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
Sunday, March 29, 2009
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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