The turmoil in mortgage market may appear to be settling down by some standards - although certainly not with respect to impending foreclosures, as those are still projected to reach 2.5 million this year - but there is another wave of foreclosures that may soon begin. Many so-called Alt-A loans (also referred to as "no-doc loans" or even "liar loans") are projected to reset beginning in the latter part of 2009 through the beginning of 2012. (For an illustrative chart, visit: http://www.dailymarkets.com/economy/2009/02/08/default-of-mortgage-loans-alt-a-and-option-arms-are-next/.) This category encompasses loans with very risky structures that include things like interest-only payments (I/O loans) and Option-ARM loans that are all but pre-ordained for default. Under these structures, borrowers are permitted to pay less than what would otherwise be required each month, with the unpaid balance from each month being added to the loan principal at a later date. That capitalization of monthly underpayments will cause monthly payments to jump substantially (increases of 60%-70% in monthly payments are quite possible and will likely not be uncommon) when the terms of the loan reset. This wave of trouble will crest during 2009-2012 because many Alt-A loans have 5-year introductory periods, which accords with the bulk of origination activity of "innovative loans" between 2004 and early 2007.
In fact, the graphic representation of the instance of reset of those Alt-A mortgage correlates with Alt-A loan origination information, which information can be found in a GAO report at: http://www.gao.gov/htext/d09922t.html. As can be observed from the data (numbers available in the text version of the report), the origination of Alt-A loans rose substantially from 2002 to 2003, jumping from 231,000 to 436,000 loans. In 2004, that number rocketed to 937,000 Alt-A loans. In 2005 and 2006, the origination of Alt-A loans was well over 1 million for each year. Given the typical 5-year introductory period of these instruments, the wave of Alt-A loan resets will build substantially this year and then continue to crescendo through 2011, as depicted in the graph referenced above. As the origination of Alt-A's plummeted in 2007 to 436,000 loans, so too will the wave of defaults likely tail off in 2012, again, as depicted by the graph.
Unfortunately, this second wave of foreclosures will likely be just as devastating as the first, and last just as long.
Wednesday, September 30, 2009
Wednesday, April 22, 2009
Breaking the Toxic Asset Pricing Logjam
The previous post listed several reasons that the PPIP would best be implemented by simply having the government purchase loan pools directly, modify any defaulting loans, and then issuing notes based on the loan pools. In addition to the reasons set forth in that previous post, there is one additional, very significant role that the government can play in addressing the problem of toxic assets that no other entities can effectively accomplish. The issue of pricing the toxic assets has apparently not yet been seriously addressed, but it will be addressed sooner or later. However, as many have noted, there is a wide gulf between estimates placed on the value of toxic assets by banks and estimates placed on the value of those assets by potential buyers. Given that gulf, it is unlikely that many assets will be sold. However, it was also noted in the previous post that the problems causing difficulty in valuing those assets can be sensibly addressed, and that sensible analyses can then be performed to better estimate the value of those toxic assets. Of course, there may still be resistance by parties on either or both sides to accepting any values so calculated. If the PPIP relies on private parties to agree on mutually acceptable prices for the toxic assets, even more accurate valuations may not result in many successful purchases of those toxic assets.
However, if the government intervenes to purchase the toxic assets directly, then reticence to accept the estimated values placed on the toxic assets will not unnecessarily hinder the purchase of those toxic assets. The government has at its disposal two powerful tools for encouraging even reticent banks to sell their toxic assets at fair prices. For the time being, I will not elaborate on either of those options. Suffice it to say, though, that either tool could effectively break the logjam that we may experience if the private parties and the banks cannot find mutually acceptable price estimates for the toxic assets.
However, if the government intervenes to purchase the toxic assets directly, then reticence to accept the estimated values placed on the toxic assets will not unnecessarily hinder the purchase of those toxic assets. The government has at its disposal two powerful tools for encouraging even reticent banks to sell their toxic assets at fair prices. For the time being, I will not elaborate on either of those options. Suffice it to say, though, that either tool could effectively break the logjam that we may experience if the private parties and the banks cannot find mutually acceptable price estimates for the toxic assets.
The Elusive Details for the PPIP
Last month the Treasury Department unveiled the general parameters of its plan to address the toxic assets dragging down banks' balance sheets. Since that time, Treasury has been trying to figure out the particular details and structure through which to effectively implement the plan. While the PPIP plan proposes to rely on private investors to relieve the banks of their bad assets, there are several major problems that just have not been addressed. First and foremost, and a point which, curiously, is being not being directly addressed, is the fact that simply moving the toxic assets from one place to another will do nothing to alter the toxic character of those assets. Second, and the issue upon which most people have focused, is the challenge of pricing the toxic assets to be moved. And third, there are challenges in developing an effective mechanism for permitting investment in those assets.
One significant issue that nobody seems to be discussing directly is the fact that merely moving the toxic assets from one place to another will not change the fact that they are toxic. This point is always tacitly subsumed into discussions about finding an appropriate price for those assets. But it is better to address these considerations separately. First, it is unclear just how vast the problem of toxic assets is, although some estimates have been made. Second, it is unclear just how toxic those assets are (i.e. how much a particular loan will perform, if at all, or how many loans in a securitized pool will fail, affecting the value of the securities). Both of those uncertainties will affect any attempted valuations of toxic assets.
As an example, information recently released by one particular bank is rather instructive. Despite the fact that the bank in question recently reported a first quarter gain of $4.25 billion, its stock plunged 24% on that same day. Investors and analysts saw past the glitz and identified numerous troubling signs at the bank. Of predominant importance for this discussion was the year-over-year increase in non-performing assets from 0.9% to 2.65%. At the same time, the bank increased its loan loss reserve to $13.4 billion, an increase of 57% above its fourth quarter reserve. However, due to the increasing failure of loans, the ratio of the loan loss reserve to non-performing loan value actually dropped from 1.41 to 1.21. Yes, despite a 57% increase in the loan loss reserve, the ratio of the reserve to bad loans actually fell by 14%. (See articles from the Wall Street Journal, April 21, 2009: http://online.wsj.com/article/SB124021187032334351.html and http://online.wsj.com/article/SB124027011654636755.html.) This demonstrates that the breadth of the toxic asset problem has not yet been defined and that a significant portion of assets are continuing to become toxic. Due to the fact that questionable loans were originated through the first quarter of 2007 and that most of those loans had 3-year reset provisions, it can be anticipated that the toxicity of assets will continue to spread well into 2010. While subprime borrowers are likely to default quickly once the terms of their loans reset, prime borrowers may succeed in staving off default for some time by liquidating other assets. This may result in a "slow roll" wave of defaults by prime borrowers. The deterioration of the assets held by this bank - or any other bank - will not cease if those assets are simply transferred elsewhere.
Given the uncertainty in determining how many assets will may become toxic and the depth of that potential toxicity, it would be very difficult to try to place a value on those assets. Indeed, articles have consistently reported a wide disparity in the values placed on such assets by banks and by investors. Many articles report bank valuations in the range of 60-80 cents on the dollar for such assets, while potential investors place their value at closer to 20-35 cents on the dollar. With such a wide gulf between the estimated values reached by the parties to these ostensible transactions, it is highly unlikely that many sales of the toxic assets will be completed.
That brings me to the second issue: that of determining accurate values for the toxic assets. If the defaulting loans that comprise those toxic assets (or elements of loan pools on which toxic assets are based) are modified, then the breadth and toxicity of those toxic assets can be contained. This is not to say that some loans will not continue to default, but they will do so in a much more predictable pattern. Banks routinely use prepayment curves and loan default curves to estimate how many loans in a healthy loan pool are likely to prepay or default over the lives of the instruments. By relying on these estimates, the banks can closely estimate the actual performance of the loan pools, and therefore the anticipated revenue that will be generated from such loan pools. This enables those banks to place values on the assets based on those loan pools. Of course, in a bad economic environment, like the current recession, the loss of jobs means that more borrowers are likely to suffer economic hardships, and therefore to default on their loans. However, estimates can also be made to gauge the impact of these job losses on the performance of loan pools, and thereby their effect on the values of assets based on those loan pools. This may be a challenging assessment, but should be eminently feasible if conducted with diligence, intelligent assumptions, and careful analysis of relevant information from similar prior economic circumstances.
Finally, there remains the real problem of finding the proper vehicle for enabling investors to invest in these toxic assets. It has recently been pointed out that there are some regulatory prohibitions that might prevent the establishment of mutual fund-like investment funds to facilitate private investment in such assets. Currently, regulations prohibit open-end funds (like mutual funds) from investing more than 15% of their funds in illiquid assets. There is some question as to whether closed-end funds would be permitted to invest 100% of their funds in such illiquid assets. Perhaps this would be permitted, perhaps not.
As an alternative, I would propose that the government establish these funds for several reasons. First, the PPIP already proposes that most of the money used to purchase the toxic assets would come from the government. The government would stand to earn some profit if the assets recover value above that for which they are purchased, but it would also bear substantially greater downside risk if the assets do not recover. If the government simply purchases the assets in the first instance, it will commit only a small additional proportion of funds, but will obtain a much better balance of potential upside benefit against the downside risk. Second, the government could much more easily marshal all of the assets in a single mortgage pool than could private investors. This is significant because it would facilitate the modification of toxic assets to render them non-toxic, thereby making it more likely that the assets would continue to perform, and making it much easier to value those assets. Third, the government could then sell government-guaranteed shares in these pools directly to investors, essentially skipping the middleman. Demand for other types of government notes is extremely high right now, and it is likely that investors would also feel secure in purchasing guaranteed notes from these loan pools. As a significant additional benefit, the sale of those notes would replenish the government's coffers, enabling it to target additional mortgage pools, modify those toxic assets, and perpetuate the process.
One significant issue that nobody seems to be discussing directly is the fact that merely moving the toxic assets from one place to another will not change the fact that they are toxic. This point is always tacitly subsumed into discussions about finding an appropriate price for those assets. But it is better to address these considerations separately. First, it is unclear just how vast the problem of toxic assets is, although some estimates have been made. Second, it is unclear just how toxic those assets are (i.e. how much a particular loan will perform, if at all, or how many loans in a securitized pool will fail, affecting the value of the securities). Both of those uncertainties will affect any attempted valuations of toxic assets.
As an example, information recently released by one particular bank is rather instructive. Despite the fact that the bank in question recently reported a first quarter gain of $4.25 billion, its stock plunged 24% on that same day. Investors and analysts saw past the glitz and identified numerous troubling signs at the bank. Of predominant importance for this discussion was the year-over-year increase in non-performing assets from 0.9% to 2.65%. At the same time, the bank increased its loan loss reserve to $13.4 billion, an increase of 57% above its fourth quarter reserve. However, due to the increasing failure of loans, the ratio of the loan loss reserve to non-performing loan value actually dropped from 1.41 to 1.21. Yes, despite a 57% increase in the loan loss reserve, the ratio of the reserve to bad loans actually fell by 14%. (See articles from the Wall Street Journal, April 21, 2009: http://online.wsj.com/article/SB124021187032334351.html and http://online.wsj.com/article/SB124027011654636755.html.) This demonstrates that the breadth of the toxic asset problem has not yet been defined and that a significant portion of assets are continuing to become toxic. Due to the fact that questionable loans were originated through the first quarter of 2007 and that most of those loans had 3-year reset provisions, it can be anticipated that the toxicity of assets will continue to spread well into 2010. While subprime borrowers are likely to default quickly once the terms of their loans reset, prime borrowers may succeed in staving off default for some time by liquidating other assets. This may result in a "slow roll" wave of defaults by prime borrowers. The deterioration of the assets held by this bank - or any other bank - will not cease if those assets are simply transferred elsewhere.
Given the uncertainty in determining how many assets will may become toxic and the depth of that potential toxicity, it would be very difficult to try to place a value on those assets. Indeed, articles have consistently reported a wide disparity in the values placed on such assets by banks and by investors. Many articles report bank valuations in the range of 60-80 cents on the dollar for such assets, while potential investors place their value at closer to 20-35 cents on the dollar. With such a wide gulf between the estimated values reached by the parties to these ostensible transactions, it is highly unlikely that many sales of the toxic assets will be completed.
That brings me to the second issue: that of determining accurate values for the toxic assets. If the defaulting loans that comprise those toxic assets (or elements of loan pools on which toxic assets are based) are modified, then the breadth and toxicity of those toxic assets can be contained. This is not to say that some loans will not continue to default, but they will do so in a much more predictable pattern. Banks routinely use prepayment curves and loan default curves to estimate how many loans in a healthy loan pool are likely to prepay or default over the lives of the instruments. By relying on these estimates, the banks can closely estimate the actual performance of the loan pools, and therefore the anticipated revenue that will be generated from such loan pools. This enables those banks to place values on the assets based on those loan pools. Of course, in a bad economic environment, like the current recession, the loss of jobs means that more borrowers are likely to suffer economic hardships, and therefore to default on their loans. However, estimates can also be made to gauge the impact of these job losses on the performance of loan pools, and thereby their effect on the values of assets based on those loan pools. This may be a challenging assessment, but should be eminently feasible if conducted with diligence, intelligent assumptions, and careful analysis of relevant information from similar prior economic circumstances.
Finally, there remains the real problem of finding the proper vehicle for enabling investors to invest in these toxic assets. It has recently been pointed out that there are some regulatory prohibitions that might prevent the establishment of mutual fund-like investment funds to facilitate private investment in such assets. Currently, regulations prohibit open-end funds (like mutual funds) from investing more than 15% of their funds in illiquid assets. There is some question as to whether closed-end funds would be permitted to invest 100% of their funds in such illiquid assets. Perhaps this would be permitted, perhaps not.
As an alternative, I would propose that the government establish these funds for several reasons. First, the PPIP already proposes that most of the money used to purchase the toxic assets would come from the government. The government would stand to earn some profit if the assets recover value above that for which they are purchased, but it would also bear substantially greater downside risk if the assets do not recover. If the government simply purchases the assets in the first instance, it will commit only a small additional proportion of funds, but will obtain a much better balance of potential upside benefit against the downside risk. Second, the government could much more easily marshal all of the assets in a single mortgage pool than could private investors. This is significant because it would facilitate the modification of toxic assets to render them non-toxic, thereby making it more likely that the assets would continue to perform, and making it much easier to value those assets. Third, the government could then sell government-guaranteed shares in these pools directly to investors, essentially skipping the middleman. Demand for other types of government notes is extremely high right now, and it is likely that investors would also feel secure in purchasing guaranteed notes from these loan pools. As a significant additional benefit, the sale of those notes would replenish the government's coffers, enabling it to target additional mortgage pools, modify those toxic assets, and perpetuate the process.
Tuesday, April 7, 2009
The Effect of Loan Modifications
Last Friday the Office of Thrift Supervision released a report about the effectiveness of loan modifications that should not have surprised anybody. The upshot of the report found that modifications that did not reduce monthly mortgage payments resulted in re-defaults in about 51% of cases, but that loan modifications that reduced borrowers' monthly mortgage payments resulted in a substantially lower rate of re-default, either 23% or 26%, depending on source. It should not take a government study to demonstrate the correlation between lowering monthly mortgage payments and lower rates of re-default on loans, but at least the measure of effectiveness is useful.
The report found that many loan "modifications" were actually forbearances, meaning that they did not alter the terms of the loan, but simply permitted borrowers to make missed payments at a later date, or factored already-missed payments into the borrowers' current monthly payments. The latter scenario actually increases borrowers' monthly payments. If the borrowers were already having trouble making payments, it should be no surprise that the failure to lower those payments does not alleviate the burden on the borrowers. As stated above, the report found that about 51% of borrowers receiving such modifications fell back into default within six months.
By contrast, loans that were truly modified to result in lower monthly payments for the borrowers resulted in much lower rates of re-default. When loans were modified so that the monthly mortgage payments were lowered by 10% or more, the rate of re-default six months later was only about 26%. That is half the percentage of re-defaults of the other category. Most of the articles describing the study did not specify how the loans were modified, but it appears to have been accomplished through lowering the interest rates and extending the life of the loans. In many cases, it appears that the monthly payments were kept lower by reducing interest rates. (See press release from the Office of the Comptroller of the Currency from April 3, 2009, listed at: http://www.occ.treas.gov/ftp/release/2009-37.htm.)
The 10% reduction to monthly payments appeared to be an arbitrary reduction level that is not tied to any particular level of the borrower's income. In such a case, it is not surprising that such a high percentage of even the modified loans continue to re-default. Many people have recently advocated identifying viable levels of mortgage payments based on the borrowers' income and then adjusting monthly payments to those levels. Such an approach is much more likely to establish viable levels for borrowers and to prevent re-defaults. However, many of those plans require lenders to forfeit some amount of principal from the loan in order to reach the targeted payment levels. Once again, I submit that my plan would facilitate the lenders' efforts to reduce borrowers' monthly mortgage payments, but would compensate the lenders in a fair manner for writing down the principal of the loans.
The report found that many loan "modifications" were actually forbearances, meaning that they did not alter the terms of the loan, but simply permitted borrowers to make missed payments at a later date, or factored already-missed payments into the borrowers' current monthly payments. The latter scenario actually increases borrowers' monthly payments. If the borrowers were already having trouble making payments, it should be no surprise that the failure to lower those payments does not alleviate the burden on the borrowers. As stated above, the report found that about 51% of borrowers receiving such modifications fell back into default within six months.
By contrast, loans that were truly modified to result in lower monthly payments for the borrowers resulted in much lower rates of re-default. When loans were modified so that the monthly mortgage payments were lowered by 10% or more, the rate of re-default six months later was only about 26%. That is half the percentage of re-defaults of the other category. Most of the articles describing the study did not specify how the loans were modified, but it appears to have been accomplished through lowering the interest rates and extending the life of the loans. In many cases, it appears that the monthly payments were kept lower by reducing interest rates. (See press release from the Office of the Comptroller of the Currency from April 3, 2009, listed at: http://www.occ.treas.gov/ftp/release/2009-37.htm.)
The 10% reduction to monthly payments appeared to be an arbitrary reduction level that is not tied to any particular level of the borrower's income. In such a case, it is not surprising that such a high percentage of even the modified loans continue to re-default. Many people have recently advocated identifying viable levels of mortgage payments based on the borrowers' income and then adjusting monthly payments to those levels. Such an approach is much more likely to establish viable levels for borrowers and to prevent re-defaults. However, many of those plans require lenders to forfeit some amount of principal from the loan in order to reach the targeted payment levels. Once again, I submit that my plan would facilitate the lenders' efforts to reduce borrowers' monthly mortgage payments, but would compensate the lenders in a fair manner for writing down the principal of the loans.
Sunday, March 29, 2009
Fundamental Problems Remain Unaddressed by the Public-Private Investment Program (PPIP)
Last month the Treasury Department detailed its plan to try to stabilize the housing market, and by extension the financial system, by sponsoring investments and backstopping any potential losses by private investors in mortgage pools and mortgage pool-derived securities. While this theory sounds promising and may encourage some investment – indeed, a few investment banks have already expressed keen interest[1] – this plan suffers from the same serious flaws as other plans that have come before it.
The flaw upon which most people have focused is that there is no reliable means of pricing the assets in question at this time. Many point to Merrill Lynch’s fire sale of similar assets for 22 cents on the dollar last summer[2], and question whether buyers and sellers will be able to agree on a price. Without such agreement, the plan cannot be implemented. However, the more serious flaw is that this plan does nothing to address the underlying toxicity of the assets in question. We cannot simply hope that these assets will somehow miraculously recover their value of their own accord once they are sold. Without a plan to address the underlying problem that has caused the assets to become toxic, the government is simply transferring the risk of these assets from the large financial institutions to the taxpayers. Again.
Unfortunately, the PPIP utterly fails to address the toxic nature of the mortgages upon which so many assets are based. If we do not find a way to address the problems that are causing loans to default, the loans that have already defaulted will remain in default and will not recover, and troubled loans that have not yet defaulted will not be prevented from defaulting in the future. And, make no mistake, many more loans will default if those problems are not addressed. Most of the loans that default are adjustable-rate mortgaged (ARM’s), or loans with a similar structure, such as interest-only loans (I/O’s) or negatively-amortizing loans; most of those loans have 3-year to 5-year introductory periods; and such loans were aggressively made to investors through the end of 2006.[3] This means that those loans will continue to reset, and then default, through the end of 2009, and some perhaps even as late as 2011. That’s several more years of potential mortgage defaults. Of course, as mortgages continue to default, the assets that are based on those mortgages will continue to lose value as well.
However, if the Treasury Department would adopt a bottom-up approach, rather than this top-down approach, it could address the underlying problems that have made the mortgage-backed assets toxic in the first place, and prevent defaults and foreclosures. By preventing further defaults and foreclosures, we could provide a stable foundation in the primary instruments (the mortgages) that would, in turn, provide stability to the secondary instruments (the mortgage-backed securities and other mortgage derivative instruments) that are based upon those mortgages. The plan that I have proposed describes a fair and effective model for preventing such further defaults and foreclosures and could provide the stabilization that the Treasury Department seeks.
[1] See, for example, “Can Geithner’s Toxic Asset Plan Work?,” BusinessWeek, March 26, 2009: http://www.businessweek.com/magazine/content/09_14/b4125024185951.htm?chan=top+news_top+news+index+-+temp_news+%2B+analysis
[2] See, for example, “Merrill Fire Sale Just Another Ponzi Scheme,” MoneyNews, July 30, 2008: http://moneynews.newsmax.com/hans_parisis/merrill_ponzi_scheme/2008/07/30/117582.html
[3] See, for example, “May 2007 Economic Outlook,” Freddie Mac, Office of the Chief Economist: http://www.freddiemac.com/news/finance/pdf/May_2007_FRECOM_Outlook.pdf
The flaw upon which most people have focused is that there is no reliable means of pricing the assets in question at this time. Many point to Merrill Lynch’s fire sale of similar assets for 22 cents on the dollar last summer[2], and question whether buyers and sellers will be able to agree on a price. Without such agreement, the plan cannot be implemented. However, the more serious flaw is that this plan does nothing to address the underlying toxicity of the assets in question. We cannot simply hope that these assets will somehow miraculously recover their value of their own accord once they are sold. Without a plan to address the underlying problem that has caused the assets to become toxic, the government is simply transferring the risk of these assets from the large financial institutions to the taxpayers. Again.
Unfortunately, the PPIP utterly fails to address the toxic nature of the mortgages upon which so many assets are based. If we do not find a way to address the problems that are causing loans to default, the loans that have already defaulted will remain in default and will not recover, and troubled loans that have not yet defaulted will not be prevented from defaulting in the future. And, make no mistake, many more loans will default if those problems are not addressed. Most of the loans that default are adjustable-rate mortgaged (ARM’s), or loans with a similar structure, such as interest-only loans (I/O’s) or negatively-amortizing loans; most of those loans have 3-year to 5-year introductory periods; and such loans were aggressively made to investors through the end of 2006.[3] This means that those loans will continue to reset, and then default, through the end of 2009, and some perhaps even as late as 2011. That’s several more years of potential mortgage defaults. Of course, as mortgages continue to default, the assets that are based on those mortgages will continue to lose value as well.
However, if the Treasury Department would adopt a bottom-up approach, rather than this top-down approach, it could address the underlying problems that have made the mortgage-backed assets toxic in the first place, and prevent defaults and foreclosures. By preventing further defaults and foreclosures, we could provide a stable foundation in the primary instruments (the mortgages) that would, in turn, provide stability to the secondary instruments (the mortgage-backed securities and other mortgage derivative instruments) that are based upon those mortgages. The plan that I have proposed describes a fair and effective model for preventing such further defaults and foreclosures and could provide the stabilization that the Treasury Department seeks.
[1] See, for example, “Can Geithner’s Toxic Asset Plan Work?,” BusinessWeek, March 26, 2009: http://www.businessweek.com/magazine/content/09_14/b4125024185951.htm?chan=top+news_top+news+index+-+temp_news+%2B+analysis
[2] See, for example, “Merrill Fire Sale Just Another Ponzi Scheme,” MoneyNews, July 30, 2008: http://moneynews.newsmax.com/hans_parisis/merrill_ponzi_scheme/2008/07/30/117582.html
[3] See, for example, “May 2007 Economic Outlook,” Freddie Mac, Office of the Chief Economist: http://www.freddiemac.com/news/finance/pdf/May_2007_FRECOM_Outlook.pdf
Wednesday, March 25, 2009
De-Toxifying Those Toxic Assets
We’ve all heard the term, ad nauseam, lately: “toxic assets.” There is no specific definition. People use the term to refer, generally, to any mortgages that have failed, and to mortgage-backed securities that have lost significant value. It is those toxic assets that are causing so much consternation with regard to all of the plans that have been developed thus far to address the mortgage crisis. The reason is that none of those plans tries to fix the underlying problems that have made the assets toxic. Instead, they simply shift the problem from one place to another – typically from the balance sheets of private banks to government accounts supported by taxpayers. That is not a solution; it is an accounting gimmick.
By detoxifying the toxic assets, we achieve several benefits. First – and this is really the lynchpin for the whole system – we reduce borrowers’ payments to sustainable levels. By reducing payments to a stable level that borrowers can afford, we make it much more likely that borrowers will avoid default and continue to make timely payments on their mortgages. That, in turn, means that we will slow the wave of foreclosures that has driven down property prices so far so quickly. It will also slow or even halt the precipitous decline in the value of assets based on those mortgages. If we can effectively detoxify the toxic assets then we don’t have to play a shell game that simply shifts bad assets from one place to another – we can actually mitigate this disaster and begin to stabilize our economy.
Some of the plans that have been proposed, including the plan I have devised, address the underlying problems that make the assets toxic. All of those plans, except mine, rely on a combination of lowering interest rates, extending the life of the loan, and requiring the forfeiture of some of the principal of the loan in order to lower mortgage payments to a certain level. These plans all suffer several deficiencies. First, interest rates must be lowered, once again, to artificially low levels. They may not be set as low as during the introductory period of the loan, but it establishes the same kind of latent problem from which all these toxic assets initially sprung. Even if those interest rates are increased by only 1% per year, the payments will soon rise to levels that again will seriously stress borrowers. Second, the extension of the life of a loan from 30 years to 60 years provides significant reductions only when the interest rate is about 3% or lower, but has very little effect when the interest rate is higher than 3%. Those plans would not even extend the life of the loan that far, though. They only propose extensions to 40 years, which would produce even less effect in lowering monthly payments. Finally, if the target monthly payments have not been achieved with the other two mechanisms, those plans advocate the forfeiture by banks or lenders some of the principal balance of the loan. The obvious problem here is that the banks are asked to take a loss on the mortgage without any compensation. Some may feel that this is justified because the banks engaged in reckless or predatory lending practices. However, the borrowers also share some of the blame for buying properties they could not really afford, but this approach gives them a partial free pass. In summary, these plans contain moral hazard problems (in forgiving parties for their bad behavior), and do little to actually detoxify the toxic assets. Indeed, studies have found that approximately half of all loans modified according to such plans re-default within one year.
The plan I have devised, however, truly detoxifies the toxic assets and also avoids the moral hazard problems. As opposed to the other plans, my plan focuses on modifying the principal balance of the loan because that is the most effective way to reduce the monthly mortgage payment. In addition, my plan does not require the banks or lenders to simply forfeit the principal that is reduced. Rather, that reduction in principal is treated as an investment by the banks – they get something in return for modifying the loan. This provides a crucial incentive to induce the banks to participate in the process. Just as importantly, though, is the fact that my plan does not try to fix the problem of default by creating another artificial situation just to ease the borrowers’ payments. Under my plan, the interest rates of loans remain at market rates and the lives of the loans remain unchanged. That means that the interest rate does not need to be “corrected” back to its market level later. This means that the borrowers will not face increasing pressure on their payments again, as in the other plans, due to interest rates being increased. My plan does not just postpone the problem; it addresses it.
By detoxifying the toxic assets, we achieve several benefits. First – and this is really the lynchpin for the whole system – we reduce borrowers’ payments to sustainable levels. By reducing payments to a stable level that borrowers can afford, we make it much more likely that borrowers will avoid default and continue to make timely payments on their mortgages. That, in turn, means that we will slow the wave of foreclosures that has driven down property prices so far so quickly. It will also slow or even halt the precipitous decline in the value of assets based on those mortgages. If we can effectively detoxify the toxic assets then we don’t have to play a shell game that simply shifts bad assets from one place to another – we can actually mitigate this disaster and begin to stabilize our economy.
Some of the plans that have been proposed, including the plan I have devised, address the underlying problems that make the assets toxic. All of those plans, except mine, rely on a combination of lowering interest rates, extending the life of the loan, and requiring the forfeiture of some of the principal of the loan in order to lower mortgage payments to a certain level. These plans all suffer several deficiencies. First, interest rates must be lowered, once again, to artificially low levels. They may not be set as low as during the introductory period of the loan, but it establishes the same kind of latent problem from which all these toxic assets initially sprung. Even if those interest rates are increased by only 1% per year, the payments will soon rise to levels that again will seriously stress borrowers. Second, the extension of the life of a loan from 30 years to 60 years provides significant reductions only when the interest rate is about 3% or lower, but has very little effect when the interest rate is higher than 3%. Those plans would not even extend the life of the loan that far, though. They only propose extensions to 40 years, which would produce even less effect in lowering monthly payments. Finally, if the target monthly payments have not been achieved with the other two mechanisms, those plans advocate the forfeiture by banks or lenders some of the principal balance of the loan. The obvious problem here is that the banks are asked to take a loss on the mortgage without any compensation. Some may feel that this is justified because the banks engaged in reckless or predatory lending practices. However, the borrowers also share some of the blame for buying properties they could not really afford, but this approach gives them a partial free pass. In summary, these plans contain moral hazard problems (in forgiving parties for their bad behavior), and do little to actually detoxify the toxic assets. Indeed, studies have found that approximately half of all loans modified according to such plans re-default within one year.
The plan I have devised, however, truly detoxifies the toxic assets and also avoids the moral hazard problems. As opposed to the other plans, my plan focuses on modifying the principal balance of the loan because that is the most effective way to reduce the monthly mortgage payment. In addition, my plan does not require the banks or lenders to simply forfeit the principal that is reduced. Rather, that reduction in principal is treated as an investment by the banks – they get something in return for modifying the loan. This provides a crucial incentive to induce the banks to participate in the process. Just as importantly, though, is the fact that my plan does not try to fix the problem of default by creating another artificial situation just to ease the borrowers’ payments. Under my plan, the interest rates of loans remain at market rates and the lives of the loans remain unchanged. That means that the interest rate does not need to be “corrected” back to its market level later. This means that the borrowers will not face increasing pressure on their payments again, as in the other plans, due to interest rates being increased. My plan does not just postpone the problem; it addresses it.
Sunday, March 22, 2009
My Plan to Address the National Mortgage Crisis
I have established this blog in order to more effectively broadcast a plan I developed last summer to address the national mortgage crisis and to spur further discussion to find additional solutions to the problem.
Recent Developments:
Over the past several months, people have finally begun to talk about adjusting the principal balances of failing or threatened loans. At the same time, though, they have identified some problems associated with such an approach, which they label "moral hazard" problems. The concept is that some people (typically borrowers) will get a free ride, to some extent, by being let partly off the hook for money they borrowed and agreed to repay.
The plan that I developed avoids these moral hazard problems because it does not simply advocate writing off part of the principal balance of the loan. Rather, the approach I have devised would treat the reduction in loan principal as an investment by the bank, which must later be repaid by the borrower when the house is sold. In this way, both parties will share the risk and the benefit of the loan; both have incentives to participate in such a program; and the program can prevent foreclosures, thereby slowing the decline of housing values in markets around the country.
Plan Overview:
Most of the loans that have gone bad consist of some kind of adjustable-rate mortgage (ARM), or similar loan structure that had an introductory period during which mortgage payments were artificially low. Once those introductory periods ended, borrowers' monthly payments increased significantly, often more than 15% or 20%. Because many borrowers had reached simply to make the payments during the introductory period, they could not afford to make payments once the terms of their loans reset.
The premise on which my plan is based is that, if borrowers could afford to make the monthly mortgage payments during the introductory period of the loans, then they could probably continue to make payments at that same level. The borrowers could then avoid foreclosure, remain in their homes, and continue to build up equity in the property with each payment. At the very least, this would help to stabilize housing markets and slow the decline of property values.
My plan describes how to calculate the extent by which to reduce the principal balance of a loan in order to return payments to their introductory levels. It further describes how to calculate the future compensation for the lender who agrees to reduce the principal balance. Finally, it describes how and when that compensation should be recouped by the lender.
This plan can be applied to any loan, whether already in default or soon to be in default, whether the loan is securitized or unsecuritized. The application of the plan to securitized loans would require participation by either a government agency, or by Fannie Mae or Freddie Mac (the government-sponsored entities, or GSE's), but would be a perfect application for TARP funds.
The details of the plan are described in a short (7-page) white paper that I have attached to this post. For those who wish to skip the detailed algebra, I have also attached a 6-page version of the white paper that includes only the illustrative formulas.
-Marc Gilmore
Recent Developments:
Over the past several months, people have finally begun to talk about adjusting the principal balances of failing or threatened loans. At the same time, though, they have identified some problems associated with such an approach, which they label "moral hazard" problems. The concept is that some people (typically borrowers) will get a free ride, to some extent, by being let partly off the hook for money they borrowed and agreed to repay.
The plan that I developed avoids these moral hazard problems because it does not simply advocate writing off part of the principal balance of the loan. Rather, the approach I have devised would treat the reduction in loan principal as an investment by the bank, which must later be repaid by the borrower when the house is sold. In this way, both parties will share the risk and the benefit of the loan; both have incentives to participate in such a program; and the program can prevent foreclosures, thereby slowing the decline of housing values in markets around the country.
Plan Overview:
Most of the loans that have gone bad consist of some kind of adjustable-rate mortgage (ARM), or similar loan structure that had an introductory period during which mortgage payments were artificially low. Once those introductory periods ended, borrowers' monthly payments increased significantly, often more than 15% or 20%. Because many borrowers had reached simply to make the payments during the introductory period, they could not afford to make payments once the terms of their loans reset.
The premise on which my plan is based is that, if borrowers could afford to make the monthly mortgage payments during the introductory period of the loans, then they could probably continue to make payments at that same level. The borrowers could then avoid foreclosure, remain in their homes, and continue to build up equity in the property with each payment. At the very least, this would help to stabilize housing markets and slow the decline of property values.
My plan describes how to calculate the extent by which to reduce the principal balance of a loan in order to return payments to their introductory levels. It further describes how to calculate the future compensation for the lender who agrees to reduce the principal balance. Finally, it describes how and when that compensation should be recouped by the lender.
This plan can be applied to any loan, whether already in default or soon to be in default, whether the loan is securitized or unsecuritized. The application of the plan to securitized loans would require participation by either a government agency, or by Fannie Mae or Freddie Mac (the government-sponsored entities, or GSE's), but would be a perfect application for TARP funds.
The details of the plan are described in a short (7-page) white paper that I have attached to this post. For those who wish to skip the detailed algebra, I have also attached a 6-page version of the white paper that includes only the illustrative formulas.
-Marc Gilmore
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