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Aug 23 2009

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The Real Key to Recovery

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Let me premise this post with the admission that I am no economist by training; that getting a particular fact wrong or premising my argument tenuously is a real possibility here.

I’m writing about what I sense, not what I know.

You see, my libertarian streak can’t shake the sense that a tremendous injustice is being exacted upon average Americans still reeling from wealth evaporation that resulted from the market meltdown and the continued decline of the economy.

I am talking about an elaborate game of “hide the pea” being played out between the housing/financial industry and average American homeowners over the yawning gap between mortgage value and home value, and what we ultimately do about the delta or difference.

In the current game of musical chairs, it is the citizen homeowner who is left standing when the music stops. The cumulative impact of these individual mortgage decisions has the power to snowball into a profound economic impact in its own right, threatening any sustained economic recovery.

Until we deal with it, we will face potential continued economic turmoil.

We all know the basics.

A perfect storm developed as sustained, year-to-year real estate appreciation met public policy goals of promoting home ownership through all income strata in the US. The housing/finance industry saw the profit potential in inventive new mortgage instruments to make home ownership artificially more affordable, lending standards went lax and the power to securitize mortgage debt into mortgage backed securities (MBS) that traded on Wall Street – ostensibly to spread and thus lower risk – created a new, if under-appreciated tie between Main Street and the NY financiers.

As complex as the new system was, with new financial instruments spawning yet more exotic financial tools to generate profit, the core principle from which all wealth and expanded ownership derived was the simple necessity of real estate appreciation as a constant.

Once that bubble popped through a slowing economy and the first subprime housing defaults, the system unraveled at frightening speed. Financial institutions, enormously over leveraged and exposed to each other in the now questionable MBS market couldn’t meet their cash calls, and melted down in a cascade of spectacular financial failure over the issue of value.

The panic and potential global financial ruin that the MBS related crisis sparked forced a federal response.

The Bush administration proposed and Congress passed the Troubled Assets Relief Program (TARP) specifically; “to purchase or insure up to $700 billion of “troubled” assets. Troubled assets” are defined as “(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages that in each case was originated or issued on or before March 14, 2008.” 

In short, as originally envisioned, TARP would allow the Treasury to purchase illiquid, difficult to value assets from banks and financial institutions (the MBSs) to stabilize the balance sheets of participating institutions and avoid further losses, and more importantly, unfreeze credit to keep businesses working.

But it is not the way it worked out in practice.

Days after the TARP was approved, the Treasury Secretary announced that TARP money would be used instead to buy senior secured debt in the banks, providing liquidity directly the institutions, allowing them to stem the losses through direct cash infusions.

The matter of the underlying value of the MBSs or Collateralized Debt Obligations (CDOs) was not be immediately resolved as it had been originally intended.

TARP and the actions of the Federal Reserve in October-December 2008 saved the US economy from an economic calamity that could have rivaled the Great Depression. But the recession that followed the meltdown on Wall Street, harsh as it is, presents new and complex problems.

As we know, during a recession, production, employment, investment spending, capacity utilization, household incomes and business profits all fall.

In this recession, Americans were faced with the dual challenges of extraordinary loss of wealth in the stock market – felt keenly in their 401ks and retirement accounts -and the companion loss of value in their homes, for most Americans, the primary form of investment and wealth creation.

Uniquely, both losses were tied to the securitization of mortgages on Wall Street and the ensuing meltdown.

As in medical triage, in sorting out the crisis, policy makers first focused on the most badly hurt by the collapse of the market; subprime borrowers with unsustainable mortgages, facing foreclosure.

But the subprime foreclosure crisis only exacerbated the overall decline in housing values nationally. And as recession led to increased unemployment, the virus spread to prime borrowers.

According to the Washington Post, 1.8 million Americans will lose their homes to foreclosure this year, a trend that “has been exacerbated by falling home prices (emphasis added).”[1] Interestingly, the article also noted that, “Currently, unemployed borrowers have few options to save their homes. Banks often will allow two or three missed payments known as forbearance, to give borrowers time to find a job. Others offer to temporarily lower their payments by 50%. But both of these options are not permanent….(emphasis added).”

So here is the rub.

After engaging in risky to reckless behavior to profit from real estate appreciation – appreciation that they helped drive – financial institutions received multi-billion dollar bailouts from the federal government.  The “moral hazard” of the government “rewarding” bad practices was brushed away because the institutions were too big to fail, or too important to the economy to fail.

Now, these same organizations are now insisting, amid the downstream wreckage that they helped create, that individual borrowers follow a set of rules established prior to the crisis as if nothing had occurred.

The world has changed since September 15th, but when it comes to enforcing mortgage collection on properties that are worth significantly less than the paper the numbers are printed on, the institutions have been merciless.

This is a travesty.

And what’s more, it makes little sense, except for the lenders.

Go back to TARP for a second.

The reason Secretary Paulson fundamentally changed course and invested  directly in banks as opposed to purchasing “toxic assets” in the form of MBSs and CDOs, was based in bank reluctance to sell those assets at fair market value because of the hit this would make on their capital reserves from substantially lower real estate prices, affecting company profit and shareholder value. That is, if the financial institutions could even realistically price the debt obligations.

Here’s the hidden “pea.”

The banks realized that the underlying value was less for the purposes of the bailout, but never translated that change in their lending/foreclosure practices with residential borrowers.

Despite federal largesse that bailed them out of bad decision making, banks are simply unwilling to acknowledge that the process that led them to back significantly inflated mortgage prices was in fact at least half their responsibility, as well as their willing co-conspirators, the appraisers, who magically never saw a property that didn’t appraise for the amount of the mortgage being sought (the other half being the borrower willing to pay).

The financial institutions get a Mulligan, and the borrowers get stuck with the bill.

And the lenders are still in denial, with deleterious results across the board.

Consider the following hurdles.

Beyond the families ruined in a foreclosure, foreclosed homes can lie empty for months, falling into disrepair or become the victims of vandalism.

It also impacts local home values. When you have full neighborhoods of foreclosed properties, the lost value can be staggering on regional housing prices. Banks know that in a foreclosure they will never get full paper value for the home, so they have already premised a loss.

Large scale foreclosure, and the real life impact it has on people and properties only makes that declining value more alarming.

Then consider the next tranche of borrowers who have not made the news yet.  These are borrowers on the edge. These are the people who have continued to make timely payments on their mortgages despite tighter budget or less income because of the recession.

These people are unable to seek relief through refinancing at more favorable rates because of stringent new equity and income limits, not to mention that their property is worth less than the mortgage they are paying on.

Have any of you called your mortgage holders on this?

They counsel that the only way to get assistance is to go into default.. How back-asswards is that as a strategy?

Ultimately, when the delta between a home value and a mortgage reaches a point where a property will likely take years if not longer to regain its mortgage value, people simply walk away rather than spending on a losing proposition.

That is what the lenders are facing; people willing to face bankruptcy rather than be chained for decades the real estate equivalent of the Titanic.

This is the next phase in the housing crisis.

Faith in the market is a corner stone of a thriving private sector, with its risk/reward proposition. Had this been an ordinary market correction, the need for massive government assistance would not have been necessary.

But this was more than a simple correction, but a meltdown that was incapable of self correction.  TARP and the Fed stabilized the market and addressed half of the securitization crisis.

It is now time to address the other half.

The solution lies in a very bold and new public-private partnership.

Reset the housing market.

Specifically, the Obama administration could profitably redirect undisbursed Stimulus monies to a program that addresses the housing value issue directly.

Under the program, lenders would re-assess mortgaged properties at their fair market value today.

The delta between the existing mortgage on the property and its current value would be divided three ways.  The borrower would agree to assume obligation for 25% of the unrealized value of the property.

This would represent the borrower’s interest and risk in property appreciation. The lender would grant a new mortgage at the new price into a new 30 year, fixed interest rate mortgage for the borrower, easing the burden of large payments, making the borrower responsible for interest and principle and most importantly, restore a sense of confidence that the property is a value accruing asset, and help stabilize the market.  The impact of consumer psychology cannot be under-estimated as a tool in general economic recovery.

The lenders and the federal government would divide the 75% of the unrealized value in half. The banks would take a write-down as a one-time hit. The federal government would assume payment for the remaining 50%.

To contain additional real estate bubble formations in the future, new mortgages would contain a provision that should the borrower sell the property in a ten year window at a price that exceeded the defunct mortgage value, the federal government would receive 50% of value over that original mortgage value, providing a mechanism for the taxpayers to recoup some of the tax dollars expended.

As an incentive for lenders to participate in the project, the federal government would also make available community redevelopment funds to the banks, on a 1:3 ratio to their write downs, which would be used to fix previously foreclosed homes, or for lenders to work with developers to enhance property values in communities through the addition of parks, bike paths, community centers etc, with the approval of local authorities.

This would help sustained private sector activity in the real estate sector as the economy moves toward recovery and add additional bank business to cushion the blow of their write downs, adding value to communities in the process and arresting declining home values.

Advocating government debt forgiveness in support of mortgage relief is not an easy thing for this journal to support.

But the loss of wealth through the stock market and housing values was triggered by the same event when lenders colluded with Wall Street to generate profits on the gospel of appreciation. Recovery requires remedial attention to borrowers in a sustained manner.

As the Stimulus money is already appropriated, it can at least be appropriately allocated to purposes that will generate immediate results. The fact is that no recovery will be sustainable until this issue is addressed. That it can only be done with the government’s intervention is a sad but necessary reality and key to moving forward.


1. Washington Post, August 18, 2009

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