naked capitalism

It certainly is gratifying to see the Board of Governors of the Federal Reserve, via a paper released on Wednesday, “The U.S. Housing Market: Current Conditions and Policy Considerations,” (hat tip Calculated Risk) finally acknowledge that US has a mortgage/foreclosure mess that is not going to go away by virtue of QE or other efforts to goose financial asset prices. However, just as the Fed was late to see the global housing bubble (even the Economist was on to it in June 2005), so to is it behind the curve in its take on the housing problem. This paper at best constitutes a good start, when, pace Churchill, the Fed is at the end of the beginning when it really needs to be at the beginning of the end.

However, before we get to the housing/mortgage market issues, we wanted to focus on a political element of the paper which may be more important that its analytical content. The Fed is openly crossing swords with the FHFA.

The paper has four sections: background, a section on what to do about foreclosed properties that have not been resold (known as REO for “real estate owned”), borrower remediation efforts, and idea for improving mortgage servicing practices. The REO section is entirely about GSE REO.

Although the document is studiedly neutral in its tone, it makes clear in its coded way that it regards the GSE focus on short term loss minimization as destructive (note the Fed is hardly alone in this view). The Fed argues (with some supporting data) that in a lot of cases, converting REOs to rental would be a better policy, although it bizarrely fails to consider the “own to rent” option of keeping the current borrower in place. The paper is also a bit clueless about the realities of managing rental properties (it seems to fall for the economist’s default view that at some mythical market clearing price, demand will of course meet supply, when spread out properties, which is what you are likely to have in suburbs and low density areas of cities, does not make for an attractive property management opportunity on anything beyond a modest scale of operation).

This Fed paper happens to have been released just as Fannie and Freddie are about to embark on a program of bulk REO sales. Daily Real Estate News in October raised concerns (hat tip reader Mark P):

Will the Obama administration’s upcoming plans to sell REOs in bulk to mega-investors…be bad news for small-scale investors who no longer will be able to compete because entire chunks of the agencies’ portfolios will be stamped “for bulk only”? Won’t this further the impression that Washington favors the fats cats on Wall Street over Mom and Pop on Main Street?

The article also recounted how Fannie, Freddie and the FHA had accelerated their liquidation of properties in the first three quarters of the year, yet had recovery rates of over 90% of mortgage value. With those results, why the rush for bulk sales, which will clearly be at deeper discounts? Again to the article:

Current REO disposition techniques appear to be working well — lowering inventories, yielding significant recoveries for the government, putting owners into houses and yielding significant commission dollars to the brokers, agents and ancillary service providers around the country who help make this all happen.

Which raises the question: Why mess with success? This past Aug. 10, the Treasury Department, HUD and the Federal Housing Finance Agency — which oversees Fannie and Freddie in conservatorship — issued an unusual “request for information” on how they might sell REOs faster by offering homes in giant bulk sales of $50 million to $1 billion.

The main targets: hedge funds, large institutional investment groups, and real estate companies that have the capital and the national or regional scope and management teams to purchase and handle mass conversions of REOs into rentals, thereby getting REOs off the agencies’ books much faster than is possible today.

The request produced more than 4,000 responses, which the FHFA has been analyzing for the past two months. So how’s it going and what’s the timetable?

For starters, officials speaking on background made clear that they recognize the recent efforts of Fannie, Freddie and FHA to reduce their inventories. However, said one official, the three agencies face a tsunami-sized shadow inventory that is now heading their way — a combined 1.4 million delinquent loans on their books, at least half of which, they estimate, will end up in foreclosure. Even with heroic efforts, Fannie, Freddie and FHA won’t be able to handle that level of REO volume using their current systems of individual sales, directed at owner-occupants and small investors, via realty agent networks.

It’s that looming wave that is the real focus of the bulk-sale project, officials told me, not the relatively smaller numbers currently in portfolio. On the other hand, they also recognize that flooding local markets across the U.S. with rental conversions of REO would not be productive.

In a more recent article, Housing Wire notes that local groups urge that buyers be properly vetted, since negligent new owners could make matters worse:

Nonprofits and trade groups are stressing the importance of documenting any partnership with an investor to make sure these neighborhoods are maintained and begin recovery after the REO is sold. Most want documentation to ensure investors with poor management histories do not have access to bulk transactions.

And what about hedge funds with no management histories?

The REO section of this paper (without acknowledging the existence of the GSE bulk sales program)) is calling for more study before the GSEs embark on an REO disposition program, and recommends considering having “the REO holder rent the property directly” (ie, have the GSEs become landlords), selling to investors, or entering into JVs with investors (oddly, there was no consideration of having local governments become landlords, say in partnership with the GSEs, since many cities have low income housing and are thus already in the property management business).

The rest of the paper is good at points and provides some helpful data. It mentions a pet issue of mine early on: “economic losses remain and these losses ultimately must be allocated among homeowners, lenders, guaranators, investors, and taxpayers.” It also has some comparatively strong language about how bad servicers are, while refusing to acknowledge that they are engaging in large scale fraud (can’t have anyone in the officialdom admit that, now can we?).

However, the report is marred by nails-on-the-chalkboard omissions and biases. Consistent with commentary by bank regulators, the report gives short shrift to the interests of MBS investors, despite the fact that a lot of delinquent and defaulted loans sit in private label securitizations. It is almost as if the losses borne by ordinary Americans in their retirement accounts aren’t part of the equation.

Similarly, while it gives lip service to the idea that some reduction in mortgage credit availability is necessary and salutary, the article takes the position that lenders have become too stringent with mortgage credit, noting that half the banks aren’t offering products for borrowers with FICOs of 620 and 10% down payment. Yet it also repeats the policy mantra that the powers that be want the mortgage market off government life support. Investors like Bill Frey of Greenwich Capital, who advised Russia on the creation of its MBS market and did not blow up in the global crisis, argues that down payments of less than 20% should be rare. And in the early 1980s, downpayments of less than 20% were rare. Given how the labor market has deteriorated (much shorter job tenures, which means periods of no income are almost assured, low certainty of being able to find a new job at the same pay and benefits level of the old job), if anything, mortgage terms should be more conservative. The behavior that the Fed sees as an irrational overshoot is likely to be an uncomfortable adjustment to better risk pricing, particularly since we also now know that FICO scoring was a crappy approach but no one seems willing to go back to more costly but more information rich in person, local assessment.

The paper also dicusses principal mods. The Fed takes the peculiar position that since it isn’t sure principal mods will work, they probably aren’t such a hot idea. Notice the contortions the paper goes through to discount evidence that defaults are highly correlated with negative equity (and those findings make sense. Why should someone under stress struggle all that hard to hang on to a house with a guaranteed future loss?):

These potential benefits, however, are hard to quantify. Based on the evidence to date, the effect of negative equity on migration between labor markets appears to be fairly small. The effect of reducing negative equity on default is hard to estimate because borrowers with high LTV ratios tend to have other characteristics correlated with default. For example, high-LTV homeowners often made small initial down payments–perhaps due to a lack of financial resources–and tend to live in areas with greater declines in house prices, where unemployment and other economic conditions also tend to be relatively worse. Hence, principal reduction is likely to lower delinquency rates by less than the simple correlation between LTV and default rates would suggest.

This is completely silly. For every other type of credit, principal writedowns are standard and given without fuss and handwringing. It is normal creditor behavior, when a borrower gets in trouble, to consider whether the lender will come out ahead by liquidating the loan or modifying it.

The reason principal mods are a sound option for mortgages is bloomin’ obvious. In a lot of cases, lowering interest rates is not going to make enough of a difference in payment relief to the borrower to change outcomes. By contrast, even on prime mortgages, loss severities are 50% and rising as more borrowers contest foreclosures and housing prices continue to decline in most markets. There is a lot of room to do principal mods for qualified borrowers. If the Fed talked about operational difficulties, that would show they had thought about this issue seriously, but this is tantamount to a blow-off.

And the next bit implicitly sets up a straw man, that if you offer principal mods to borrowers that are under water, you are going to have to give them on a broad basis:

At the same time, the costs of large-scale principal reduction would be quite substantial. Currently, 12 million mortgages are underwater, with aggregate negative equity of $700 billion. Of these mortgages, about 8.6 million, representing roughly $425 billion in negative equity, are current on their payments.

This is spurious. The reason the Administration has created big unwieldy and not-very-successful mod programs (and those just payment mods) is that it is not willing to take tough measures that would create incentives for banks and servicers to give mods privately. In the old fashioned days of George Bailey’s bank, no one knew if his neighbor got a mod because it was handled privately. Make banks write down seconds (which is a big impediment to mods) and have examiners make banks explain why they are doing more mods for the loans they own rather than the ones they service, and encourage investors to pressure banks (investors are now terrified of bank retaliation; having regulators protect their backs would change the dynamics). The regulators have the tools. They lack the will.

There is also a pretty disappointing discussion of what to do about servicers. The Fed really does not get it. It chides servicers for not investing in more default services when times were good. Earth to base, the fee structure is all wrong for that (which the Fed acknowledges) and how can you expect a firm to hire people to sit around and do nothing waiting for a big increase in defaults? The problem is that what it takes to do routine servicing (highly automated, staffed with low skilled people) and default servicing (high touch, and ideally pretty high discretion, which takes high caliber and presumably much better paid staff) are so different that it is hard to accommodate them under the same roof (I can put on my consulting hat and give you a speech about core competencies, but I’ll spare you).

Another obstacle is that borrowers don’t trust their servicers, yet stressed homeowners need to make pretty complete disclosures about their personal finances for someone to see whether they can be salvaged and how much of a mod it will take. Some reports from mod programs like HAMP report that borrowers didn’t tell servicers about all their debts. Given how incompetent servicers were during HAMP (record losses were pervasive), I’m not sure how much was servicer error versus borrower malfeasance and borrower distrust. The Fed doesn’t know either, but the predisposition among regulators seems to be to assume the worst of borrowers.

Similarly, there is a discussion of servicer incentives which is woefully superficial; they should have just cited the early 2011 paper “Mortgage Servicing” from the Yale Journal on Regulations by Adam Levitin and Tara Twomey.

Despite its efforts to muster data, this Fed is badly blinkered by the fact that it operates inside a club. Anyone who has done research in areas where the data stinks (and it does in the housing arena) will tell you you have to do primary research, but economists are allergic to that (Nobel prize winner Wassily Leontief found that less than 0.5% of the articles published in top economics journals were based on data developed by the authors). The Fed is unduly influenced by the view of people who are part of the problem, and it shows in this paper.

In some ways, this failing does not matter. The Fed and the rest of the officialdom do not seem to realize that events have spun out of their control. Their denial of the elephant in the room, the extent and pervasiveness of the frauds perpetrated by servicers on borrowers and investors, means that the battlefront has moved into the courtroom, an arena in which the Fed has little sway. The only way to forestall that is to implement far more radical solutions than contemplated in this cautious paper. In the crisis, the Fed was behind the curve and then overreacted when the situation went critical. It appears to be on the same path once again.