In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.
Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks…
My guess is that [the solution] would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms. But I’m happy to listen to better ideas.
Based on my understanding of mortgage securities markets, I think there may be problems with this sort of idea. If you are a mortgage borrower and your loan is “securitized,” that means that it is pooled with a lot of other loans that are sold as a large security. Once a loan has been pooled, there is no simple way to un-pool it. If the a third party were to buy the individual loan at a discount, this would have to be treated as a mortgage prepayment within the pool. Prepayments advantage some investors and disadvantage others, so the companies that created the securities could face legal challenges from investors if they do something that alters prepayment patterns. One of the disadvantages of securitization (there are many advantages) is that the rules for servicing the loans cannot be changed after the fact.
What Krugman wants is for the borrowers to keep their houses and the financiers to lose money. I think you have to pick one or the other. Either subsidize the borrowers, so that they can stay in their houses, which bails out the financers; or let the foreclosure process play out, which will give the financiers the losses they deserve.
READER COMMENTS
spencer
Aug 17 2007 at 12:42pm
Many of the mortgages were made with the assumption that in a couple of years they would be refinanced.
If this is the case there would have to be some mechanism in the process for an individual mortgage to be paid off.
I never worked in this area but prepayment is one of the factors that goes into the value of a mortgage security — a pool with many prepayments will have a
different value than an identical pool with a different prepayment record.
KaySha
Aug 17 2007 at 2:50pm
Remember that many of the ‘financiers’ of these mortgage securitizations (any many other types of securitizations) are ultimately pension funds, endowments, foundations, etc. (either directly or indirectly through high yield bond or hedge funds). Any losses felt by the financiers will be felt by these parties, with perhaps even more pain if leverage was involved.
So the question is do you have (a) the unqualified home owners, who have tasted home ownership and now believe is their right; or (b) the pension funds, endowments, foundations, etc., who recently blindly allocated to alternatives as a trend, take the loss?
I am split on this since I work at an endowment with a heavy allocation to hedge funds and while we have weathered this well turmoil so far, I am sure we will be taking a hit at some point. Of course a fire sale of these securitized loans present buying opportunities for hedge funds dealing in distressed securities…
Matt
Aug 17 2007 at 3:27pm
I am with Arnold on this. Inflating the economy because some wealthy people got into trouble is not a solution.
Lord
Aug 17 2007 at 4:22pm
It’s the art of monetary policy. Allow those responsible to feel enough pain, but not so much that everyone else does, and the wisdom to know when that is the case.
David Thomson
Aug 18 2007 at 12:51am
Whatever happened to Paul Krugman? He sounded so sensible only a few years ago. I truly enjoyed reading his Slate.com articles. He now seems incapable of comprehended basic economic reality.
Krugman is another reason why I can’t buy into Bryan Caplan’s thesis that the professional economists are essentially on the same page. I still think he is finding every half baked excuse to not find fault with left wing Democrats.
Boonton
Aug 18 2007 at 10:33am
Krugman has touched upon the herd problem. If one house on the block gets foreclosed on it’s no big deal except for the bank and the homeowner. If ten houses go down then everyone suffers and the banks that foreclose suffer all the more because with such a disaster houses will sell for much less.
But no bank wants to hold off on foreclosure because if they don’t get what cash they can early they may get nothing if they end up being foreclosure number eleven. It seems to me restructuring the loans is the optimal option, it is done all the time when the name on the property is Trump.
Perhaps there should be a progressive tax or fee placed on foreclosures. For the first house on the block the sheriff collects the normal fee but each additional house within the same block and within the same year the fee will be $7,000 times the number of homes. The third home then will cost the bank $21,000, fourth $28,000 and so on. After a few homes, there would be a tremendous incentive for mortgage holders to do everything they can to restructure the loan if possible or hold off foreclosure until the market calms down.
True fraudsters, the people who never made a single payment and claimed to make $100,000 a year when they are unemployed will end up in foreclosure and those who foolishly lent to them will take a well deserved hit. But many people who are making payments and theoretically could continue to making payments will be given a chance & everyone else will benefit for it.
No one is really getting bailed out. Those who get a ‘restructuring’ will no doubt have their credit scores hurt and the owners who permitted the restructuring will have less revenue than they were originally expecting. The person who is able to make normal payments even after their loans ‘reset’ and high variable rates kick in will still get a great deal of credit and the holder of his mortgage will get a good deal of revenue.
Thoughts?
Boonton
Aug 18 2007 at 11:07am
If the a third party were to buy the individual loan at a discount, this would have to be treated as a mortgage prepayment within the pool. Prepayments advantage some investors and disadvantage others, so the companies that created the securities could face legal challenges from investors if they do something that alters prepayment patterns.
From what I understand the typical sub-prime loan went something like this:
“You qualify for a 2/28”
“What’s that?”
“Well for 2 years you have a fixed payment that you can just about make. Then it becomes variable which means it will probably go up”
“How can I do that? I’ll lose the house then in two years”
“Ohhh, no. In two years you will have better credit after making on time mortgage payments. Plus even if home prices continue to increase even slightly you’ll have more equity just from the natural increase in home prices. You get a new mortgage then at a fixed rate or if you want sell the house, pay off the mortgage and then go into a better house with the same 2/28 plan”
Now we can all see what’s wrong with this plan in hindsight. Home prices have stayed level or fallen in many areas. Even though people improved their credit now no one wants to loan unless you have amazingly perfect credit.
But what were the mortgage writers and securities purchasers thinking? Obviously they were expecting many ‘prepayments’ when the 2/28 people started refinancing after two years. What purchasing the loan looks like to me is just about the same thing except a fed. agency would be behind the refinancing rather than another mortgage company.
Yes the difference is that a loss is involved BUT remember the only way a loss wouldn’t be involved is if the above ‘blue sky’ scenaro had came to pass.
Bill
Aug 18 2007 at 6:07pm
It’s not hindsight for me. I saw these problems years ago. Anyone else that didn’t see this was either ignorant or willfully blind. I don’t really see the big deal. If you bought a home that you couldn’t afford, you deserve to lose it. Big deal. Your credit takes a hit and you go back to renting. It’s not the end of the world. Those that bought the securities based upon these loans will takes a hit, and they should. Investments don’t always pay off. They are investments, not guarantees. Whatever happened to due diligence? I guess it’s better to take money from people that practice due diligence–taxpayers that didn’t buy homes they couldn’t afford–and give it to those that didn’t–people that think that there IS such a thing as a free lunch.
Boonton
Aug 18 2007 at 7:45pm
I don’t disagree with you Bill but is the market right now rational or has the fear of the subprime ‘toxic waste’ inhibited even normal lending?
The ‘plan’ I outlined above is not totally crazy. If you have made your payments on time and have a bit of equity then the market should be available with refinancing. There are many people who got in over their head and there’s no real way to avoid them losing their houses and the investor s are going to take a hit….but there are also people who are marginal…who can and are making payments that should be able to keep them in their homes but the markets will not service them because of fear.
Whether or not you ‘deserve’ to lose it is besides the point. The question is what is optimal here. It seems there may be something of a ‘lock in’ going on. It doesn’t make sense to foreclose on all these loans because then those holding the securities will take real hits that could be avoided because foreclosing on everyone at once will swamp the market and ensure many cases where the foreclosure will not pay off the mortgage…plus falling prices can start causing additional defaults and foreclosures on their own.
Long story short, the analogies to bank runs are looking kind of apt. In a bank run it was perfectly rational to race to the bank and try to be the first to close out your account. But also everyone deep down knew that by doing this they were causing the run. It was, though, irrational for them to have not taken out their money because if they tried to be the ‘good citizen’ and held off they would very likely end up being the sucker at the end of the game with a worthless account.
Bill
Aug 18 2007 at 7:56pm
Boonton,
The market wasn’t rational on the way up, and it won’t be on the way down.
I disagree, unless you have a lot of equity. Home prices, at least in real terms, are likely to fall quite a bit more over the next few years. In addition, if you needed to use a 2/28 to purchase a home, with the expectation that you could refi, I don’t have any sympathy for you (just as I don’t have any sympathy for people who lose money in Las Vegas). Don’t expect to be bailed out when you gamble.
I quoted you, but my main gripe is with Krugman.
Gary Rogers
Aug 18 2007 at 8:55pm
First, I cannot see how un-pooling is an issue. As spencer pointed out, many of these mortgages are already un-pooled through refinancing and prepayment. Forclosure also results in a form of un-pooling, though with a much lower return to the pool. So it is not that much of a stretch to see that any loan that can be sold at a discount somewhere between the prepayment value and the forclosure value would also be possible and beneficial to the mortgage holder. The price of the buyout would depend on the face value of the mortgage, the probability of forclosure and the ability of the buyer to find additional value in the deal.
But this is just restating how markets work. The readers of this blog are already well versed in this subject. Not only could risky mortgages be handled through markets, but that is how Mr. Krugman describes risky mortgages being handled in the past. The two parties get together and work out the best value for both sides. The fact that the investment instrument that owns the mortgage is not in a position to handle this does not rule out selling it to someone who can.
The danger to this process is selling these loans to a government agency, which is a step farther away from the efficient handling that is required. I am sure there are interests that would like to see taxpayer money spent minimizing the losses to the investors on one side or bailing out homeowners who are in over their heads on the other, but neither is good for the economy. In short, I think Paul Krugman is wrong for suggesting it.
R. Richard Schweitzer
Aug 19 2007 at 8:26am
Isn’t something being overlooked here?
In the “credit” markets, and on the books of investors (endowments, pension funds, etc) the price of a bundle of mortgages is not determined solely by its interest rate and “default” or delinquency rate, but is impacted by the value (forced resale price) of the underlying collateral. That, in turn, is impacted by the market prices for properties, by class, economic area (Atlanta v. Detroit), and other perceptions of factors that might affect performance of obligations.
Most bundles probably were not assembled on the basis of the income producing level of the obligor as the primary security, but on the “hard” collateral. We are not reading much about the impacts on Private Mortgage Insurance issuers are we?
A more pervasive issue now is the impact of re-pricing the bundles more precisely, based on the prospective re-valuation of the collateral, regardless of the rates of foreclosure in various kinds of bundles.
All these proposals to deal with opening the bundles, extending terms, preventing foreclosures, do not face up to the issues created by changes in the markets for the underlying collateral.
R. Richard Schweitzer
s24rrs@aol.com
Boonton
Aug 19 2007 at 9:37am
The market wasn’t rational on the way up, and it won’t be on the way down.
Indeed it won’t which is the problem.
I disagree, unless you have a lot of equity. Home prices, at least in real terms, are likely to fall quite a bit more over the next few years.
Again it isn’t about having sympathy for any one particular situation but about what is optimal. In any one case I could say your right but when you have many cases at once trying to sell off everyone’s house makes the situation worse because it drives prices all the more down. That also adds to the problem since there are people who have equity and are ok now but won’t be if prices start falling dramatically.
I’m more inclined towards my idea of making foreclosure more expensive and difficult. That would force mortgage holders to be more selective and cut deals when the owner is making payments and has income and use foreclosure in the truly hopeless cases (such as the people who have no income who basically got 6 months of free rent from the company). It’s a lot to ask the gov’t to try to figure out which sub-primes should be purchased and how steep a discount should be demanded but as Keynes said if nothing else bury the money in glass bottles if you have to to get the system going again.
8
Aug 20 2007 at 11:10am
Foreclosures = liquidity. Do you want a liquid market with lots of foreclosures or an illiquid market with few foreclosures? You are choosing between people who want to live in their current home and geographic area versus people who want to move within the next 5 years, because without foreclosures, prices will not fall and new buyers will be priced out of the market.
Boonton
Aug 20 2007 at 4:31pm
Good point, there’s always a good side to a bubble bursting. Lots of foreclosures mean lots of opportunitites for people to win houses at the Sheriff’s sale plus the possibility that some overheated places may finally see houses that are priced in the affordable range.
This is a two way street, though. If mortgage holders are losing their shirts in foreclosure there’s going to be a lot of resistence to making new loans to purchase those properties at the Sheriff’s sale (which will lead to even more foreclosures). What should happen is not a bail out but a deflating…not letting it all happen at once in other words.
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