The Sweep-It-Under-the-Rug Housing Plan (updated)
There is $700 billion in negative equity in the US. That is the critical figure. Any housing plan that doesn’t take a serious bite out of that $700 billion isn’t worth discussing. It’s just window dressing. And that’s exactly what the latest iteration of the Tom Miller-led AG mortgage servicing settlement is. Sure it’s been sweetened by the addition of some interest rate reductions for underwater, but current homeowners (discussed at the end of this post), but that’s small potatoes. The latest settlement proposal is an exercise in rearranging deck chairs on the Titanic.
It’s time that we recognize that negative equity is the critical problem in the US economy. Fix negative equity and you will fix the US economy. That is because negative equity is the key for repairing household balance sheets, and that is the catalyst for getting consumers spending again, getting banks lending again, and getting businesses hiring again. If we're serious about dealing with negative equity, we need to address it directly and not engage in an extend and pretend dance.
It's also time that we recognize that negative equity didn't just appear by itself. This wasn't a freak weather event. It was a man-made disaster. We ended up with negative equity because of a housing bubble inflated by very deliberate acts by a limited number of financial institutions that profitted greatly from bloating the economy with cheap and unsustainable mortgage financing. We witnessed a macro-economic crime and are living with the consequences of it.
Why negative equity matters for the economy
Consumer spending is 70% of GDP. If there’s any stagnation or contraction in consumer spending, its effects reverberate throughout the economy. That’s where we are today. We’re in a balance sheet recession caused by households pulling back on their spending because their concerned about their households’ financial position. The central reason for this concern is that houses—historically the major asset of most households—are worth much less than they were and, in many cases, worth less than the debt they secure. Unless households feel more confident in their balance sheets, they won't go out and spend (and banks won't make them loans to spend). And that means less consumer demand for goods/services, which means less jobs, and a vicious cycle starts.
The Administration and the AGs’ goal seems to be to make the housing problem go away. It won’t go away. That should be patently obvious by now. The goal has to be to fix the market, not to cover it up its problems.
Negative Equity is a Market Clearing Problem
To understand what is so problematic about negative equity, it’s worth thinking about how a market should function—willing buyers and willing sellers should meet and agree on a price. When they do the deal, the market clears at the deal price and welfare is enhanced through exchanges that both parties see as value-enhancing. The problem with the housing market is that willing buyers and willing sellers can agree on a price, but can’t do the deal. They can’t do it because of the presence of a mortgage on the property. To wit, if you agree to buy my house for $200k, we can’t do the deal if there’s a $265k mortgage on the house. There’s a “due-on-sale” clause on the mortgage, that would accelerate the entire debt. And unless I can pay off the mortgage, it would continue to be on the house, and the lender could foreclose and take the house away from you unless you paid the $65k.
Foreclosures Are an Inefficient Market Clearing Mechanism
We do have one way of clearing the housing market: foreclosures. But foreclosures are an incredibly slow and inefficient method of market clearing, even in the best of times. Foreclosures are rife with negative externalities on neighbors, communities, and local government, and they can result in the market over-clearing because of information problems (foreclosure sale purchasers don’t have a right of inspection pre-sale, so they can’t tell if the plumbing has been torn out before they buy. No refunds. Even if the house is packed with dead cats. Yup. That’s a real case.)
What this means is that Mitt Romney is just delusional when he suggests that the solution to Nevada’s problems is to speed up the pace of foreclosures. The foreclosure timetable has gotten a lot slower, not least because of banks’ paperwork snafus, but there are also system capacity issues. And lots of fast foreclosures would have a firesale effect on prices and drive down prices further. We saw this in other markets in fall 2008. And yes, even delinquent borrowers have due process rights. Delinquent homeowners are people too, my friend.
Now this isn’t the first time in recent memory we’ve had a market freeze. In the fall of 2008, we had market freezes across the economy—markets weren’t clearing because sellers were concerned whether their buyers would be money good. We fixed that with a simple tool—the government guarantee. The government pretty much said it stood behind everyone major. That unfroze markets. But it didn’t unfreeze the mortgage market because the government didn’t stand behind the mortgages. Indeed, the thought of doing so wasn’t even on the table. Treasury and the Fed really only have one tool in their toolbox—throwing the financial wherewithal of the United States behind a faltering entity. That’s easy to do with a few thousand banks. But with millions of homeowners? Not in Treasury’s conceptual universe.
How to Deal with Negative Equity
So we’re left with the problem of negative equity preventing the housing market from clearing. There’s only one way to skin this cat. The negative equity has to be eliminated. Period. We hoped at first that we’d grow out of it. Fat chance. This is the anchor weighing down the ship. So now it’s just a question of whether we try to clear the market via foreclosure or whether someone pays to clear the market, meaning that the book values at which mortgages are carried are written down to market values or something close to it.
Who should pay? This is basic justice. Those who broke the economy should pay to fix it. You break it, you take it. We bailed out the banks because they are indispensible to the economy as a whole, but that doesn’t mean that they shouldn’t have to pay now. $20-25 billion is a fine price tag for robosigning. But this isn’t and shouldn’t be about robosigning. Robosigning was symptom of a much larger endeavor in reckless lending, in which corner cutting was the order of the day, from MERS to securitization paper work to no-doc loans. All of this was done to maximize profits and to enable a housing bubble that was hugely profitable to a limited number of financial institutions and with extraordinary collateral damage. Simply put, there needs to be accountability for blowing up the economy.
Again, those who broke the economy should pay to fix it. And someone needs to go to jail. (We sent over a thousand folks to the pokey for the S&L debacle. So far we’ve sent a couple of small fry to jail. That’s grossly inadequate for justice. But that’s another matter.) The point is that $20-25 billion is 3% of the book value of the 5 big servicers and just 6% of their market cap. Hardly “breaks the bank.” This settlement is a blip for them. If they can pay $25 billion and see their market value go up $40 billion because of the uncertainty cleared up, it’s a no-brainer for them. But when you look at BoA and see that it’s market cap is $65 billion against a book value of $220 billion, it shows that the market recognizes that BoA’s assets aren’t worth what BoA claims (or that BoA’s got huge unrecognized liabilities). Writing down negative equity would start to make book and market values converge, which is where they should be. And that’s important for getting banks lending.
The Latest Version of the Tom Miller AG Settlement Plan
Sadly, the Tom Miller-DOJ plan doesn't seem to do anything on this front. As far as I can tell, the Tom Miller-DOJ plan is only about servicing issues. But while servicing is the consumer protection issue of the day, it’s a nothing relative to the scope of the harm involved. If one approaches this as a prosecutor, the major harm done wasn’t the servicing fraud. It was the pump-and-dump the banks did on the entire housing market. They recklessly inflated the housing prices and profited greatly from it. And the taxpayers, the government, and mortgage investors were left holding the bag. Tagging the banks for $20-25 billion and calling it a day would be nothing short of a disgrace. On this one the Tom Miller-led group of AGs need to need to play big or they need to pack it up and go home. Dicking around over $25B with five institutions that have a market cap of around $400 billion is just bush league. But then, that’s all they really can hope to get when they try to negotiate a settlement without doing any investigation. It’s frankly an abuse of the public trust for AGs to be settling claims without investigation.
[update: now we learn that this settlement is going to include a release of origination fraud claims against the banks in exchange for an additional $2B-$4B. It's
Keystone Cops worse than Keystone Cops. For a while the AGs just looked incompetent in the settlement negotiations. But now it's gone from incompetence to outright malfeasance. To contemplate a release of origination claims that have never been investigated for an additional $4B is so shocking that I have trouble finding genteel words to say about it. To paraphrase Rep. Elijah Cummings, "Is Tom Miller a chump?" Why on earth does he feel compelled to even discuss such a patently bad deal?]
How Many People Will It Help? Not Many. [Perhaps 60,000.]
Turning to the newest proffer on the table from the banks, they are offering to lower interest rates on performing, underwater mortgages that they hold on their own balance sheets. How many homeowners does that help and how does that compare to the scope of the problem? Let’s assume that there are no eligibility requirements other than that a mortgage be held by a commercial bank, that it be performing, and that it be underwater (which might require a fresh appraisal, but that’s another matter). Commercial banks hold about 20% of the mortgages in the US by principal ($2.12 trillion and roughly 50 million mortgages, we think). The big 4 hold $1.1 trillion in performing mortgages. That’s roughly 10% of the mortgages in the U.S. Let’s assume that 25% of those are underwater, so that’s 2.5% of the mortgages in the US ($279.2 billion or roughly 1.4 million homeowners) that might be affected.
So we’re looking at an upper bound figure of 1.4 million homeowners being helped. I suspect it will be quite a bit lower in practice. The banks might not agree on which mortgages are underwater and might require various further requirements for getting the interest rate reduction, including waiver of claims by the homeowners. The effect will be to lower the number of homeowners helped, much as all of the various HAMP eligibility requirements made the program capable of helping very few homeowners.
[update: Actually, we now know roughly how many homeowners will be helped. Perhaps 60,000. Yup. I didn't forget a zero there. it will be much lower. The debate at present is whether there will be $2B or $4B applied to interest rate reductions. The banks are offering $2B and Tom Miller is pushing for an extra $2B. Now we could assume that lots of homeowners get a very small interest rate reduction. If so, it's a yawn. But let's assume that this money is being used to pay down interest rather than pay down principal--both are economically interchangeable, but only a principal reduction affects the balance sheet. (I recognize that one can argue with me on this, but if I'm wrong, it's not by an order of magnitude. It's by a multiple of 2-3 at most.) The average amount of negative equity on a home is $65,000. Take $4B and divide by $65,000 and you get 61,538. That's a pretty good measure of the number of homeowners who will be helped nationwide. So if Tom Miller gets his way, another 30,000 homeowners nationwide will get some relief.
If you want to test my numbers, try thinking of it like this. With a $200k mortgage at 6.5% the interest payments in a year are $13k. If the mortgage were refi'd to 4%, the interest payments would be $8k annually. So a difference of $5k per year. Assume that this lasts 7 years. That's a cost of $35k/mortgage. (I'm not going to try discounting to present values and am not sure if the $2B or $4B figures include such discounting, but I would guess not.) So with $4B, we're looking at 114,000 homeowners being helped, and with $2B, we're looking at 57,000 homeowners. That tells me that I'm in the ballpark. It might be 50,000, it might be 80,000, it might be 120,000, but it's no where close to the 11 million at-risk mortgages identified by Laurie Goodman of Amherst Mortgage Securities. $4B is a rounding error when dealing with the US mortgage market. At best this settlement helps 1% of the at-risk population. How do you think the rest of them are going to feel about their AGs come next election?]
The proposal is also terribly arbitrary in who it helps. You get some help if your loan wasn’t securitized. But homeowners don’t choose whether their loans are securitized. That means if you had a Countrywide Loan, you’re SOL, because there’s a 96% chance your loan was securitized. Given that some lenders had much bigger shares in certain states, the relief will be geographically uneven. I would think that California, for example, would come up short on this deal, even within the context of it being a bad deal in the first place.
How Much Will It Help? Not Much.
What about the substance of the relief? The plan seems to be to refinance these underwater, but current homeowners into new loans. Whatever the transaction form, the proposal is effectively for payment mods (albeit with the elimination of all claims and defenses that could have been raised regarding the original loan). To repeat, these refis, are payment mods, not principal write downs. We know that payment mods just don’t work very well, especially if there is deep negative equity. Why are we repeating the same bad idea here? It avoids the banks having to take a write-down (interest shows up on the income statement over time, not the balance sheet).
The mod will make the mortgage more affordable, but will the monthly P&I payments be market rate for the property? Not a chance. The homeowners will still be paying too much for houses in which they have no equity. They won’t be paying quite as much as before, but they’ll still be overpaying. If they run into any trouble and encounter the 4 “D”s: divorce, disability, dismissal, and death, the home will go into foreclosure. These are life cycle events that aren’t going away. Payment mods might have some economic stimulus effect, but this plan isn’t going to save very many homes.
And it’s also not clear what this sort of relief has to do with servicing, if that is what the settlement is about, as the servicing problems are really much more on securitized than portfolio loans. Requiring short sale approval if the sale offer is within 5% of current appraised value would be a much better approach if you want to try to deal with negative equity. It would let borrowers get out of their homes if they wanted to leave.
So the newest feature to the Tom Miller plan would help very few of the underwater homeowners around and won’t help them that much. And this is front-page Wall Street Journal news why? Every time the Administration comes out trumpeting a breakthrough and then fails to deliver something that helps the majority of homeowners it takes a political hit. Haven’t they learned this doesn’t work?
I don’t know what is motivating Tom Miller and the AGs who are going along with the settlement or the DOJ or the Administration in general other than the desire to make this problem go away (US Attorney General Eric Holder has a bit of a conflict in all of this since his old law firm, Covington & Burling, issued the infamous MERS
insurance policy opinion letter, blessing that operation--has he recused himself?), but the AG settlement plan that they’re proposing is a travesty. It won’t help fix the economy in a meaningful way, much less address the scope of the wrongdoing: the crippling of the US economy. That’s serious harm, and it calls for a serious remedy. This ain’t it.