Arnold Kling  

Subprime Daily Briefing, Dec. 6

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Here is today's edition.

LATER: more added

The Washington Post reports,


The FBI today will launch a mortgage fraud task force in its Washington field office, joining a widening net of state and local investigators digging into the market crisis.

So the barn door is finally going to start to close.

The New York Times reports,


Almost a year ago, on Dec. 14, 2006, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting. The investment bank’s mortgage desk was losing money, and Mr. Viniar, with various officials, reviewed every position in the bank’s portfolio.

Read the whole article. It sounds as though some Wall Street folks closed their barn doors in time. Others didn't.

Finally, the teaser freezer seems to be a done deal.


The plan, hammered out after weeks of talks among Treasury Department officials, mortgage lenders and Wall Street firms, would allow distressed borrowers who are current on their payments to keep their low introductory rates and escape an increase of 30 percent or more in their monthly payments when the rates expire.

Democratic lawmakers and presidential contenders quickly criticized the plan as being too timid and promoted more ambitious proposals of their own.


Lord help us.

If the problem here consisted of poor, strapped borrowers needing a break from impending rate increases, this might be a solution. But the problem is (a) the housing market is looking for a bottom and (b) securities markets are illiquid. For both of these problems, the teaser freezer is at best irrelevant and at worst counterproductive. The best that might be said for it is that it forestalls the "more ambitious proposals" which no doubt would muck things up even worse.

Keep in mind, however, that neither a teaser freezer nor a "more ambitious proposal" is going to turn those loans that are defaulting within 6 months of purchase into good loans. You can't make a silk purse out of a sow's fraud.

LATER:

Speaking of fraud, Felix Salmon passes along this doozy.


more than 100 defaulted and foreclosed-upon properties can be traced to associates of Crisp & Cole. ..

Here's how one scam worked, as reported by the Bakersfield Californian. On July 12, 2006, Crisp & Cole sales agent Jeriel Salinas bought a Bakersfield home for $620,000. The deal was "fully financed" -- meaning Salinas put no money down. On Aug. 21, Salinas granted -- for no apparent compensation -- a 99 percent interest in the home to Aiden, Logan & Associates Inc., another company affiliated with Crisp & Cole. The very next day, on Aug. 22, Aiden, Logan sold the home to David Crisp's mother, Tu Crisp, for $959,000 -- a 55 percent markup in just one month. Again, the deal was fully financed. Both the Salinas and the Tu Crisp transactions were notarized by Crisp & Cole employees.

On May 10, 2007, Tu Crisp's loan defaulted. On Sept. 17, the lender foreclosed.


I don't think that the teaser freezer is going to make these loans any better.

Mark Thoma points to David Wessel's column.


Big banks are reluctant to lend even to each other for more than a few days, and are hoarding cash. In a symptom that the financial fever hasn't broken, interest rates for one- and three-month loans among banks are up sharply. The Fed and the European Central Bank are now forced to consider the economic equivalent of alternative medicine.

Bank capital standards may be counterproductive at this point. I worry about this scenario: Every bank has to mark down some of its securities, and this means that they need more capital. So they all start selling securities, which means that the prices go down, which means more markdowns, more need to raise capital, etc. I'm not sure that such a vicious cycle truly can occur, but it seems like a possibility worth worrying about. The way to stop it, of course, is to loosen up the capital regs for a bit, under the assumption that the banks really are solvent if the market is given time to recover in an orderly fashion.


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COMMENTS (11 to date)
Richard writes:

I'm not familiar with the comprehensive solution but if, say, there was a 5 year freeze of today's rate (for the designated borrowers)and that rate was thereafter adjusted for the remaining term to provide the lenders the original net rate over the entire period, might this not keep the borrowers in their homes repaying their loans and ultimately provide the lenders with the return they anticipated?

dearieme writes:

Whatever happened to the idea of "contract"? Are you really going to throw away a foundation of our civilisation?

Brad writes:

I don't see anyone mentioning that teaser rates are typically paired with prepayment penalties that cover the teaser rate term. Many of these loans were marketed as "credit repair" loans, where the borrower expected to refi soon after the teaser rate period ended. It worked great for people with credit issues who had 50% equity in their homes already due to property value increases early in the decade. It didn't work so great for people with 0 to little equity, as they soon owed more than their home was worth and had no chance to refinance.

John Thacker writes:

Whatever happened to the idea of "contract"? Are you really going to throw away a foundation of our civilisation?

A contract can be modified with the consent of all parties, yes? I suspect that in some cases, if a lower interest rate results in the property not defaulting, it is a win-win for all parties involved.

However, as Professor Kling notes, that's only a limited number of the loans. Indeed, that seems to be a point of criticism in the article from Democrats and others who want to "do more," that this plan would not help those who can not make their payments anyway.

John Thacker writes:

Every bank has to mark down some of its securities, and this means that they need more capital.

This kind of vicious cycle is the argument that I've heard for why banks don't want to auction off foreclosed properties and get things to their true valuation. Many foreclosed properties can be counted as an asset at a higher value (based on the mortgage) than if they were sold, since they have decreased in value. Therefore, selling at a loss reduces the paper reserves of the banks, forcing them to sell off more securities.

Dan Weber writes:
might this not keep the borrowers in their homes repaying their loans and ultimately provide the lenders with the return they anticipated?
It could well do the first, but definitely not the second. The lenders anticipated that they were making a variable-rate loan, not a fixed-rate loan.
GawainsGhost writes:

As a Realtor who works almost exclusively with repossessed homes, I can tell you exactly what is going on. Lenders abandoned all credit standards in 2005-06, handing out no-documentation, interest-only and adjustable-rate loans, etc. (also known as creative financing, but properly known as predatory lending). These loans were then bundled into securities and sold on the secondary market as collaterized debt obligations.

The problem is that when these loans are sold on the secondary market, the lender is supposed to write and have signed an assignment to designate the investor as the "holder in due course." But these lenders didn't bother with all that paperwork and instead simply bundled thousands of loans and sold them.

There have been several court cases recently in which the judges ruled that the investors, i.e., the holders of the notes, did not have the right to foreclosure, even though the borrowers were in default, because the investors could not prove they are the holders in due course on the loans. That's the problem right there.

No one knows who is the real holder of the note. It's going to cost a whole lot of money to file the proper paperwork to designate the investors as holders in due course before the foreclosure process, which in itself is expensive, can even begin.

So it's no wonder the lenders and investors are willing to agree to freeze interest rates on questionable loans. They have no right to foreclosure, and thus have no way of recuperating their losses.

This whole thing stinks to high heaven. Welcome to the wonderful world of 21st century financing, where no one has any idea of what they're doing, other than losing money.

Jeff writes:

The problem is the combination of low down payments and falling house prices leading to negative equity for homeowners. When an adverse event (job loss, divorce, etc.) occurs, the house can't be sold for enough to cover the mortgage, and foreclosure is the result. Even worse, once enough foreclosures have happened, the stigma starts to diminish, and that may lead millions of negative-equity homeowners who can afford their payments to walk away from their loans.

There doesn't seem to be a way to unpop the bubble.

Richard writes:

Dan responded to the second part of my question by indicating that the lenders wouldn't enjoy the return they expected since they transacted for a variable rate loan. Are not the lenders seeking a dollar return that is a function of a series of interest rates. Presumably they calculated a PV amount for the teaser period of rates and a PV amount for the reset period (or periods). If that amount is ultimately realized via a longer teaser period (the Bush/Paulson solution) and a reset rate that with the teaser return, produces the original expected amount, it seems that the lenders should be indifferent. Of course, this assumes that at the reset period the borrowers won't default.

GawainsGhost writes:

Well, speaking strictly as a Realtor, I have and would never counsel a buyer to do anything other than to buy a house within his means and put 20% on a fixed-rate 15-year mortgage. That is the best way to buy a house. You have equity when you move in, the lowest interest rate, no private mortgage insurance, and pay off the loan twice as fast as on a 30-year note.

But nobody listens to me. Oh, well. I represent the seller, unless I have a buyer's representation contract in which case I represent the buyer (on a property not listed by one of my sellers--otherwise, it would be a conflict of interest). It is not my job to be the buyer's financial manager. All I can do is offer advice and opinions on real estate.

Someone comes to me and wants to buy a house. As long as he has proof of financing or proof of cash, a signed, written contract and an earnest money check, I have no choice but to present that offer to the seller. If that offer is accepted and proceeds to closing, then I have done my job.

Should the buyer then find out that he has negative equity, for whatever reason, that is not my problem. There are no guarantees after closing. He should have listened to me, but he chose not to.

Gary Rogers writes:

Just to verify what I thought I knew, I downloaded the house price index from the ofheo.gov web site and compared it to the consumer price index. Since 1975, which is the first year of the house price index, housing prices have never gone down. The HPI also increased slightly more than the CPI until about 1997, when it really started to outpace the CPI. From about the middle of 2004 to the middle of 2006, the HPI was growing at a rate of about 12% per year. Is it any wonder that people were taking out interest only loans with no down payment to buy as much house as they could possibly afford? Why put money in a savings account when your money grows faster in real estate? Lenders also were attracted to the mortgage markets because there is no safer bet than a loan that is backed by collateral that is almost sure to increase in value. This was all great until reality happened.

So, why did housing prices grow at a faster pace than the rest of the economy? The answer is government interference. Mortgage interest is tax deductible. Fannie Mae and Freddy Mack made sure there is plenty of liquidity in the market. And, eventually the expectation started feeding on itself creating a classic economic bubble.

My take on all this is that an important property of free markets is that money constantly moves from one place to another propelled by changes in the relative values of investment alternatives. Stocks, bonds, oil, gold and Euros are all part of the same complex interaction, where investment decisions are based on the expected future value and expected probability of success. Right now money is moving out of the mortgage market, not because there is not enough liquidity, but because the expectations changed. If we use a general stimulant (cutting interest rates) will the added liquidity overcome the changed expectations? What other unintended consequences might we expect?

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