Bankers: The New Socialists (Real Estate Bailout Edition)

We’ve often observed that the reason to keep the banking industry (and Wall Street, now that some firms are too big to fail) on a short leash is that it plays with the public’s money: gains go to employees and shareholders but losses are socialized.

We now see a bald-faced example of that problem in the latest machinations in Washington, as reported in the Wall Street Journal, “Worried Bankers Seek to Shift Risk to Uncle Sam.” There are plans afoot to dump subprime risk on our collective shoulders, courtesy various proposals to guarantee subprime refinanciings.

In fairness, as outlined in the Journal, one scheme involves getting the government on the hook, via expanding the mandate of the FHA to include refinancing delinquent borrowers. Note that this turns the previous operation of the FHA on its head. The big reason that the FHA lost market share to subprime lenders was that its lending standards were conservative and required borrowers to undergo screening (horrors!). The second one. of letting servicers write down mortgage balances in line with current market value of the home is oddly similar to the bankruptcy law changes that heretofore the industry has fought tooth and nail (those revisions would have given judges the same power over residential mortgages that they have over commercial: to reduce the secured borrowing to the level of the security, i.e., the value of the real estate, and also modify payment terms).

Note that the article focused on the first plan, as will this post. The second one is not bad in concept (remember, no solution is good here; we are talking about less bad among lousy choices), except it leaves the investors as the sole bagholders for lapses that operated all along the securitization chain (it was far more equitable when banks owned the loans they booked, but then again, they could and did make mods without a lot of drama).

No one seems to be learning the lesson playing out before our very eyes from the bond insurers: guarantees can become very costly when entered into casually. The promises of various government sponsored enterprises, such as Fannie Mae and Freddie Mac, live in a dubious never-never land, where they are nominally private enterprises but everyone expects that if things got ugly and their mortgage guarantees were to look questionable, the GSEs would be supported by the Federal government.

James Hamilton, at the Fed’s Jackson Hole conference, pointed out that Freddie and Fannie were undercapitalized and overextended; this was before their ceilings were raised to include jumbo mortgages. Now we are gong to add even worse credits to the burgeoning pile of government guaranteed paper.

When I was much younger, I took a business school course taught by Henry Cabot Lodge, Jr. He said that he could remember the day in 1968 when he realized that there were limits on what the US could do, that it could not simultaneously combat poverty, fight a ground war in Asia, and send a man to the moon.

It’s 40 years later, and most of Washington seems unable to accept what Lodge saw back then, that America is no longer so powerful and economically dominant that it can have whatever it wants.

And the comparison to the monolines is not idle. Moody’s has already warned that the US is at risk of losing its AAA rating within a decade if it does not rein in spending (aside: we noted that the report had an unduly political spin, arguing for curbing healthcare and Social Security costs. As Paul Krugman, Dean Baker, and others have pointed out, Social Security is not a problem; if one want to be conservative, eliminating the ceiling on FICA would solve the problem. The big problem with Medicare is not demographic, but spiraling health care costs; health care reform with teeth would end that pressure). The more the Federal government makes itself the remedy to all ills, the more it will become incapable of solving any problem.

What is particularly disturbing about this latest salvage operation is that it involves no penalty to the firms that created this mess. Of course, that’s one of the beauties of the originate and distribute model: there are so many parties in the food chain that it is hard to parse out culpability.

But consider one successful model of dealing with a financial crisis, one classified Carmen Reinhart and Kenneth Rogoff designated as one of the “big five” deep and nasty post WWII financial crises, that of Norway. Barry Ritholtz summarized the program:

• Private solutions were explored before the government intervened.
• Share capital was written down to zero before committing public funds.
• The government acted swiftly to limit contagion, but did not provide a blanket guarantee.
• Liquidity support was given to illiquid, but solvent institutions.
• The government did not use an asset management company.

Notice two critical elements lacking in any of the current thinking: taking out public shareholders completely before providing government support and providing only narrow support. The perps take the pain and do not have the opportunity to enjoy any upside from public rescue efforts. And no broad scale guarnatees were made. The FHA proposal on the table, while it may not be mplemented, comes close to that sort of action.

Consider: if the parties coming hat in hand to DC for a rescue had to write down all their equity to get help (or even merely all the equity in the directly related operations) I suspect you’d see an outburst of creativity. As Samuel Johnson once said, the prospect of being hanged at dawn wonderfully focuses the mind.

But the discussion above assumes that refinancings will work, that upside-down homeowners will embrace these programs (note that the alternative program, the principal charge-off, requires investors to take the hit). But refinancings may not work, that is, they may not get the anticipated level of participation, and even among those that do participate, it may not improve outcomes much. Mark Thoma featured a post by Richard Green, “Is Everything we ‘Know about Subprime Wrong?” that in turn summarized a presentation by Paul Willen of the Boston Fed:

(1) Falling house prices lead to defaults more than defaults lead to falling house prices. In the early
part of the decade, when delinquencies reached record levels, default rates remained extremely low, because house prices were rising

(2) Interest rate resets have little if anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. It is moreover the case that the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high.

(3) While ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs will not necessarily reduce defaults. In the first place, as people move out of ARMs into FRMs, the denominator in the default proportion ratio will decline for ARMs, while increasing for FRMs, meaning that if the number defaults stay constant, the default share in ARMs will still rise.

Note that Willens is not the first to suggest that declining housing prices may be a bigger culprit in defaults than payment stress.

So these moves may effectively rearranging the deck chairs on the Titanic, at considerable taxpayer risk.

From the Wall Street Journal:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers….

The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss…

Another plan gathering support seeks to make it easier for banks to write off part of the unpaid balance on loans that exceed a property’s value, people familiar with the matter said. If that happens, homeowners would owe less, and they might be able to refinance their loans and avoid foreclosure.

Several lenders are already considering the move, known as a “principal charge off,” but are hesitant to move forward. Loan servicers — the companies that collect monthly mortgage payments — worry that if they take big write-offs, they might be sued by investors who hold mortgage-backed securities. However, if the industry came forward with a standard backed by the Treasury Department, the legal concerns would likely fade…..

The Credit Suisse plan would open the way for nearly 600,000 subprime borrowers, many of whom are delinquent on their mortgages, to refinance into loans backed by the FHA. Some 1.3 million borrowers were either seriously delinquent or in foreclosure at the end of the third quarter, the most recent numbers available from the Mortgage Bankers Association…..

In a 20-page summary handed out to lawmakers, policy makers and regulators, Credit Suisse said the plan would make $89 billion in subprime loans eligible for refinancing. Credit Suisse spokeswoman Victoria Harmon said bank officials have “shared our ideas and technical advice on FHA” and received “constructive” responses from the government.

Officials from J.P. Morgan Chase & Co. are pulling together their own proposal to expand the number of homeowners who could refinance into FHA-backed loans…

Senior Treasury Department officials have been wary of proposals that could expose taxpayers to losses and bail out lenders, but they have been willing to entertain most ideas. Some congressional Republicans are becoming worried that as more bad news and data are released about the housing market, some proposals could expose taxpayers to severe losses.

“I would share the concern and nervousness about going in that direction,” said Rep. Scott Garrett (R., N.J.), a member of the House Financial Services Committee.

Sen. Charles Schumer (D., N.Y.) earlier this week urged the lending industry to move toward a standard of partially writing down the principal of “under water” loans, where the borrower owes more than his or her home is worth.

Separately, Sen. Schumer called the Credit Suisse plan “an interesting idea, which we are looking at pretty seriously.” However, Credit Suisse hasn’t won the endorsement of the American Securitization Forum, an influential group of investors.