bernanke is asking taxpayers to bail out banks. In a rehash of already failed ideas, plus one new one, let’s tune into Bernanake’s speech on Reducing Preventable Mortgage Foreclosures.
Over the past year and a half, mortgage delinquencies have increased sharply, especially among riskier loans. This development has triggered a substantial and broad-based reassessment of risk in financial markets, and it has exacerbated the contraction in the housing sector. In my remarks today, I will discuss the causes of the distress in the mortgage sector and then turn to the key question of what can be done in this environment to reduce preventable foreclosures.
The recent surge in delinquencies in subprime ARMs is closely linked to the fact that
many of these borrowers have little or no equity in their homes. For example, data collected under the Home Mortgage Disclosure Act suggest that nearly 40 percent of higher-priced home-purchase loans in 2006 involved a second mortgage (or “piggyback”) loan. Other data show that more than 40 percent of the subprime loans in the 2006 vintage had combined loan-to-value ratios in excess of 90 percent, a considerably higher share than earlier in the decade.3 Often, in recent mortgage vintages, small down payments were combined with other risk factors, such as a lack of documentation of sufficient income to make the required loan payments.
This weak underwriting might not have produced widespread payment problems had house prices continued to rise at the rapid pace seen earlier in the decade.
My Comment: Bernanke is essentially saying there would be no problems if we did not have any problems. The trend of ever rising home prices was standard deviations above both wages and rent. Had the prices of houses continued to rise, there simply would have been a bigger problem down the road. The only real solution is to allow home prices drop to levels that are affordable.
Delinquencies and foreclosures likely will continue to rise for a while longer, for several reasons. First, supply-demand imbalances in many housing markets suggest that some further declines in house prices are likely, implying additional reductions in borrowers’ equity. Second, many subprime borrowers are facing imminent resets of the interest rates on their mortgages. In 2008, about 1-1/2 million loans, representing more than 40 percent of the outstanding stock of subprime ARMs, are scheduled to reset. We estimate that the interest rate on a typical subprime ARM scheduled to reset in the current quarter will increase from just above 8 percent to about 9-1/4 percent, raising the monthly payment by more than 10 percent, to $1,500 on average. Declines in short-term interest rates and initiatives involving rate freezes will reduce the impact somewhat, but interest rate resets will nevertheless impose stress on many households.
My Comment: This is an honest assessment for a change. You know things are bad when political hacks are forced to admit the truth.
In the past, subprime borrowers were often able to avoid resets by refinancing, but currently that avenue is largely closed. Borrowers are hampered not only by their lack of equity but also by the tighter credit conditions in mortgage markets. New securitizations of nonprime mortgages have virtually halted, and commercial banks have tightened their standards, especially for riskier mortgages. Indeed, the available evidence suggests that private lenders are originating few nonprime loans at any terms.
My Comment: This too is an honest assessment for a change.
This situation calls for a vigorous response. Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy. At the level of the individual community, increases in foreclosed-upon and vacant properties tend to reduce house prices in the local area, affecting other homeowners and municipal tax bases. At the national level, the rise in expected foreclosures could add significantly to the inventory of vacant unsold homes–already at more than 2 million units at the end of 2007–putting further pressure on house prices and housing construction.
My Comment: Nonsense. Falling prices are exactly what is needed and more home construction when inventories are already sky high is exactly what is not needed. The situation calls for no response. The free market, if left alone, would take care of the situation nicely. And if that causes some bankruptcies at banks then so be it. Lenders who make bad decisions should not be bailed out by taxpayers. Fed manipulation got us into this mess. Fed manipulation will not get out out of this mess.
Of course, care must be taken in designing solutions. Measures that lead to a sustainable outcome are to be preferred to temporary palliatives, which may only put off foreclosure and perhaps increase its ultimate costs. Solutions should also be prudent and consistent with the safety and soundness of the lender. Concerns about fairness and the need to minimize moral hazard add to the complexity of the issue; we want to help borrowers in trouble, but we do not want borrowers who have avoided problems through responsible financial management to feel that they are being unfairly penalized.
My Comment: The only way to eliminate moral hazards is to do nothing.
Let me turn now to some recent efforts to help distressed borrowers refinance. The FHASecure plan, which the Federal Housing Administration (FHA) announced late last summer, offers qualified borrowers who are delinquent because of an interest rate reset the opportunity to refinance into an FHA-insured mortgage. Recently, the Congress and Administration temporarily increased the maximum loan value eligible for FHA insurance, which should allow more borrowers, particularly those in communities with higher-priced homes, to qualify for this program and to be eligible for refinancing into FHA-insured loans more generally. These efforts represent a step in the right direction
My Comment: This represents a step towards nationalization of mortgages. Clearly Bernanke does not even know what the primary goal of the FHA is. More on this in a bit.
Not all borrowers are eligible for this program, of course; in particular, some equity is needed to qualify. In addition, second-lien holders must settle or be willing to re-subordinate their claims for an FHA loan, which has sometimes proved difficult to negotiate. Separately, some states have created funds to offer refinancing options, but eligibility criteria tend to be tight and the take-up rates appear to be low thus far.
My Comment: More nonsense. Eligibility requirements are too low. There should not be an FHA at all. Nor should government be promoting housing. Government promotion of housing is one of the reasons why housing is not affordable. The other is the Fed micro-managing interest rates.
In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.
My Comment: On a one on one basis I do not object to these workouts as long as the workouts are voluntary between lenders and borrowers.
Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely. For example, trusts vary in the type and scope of modifications that are explicitly permitted, and these differences raise operational compliance costs and litigation risks. Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers. Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts. However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.
My Comment: It is not for servicers to decide (at least it shouldn’t be) what is in the best interests of everyone. By the time rules and other barriers are worked out, it will be too late anyway.
Loan modifications, which involve any permanent change to the terms of the mortgage contract, may be preferred when the borrower cannot cope with the higher payments associated with a repayment plan. In such cases, the monthly payment is reduced through a lower interest rate, an extension of the maturity of the loan, or a write-down of the principal balance. The proposal by the Hope Now Alliance to freeze interest rates at the introductory rate for five years is an example of a modification, in this case applied to a class of eligible borrowers.
My Comment: Freezing interest rates at introductory rates as an across the board measure is likely a violation of contract except when there is explicit agreement between all parties involved. Even then, it will not prevent walking away when it is in the best interest of homeowners to do so. I encourage people to walk away when it is in their best interest. Please see Disingenuous Begging By Paulson for more on this topic.
Lenders tell us that they are reluctant to write down principal. They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again. Moreover, were house prices instead to rise subsequently, the lender would not share in the gains. In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear. Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity. The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction. However, as I have noted, when the mortgage is “under water,” a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.
My Comment: If lenders write down principal it will invite everyone to ask for the same, over and over. It also punishes those who put up a substantial down payment for whom no writeoff would occur. Finally it would encourage those able to make payments to purposely get behind to ask for writeoffs. Loan writeoffs simply will not work on a broad brush basis.
In my view, we could also reduce preventable foreclosures if investors acting in their own self interests were to permit servicers to write down the mortgage liabilities of borrowers by accepting a short payoff in appropriate circumstances. For example, servicers could accept a principal writedown by an amount at least sufficient to allow the borrower to refinance into a new loan from another source. A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional writedowns or a re-default. This arrangement might include a feature that allows the original investors to share in any future appreciation, as recently suggested, for example, by the Office of Thrift Supervision.
My Comment: This idea is beyond stupid. Please see Postpone But Don’t Forget for more details.
A potentially important step to facilitate greater use of short payoffs is the modernization of the FHA, which I have supported. Going beyond the current proposals for modernization, permitting the FHA greater latitude to set underwriting standards and risk-based premiums for mortgage refinancing–in a way that does not increase the expected cost to the taxpayer–would allow the FHA to help more troubled borrowers. A concern about such an approach is that servicers might refinance only their riskiest borrowers into the FHA program. A combination of careful underwriting, the use of risk premiums, and other measures (for example, a provision that would allow the FHA to return a mortgage that quickly re-defaults to the servicer) could help mitigate that risk.
There are, no doubt, tax-related, accounting, and legal obstacles to expanding the use of principal writedowns. For example, investors in different tranches of mortgage-backed securities may not benefit equally, securitized trusts may not be permitted to acquire new equity warrants, and principal writedowns may require a different accounting treatment than interest rate reductions. But just as market participants, with the help of regulators, obtained greater clarity on the use of interest rate freezes through guidelines issued by the American Securitization Forum, industry and regulator efforts could also help clarify how this alternative type of workout might be effectively applied.
My Comment: See how complex all of this is? I had someone write me today telling me how “simple” this all is. It is only simple if you forget to look at the details. But the real scary thing here is the clear proposal by Bernanke to nationalize this mess through the FHA. In other words, Bernanke is asking for a taxpayer bailout of banks.
Reducing the rate of preventable foreclosures would promote economic stability for households, neighborhoods, and the nation as a whole. Although lenders and servicers have scaled up their efforts and adopted a wider variety of loss-mitigation techniques, more can, and should, be done. The fact that many troubled borrowers have little or no equity suggests that greater use of principal writedowns or short payoffs, perhaps with shared appreciation features, would be in the best interest of both borrowers and lenders. This approach would be facilitated by allowing the FHA the flexibility to offer refinancing products to more borrowers.
Ultimately, though, real relief for the mortgage market requires stabilization, and then recovery, in the nation’s housing sector. Modernization of the FHA would be of help on this front as well. I am sure that the FHA and the Department of Housing and Urban Development, given the appropriate powers by the Congress, will make every effort to expand their operations and to help improve the functioning of the market for home-purchase mortgages. For community bankers, FHA modernization and expansion would provide an important opportunity–of which I urge you to take advantage–to better serve your customers and community.
The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise could do a great deal to address the current problems in housing and the mortgage market. New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize. With few alternative mortgage channels available today, such action would be highly beneficial to the economy. I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms.
Laying the Groundwork for Nationalization of Housing
Bernanke’s speech was mostly a rehash of old ideas that have failed spectacularly. However, Bernanke proposed one new, and scary idea: nationalization of mortgages by the FHA on a grand scale. Bernanke is clearly asking taxpayers to foot the bill for irresponsible bank lending. I urge Congress to do nothing.
Professor Depew on Minyanville seems to agree. He wrote an excellent post today on Bernanke’s speech .
With that let’s review the FHA Mission
The original goal of the FHA was to provide a stable mortgage market for American families who dreamed of home ownership. The FHA would also provide the funds needed to construct low-income housing, something that was desperately needed.
Because the plan was working so well, the FHA soon became part of the Department of Housing and Urban Development. This allowed even more Americans to have access to affordable housing. In fact, since its inception, the FHA has grown to become the world’s single largest insurer of home mortgages.
The FHA’s Failed Mission
The Mission of the FHA was to provide affordable housing. How could it possibly have failed more than it did? In fact, it has failed so badly, that the proposed new mission is to bail out banks that made poor lending decisions to people who could not afford to buy houses.
Those poor lending decisions drove up the price of homes. Taxpayers paid thru the nose to support the original mission, now taxpayers are asked to pay through the nose to support the new mission.
Mike “Mish” Shedlock
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