Has Roubini gone to the Dark Side?
Nouriel Roubini, normally the voice of prudence, makes a marked shift in his latest post, “Fiscal versus Monetary Solutions to the Subprime Crisis. ” He sympathizes with those like Bill Gross of Pimco who call on the federal government to rescue mortgage borrowers at risk of losing their homes:
Bill Gross…is now proposing the creation of a fiscal institution …. to resolve the subprime credit problems. While this may sound as a fiscal bailout of borrowers (and by default of lenders) the alternative… is destructive home price deflation (as much as 10% fall in home prices…) and million of homeowners ending up in foreclosure. Folks at Goldman Sachs are actually predicting that home prices will fall as much as 15%…
Larry Summers… correctly argues ..that in situations of severe credit distress it is important to be pragmatic rather than religious on issues of moral hazard…
Dean Baker wants to help the victims (the subprime borrowers in his view) rather than the reckless lenders (the “bloated bankers); so he is suggesting changes in foreclosure rules to allow moderate and low-income homeowners to remain in their homes indefinitely as renters.
A number of authors – including analysts at BNP – have argued a fiscal solution is needed and that government sponsored agencies should be allowed to purchase more conforming loans.
Even the Bush Administration, that has opposed suggestions to have Fannie and Freddie expand their mortgage portfolios, is now suggesting that Federal Home Administration could help distressed borrowers….
[T]here is now a new and increasing recognition that severe credit and financial distress problems cannot be resolved with monetary policy alone…. The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue.
Now let me stress I have a great deal of respect for Roubini and normally am on the same page as he is. And he may well be correct that the political consensus is moving in the direction of Throw Money At This Problem.
I am probably being harsh because I have read too many calls to action, most of which have not given much (any?) thought to how their proposals might work on a practical level.
But Roubini lumps a whole variety of ideas together, some of which (Gross’s in particular) are just plain barmy (and for the record, the RTC bears little resemblance to what Gross is suggesting, except that it required a ton of money).
Before we discuss these recommendations, let’s address the big flaw in Roubini’s argument:
The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue
First, I had searched the logical suspect financial news sites, plus Google News and Google Blogs, and haven’t found a source for this “two million will lose their homes” factoid (this is the only reference I’ve seen besides Gross, which is hardly a well recognized source and cites unnamed studies).
I’ve seen other formulations, such as The Center for Responsible Lending saying that 2.2 million ARM mortgages will reset in the next two years. “Reset” does not mean “lose your home,” and “2.2 million” is clearly the high end of a range of estimates. Senator Christopher Dodd may be responsible for the recasting of The Center for Responsible Lending data. The Financial Times reported that he stated that 2.2 million (hhm, the very same number) could lose their homes in the next few years.
It’s one thing for a politician to take liberties with data. I would hope Gross and Roubini would hold themselves to a higher standard. And if I am wrong and there is a source that says over two million are likely to lose their homes (as opposed to face a reset and accompanying financial stress), I’d like to see it. I could have missed something, since I don’t have access to certain databases and search tools, but information like this usually shows up on the Web.
Nevertheless, the specter of “two million plus” losing their homes has become established fact.
The most granular analysis I’ve seen on mortgage resets (and I stress granular, it’s a very detailed analysis using two massive mortgage databases) is by one Chris Cagan of American CoreLogic, which projected 1.1 million foreclosures over 6-7 years. That’s bad but not catastrophic. Admittedly, things have gotten worse since the time of his estimate (March, when subprimes had already been under stress for a while), but I doubt if they are 2 times as bad. And most important, these losses are spread over time. Even if the total in the end is 2 million, it’s one thing if that happens in 2008-2009 versus over 6-7 years. The housing market will be better able to absorb the impact, as will the greater economy. But that 2 million number is becoming fact, and it’s being treated as if those defaults will hit all at once like a financial tsunami.
In keeping, the prospect of a 10% to 15% fall in house prices is being treated as if it would constitute the end of the world. Yet as we pointed out, quite a few economies have endured 25% or more housing price falls. They did not go into an economic black hole. They had short bad recessions.
The fear of recession in this country has gotten so bad that the Economist ran a story this week arguing that America needs a recession. I have no doubt they did that mainly to be provocative, but the horrified reactions from some quarters proves the point. This fear of recessions, and tendency to paint a recession in the dark colors of a depression, is dangerous and distorts policy decisions.
Now it would be fair to argue that a housing recession, given how leveraged the financial system is, will deepen an already careening deleveraging and could do real damage to the financial system. That would be consistent with Roubini’s world view, and would justify more radical measures. However, he didn’t make that case.
Now mind you, I am not saying we should do nothing, but a large scale bailout of homeowners, as I’ve argued elsewhere at considerable length, is a bad idea from the standpoint of equity and efficiency.
But there are some things worth doing. The real problem is that the thing that would be the most effective and surgical (the numbers 4 and 5 on this list) are the most difficult to implement (but vastly easier than acquiring 2 million mortgages and renegotiating them!).
1. Borrowers who were defrauded by lenders should get relief, ideally from the perp (and it is probably easiest if it also comes out of the hide of investors who bought securities with assets originated by the perp, although I am open to comments and ideas on this front. This notion would encourage much greater investor due diligence on sourcing methods).
I am all in favor of severe punishments. Organizations that institutionalized fraudulent activities should be fined out of existence. If four of the former Big Eight accounting firms perished due to their misdeeds, why should mortgage lenders get better treatment?
2. I have not thought about it deeply, but having Fannie and Freddie step up their activities is probably a good idea. Banks swing wildly from overoptimism to excessive caution, and there are signs they are now overly stringent with creditworthy borrowers.
3. Mortgage brokers and other consumer mortgage originators need to be regulated on the same footing as banks, as far as their disclosure standards are concerned, and all should be subject to tougher consumer protection requirements.
4. The best way to salvage financially stressed homeowners is via loan modifications. In the stone ages of finance when banks not only made loans but kept them, banks would when possible restructure a mortgage rather than foreclose (note that all borrowers cannot be salvaged, but banks in general were pretty good at judging who could make it).
What has screwed that up in our Brave New World of finance is that mortgage servicers are now responsible for managing the relationship with borrowers on behalf of the investors in the mortgage paper. Because the servicer has every reason to keep the borrower alive (they keep earning their servicing fees), most indentures on mortgage securitizations restrict the servicer ability to do loan “mods.” Some prohibit them altogether; others limit them, say, to 5% of the pool, which if a pool has a lot of subprime and/or Alt-A, is too low a ceiling in the current environment
The problem is that it isn’t easy to waive a magic wand and lift mod restrictions across the board. I am told the mortgage indentures are governed by state law, which means you’d need new legislation in the states where the big servicers are domiciled.
5. The last bit of borrower relief is to treat the mortgage debt of individuals who declare bankruptcy the same as corporations. As Credit Slips explained:
If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy. But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable….
MA company that cannot pay its mortgage can declare Chapter 11 and do two things: 1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion. So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged. The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure. The second insight is that this is precisely the risk the lender took: that the property would decline in value and the debtor couldn’t pay. The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral.
But notice: If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments–in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%. In other words, homeowners get a lot less protection in bankruptcy than do businesses.
Giving individual mortgage borrowers the same treatment as corporations would reduce the need for federal bailouts, make sure right people took the pain (investors who chose to buy in mortgage paper, rather than taxpayers) and be vastly cheaper than creating a new federal bureaucracy.