naked capitalism

As much as I would like to leave the matter of Hank Paulson and his dubious subprime rescue plan alone, the latest developments demand comment, first my own, followed by a roundup of other views. One tidbit later on to induce you to read the entire and admittedly long post: successful implementation of the program would worsen Fannie’s and Freddie’s losses.

Yesterday, Paulson gave a speech at the Office of Thrift Supervision National Housing Forum which gave considerable air time to his plan. Although it is not included in the text of the speech, Bloomberg reported that Paulson said that Treasury and the banks would agree on a plan this week.

If the so-called New Hope Alliance can announce anything by the end of the week, it is not a plan, but a slightly more fleshed out high concept. This is a far more complicated undertaking than the SIV rescue plan, which had procedural elements in common with normal deals, albeit with some important, novel elements that needed to be worked out.

What interested parties, particularly investors who need to be reassured that net net they won’t wind up worse off, is the equivalent of a term sheet, what the eligibility criteria are, how many investors are likely to participate, and what the ramifications will be. It is impossible to have this in any credible form by the end of the week (there might be some smoke and mirrors backup, but there aren’t even any reliable national statistics about subprime borrowers due to inconsistencies in classification).

Look what happened with the SIV plan. Paulson is again breaking the classic rule of expectations management; underpromise and overdeliver. He does the reverse. On SIV front, the notion was leaked in mid-October, and the public was initially told the plan would be up and running by the end of November. That was clearly nuts. Here it is December, and the absence of further progress reports (syndication was supposed to have started right after Thanksgiving, but there is no sign that that has happened) suggests the botched effort is being allowed to die behind the scenes (although Paulson claimed in an interview that the plan is still “on track” to start at year end).

The other reason for pause is that a constituency vital to the success of this program has been excluded from planning. Paulson, in his speech described the genesis of the Hope Now Alliance:

Treasury and HUD helped bring these two groups together in the HOPE NOW alliance – a coalition of mortgage servicers, counselors and investors that are working to avoid preventable foreclosures and to improve the functioning of the mortgage markets.

None of the descriptions of who is involved in the negotiation of the subprime plan have mentioned mortgage counselors. Instead, they appear to have been excluded and investor representatives (Freddie, Fannie, and the American Securitization Forum, which is being treated as if it is authorized to negotiate on behalf of members when it is a mere lobbying group) have joined. Why is this omission a bad sign?

As we pointed out in an earlier post, this plan is to come up with a streamlined alternative to the allegedly too time consuming loan mod process. Yet the fatal flaw in this program is once you get past the triage (or in this case, quadrage, since Paulson described four types of borrowers) you still have to evaluate borrower ability to pay. There is no way around it. It has to be done on a case-by-case basis.

Now where could this bunch come up with a way increase scarce borrower assessment capacity? The servicers clearly don’t have it, that’s one of the reasons for this program in the first place.

The counsellors are the only ones near-term who can fill this skill gap. Their current role is to help borrowers evaluate their financial condition and figure out what options they have. These guys are a vital, perhaps the vital, component in this operation. Yet they don’t have a seat at the table. (BTW in case you think I am going off half-cocked on this one, I have confirmation from a source with inside knowledge). So how can the group Paulson has assembled possibly come up with targets and timetables, which is one thing they will certainly announce, when they haven’t bothered to talk to the most important working oar?

Another disturbing aspect of Paulson’s speech is his effort to pin the responsibility for fixing the mess on Congress. This aspect of his speech was sufficiently prominent so as to become the focus of the Wall Street Journal story on the speech. Its leading paragraphs:

The Bush administration is putting the burden on Congress to fend off an approaching wave of home foreclosures.

With two million borrowers in the U.S. expected to see interest rates jump on their adjustable-rate mortgages in the next two years, Treasury Secretary Henry Paulson urged the Democratic-controlled Congress to pass stalled housing legislation and support a new White House proposal to use tax-exempt bonds to refinance troubled subprime mortgages.

This is disingenuous, to put it mildly. Let’s go through the “stalled” initiatives mentioned in the speech (our numbering, not Paulson’s). In fact, a speech by Speaker of the Hour Nancy Pelosi reports that ALL the measures cited by Paulson (save one that appears to be new) have been approved by the House of Representatives, plus other ones he isn’t so keen about, like anti-predatory lending and bankruptcy legislation to give judges more power to modify mortgages. The indented text is from Paulson’s speech:

1. For this public outreach campaign to be successful there must be enough trained mortgage counselors to answer the phone when homeowners call. The Administration requested funding for NeighborWorks America and other non-profit mortgage counseling operations in its budget. But the appropriations bill has yet to be finalized; Congress needs to get it done quickly.

There is no reason to think this won’t happen.

2. Since August, the President has been calling on Congress to pass his FHA modernization proposal which, by lowering the down payment requirement, increasing the loan limit and allowing risk-based pricing, will make affordable FHA loans more widely available. The Administration’s proposed bill would help refinance another estimated 200,000 families into FHA-insured loans.

I am not aware of where this stands in the Senate, but when we looked at the plan back in August, we deemed it to be mainly a PR move (see our posts “Bush’s FHA Band Aid” and “Bush’s Mainly Cosmetic Homeowner Rescue Proposals“).

3. Since August, the President has also called on Congress to provide tax relief for mortgage debt forgiven; homeowners who finally find relief shouldn’t get put back in financial straits because of the tax code.

Again, although I am not certain of how this is progressing in the Senate, it has become a popular cause. The bill had bipartisan support in the House, so there is no reason to think it won’t be approved (as an aside, I have mixed feelings about it, but that’s not the point of this discussion).

4. Additionally, Congress needs to complete its work and create a strong, independent regulator for Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac have an important role to play in making mortgages available and affordable, and appropriate regulatory oversight is critical to their ability to serve their public policy purpose.

Fannie and Freddie are currently in very good hands with their supervisor, OFHEO’s toughminded and principled James Lockhart. Despite OFHEO’s limited authority over the two GSEs (the call for a new regulator is correct and supported by Lockhart), Lockhart has successfully resisted most efforts to expand their already thinly-capitalized balance sheets. Delay here is less than ideal. However, given that the earliest that Lockhart might be required to lift capital and portfolio-growth restrictions would be after February 2008 (and then only if financial performance warrants it), there appears to be some breathing room on this front.

5……legislation to temporarily increase capacity and allow state and local governments new flexibility to use tax-exempt bonds for home mortgage refinancings

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All the other measures Paulson mentioned in the body of the speech and repeated in his summation. This one appears only at the close, and frankly is news to me, which means it is likely a very new proposal and hence unlikely to be approved this session (any readers having more insight are encouraged to speak up).

Now a brief review of some other critiques:

Caroline Baum, a columnist at Bloomberg, has a sharply negative piece on the plan, which includes this choice quote:

“The modification of existing contracts, without the full and willing agreement of all parties to these contracts, risks significant erosion of 200 years of contract law,” said Joshua Rosner, managing director at Graham-Fisher & Co., an independent research firm in New York.

Rosner, by the way, is no card-carrying member of one of the right wing think tanks; in fact, he was the co-author of one of the very best papers on the problems with CDOs. And get this bombshell:

The recidivism rate for non-credit-worthy borrowers is high, according to Rosner. Even during the boom in housing prices, the re-default rate on subprime and Alt-A loans (one step above subprime) two years after a modification was 40 percent to 60 percent, he said.

While Paulson has been busy devising a plan that limits the damage to the economy without encouraging more risk-taking in the future, “Treasury hasn’t thought through” one aspect of the plan, Rosner said: the implication for Fannie Mae and Freddie Mac, the two government-sponsored mortgage behemoths.

“Guess who’s the largest single holder of AAA notes? Fannie and Freddie,” he said.

The way these CDO structures are set up, defaults in underlying mortgages trip certain triggers that serve to protect senior noteholders. If the plan inhibits defaults, “the cash flows that should be reserved for the AAA holders will end up going to the residual owners,” Rosner said. “Treasury is pushing a plan that could cause more losses at already weakened Fannie and Freddie.”

The news section of Bloomberg features analysts giving a thumbs’ down to the Treasury plan:

Few homeowners may qualify for the proposed aid and many are likely to default even before rates reset higher, Barclays analysts wrote in a report today.

“The subprime reset plan, as it currently stands, is unlikely to be a big help,” New York-based Barclays analysts Ajay Rajadhyaksha and Sharon Greenberg wrote.

Most borrowers who would be helped by the plan would have their loans reworked without a coordinated effort, UBS’s Thomas Zimmerman wrote Nov. 30. Details of the Paulson proposal haven’t been announced….

Only 12 percent of all securitized subprime adjustable-rate loans in California would qualify for fixed payments under a similar agreement between the state and four mortgage servicers last month, the Barclays analysts wrote, based on an announcement saying the deal applies to borrowers who occupy homes, have been making on-time payments and can’t afford higher rates.

Assuming that half of subprime balances default or are repaid before rate resets, another 30 percent of borrowers don’t qualify because they’ve missed payments and 20 percent of modified loans eventually default anyway, the Paulson plan only eliminate losses of 60 cents per $100 of subprime loans, versus a total that may be as high as $18 to $20, they wrote.

The extent of home price declines and economic conditions will have a “far greater impact” on the rates of loan modifications and foreclosures, wrote UBS’s Zimmerman, who is also based in New York.

“I think it’s lip service and essentially not meaningful,” said Michael Burry, president of Cupertino, California-based hedge-fund firm Scion Capital LLC, which manages about $1 billion. “It will only help those who don’t need to be helped.”…

“The only way to ensure a major increase in modifications is for the Federal government to impose a massive, wholesale modification, but that would call into question the sanctity of the legal documents of securitization,” he wrote. “From all reports no one is seriously considering such an approach.”…
Collateralized Debt Obligations

“No amount of government intervention less a complete bailout will save” subprime-mortgage bonds that originally carried low-investment-grade ratings, they [Deutsche Bank AG analysts including Karen Weaver and Anthony Thompson] wrote…

Modifying loans too aggressively may harm mortgage-bond investors more than it helps them, and not just because the action may reduce payments from borrowers who don’t need the help, said David Stevens, head of a home-lending venture for Fairfax, Virginia-based realty firm Long & Foster Cos.

“In more cases than not, you’re either deferring a problem that will end up being more costly” because of declining home prices or issues that can’t be cured, or cutting borrower payments unnecessarily, said Stevens, who once held executive roles at a servicer purchased last year by Charlotte, North Carolina-based Wachovia Corp.

Michael Shedlock provides an additional sighting that throws a bucket of cold water on the plan:

….an email I received from an industry insider this weekend who wishes to remain anonymous. Here goes:

The homeowner bailout sounds a lot better in the headlines than it does when you dig deeper. For instance, HomEq reports that for every 5,000 resets that come in every month, only 1,000 meet standards to even begin loan modification, and of those only 10% of borrowers actually begin the process. That’s 2% of all borrowers undergoing resets.

One of the problems is that in many cases, a W2 is required, and many of these homeowners are reluctant to provide one since they presumably lied about their income to qualify for a mortgage. Still others are in trouble not because of the reset, but because they can’t even afford their teaser rate. Many in foreclosure won’t pick up the phone when contacts are attempted from lenders.

And that’s before we even talk about getting servicers to sign off on the proposal, deciding which of the millions of homeowners in trouble deserves help, and moral hazards of the plan on the part of borrowers who might stop making payments in hopes of getting a freeze and of lenders who might decide to shun the MBS market completely if the government is going to force them to modify contracts. And even for those who do get a government-aided freeze, all this will do is keep them in an underwater home for longer, making them permanent debt slaves on a bad asset.