naked capitalism

A speech by New York Fed president William Dudley is a bit of a surprise, in that it acknowledges the severity of the deepening mortgage crisis and sets forth some specific policy proposals. I still find these recommendations frustrating, in that they are insufficient given the severity of the problem and also fail to come to grips with widespread servicer abuses (not just servicer driven foreclosures, but also what amounts to theft from investors, via schemes such as double charging fees to borrowers and investors, inflating principal balances, reporting REO as sold months later than the transaction closed, and getting kickbacks on third party charges). But they are more serious than other ideas from senior financial officials. Specifically, the Dudley advocates principal relief via a program of “earned principal reduction” which would allow for put options for all severely underwater borrowers who stay current on their mortgages for three years. But as we will discuss, this proposal is less meaningful than it sounds.

It looks at if the NY Fed is trying to provide intellectual leadership in the debate around the housing mess, which given the level of denial and kick the can down the road strategies being offered as alternatives, means this effort stands out in part by virtue of the shoddy alternatives. And this posture put it squarely at odds with the Board of Governors, whose paper published earlier this week pooh-poohs principal writedowns and specifically opposes giving broad scale principal reductions to homeowners with negative equity. One has to wonder whether the Board of Governors paper was released prior to the Dudley speech with the specific aim of undermining it. Similarly, the NY Fed is also in opposition to the GSE’s resistance to offering principal mods, as evidenced by the leak from the mortgage settlement talks, in which the GSEs refused participate in the banks’ scheme to use mods on securitized loans (which would include GSE loans) as a way to reach the settlement target for principal mods.

One of the reasons this speech is nevertheless encouraging is that it acknowledges that regulatory/housing policy and macro-economic activity are linked:

Monetary policy and housing policy are much more complements than substitutes.

As I hope I have convinced you today, while the Fed has will do all it can to achieve our dual mandate of maximum sustainable employment in the context of price stability, we have to recognize that there is more to economic policy than just monetary policy. Low interest rates help housing, but cannot resolve the problems in that sector that are pressing on wider economic activity. With additional housing policy interventions, we could achieve a better set of economic outcomes than with just monetary policy alone.

Although the Board of Governors paper earlier this week implicitly admitted that monetary policy could not solve housing market problems, Dudley’s more forthright statement makes a case for more intervention.

Here is the principal relief trial balloon in the Dudley speech:

One option developed by my staff is for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments. For instance, the borrower could be given an open-ended option to pay off the loan at an LTV of 125 percent, and the right to pay off the loan at an LTV of 95 percent after three years of timely payments.

The borrower would be protected from further declines in home prices, but in return would give up a portion of any upside from future capital gains on the home via a shared appreciation agreement. Note that under this arrangement some of the reduction in the loan amount would be paid by the borrower as the outstanding balance was amortized by continued monthly payments….

Based on recent data on borrower behavior, my staff calculates that the taxpayer (through the effect on Fannie Mae and Freddie Mac) would be better off with earned principal reduction under a base case of roughly flat house prices and persistent weakness in the jobs market. Under a scenario of modest house price increases, the combination of fewer defaults and shared appreciation also produces a net benefit.

This result occurs before taking into account the positive externalities of nudging house prices onto a stronger path, which would reduce the magnitude of losses on loans that do default. On an expected value basis, such a program appears still more compelling, since Fannie Mae and Freddie Mac are currently exposed to the downside risk of further declines in home prices.

While it isn’t hard to imagine that any approach is better than “do nothing,” I wish I could see the assumptions being used in the model. One troubling bit is the apparent failure to consider that housing prices could deteriorate further, particularly since shadow inventory appears to be larger than most commentators recognize.

More important, it isn’t clear how many people will really be helped. Borrowers won’t get any concrete benefit unless they sell the house. And if they have a home equity line of credit in addition to the first mortgage, they may still be under water, and the second lienholder may block a sale as brokers report they do now. So this plan may increase liquidity, but only for some borrowers, and would also provide a new fee source for Wall Street firms (you can bet they will securitize the shared appreciation rights). This scheme appears to be mainly a carrot to give underwater borrowers more incentive to stay current, in other words, to prevent strategic defaults. Given that we think the “strategic default” meme has been considerably overhyped, we are puzzled at Dudley giving so much attention to this aspect of the mortgage mess.

But the probable small tangible impact of this program may in fact be quite deliberate, a cheap gimmie to borrowers who were prudent but are upside down by virtue of buying near the peak in the markets than went into the biggest tailspins. Devising a low cost program that provides a benefit to homeowners who have remained current may be seen as a necessary sop to forestall objections to programs that provide more substantial relief to borrowers where deeper loan mods would be a win/win to both the homeowner and the investor/guarantor.

But the additional forms of relief that Dudley advocated would certainly be helpful, but again were narrow. One was a bridge loan program for the unemployed, which he estimated would cost $15 billion a year. Note that Dudley suggested that lenders be required to write down mortgages to allow for the bridge loan to be secured to avoid it serving as a bail out to the lender. That is nice in concept, but probably makes the program a non-starter . Logically, any seconds should be written down first (frankly, most should be written off, but that is another story), and it is hard to see banks going along with that, plus you have no ready mechanism for cramming down mortgages in private label securitizations.

Dudley also advocated a more borrower friendly Freddie and Fannie program (as in a more generous revision of HARP) and more aggressive moves to convert foreclosed properties owned by the GSEs, banks (as principals and on behalf of securitized trusts) moved into rentals, including having Fannie and Freddie lend to prospective landlords and accelerating depreciation schedules for residential rental property.

These are all good ideas, but they have a rearranging-the-deck-chairs-on-the-Titanic feel to them. They don’t come to grips with the central problem, that many people are in the process of losing their homes or will lose them if their finances come under further stress, and given how steep loss severities are (and they are only getting worse), a lot of them could be salvaged with deep principal mods. And the Fed fails to acknowledge the existence of a second large problem, the extent of servicer fraud, not just foreclosure-related abuses, but servicer driven foreclosures and out and out theft from investors (inflated and double charged fees, kickbacks from third party providers, overstated principal balances, delayed reporting of sales out of REO).

The Venezuelans have a saying I am fond of: “They have changed their minds, but they have not changed their hearts.” The good news is that the officialdom is beginning to come to recognize how bad the mortgage mess is. The bad news is that they don’t have the stomach for the sort of aggressive measures needed to remedy it.