Even if two million households facing subprime resets reduced their consumption 25%, overall national consumption would decrease just 0.3%. A consumption drag must extend far more broadly than that -- perhaps from falling home and high energy prices -- to be a major macroeconomic event.
The Organization for Economic Cooperation and Development estimates $300 billion investor losses centered in real estate. That is just one-half of 1% of Americans' net worth. In a $14 trillion economy, such losses can be absorbed. But as other financing is delayed (commercial and industrial lending, and commercial paper outstanding, are both down sharply), the harm will spread to the general economy and its firms and workers. That is what economic policy should aim to mitigate.
This is why I think that efforts to keep the subprime borrowers afloat are so counterproductive. If we just took the hit and put it behind us, we would be fine. It would be a lot cheaper to give subprime defaulters a tax credit than to turn the whole mortgage market upside-down to keep them in their homes.
When financial institutions see potentially criminal activity in customer transactions, they are required to send a Suspicious Activity Report (SAR) to the Treasury's Financial Crimes Enforcement Network (FinCEN). From 2000 to 2006, SARs related to mortgage fraud increased by almost 700%.
SARs and resulting federal investigations are often aimed at "frauds for profit," in which the goal is typically to take cash out of a closing. Often orchestrated by unscrupulous mortgage professionals, these scams are frequently the subject of media coverage. However, a new report soon to be released by FinCEN shows that borrowers are almost as likely to be implicated in such cases as the crooked brokers so frequently profiled in the press.
Even more shocking to Beltway ears, the upcoming FinCEN data show that "frauds for housing," in which the scam is simply to secure a more expensive property than one's history and finances would justify, account for 60% of all SARs related to mortgage fraud. Based on Treasury's data, it is the borrowers, not the brokers, who are most likely to be the culprits when a lender is victimized.
As I've said several times, when a mortgage goes into default within 12 months of closing, you should presume fraud. And it should go without saying that bailouts for fraud are neither wise nor just.
Donald Wagner, a professor of Middle East studies and comparative religion at North Park University on Chicago’s North Side, is a One Source client who has talked to the attorney general about his troubles with a Countrywide pay option loan. In March 2005, he refinanced his fixed-rate mortgage to help pay for his daughter’s college education. He said the One Source broker did not tell him his low teaser rate — less than 2 percent — would jump after just one month.
“I kept asking them and checking on that,” Mr. Wagner said. “Then it jumped to more than 7 percent and now it’s up to 8 percent plus and it’s going to jump again. I am actually paying out over 60 percent of my monthly income, and it’s only so long that I can do that.”
Because Mr. Wagner cannot afford to pay both the interest and principal, the amount of his Countrywide loan has risen to $307,000, from $292,000 two and a half years ago. He has had to borrow against his 401(k) and university pension to meet his payments, he said. Making matters worse, when he tried to sell his house last summer to get out from under the mortgage, he learned that the loan carried a prepayment penalty of $12,000.
Under the Term Auction Facility (TAF) program, the Federal Reserve will auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window. All depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank and that are eligible to borrow under the primary credit discount window program will be eligible to participate in TAF auctions. All advances must be fully collateralized. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.
Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). The first TAF auction of $20 billion is scheduled for Monday, December 17, with settlement on Thursday, December 20; this auction will provide 28-day term funds, maturing Thursday, January 17, 2008. The second auction of up to $20 billion is scheduled for Thursday, December 20, with settlement on Thursday, December 27; this auction will provide 35-day funds, maturing Thursday, January 31, 2008. The third and fourth auctions will be held on January 14 and 28, with settlement on the following Thursdays. The amounts of those auctions will be determined in January. The Federal Reserve may conduct additional auctions in subsequent months, depending in part on evolving market conditions.
How does this differ from just reducing the interest rate in order to encourage banks to borrow more from the Fed's discount window? Steve Randy Waldman writes,
It will set precisely how much money it will lend ($40B just in the next cople of weeks!), and let banks bid on how much they are willing to pay for the use of that money. The scale of this program is immense. Typically direct borrowings from the Fed are under $1B. It was a big deal in August when in a clearly orchestrated and coordinated move, 4 big banks were persuaded to temporarily borrow $2B total
So, if nothing else, it's big in terms of dollars. Many people point out that the banks can use their highly illiquid and perhaps low-value securities as collateral for this borrowing. Waldman calls this a bailout. I am not sure what it is, but here are some possibilities.
1. It could be an attempt to prevent the "vicious-cycle" phenomenon that I have been talking about, where every bank that needs capital tries to sell securities, causing these securities to lose value, causing more capital worries, etc. The idea is that for several months the value of these securities will be propped up, until the market can gradually ascertain their true values.
2. It could be an attempt to "target" liquidity better than a more general interest-rate cut.
3. It could be an attempt to ease the concerns of foreign central banks that the Fed will drive interest rates and the dollar much lower. I am not sure how it would alleviate that concern, exactly, but you never know what a bunch of international finance types might dream up.
Tyler Cowen provided some of these links, as well as these thoughts:
the Fed seems to be promising to "hold the bag" on the collateral offered by the soon-to-be borrowing banks. Could this be a collateral pledge disguised as a liquidity injection? Or is the main goal simply to reroute liquidity injections away from the main banks and toward the troubled cases?