Tuesday, March 23, 2010

Homeowner Bailouts? Look Again - It's a Bank Bailout

Louise Story has an article in the NY Times today about pending "homeowner bailouts."

"Arizona is one of five states that, with money from Washington, hopes to help at least some of these people hold on to their homes. Under a new, federally financed pilot program for the hardest-hit housing markets, state officials will decide who will get a homeowner bailout, and who will not.

The idea is as controversial in Washington as it is here. Do the neighbors next door who lived beyond their means — the ones who, say, bought that house they could not afford, or who binged on home equity loans to buy new cars and flat-panel TVs — really deserve to be bailed out with taxpayer dollars? Do they deserve to have some of their debts forgiven? And is that fair to the cautious ones who paid their mortgages?"

Well, my position is clear on that question:  the answer is NO.  But let's not get bogged down in an idealogical battle:  if you believe that homeowners who borrowed and spent beyond their means should be bailed out, we really have nothing to discuss - I strenuously disagree.  I do, however, ask those who are pro-bailout to refrain from using the "hey - banks were bailed out, why shouldn't we be bailed out too?" argument.  After all, we all learned by age 5 the old adage:  two wrongs don't make a right.

There is also a key point that lots of people seem to gloss over when talking about homeowners who are having trouble paying their mortgages:  there are millions of others on the sideline waiting, saving, and hoping to prudently buy houses of their own!  For every imprudent borrower we aid, we are impeding a prudent saver from buying a home they can afford - because we are keeping home prices inflated, and preventing house prices from falling to affordable levels where new savers can finally purchase them.

Since the NY Times gives us some actual data, let's look at one of the troubled homeowners who had to throw in the towel before this bailout program:

"Ms. Carter, at 4344, arrived in 2005, as the bubble was inflating. She took out tens of thousands of dollars in home equity for repairs and other items, and by this year, she was underwater on her mortgage by $86,000. A single mother, she moved out this month, days before her home was sold in a short sale, which meant her mortgage lender allowed her to sell for less than the value of her mortgage and the lender took the loss."

I'm a compassionate guy, but if you expect me to sympathize, I don't (and to her credit, I don't think she's asking for sympathy - as we'll get to in a minute).  The Times, in the attached graphic, gives us some more data on Ms. Carter: 

original mortgage: $207,920
current mortgage: $307,000
purchase price: $259,000
current value: $221,000

It seems that the "tens of thousands of dollars in home equity" that Ms Carter withdrew from her home is closer to $100,000.  Her current mortgage is $86,000 underwater.  If she hadn't spent her paper profits (perhaps on the Mercedes and the expensive lawn we'll encounter in a moment?), she wouldn't be underwater!

Now, I don't mean to pick on Ms. Carter, in fact, she is honest about her situation:

"Years ago, she considered filing for bankruptcy but then changed her mind. She said she was accountable for her actions and was making what amounted to a business decision to leave her home.

“I had to take emotion out of it,” said Ms. Carter, 36. “If I had a business, and every single month I was losing money, would I keep on paying? No, I wouldn’t.”

Sitting at her dining room table, before a large tank of fish, she recalled how she had made this a perfect home. It is one of the few on East Montgomery Road with grass in the yard, an expensive proposition in the desert. A Mercedes sits in the driveway.

She said she did not feel she deserved to have her debts forgiven, but added that if her mortgage had been lowered, she would have tried harder to stay."
This "homeowner bailout" program will certainly be difficult to implement morally.  The director of the program is quoted in the article as saying:

"he was reluctant to help homeowners with “self-inflicted wounds,” like those who overspent or cashed out the equity in their homes during the bubble years. He wants the banks to match the public money being used for debt forgiveness, and he is focusing on people whose incomes have fallen but who still hold jobs." 

And here is the key epiphany that I've been marching toward:   guess what - this isn't really a homeowner bailout at all.  It's ANOTHER bank bailout!  Remember - just like Ms. Carter made the "business decision" to leave her home, banks can make the business decision to adjust the outstanding mortgage balance (lower) on borrowers who cannot pay and will otherwise default and induce foreclosure.  There's one huge problem with that, though: I've written at length about the deadly game of extend and pretend we're playing with our debts.  The banks are carrying so many of these mortgages at the full loan value, even though they know that in reality they will not be getting the full mortgage value back.  If they do a mortgage principal writedown (reduce the amount the homeowner owes), however, they have to write down the value of the loan too - and take a loss.

What's the solution?  Extend and pretend... close your eyes and pretend the losses don't exist by refusing to acknowledge them.  That's why you see articles like this from Calculated Risk, describing home "owners" who haven't made a payment for three years and still haven't been foreclosed on!

Think about it - the banks know that the real estate market sucks. They don't want to take your house from you and have to sell it themselves - that is expensive, AND it requires them to take the actual loss on their books.  On the other hand, they don't want to lower the mortgage balance to an amount the borrower can actually pay, because that ALSO requires them to take the loss on their books.  So, they just delay and pray.

Which brings us back to the "homeowner bailout."  Do you see, now, who the end beneficiary is?  Homeowners don't need a government subsidy  - what they really need is for banks to make sensible business decisions and write down mortgages to levels where homeowners are willing to pay (side note:  of course, the banks could also foreclose, but that's more expensive for the bank.  Despite biases individual bystanders may have on homeowner responsibility, it's probably a better business decision for the banks to do a principal writedown than a foreclosure).  As we've just established, if banks do these principal writedowns, they have to recognize losses which further decimate their already fragile (insolvent??) balance sheets - so they avoid the writedowns. 

Solution?  The government comes in and essentially subsidizes the writedown!  The government could send the money to the bank on behalf of the homeowner and get the mortgage balance reduced accordingly, which would be a wash for the bank, or it could allow the bank to keep the mortgage balance as is (also a wash for the bank), and aid the homeowner directly.  Either way, banks avoid the reality of marking their bad assets (mortgage loans) to market.  

Mr. Traylor, the director of the Arizona housing department, said that he wants banks to match the public money.   We will have to wait and see how the program actually plays out, but either way, the banks are getting a subsidy here.


disclosure:  short XLF


scharfy said...

Great topic.

It is true that you cannot hide a principal writedown. Nor can you pay bonuses from one.
And you can't hide them off balance sheet.

It means admitting the money is gone.

Anonymous said...

Maybe some of you other readers can help out here a little; But it seems that banks ARE restructuring loans in ways that benefit them.

Banks seem willing to stretch out the terms of a mortgage, taking a 15 year mortgage and spreading it out (For a fee of course) to 20 years, a 20 year mortgage into a 30year.

This keeps the house at the same inflated price, but allows some monthly financial pressure to be taken off the home owner so they continue to make payments.

This of course is a win for the banks because they get to keep the price of the house the same, get to collect extra fees for re-signing the mortgage and get to lock the home own in for more years of debt.

And this is a win for the home owner, because they get a free toaster and re-signing.

Banks are also allowing some home owners to pay “Interest Only” on existing loans. It is pretty apparent how this is a win for the banks as the value of the loan never goes down. But what might not be so apparent is how this is NOT a win for the home owner, because they did not even get a free toaster.

Also if the home owner actually did get the debt lowered or forgiven or defaulted on it, it is not a good thing.

Lets just say that the $86,000 that Ms.Carter owes, magically vanishes – She now owes taxes on it.

What a deal, you can either stay in a loan and get screwed by the bank or get out of it and get screwed on taxes – YEAAAAAAAA!!!!!!!

But at least we all get free health care and that is WAY better then a toaster….. I think…….

James/Mangy Mutt

Joel said...

I'm just a normal guy investor and I've been thinking about trying to short the financials as well. I've never shorted anything before. Are the proshares funds a reasonable way to do that? i.e. proshares short financials SEF

Thanks for any insight!

Kid Dynamite said...

Joel - it is important to note that nothing i write on this blog should be construed as investment advice. I hope you can understand that I have no desire to give investment advice.

SEF trades very low volume - that alone is usually a signal for me to stay away.

oddlot said...

why do you focus on the banks? they barely exist - people change, names change, buildings change... the villains in this thing are do-gooder busy-body policy people who have infused the system with bad incentives and complexity. inevitable, i know.

now, massive inflation will lower living standards for rich and poor. you can believe Mish, I am going to believe my eyes.

Anal_ said...

@ anonymouse

This is a gross oversimplification but if the bank extends the maturity (to the point where worse case the foreclosure sale price will cover at least the loan balance), and the borrower keeps paying interest the whole time, it could make sense to do so.

Its a pv/fv, future expectations, etc decision a bit too nuanced for me to explain here/now.

scharfy said...

Refinancing to a longer loan, would normally mean a higher rate, but I'll leave that out and assume the rate stays constant ( courtesy of uncle sam )....

here's how it would affect monthly payments.

20 year note on $250k @ 5.0% = $1649.89/month

30 year note $1342.05/month

40 year note $1205.49/month

You are picking up some breathing room, but if you're not working, doesn't help much....

Further, I think alot of people are jammed up in ARM's which have a lower rate (except for the criminal ones) - and still can't make the payments

With respect to interest only.. that called renting. And yes that will be one of the next steps. Wells Fargo the landlord.

scharfy said...

Interest only would come in @ $1041.50 from above example..

Anonymous said...

Scharfy - Good math and although this type of re-structing does not give the home owner much more disposable income, it does make them feel like they are getting something for nothing.

And like you said, intrest only is just renting - Except the home owner also gets to pay tax and insurance and if the house sells for at the original purchase price, they get NOTHING, but if it sells for a loss they still get to pay taxes on the difference.

I completely forgot about all those ARMS. YIKES!!!!!

It ain't looking good for home owners, but at least they get a free toaster for re-finacing.

James-Mangy Mutt

getyourselfconnected said...

spot on re the banks.

Sadly home prices are still WAY too high relative to real incomes in many areas (Metro Boston Mass is a shining example) and fighting that war is costing big bucks for us the taxpayer.

Anonymous said...

It is very difficult to draw a line given the ability to help some but not others. If someone purchased at the market high - Well, I'd ask the lenders, "would you with all the referent power do the loan knowing what you know now about the collapse in values?". Yes? No? Puts the lenders in the spotlight to say the least. I am on the Housing Finance Authority Board in Arizona, this is being debated but no borrower that "Cashed Out" gets bailed out.

Kid Dynamite said...

well, anon, it's good to hear that no borrower who cashed out gets bailed out. i think it's important to realize that the lenders didn't prey on borrowers - no one makes money by lending money to people who can't pay it back.

both the lenders and the borrowers were victimized by the mortgage brokers, who got in the middle and totally f'd up the whole process by lying to both parties.

purchasing at the market top absolutely does NOT mean someone should be aided. in fact, it should have nothing to do with current home value vs mortgage value - your current home value is IRRELEVANT to your ability to pay your mortgage. said differently - you may be $300k underwater, but still able to pay. if you choose not to, that's your personal "business" decision - and not one that you should be bailed out of. if you think of your home as a HOME and not an investment, the current value is meaningless.

the relevant factor is your mortgage payments vs your ability to pay them. market value and your current paper losses should play ZERO factor in aiding homeowners - except, if anything, to disqualify borrowers who are too far underwater because they may be MORE likely to walk away even after receiving aid!

Anonymous said...

The banks have been making profit on the future value of money and that expected cash flow must materialize or they are in trouble and they know it - derivatives! They need that cash flow and with little volume coming into new pools their game is over. The mortgage origination problems where fueled by "the other" mortgage industry. Happened in medicine a long time ago.

oc bear said...

The wild card for banks is that the word gets around that you can live rent free for 1, 2, or 3 years. It's really difficult to justify any accounting gimmick when there's NO money coming in. Then what?

Joel said...

Thanks, I totally understand. Love the blog. I have learned a lot over the last 9 or so months of reading.

Love the old poker entries too...

Blurtman said...

It is a dangerous slippery slope. The rationale of the Obama administration is that the ends justify the means. That is, they justify using taxpayer dollars to reduce principle on folks' mortgages because it will achieve their end goal - stabilization of the housing market.

Very dangerous. Perhaps the next ends justifies means action will be to borrow everyone's 401k to stabilize the next financial markets meltdown.

Not a tin-foil hat wearer, but if we can reward folks whose housing investment is underwater by transferring other folks' money to pay off their losing bets, which is clearly outrageous, where does it stop?

acerbicone said...

I don't disagree with the thrust of your article, but you should be aware that allowing people to remain in their homes without payment does NOT mean that the bank avoids a loss. Regulatory requirements force banks to write down the loan when it becomes a certain number of days delinquent. There are some issues with modifications and values used, but in general there is no "free lunch" for the banks in avoiding foreclosure.