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Discussions of the Kind That I Stimulated By My First Post

posted by James White

Discussions of the kind that I stimulated by my suggestions on Monday (about what Congress might do) reveal widely different assumptions about the number and type of debtors that will default. Shouldn't we look for the data? The data might keep conservatives from falling off the cliff to the right and the liberals from falling off on the other side- at last that is my hope. So who are the debtors and how many will default? Those are the questions for investors, legislators and lenders. But the answers are not easy to find, and, with incomplete data, each of us is the captive of his political bias. What about the defaulting debt and about the deserts of the debtors (Fools all? Every one defrauded?)

THE INVESTORS: HOW MANY WILL DEFAULT?

Everyday one sees bits of data in the financial press about "default rates in California (or Florida or Michigan) for mortgages written in 2006." The next day's paper will bring data that cannot be easily compared with the first day's data, e.g. "percentage of sub prime loans that are in foreclosure in Michigan or in Riverside County in Calif." On the third day the press will tell us that even sophisticated owners of this debt such as Citi or Merrill are uncertain about the long term default rate. If the ultimate default rates on Alt-A and sup prime loans top out at 15% of all loans, the game for investors is much different than if 80% of this debt goes bad.

Surely there will be bargains as banks unload their toxic debt at bargain prices. Driven in part by regulators' uneasiness about junk debt on banks' balance sheets, banks have often sold such debt at what later proved to be improvident prices. But, of course, if the default rate proves as high as some suggest, this time would be different and the price will not be favorable to the buyers.

THE LEGISLATORS: WHO WILL DEFAULT?

Legislators and others inclined to spend public funds in aid of some of the debtors, need to know not only how much debt will go bad but also about the debtors' comparative worthiness. Consider a few stereotypes.

Least deserving of help are those who have bought properties not to occupy but as investments in hot markets with the intention of selling the properties at a gain in a short time. Even the most generous would say that these people have made a bet, and should live with the consequences. I doubt anyone will favor bailouts for these debtors.

Next are people who knowingly took on too much debt to buy a new house in 2005 and are now unable to make their payments. As an act of enlightened self interest their mortgagees might want to modify their mortgages, but most of us would not want our taxes bailing them out. By hypothesis no broker's fraud induced them to borrow, and they have lived in their new places only a couple of years, so the mortgagee is not snatching a treasured homestead out from under its long term owners.

Home equity borrowers' long occupancy of their homes makes them more appealing candidates for help. There will be no movies about a mortgagor getting tossed from a newly purchased $700,000 house, but a debtor--even a foolish debtor--arouses instinctive sympathy when he is about to lose the house in which he raised a family.

All of these stereotypical debtors are distributed along a scale of blameworthiness from gullible, ignorant and innocent to clever, knowing and greedy. While there are some determined Darwinians who would give nothing even to the most pitiful and others so open-handed that they would give to all, most who are disposed to give anything would find the least blameworthy, most ignorant and gullible to be the most deserving of help. For this group, who is willing to help some but not all, one would need some way to approximate the blameworthiness of the debtors as a whole. Are 90% poor naifs who were duped by brokers? Or are 90% merely disappointed bettors who, with full understanding of the possibilities and consequences, reached too far?

Here is what I want to hear--

For the investors: Ten years from now, how many of the sup prime mortgages written in 2006 will have escaped default?

For the helpers: What is the distribution of defaulting debtors on the blameworthy scale?

Comments

If I'm understanding this post correctly, Mr. White believes all possible responses to the crisis will benefit from better, more transparent information. I agree. Indeed, I agree so much that I re-read Mr. White's previous post that, among other things, extolled a Ron Paul approach that lets the chips fall where they may while castigating a variety of Congressional approaches that, among other things, would go a long ways toward ensuring that these financial markets operated with better, more transparent information.

So, it would appear that Mr. White's libertarian philosophy calls for better information but just doesn't want to incur any government-imposed costs in support of that information.

Why do we have to play the blame game again and again? Haven't Sullivan, Warren & Westbrook (and many others recently in Europe) proven time and again that the overwhelming majority of cases that end up in distress are there not because of foolish gambles, but because of unforeseen income interruptions? Even in the cases of the most foolish debtors, there's plenty of blame to spread around to the brokers, lenders, and investors who facilitated if not caused this mess. Whatever our view of the blame, though, the bottom line is that someone has to take a haircut--the debtors are just not able to pay. Rather than looking back for blame, shouldn't we instead look forward and find the most reasonable solution going forward? It seems to me that the biggest part of the problem now is lenders'/servicers' inability or unwillingness to accept hard reality and renegotiate something reasonable to avoid even greater losses to lenders, investors, communities, and the economy when a wave of foreclosures crashes over the country. Bankruptcy law is the most effective mechanism, it seems to me, for overcoming this irresponsible intransigence (this is the primary policy objective of the new personal insolvency laws in Europe).

No one is advocating giving anyone here a free ride for their foolish real estate investment decisions. We're advocating a more even-handed negotiation, where the lenders and investors involved have to face facts, accept that an income interruptions has undermined the borrower's ability to service the loan (as is usually the case), the value of the property is the only protection they have, and negotiate on that basis, rather than on the basis of an income expectation and valuation (a few months or a few years ago) that proved to be wrong. I wouldn't think that we need to bend over backwards just to keep people in their homes (former CreditSlips blogger Melissa Jacoby has a great recent paper on this point coming out in Fordham Law Review, see http://ssrn.com/abstract=1074442). But if a reality check would lead to a negotiated soft landing for the borrower and the community (and arguably a mitigation of losses for lenders and investors), why should we resist that route because of one of the parties' foolishness in retrospect?

I guess I just don't understand what use it is to say "you foolish borrowers have to lie in the bed that you made" when scores of folks are losing their homes, dragging down property values and the general economy (indeed, the world economy, it seems). Why not acknowledge that every participant in these sour deals contributed to the problem and has a responsibility to negotiate a solution that minimizes negative externalities?

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