Arnold Kling  

Bailie Mae

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According to Felix Salmon,

take a borrower who's underwater, with a mortgage for more than their house is worth. Refinance the mortgage so that it comes down to the value of the house, and then give the lender a tradeable warrant for the difference. Mortgage payments come down, because the mortgage has come down, and the lender, if it needs cash, can simply sell the warrant on the secondary market. If the house gets sold for more than the value of the new mortgage, the excess goes in the first instance to the warrant holder; the homeowner makes money only if the house is sold for more than it was bought for.

He credits the Office of Thrift Supervision with the idea. But it sounds a lot like what I proposed six months ago.

I called it Bailie Mae, because whoever trades the loan amount for the equity piece is probably going to end up on the short end. I figured we'd need a government agency to do that.

I'm not sure who Bailie Mae is supposed to be in the OTS proposal. Suppose X is servicing the loan (collecting the payments), but the loan is bundled in a security owned by a whole bunch of different folks. Does X play the role of Bailie Mae? As a mere servicer, X had no participation in the mortgage cash flows before, so why would X want to participate now, on adverse terms?

With a securitized loan, I would think that the mortgage pool owners would have to replace some of the debt with equity. And then you have to figure out how to divide up that transaction. Sounds pretty ugly. That's why I assumed that the idea needed Bailie Mae. But if they can figure out a way to turn the security owners into Bailie Mae, more power to them.

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COMMENTS (13 to date)
Ajay writes:

Not a point about the article, Arnold, but your use of the variable X to refer to the lender. Wouldn't your post have been more clear if you had just chosen a hypothetical lender, like Countrywide, and used their name? The fashion of using mathematical variables like x and y comes from poseurs who would like to wrap their dim-witted arguments with the patina of mathematics. It started with the physicists and moved down through all the other disciplines. Hopefully, someone like you, who decries the over- and mis-use of mathematics by economists, can help reverse that trend by setting a good example with your own writing.

psb writes:

Ouch. Was that really quite necessary?

Jody writes:

Ajay - I find reading "Countrywide" instead of "X" more difficult to read because the frequency with which X is used for a stand-in for an arbitrary quantity is so much greater than Countrywide.

Seriously - as you read what I just wrote, how many times did you naturally substitute "arbitrary mortgage company" instead of just thinking of Countrywide the specific company?

In theory we could redefine any word to mean anything else, but because of the lack of a shared convention, it really makes it hard on the reader. Sometimes a little bit of math (or more specifically symbolic language) is actually easier because of a shared convention.

shayne writes:

An alternative ...

It strikes me that the most significant artifact of the current housing finance phenomena is that substantially none of the players (buyers, lenders, etc.) allowed for the probability of decline in property market values when consummating lending agreements. Most of even the riskiest sub-prime lending would have been acceptable and addressable with existing risk pricing mechanisms had the market merely reverted to the mean appreciation rates after the bubble, rather than entering a decline (depreciation) of property values. Worse, the market value decline precipitates further decline, there is no readily identifiable "floor", and the financial assets based on real asset collateral can't be valued rationally.

It is curious that the financial community requires insurance against their financial loss (homeowners insurance, fire, damage, etc.) due to conventional risks, but does not require (or even have) an insurance against this sort of market value decline. I suppose that is because it is an extremely rare event, except in very localized terms.

Rather than implementing some form of taxpayer funded "bailout", I would rather see the financial industry implement a "market decline" insurance program - with premiums funded by a nominal addition to mortgage interest rates - that could be tapped by the financial industry in either localized or more generalized market declines. If the lender had to foreclose and subsequently resell a property at lower than the loan balance, the "market decline" insurance would offset the loss.

Such an approach would be a commercial market-based solution to an apparent market failure, rather than contriving a taxpayer-funded bailout scheme. Somehow I can't bring myself to endorse any scheme that transfers the costs of the financial industry's risk to the taxpayers.

Steve writes:

How do you determine the value of the house? I live in a 50 house subdivision built in the late '90s. I moved in in 2003. I don't think a house has sold since.

Dan Weber writes:

Having this warrant would be preferred for banks in California, where the borrower can just turn over the deed to the house and walk away. (Google up "jingle mail".)

Surely they'd rather have $40,000 in a secured loan or $40,000 in cash rather than a $40,000 that might be worth $0. But it's better than having $0.

How long does the warrant attach? If I can sell the house to my brother at market value and wipe out the warrant, that seems like it would make them just about valueless.

On the other hand, if they attach to the property, it could be a nasty surprise for someone down the road who doesn't read their mortgage docs all the way through.

Ajay writes:

Jody, your "shared convention" is one that isn't shared by 99.999% of possible readers. Those people, and I, would prefer that bloggers wrote in a more clear way.

Joe Marier writes:

Shayne, isn't what you're describing basically Private Mortgage Insurance?

Bob Knaus writes:

Here is an NYT article on the subject.

BofA is pushing it. The banks would get to choose which mortgages to offload, not the homeowners.

Seems like a good way to encourage bad homeowner behavior. Wanna get that mortgage monkey off your back? No need for embarrassing interviews with social service workers to determine if you're deserving of help. Just miss a few payments, and the bank will make that decision for you.

shayne writes:

To Joe:

That may be. I confess to not being very well versed on the various existing insurance mechanisms in place in this industry. Observing the current symptoms however, leads me to believe that existing insurance mechanisms have failed or do not adequately address the current problem.

It could very well be that such insurance coverage does exist, but is precluded from being exercised due to problems in traceability of ownership claims. I've seen/heard several instances where lenders attempting to foreclose were unable to do so because their lien claim is obscured by repackaging - they simply couldn't prove they had legitimate or complete claim to the property. I understand that is also an artifact of this phenomena. But if that is true, Salmon's warranting scheme would be rendered equally ineffectual.

It merely seems to me that in order to restore liquidity and rationality to the financial markets - without exerting extraordinary (regulatory) influence over housing markets - some market based means of establishing a loss-floor should be implemented. An insurance mechanism seems to be a better approach, both short-term and long-term and with benefit to both buyers and lenders.

I may have missed something, but the warranting example described in Salmon's article seems to offer protection for the lender at the expense of the buyer. Using his example - the $100K loan covered by a $20K warrant and an $80K sale - I would be dissuaded from purchasing a property that had such a warrant if I knew a lender had a claim to the first $20K of property appreciation. Again, I may have missed something.

shayne writes:

Follow-up to Joe:

It is my understanding that Private Mortgage Insurance does cover most non-performance default and foreclosure/resale costs. But it is designed (financed) to cover those situations in an environment of mean or better property value appreciation rates. In the current situation, generalized property value depreciation, it is overwhelmed and/or ineffectual. Again, it seems this market value loss of property collateral is the compounding artifact that had not been addressed or protected against.

Eric writes:

It's an interesting idea, but I have a question: if you owned an underwater house and you were suddenly freed from an obligation to find the best selling price (because your negative equity had become a tradeable warrant), wouldn't you seriously consider selling immediately? (Particularly if you thought prices would drop further in your area, or if you wanted to move, etc.)

That tendency might lead to a very high rate of non-fulfillment of the liens.

Mason writes:

Along Eric's line of thought,

If you're in a position not to benefit from any appreciation on your house, but to be hurt by any depreciation, and this situation would end as soon as you sold your house, well I can tell you what everyone and their bother would be doing.

Sounds like a very gamable situation.

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