Sunday, October 7, 2007

Sub-Prime Commentary - updated 10/11

I have been talking a lot about the sub-prime mortgage mess, as have many other people. One thing that I find striking is the sub-prime nature of some of this commentary coming from unexpected places. Who would have thought that the Chairperson of the FDIC would make a statement suggesting that mortgage servicers simply keep adjustable rates on sub-prime mortgages low to avoid problems? I will discuss many of the issues raised by this in a minute. I also heard a HUD representative commenting on the news one evening, I think it was The Nightly Business Report. The representative, who I believe was HUD Secretary Alfonso Jackson (it was pretty late and I was on may way to slumberland), said they want to help the teachers and firemen, but not those yuppies who just wanted to have a bigger house with more stuff – I couldn’t believe my ears (yes, he used the words yuppies, teachers, and firemen in this context). In Congress, your tax dollars are hard at work passing legislation that takes away the taxes that would be due if your lender decided to give you a gift and reduce the amount you owe on your mortgage or decided not to sue you for the balance if they sold the house but didn’t collect enough to pay themselves back (something I am sure many people who lost their homes in the past only to find out they owed income tax for the privilege are simply giddy about). This Congressional action is the set-up, I believe, for the next round of bail out action.

All of this is simply sub-prime. What are people in the highest levels of our government thinking? Lets look at some of the implications.

As reported in an article in the October 5 WSJ Online Edition that can be found here (or on page A12 in the print edition), FDIC Chairperson Sheila Bair has urged loan servicers to convert those sub-prime variable rate loans that are about to adjust to fixed rate loans. She would like the rates to stay at the initial teaser rates. This would apply to all of those who are current on their payments and occupying the home in question, but not to others. In other words, bail out the people who used financing trickery to purchase a home they really could not afford or maybe they could but wanted the really low rate up front. Ms. Bair is very concerned because there are approximately $600 billion in sub-prime mortgages that are about to rate-adjust and many may fall into default when they do. Forget about those who have already lost their home. Too late for you.

Well, here we go again messing around with the economic fundamentals. Of course, when you do this there are always winners and losers. At first blush, it would appear that the winners are overstretched homeowners who could use a break and the losers are those yuppies and the big Wall Street financial firms we read about. Just who the heck are those “servicers” anyway? But is this really the end of the story? I think not.

First of all, I am not convinced that all of the people who took a sub-prime mortgage are in need of a bail out, and this would be like handing them a holiday present for no reason. Many sub-prime borrowers are placed in the sub-prime category because they do not report their income (they get paid in (or collect from their customers in) cash). Do we really want to bail those people out? If we want to bail out the less fortunate, shouldn’t we first make sure they are?

If we do bail out those people who collectively owe close to $600 billion by resetting their interest rates (in effect renegotiating their mortgages for better terms) I see other indirect effects that are not pretty. For example, who actually pays for this bail out? If we just let the borrowers keep their low interest rates, then nobody really loses, right? Wrong – someone purchased those mortgages based on the contractual obligations of the borrowers to pay the higher interest rates. If all of those borrowers are handed a windfall gain of lower rates, then the value of the mortgages goes down and those who purchased them lose. Who purchased them? Well, in this day of securitization, we don’t really know. However, don’t be at all surprised if your pension fund owns some of them, because that would be part of its normal operations. As a result, Ms. Bair’s recommendation shifts the burden of this problem from homeowners and the lenders who made the loans to those who purchased the loans. Shouldn’t we at least analyze who owns those loans now before we do that? After all, it could be the pensions of teachers and firemen! Now, Ms. Bair may argue that the losses from doing nothing will be greater than the losses created by reformation of all of those loans, but I haven’t seen that analysis, nor have I heard any commentators discuss it.

In addition to shifting the losses and bailing out many who don’t need it, there are other losers. Those who are struggling, working several jobs and foregoing all luxury to make their mortgage payments will be very upset. I know some of these people. Some purchased a home to accommodate a growing family just at the peak, and got stuck on the sale side because the buyer walked or the financing fell through. What about them? They may not have a sub-prime mortgage, but they are in a mess created by the same set of forces and at no fault of their own. Many of these people are teachers or firemen, and some are even yuppies! How do these people feel about bailing out the people responsible for this mess in the first place? I’ll tell you from my observational experience – angry. In their eyes people took a risk buying homes they could not afford on the bet that prices would continue to rise and they could profit. That bet turned out to be a loser, and in a free market system they should lose. Even worse, why should they get bailed out but not those otherwise stuck holding the bag from this mess? People with sub-prime mortgages took a risk and lost, simple as that. They were told their rates and payments would go up and they knew what they were doing. If not, then the companies (and the people) that loaned them the money should suffer for not making lawful disclosures, period. If those disclosures were not being made, then I would like to know where Ms. Bair and Mr. Jackson have been for the past few years.

In the short term, a bail-out provides an incentive for those who can pay their sub-prime mortgage to default so they can benefit from the bail-out. In the long term this also creates a huge moral hazard. What do we tell people who buy more than they can afford only to get bailed out from the debt they incur? What happened to all of those arguments I heard when the financial industry was pushing for bankruptcy reform about those who cause the system to suffer should be the ones who pay? The system needs reform because the current system creates a moral hazard? How different the spin when it is the financial industry trying to “reform” the bankruptcy laws so they can make more profit as opposed to trying to get bailed out of its own mess. Maybe I’ll do a little research on this point if I have some time. If anyone can add to it please do.

There is another, less obvious victim of a sub-prime mortgage bailout. Since labels are getting applied to people here, I will use one. The good people. Those who knew they could not afford a house without first saving for a down payment. Those who deferred their consumption until they could afford it. They are also victims of any bail out. If people who cannot really afford the homes they are in are bailed out of their mortgages by giving them below market interest rates, then the prices of homes will be artificially inflated because there will be less supply on the market. At the same time interest rates are now moving up because of the risk in this market caused by bad lending practices. So, Mr. and Ms. America who waited to purchase a home until they could afford one? They are now locked out of the market altogether. Prices will remain higher than they should and their interest rate and payment will be more than they can afford.

Where have all the free market pundits gone? Gone to hide from everyone. As expressed by a friend, privatize the profits, socialize the costs (thanks for that one).

Update: Check out the statistics from The WSJ about who these sub-prime borrowers are by going to Page one and reading the article "The United States of SubPrime", online here: Also rising to the surface today, and in The WSJ, is a story about Beezer Homes and some funny business with mortgage applications. That article is available on the online edition at Finally, follow the drumbeat for the public bailout by going here:

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Palermo's Blog said...

Here begins the taxpayer bailout of the subprime mess? Countrywide will begin refinancing subprime mortgages. "A refi program for 'Borrowers currently in a subprime loan with a strong payment history.' This will allow about 52,000 C’wide borrowers to refinance about $10 billion worth of loans. They can try prime or FHA loans. For those with credit issues, 'Countrywide will offer Fannie Mae or Freddie Mac’s expanded criteria programs.'" Quoted from here:

Anonymous said...

yo. funny text.