Subprime Daily Briefing, Dec. 7
By Arnold Kling
There is a lot to digest this Pearl Harbor day. I’ll save the President’s plan for the end.First, fresh from the Sean Taylor funeral, we have America’s headline chaser, Jesse Jackson, writing in the Wall Street Journal.
Many of the victims of aggressive mortgage brokers were single women, seniors on fixed income, young couples, Latinos and African Americans. They live in every neighborhood in every one of our major cities, and elsewhere. In one block alone on West Madison Street in Chicago, every one of the homeowners is in default on their current mortgage terms. In neighborhood after neighborhood in Chicago, foreclosures have soared to more than 50 per square mile.
However, the people who resisted the siren call of subprime mortgages are feeling like victims, also. The Washington Post tells their story.
The agreement has sparked bitterness and anger among those who either sat out the housing boom or endured friends’ snickers when they stuck with a traditional mortgage and a smaller house. To some who watched prices rise out of their reach or who moved to cheaper cities, the agreement looks like a penalty for those who didn’t gamble.
I continue to believe that there are two issues. One issue is the housing market. The other issue is the credit market and the possibility of a liquidity-panic spiral: many financial institutions trying to shore up capital positions and increase liquidity at once, leading them to dump asset-backed securities, lowering the prices of those securities, causing other financial institutions to mark down their holdings and inducing them to try to shore up capital and liquidity, etc. I think that regulators need to be on top of that and they need to find a judicious way to loosen capital requirements. But Brian Wesbury disagrees.
Hedge funds, private equity firms and nonfinancial corporations also have trillions in cash that is already being put to work. Citadel, a hedge fund, bought at-risk loan pools from E*Trade, and increased its investment stake by $2.5 billion. The French parent of CIFG Services Inc., a major bond insurer, injected $1.5 billion of new capital to shore up its balance sheet. Bank of America invested in Countrywide and HSBC brought its high-risk loans back onto its balance sheet.
The only real problem is that these “fixes” are not cheap. Citibank is paying 11% to Abu Dhabi. E*Trade reportedly sold its problem loans to Citadel for 27 cents on the dollar, a price many think is well below the true value. Institutions with cash and capital will make huge profits in this environment, while those without these two things will fight to survive. While not everyone is happy about it, the market is healing itself.
Some say that we can’t risk a spillover of credit problems into the economy as a whole, but that ignores two things. First, outside of housing-related businesses and financial institutions that invested in subprime securities, the economy is in good shape.
I’ve talked before about how Freddie Mac’s charter to buy investment-quality mortgages should have kept it out of trouble. But The Washington Post reports,
federal law prohibits Freddie Mac from buying mortgages that cover more than 80 percent of a home’s value — unless the loan comes with a safety net, such as an insurance policy that would kick in if the borrower defaults.
However, in recent years, Freddie Mac permitted home buyers to borrow all or part of the remaining 20 percent by using second loans, called “piggyback” loans, with no safety net.
As early as 2005, an industry group protested that the practice was designed to get around the law and should be stopped.
That “industry group” of course wanted to keep the high-risk mortgage market to itself. But, still, if Freddie Mac had stayed out, the high-risk market presumably would have been somewhat smaller.
I find it quite ironic that Leland Brendsel, the former chairman of Freddie Mac, who I don’t think would have touched these loans with a ten-foot pole, got pilloried in the press and hounded by OFHEO (the regulatory agency that oversees Fannie and Freddie). Meanwhile, until today, I have not seen anyone go after the incompetence of Freddie Mac’s current management or the failure of OFHEO to keep Freddie within its charter.
Now, on to the President’s plan. My sense is that it was cobbled together by a bunch of trade association representatives. For example, see the press release from the American Securitization Forum.
Under the ASF framework, subprime borrowers who need assistance are divided into three segments. Borrowers falling into segment one are current on their loan payments and meet credit score thresholds and the amount of equity in their homes indicate that they are likely to be eligible for refinancing opportunities. Servicers of these loans will structure the refinancings to avoid prepayment penalties whenever possible, and the ASF recommends servicers take all reasonable steps to encourage or facilitate refinancing for these borrowers.
Borrowers falling into segment two may be eligible for a fast-track loan modification if they are current on their loans but ineligible to refinance into any available mortgage product because of poor credit scores, low or no equity in their homes or a history of delinquent payments. Borrowers in this category could be offered a loan modification freezing the interest rate at the introductory rate for 5 years. Freezing payments at a level these borrowers have demonstrated they can afford increases the likelihood of avoiding foreclosure in these circumstances, which benefits borrowers and investors alike.
Segment three is comprised of loans where the borrower is not current on loan payments at the existing introductory rate and does not qualify to refinance into any available mortgage product. These borrowers should work with their servicers, who will determine on a loan-by-loan basis without the benefit of a fast-track approach, the appropriate loss mitigation approach, which may include a loan modification such as rate reduction or principal reduction, forbearance, short sale, short payoff or foreclosure.
Don’t forget that “segment three” probably includes a lot of fraud.
Nobody knows the size of the other segments. The New York Times reports,
The Greenlining Institute, a housing advocacy group in California that began raising alarms about subprime loans nearly four years ago, estimated that only 12 percent of all subprime borrowers and only 5 percent of minority homeowners would benefit from the rate freeze. The Center for Responsible Lending, a nonprofit group that supports homeownership, said the freeze would help only about 145,000 people.
Segment one gets to refinance into a suitable fixed-rate loan at current market rates. Segment two gets to keep (for five years, I believe) the teaser rate on their original subprime loan, which conceivably makes this a better deal for segment-two borrowers.
In the interest of expediting the process of refinancing or modifying people’s loans, the mortgage servicers are not going to look at borrower income in doing the segmentation. Instead, they will look at credit scores. So, if you want to be in segment two rather than segment one, you should make sure your credit history is dinged up. If you’re current on all your debt payments, then all you get is an opportunity to refi.
The only thing that segment one gets out of the deal is that they can refi at the original home valuation, so that the lender will ignore subsequent price declines. I wonder whether it means that the lender will ignore inflated appraisals for cash-out refis.
I think that the net impact of the plan is that it adds to the uncertainty about house prices and the housing market. Economists have never had a very good seat at the table in the Bush Administration, and my guess is that they have had little, if any, influence on this policy.
The one player who could make a difference and bring some quality thinking to the policy in the subprime mess is Federal Reserve Chairman Ben Bernanke. I think he needs to take more of a leadership role.