Proposals for Taxpayer Bailout of Banks

I was reading this article in The Wall Street Journal Online Edition titled Worried Bankers Seek to Shift Risk to Uncle Sam about proposals being shopped around DC to move defaulted subprime loans to FHA. According to the article:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers.

This will almost certainly lead to a taxpayer bailout in my opinion. I have been writing about this for months and the fact that it is being considered in DC is truly troubling. Congress has been warned about the consequences of this in 2006 testimony before the Committee on Banking, Housing and Urban Affairs. You can read that testimony here. If you would like my article on this issue you can find it here. The ideas discussed in the WSJ article referenced above go beyond what I wrote about back in December.

If you object to taxpayers bailing out the banking industry, again, I urge you to write to your congressional representatives.

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More Subprime From Schumer

I just posted the opinion piece below that relates to how Senator Schumer continues to ignore Wall Street's role in the current mortgage crisis. Apparently, Wall Street and other banks were so hungry to originate mortgages, 23 year old kids were able to defraud them of millions of dollars. The FBI has geared up dramatically to uncover and prosecute those responsible. Here is a quote from this December 21 Wall Street Journal page 1 article:

Fraud goes a long way toward explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.

Here is the article I posted last night:
Charles Schumer is at it again. On December 19, 2007 he presented "A Call to Action on the Subprime Mortgage Crises: Putting Common Sense Ahead of Ideology" to The Brookings Institution. I have read those remarks and find that I must discuss them in order to keep the record, as I see it, clear. If you are new to my blog, you may not know that in October I reviewed a report sponsored by Senator Schumer that set up his current proposals. This presentation is the next logical step in the progression of deflecting attention away from the Wall Street participants and moving the burden to mortgage brokers, non-bank lenders, shareholders of Fannie Mae and Freddie Mac, and taxpayers. There is so much to be said about this that I will first provide a summary and then review the Senator’s remarks. If you are not familiar with Wall Street’s role in the subprime mortgage market, I suggest you read my October post first.

Senator Schumer’s presentation contains some things I agree with. For example, I can’t argue against a plan that says borrowers should be informed about the loans they are taking, or that borrowers should have an advocate if they are in default (two of Senator Schumer’s proposals). The problem, however, is that Senator Schumer continues to ignore the primary causes of the crisis and tailors remedies that shift the burden to other parties. According to the Senator, the crisis was caused by homeowners who were duped by unscrupulous mortgage brokers into taking out bad mortgages. To fix the problem requires regulation of those bad brokers and refinancing hundreds of thousands of loans even if it means putting taxpayers on the hook and even if these borrowers were not first-time homebuyers. I’m sure there are unscrupulous mortgage brokers and that some borrowers didn’t fully understand the terms of their mortgage. But is it the root of the problem? The Senator completely ignores the role of Wall Street and the subprime mortgage fee-fest that fed many of his campaign contributors over the past five years. He also ignores the role of the Federal Reserve and its failure to do anything to prevent this long developing crisis. Of course, his political motives for this are obvious and I believe he really does understand the origins of this problem. If not, I suggest he read some of the recent reporting to educate himself. This Businessweek article would be a good place to start learning about Wall Street’s role (the link only goes to page two – click back a page to start). He can also read this Fortune article that discusses how the Federal Reserve ignored this problem for too long.

I will give the Senator credit for at last acknowledging the issues relating to credit rating agencies and the conflicts of interest that pervade the securitization of subprime mortgages (as well as everything else). Of course, Congress was warned of these problems in connection with Enron as far back as 2002 and again in 2006 but chose to ignore these warnings. We are now paying the price for Congress’ failure to act.

Finally, Senator Schumer claims that Chairman Bernanke supports his plan to raise the caps for loans made by Fannie Mae and Freddie Mac (the GSEs) to include jumbo loans. I have two problems with this. First, Senator Schumer believes that the GSEs should use their lending capacity to refinance subprime loans on homes that cost, potentially, seven figures. He believes they should do this even though the GSEs have said refinancing these subprime loans is not profitable for them. Of course, these entities were chartered to help provide affordable housing and are owned by shareholders, but apparently that no longer matters. Let the funds be used for the well off and the shareholders pay the price.

Second, Senator Schumer states that this proposal has the support of FED Chairman Bernanke. I am not sure about that. In fact, I wrote about the exchange between the Senator and the Chairman regarding this issue. What the Senator does not state is that the Chairman did not give his support to this plan of simply raising the caps. Rather he was asked if the government could do something like this and he said yes. He said the GSEs could make loans up to $1 million and have the federal government guarantee them. That could be done. However, it would require a large political price because these would be taxpayer guaranteed loans in order to protect the GSEs. You can read about that exchange here – click on “stupidity”. The Senator does not mention anything about the taxpayer guarantee part of the exchange. If this is the “support” from the Chairman that he is referring to then this is a shameful act of political maneuvering and misinformation, and Senator Schumer should, in my opinion, clarify this point. It was obvious when he set the Chairman up for this. So obvious that I wrote about it.

At the end of the day, Senator Schumer apparently believes that taxpayers and shareholders of the GSEs should pick up the tab for this Wall Street mess, mortgage brokers and non-bank lenders should be regulated, but the Wall Street banks need not even be mentioned. It makes me wonder who is actually running Congress. It’s as good as money can buy.

With that introduction and summary, here is my review of Senator Schumer’s remarks.

Senator Schumer’s remarks begin by bashing the Bush Administration’s economic policies as too ideological and irresponsible. I agree with him, especially when it comes to tax policy and saving for baby boomer health care. His next focus is on what he calls the “Four Myths Surrounding The Subprime Crises.”

His first myth is that subprime lending led to millions of brand-new, first-time homeowners. He states that according to the Office of Comptroller of the Currency, only 11 percent of subprime loans went to first-time buyers last year, so the majority of subprime loans were for refinance or buyers who had already owned a home. He then goes on to conclude: “Too many of these borrowers were talked into refinancing their homes to gain additional cash for things like medical bills.” He provides no support for this claim and implicates mortgage brokers as evildoers out to rip off poor desperate homeowners. He then goes on to say that “too large a percentage [whatever that means] went to investors and speculators.” This point is also without support, but is worth remembering because when Senator Schumer speaks about why we need to help out these poor subprime borrowers he is clearly not speaking to this “too large a percent” of subprime borrowers. What is really amazing is that Mr. Schumer goes on to spend an entire page of his presentation talking about how the Paulson rate freeze plan will not help enough borrowers. Which ones? He also ignores steps that have been taken already to help some 300,000 borrowers through FHA programs such as FHASecure and the pending FHA Modernization Act. The spin is so bad it hurts.

His second myth he calls “The Myth of the Unqualified Borrower”. I love this one. He claims that a study of credit scores clearly indicates that many subprime borrowers could have qualified for prime loans. He fails to consider, however, any debt-to-income or loan-to-value criteria (or any other criteria for that matter). So in fact we really don’t know whether these people could have qualified for a prime loan or not. All we know is that their credit scores were in a range that could possibly have qualified them for some mortgage amount. The other thing about this “myth” is how it is in direct contrast to all of the hype we have been hearing from HUD and the FHA. The FHA Modernization Act, supported by the Senate, lowers the underwriting criteria for FHA guaranteed loans. If all of these borrowers could qualify for prime loans, then why do we need to lower the underwriting standards to refinance all of them into FHA loans? Sounds like BS to me. You can get more details on the FHA Modernization Act from my post on it, but it is enough to understand that the thrust is to reduce the amount down from 3% to 1.5% and raise the size of the loan that can be financed. (The FHA role in refinancing hundreds of thousands of subprime loans is also a potential problem that could lead to a taxpayer bailout.) The Senator concludes this “myth” by stating “it’s clear that many subprime borrowers have the financial foundation for sustainable homeownership, but may have been tricked into unaffordable loans by unscrupulous brokers.” There we go again – it’s all the fault of those brokers. Did the Senator ever consider that maybe these borrowers wanted more home with less down and pressured the brokers to come up with a financing arrangement to satisfy their demands?

Myth three is “The Myth that Borrowers Can Easily Obtain Perfect Knowledge of The Terms of Their Mortgage Loans.” Well, if he is referring to the fact that the rate varies and the payments are likely to go up, borrowers can easily obtain and understand that information. The other thing borrowers generally understand is that if they cannot make their payment they will lose the home. According to Senator Schumer, however, most people are too stupid to understand this and so we must step in to protect them. Now, I wonder which people these are. Are these the ones who had to refinance to pay medical bills or the “too large a percentage” of investors and speculators? No, these must be the ones who were duped by the unscrupulous brokers. Yah, that’s it. How many of those are there again?

Myth four is that the free market will fix everything. I agree with his supposition that free markets do not fix everything, but stupid policy doesn’t fix everything either. If the Senate had listened to all of the warning signals it got about the housing bubble and leaned on the FED a little more, or about rating agencies and acted on that, then much of this mess probably could have been avoided. Instead, the politicians (pretty much all of them) stuck their heads in the sand because they didn’t want to throw cold water on a very popular housing boom (especially when their contributors were making a fortune from it). Glass houses and all of that.

The four myths are followed by warnings of impending doom. In fact, according to Senator Schumer “we are facing an economic downturn that we haven’t seen in this country since the Great Depression.” Yikes! If this is true I’m really glad I took most of my money out of long positions in equities! He goes on to point out that “a 10 percent decline in housing prices could lead to an overall $2.3 trillion economic loss…” That would be bad, but less than half of the approximately $5 trillion in losses from the dotcom bubble bursting. I agree this is not good for the economy, but the Great Depression? I hope not.

The presentation ends with seven policy options proposed by Senator Schumer to address the subprime mortgage crisis. Here they are, in a nutshell:

1) Provide more mortgage counselors to serve as borrowers’ advocates. OK, not bad.
2) Raise the portfolio limits for Fannie Mae and Freddie Mac so they can refinance subprime loans, even though these entities have said this would not be profitable for them. Also raise the cap on the loans they can make to include jumbo mortgages (no mention of the government guarantee part). I don’t like these, especially when the GSEs are saying they want no part of it.
3) Allow states to issue tax-exempt bonds to refinance subprime loans. As long as it’s not my state tax dollars guarantying the loans, fine.
4) Modify the bankruptcy code to change the protection mortgage lenders currently enjoy – mortgage loans are exempt from restructuring in bankruptcy without the consent of the lender. OK, but this could make mortgage loans more expensive in the future. Senator Schumer understands this, and acknowledges that this could be limited to only existing loans. This one gets a maybe and a ho-hum from me. If the lenders will be better off cutting a new deal they will.
5) Enact new regulations covering practices by mortgage brokers and non-bank lenders, including limitations on the types of loans they can make. Remember these brokers and non-bank lenders? They are the bad guys in all of this, according to Senator Schumer. Notice how these are mortgage brokers and non-bank lenders, and not banks or investment banks. If you didn’t click on that link to Senator Schumer’s top contributors you may not get this point as clearly. Here it is again. The Senator simply ignores the role of Wall Street and the investment banks in this crisis and makes no mention of any remedy targeted to them.
6) Create an easy to read summary of mortgage terms for borrowers so the big bad mortgage brokers can no longer dupe them into bad loans. OK.
7) Finally, Senator Schumer proposes to closely examine the role of rating agencies in all of this. Hooray! He is finally getting warm.

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Subprime Conspiracy Theory

By now you have certainly heard that the Federal Government is taking steps to help those poor borrowers of subprime mortgages who were duped by banks and mortgage brokers. I’ll refer to this plan as the “Subprime Bailout Plan”. They plan to help as many as they can refinance into more “secure” fixed rate mortgages, and to freeze the adjustable rate for those who cannot refinance. This plan required many varied interests coming together, and they did so under the guidance of Treasury Secretary Henry Paulson.

At the same time and also with the help of Secretary Paulson, the major money center banks in the US are putting together a plan to finance the purchase of certain assets from Structured Investment Vehicles (SIVs). I’ll call this the “SIV Bailout Plan”. Word is that these vehicles were the repositories for pieces of mortgage securitizations, although finding any actual data on these has been an exercise in futility. The basic idea of this plan is to find a financing source for these assets other than the current structure because the current structure no longer works since these assets have been or may be downgraded by the rating agencies. Once they are downgraded, the SIVs liquidate selling the assets in the marketplace. Because the market for these assets is terrible and sales at current prices would produce large losses, the plan provides a purchaser (the MLEC or Super SIV) for these assets. With time, hopefully, the actual cash flows from these assets will be sufficient to repay the financing used to purchase them at above current market prices. The accounting for all of this raises serious questions in my mind, and if you are interested in that part of it you can read my previous post on that topic here.

To the conspiracy part:
Now, I am not making any direct accusations here, but I would like to point out an issue that I believe should be scrutinized carefully. If the assets in these SIVs are indeed mortgage backed securities or in any way tied to subprime mortgages, then the Subprime Bailout Plan is related to the SIV Bailout Plan because refinancing the subprime mortgages and/or fixing rates for a period of time provides both cash in the form of full repayment of these subprime loans to the owners of those loans, and time to work out the other loans that would default if the interest rates adjust. So, the Subprime Bailout Plan and the SIV Bailout Plan are related, and are both being structured with the assistance of the Treasury Secretary. This raises a potential conflict of interest regarding which subprime borrowers actually receive the assistance that the Subprime Bailout Plan is to provide because those whose mortgages are owned by SIVs or impact repayment on SIV assets could gain preference to aid the SIV Bailout Plan. I believe there should be a call for oversight and full transparency of this entire mess because there is the appearance of a potential conflict of interest here.

Unfortunately, that’s just the beginning of the “conspiracy”. Lets follow the mortgage refinancings to see where the risk of all of these defaults is going. Unfortunately, that road leads indirectly to the federal government and, ultimately, the taxpayer. HUD currently plans to refinance approximately 300,000 subprime mortgages raising serious questions about the ability of the Mutual Mortgage Insurance Fund to adequately cover potential future exposure. Any shortfall in the fund would result in a taxpayer liability. If you would like details about this, you can read my post on it here.

The other place many loans appear to be going is The Federal Home Loan Banks. These banks issue bonds backed by the full faith and credit of The United States (that would be us, the taxpayers) and use the proceeds to purchase mortgages from banks. How much do they purchase, you ask? Well, from December 31, 2005 to June 30, 2007, outstanding advances went from $619.8 billion to $640.0 billion. From June 30, 2007 to September 30, 2007, advances went from $640 billion to $824 billion, an increase of $184 billion. Humm. That would be an annualized rate of increase of ($184 x 4) $736 billion! Senator Schumer has recently questioned the quality of the loans being purchased in an open letter to Ronald A. Rosenfeld, Chairman, Federal Housing Finance Board. You can find that letter here.

Lets review. The Treasury Secretary has developed a plan with major financial institutions to move beaten down assets relating to subprime mortgages (we think) to a Super SIV to buy time to try to liquidate and recoup the value of these assets. At the same time, the Treasury Secretary has developed a plan to refinance and/or freeze the interest rate on some 1.2 million subprime mortgages. The refinance portion of this plan relies on FHA guarantees, and we don’t really know how many subprime mortgages are being refinanced through ultimate sales to The Federal Home Loan Banks. The United States taxpayers ultimately back both of these sources. So, is this really a plan to help those poor victims of the big bad banks that made these subprime mortgages or is this really a bank bailout disguised as a plan to help homeowners? I don’t know the answer, but I know I have serious doubts and there should be some oversight of this entire mess.

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More On Taxpayer Bailout of Subprime

UPDATE: Congress is likely to pass the FHA Modernization Act. This will reduce downpayments from 3% to 1.5%, provide for wider use of risk-based premiums by FHA, and raise the maximum loan amount to the "conforming loan" amount for Freddie and Fannie of $417,000.00. The Senate passed this legislation last week and the House passed similar legislation in September. You can get details of the proposed legislation at this summary of the proposed legislation.

On November 13 I wrote an article about the beginnings of a taxpayer bailout of the subprime mortgage mess. I want to add to that article some new information I have found since then. This has nothing to do with the “Paulson” plan, except that his plan seems to be more of a diversion from what is really happening than anything else.

What is really happening? As I wrote in the article referenced above, the Federal Home Loan Banks have increased their exposure to banks by some $183 billion from December 31, 2006 to September 30, 2007. The FHLBanks obtain funds by issuing federally guaranteed securities, so ultimately this is a taxpayer guaranty. Freddie and Fannie have also substantially increased their portfolios over this time period. But there is more.

The FHA is now into the act in a big way. According to this press release yesterday FHA has now refinanced 33,000 subprime loans and plans to refinance another 20,000 by year end. Plans for 2008 are to refinance 240,000 subprime loans. This is all pursuant to the Bush FHASecure Plan. Of course, as with many Bush plans, the name is deceiving. If anything, I believe this plan makes the FHA less secure and more likely to ultimately require a taxpayer bailout.

Granted the FHA program is backed by an insurance fund – the Mutual Mortgage Insurance Fund (the MMI Fund), that is supposed to stand behind these mortgages. The fund is financed with insurance premiums paid by borrowers. The problem is that the health of the fund (which has a capital ratio around 6.4% of outstanding guaranteed loans based on May 31 2007 data that you can find here) depends upon underwriting standards. With all of the buzz around helping subprime borrowers, and based on some observations, I am very concerned that the fund will ultimately be in jeopardy and have to be bailed out by taxpayers. This is based on my reading of the threats to the MMI Fund.

According to this testimony by Basil N. Petrou, Managing Partner, Federal Financial Analytics, Inc. to the Housing and Transportation Subcommittee of the Committee on Banking, Housing and Urban Affairs, United States Senate, June 20, 2006. prepared and presented in consideration of FHA reform proposals in Congress, the primary sources of financial risk are identified as low or no downpayment loans and risk-based premiums.

Regarding risk-based premiums, the report warns that FHA is likely to get it wrong. FHA does not have the ability to accurately determine which borrowers are higher and lower risk thereby justifying a higher or lower premium. The current system of cross subsidization is a key part of why the MMI Fund has been successful (cross subsidization refers to the fact that all borrowers pay the same fee, resulting in higher quality borrowers subsidizing the lower quality borrowers).

Regarding low or no downpayment loans, it warns that such loans could result in high default rates and serious harm to neighborhoods where these loans would be prevalent. Adding to the risk, according to the testimony, would be a declining real estate market. Does this sound familiar? It sounds like the justification now being given by politicians for helping to stem subprime defaults. This testimony lays out the subprime problem quite clearly, and warns that FHA should stay away from these loans.

This reform that was in front of Congress was not passed. The Bush Administration has, however, authorized modifications to the HUD program that allow HUD to utilize risk based premiums. According to a HUD press release:

President George W. Bush today announced that HUD's Federal Housing Administration (FHA) will help an estimated 240,000 families avoid foreclosure by enhancing its refinancing program effective immediately. Under the new FHASecure plan, FHA will allow families with strong credit histories who had been making timely mortgage payments before their loans reset-but are now in default-to qualify for refinancing. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay-i.e., riskier borrowers pay more. This common-sense, risk-based pricing structure will begin on January 1, 2008.

“Common sense” – hummmm. Not according to congressional testimony. I also point out the spin. If riskier borrowers pay more, doesn't that mean "less risky" borrowers pay less?

Does HUD plan to implement these changes? Well, according to the Annual Management Report of The FHA:

This past year has seen an increase in interest rates and a decrease in house price appreciation, leading to the current mortgage credit crunch. Accordingly, FHA will expand its refinance program, FHASecure, to include those individuals and families who are in default as a result of an interest rate reset. With the inclusion of delinquent borrowers under the FHASecure umbrella, the government’s largest mortgage insurance provider will now be able to assist even more troubled homeowners. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay. This administrative risk-based pricing structure will begin in early 2008.

(Again the spin - "a decrease in home price appreciation" isn't really an accurate description of the current housing market.)
What about the downpayment issue? Well, according to the same press release announcing the FHASecure plan:

To qualify for FHASecure, eligible homeowners must meet the following five criteria:
1. A history of on-time mortgage payments before the borrower's teaser rates expired and loans reset;
2. Interest rates must have or will reset between June 2005 and December 2008;
3. Three percent cash or equity in the home;
4. A sustained history of employment; and
5. Sufficient income to make the mortgage payment.

Note the 3% cash or equity in the home. This is not much. If it is cash, it is most likely not equity given the decline in home prices (as opposed to a decrease in appreciation) so you are left with 100% (or higher) loan-to-value. The implementation of these requirements also concerns me. For example, here is what the FHA website says:

WHO IS ELIGIBLE
To qualify for FHASecure, and include the delinquent loan payments, homeowners wishing to refinance must meet the following requirements:
1. Have a non-FHA insured ARM that has reset;
2. Sufficient income to make the mortgage payment; and
3. A history of on-time mortgage payments before the loan reset.
Homeowners who are current on their conventional mortgages must have sufficient income to make the mortgage payment.

What happened to the “cash or equity” requirement? It isn’t there. Is this an oversight or a reflection of the implementation of this subprime refinance plan? What is this about refinancing delinquent payments? Doesn't this reduce the loan-to-value ratio (making it negative in many cases)? I am cynical, so you know what I think. Here comes the taxpayer bailout. Don't be surprised if sometime in the not too distant future you hear about a MMI Fund taxpayer subsidization plan. Want more? Here is a clip from the Congressional Testimony referred to above:

Key points to consider for FHA reform include:
• As a government program, FHA should serve its targeted borrowers if they are not already being adequately served by the private sector. It is not appropriate for FHA, as a government program, to launch initiatives to expand its “market share.”
• Recent General Accountability Office (GAO) and Department of Housing and Urban Development (HUD) Inspector-General reports, as well as the President’s FY 2007 budget raise serious questions about the Mutual Mortgage Insurance (MMI) Fund’s financial soundness. The most recent available MMI Fund data are for only mid-FY 2005, and these show a serious reduction in the economic value of the fund that undermines its capital adequacy. Mortgage-market trends since then have shown significant weakening, as evident by recent guidance from the federal bank regulatory agencies designed to protect insured depository institutions.
• The FHA should not seek to grow its way out of its current financial problems. Doing so is reminiscent of the actions taken by distressed savings-and-loans during the 1980s.
• The MMI Fund is already taking financial risks. For example, 50% of all FHA loans insured in 2004 had downpayment assistance, with nonprofit organizations that received seller funding accounting for 30 percent of these loans. GAO analysis indicates that these sellers raised the price of their properties to recover their contribution to the seller-funded nonprofit—placing FHA buyers in mortgages that were above the true market value of the house. The Internal Revenue Service (IRS) is curtailing these programs, but the significantly higher claim rates FHA has experienced from these loans will continue for those remaining on its books. Indicative of FHA’s problems is that its delinquency rates are higher than those associated with private subprime loans. Adding yet more risk means potentially profound FHA losses that will heighten the risk of calls upon the taxpayer.
• From a budgetary perspective, the MMI Fund now is only breaking even, but even this is based only on out-dated information. Any shift in the MMI Fund’s financial condition will convert the program into a net cost to taxpayers, increasing the federal budget deficit.

So why didn’t Congress pass this plan? Looks pretty obvious to me. Of course I hope I am wrong and there is no need for a taxpayer bailout of the MMI Fund. Time will tell.

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