Hottest Potato in Washington: The Homeowner Bailout Plan

The financial bailout is on, and so far the government has injected upwards of $150 billion in a variety of banks, not to mention a $120 billion loan for insurance giant AIG (AIG) and $25 billion for the Detroit automakers.

As for helping distressed homeowners, Washington is still thinking it over.

On the surface, this might seem like the outrage of the century. The huge commitment of $700 billion in taxpayer money is supposed to help taxpayers, after all, and it's hard for many people to understand how adding a bunch of bank stock or insurance-company IOUs to the government's portfolio does that, exactly.

Giving individual homeowners a helping hand is a simpler concept, especially when the government just sent many Americans a $600 or $1,200 stimulus check a few months ago. So why not help lower mortgage payments, too? John McCain has even suggested using $300 billion of the bailout fund to aid borrowers on the brink of losing their homes.

But the regulators and bankers who would have to enact such a plan don't want to touch it. And they're not as foolish as populist politicians often portray them. Here's why a homeowner bailout plan is the hottest hot potato in Washington:

Voluntary programs don't work. There are already several voluntary efforts to encourage banks and their customers to re-negotiate failing mortgages on their own, such as the HOPE NOW program that regulators cite frequently as a stand-in for a real solution. But voluntary efforts are marginal at best. First of all, most banks are free to rework loans without any government urging at all. The reason they don't - big surprise - is that they often lose money. Even if the government tries to strong-arm the banks, that doesn't eliminate the loss, and CEOs still have shareholder money to safeguard. Telling stockholders that "the government said so" doesn't usually justify poor financial performance.

By the most optimistic assessment, the banking industry is reworking about 200,000 troubled mortgages a month, without government compulsion. That might sound like a lot, except there are about 5 million mortgages in foreclosure or at risk of default. So 200,000 workouts amounts to resolving 4 percent of the problem each month, assuming there are no additional foreclosures. But the economy is getting worse, not better, and intensifying layoffs are going to lead to more problem mortgages, not fewer. In recent testimony before Congress, FDIC Chairman Sheila Bair said that "some of the voluntary efforts have helped, but it has clearly not helped enough. We are falling badly behind."

A homeowner bailout would have millions of moving parts. Bailing out banks requires a lot of money and a very careful strategy, but once the Treasury Department has determined which banks to help, the process is straightforward: The government buys preferred shares in the bank, according to standardized rules. Even if the government invests in 1,000 banks, the procedure should be the same in virtually every case.

It's extremely difficult to establish standardized rules for salvaging individual mortgages. Of the 5 million problem mortgages, the majority have been "securitized," which in many cases means the loan has been carved up into various pieces representing repayment of the principal, say, or the interest payments, and then bundled up with pieces of other mortgages and sold as securities to investors worldwide. Some of those have been resold to other investors or pledged as collateral in other deals. It could take as much work to identify all the investors in a single $300,000 mortgage as it does to execute a $3 billion federal investment in a bank with thousands of customers. Now, multiply that effort by 5 million loans. Wanna manage that program? Neither does Bair or Treasury Secretary Henry Paulson.

Homeowner bailouts could worsen the problem. Even when reworking a loan might help save a home and keep the payments coming, there still might be risks to the bank - especially if it's a local bank that issued a lot of mortgages in a concentrated area. "If you suddenly tell borrowers there's a lower amount due, others may see that and stop paying," says economist James Barth of the Milken Institute. So bailing out one guy might persuade his neighbor to stop making payments, even if he can still afford to, and hope for a better deal instead. That makes banks reluctant to re-negotiate in the first place, and when they do, they often ask for concessions that the borrowers reject.

One stipulation of a federal program, for example, is that in exchange for a loan guarantee, the government gets a big chunk of any future appreciation in the house, even if you don't sell for 25 years. But sharing your house with Uncle Sam is a strange proposition, and even distressed borrowers are reluctant to go along with that.

The worst loans are the hardest to track. If banks simply issued mortgages and then held onto them, as in the George Bailey days, the problem wouldn't be so complicated. In fact, the FDIC is already reworking at least 40,000 troubled mortgages at IndyMac, the big California bank it took over in July. When the loan is held by the bank that issued it, there are no downstream investors to consult, and the mortgage is usually still intact. At IndyMac, workout efforts are aggressive, because the FDIC doesn't have shareholders to answer to and it wants to fix the bank's balance sheet as fast as possible.

But the riskiest subprime loans - and especially adjustable-rate subprimes, the most "toxic" of all - aren't typically held by banks. Here's the math, according to recent analysis from the Milken Institute:

• About 50 percent of all foreclosures involve subprime mortgages.
• About 68 percent of all subprime mortgages are securitized.
• About half of all securitized subprime loans are held by private institutions, rather than government-controlled entities like Fannie Mae (FNM) and Freddie Mac (FRE).

That means the majority of the bad loans bringing down the housing market are controlled by the private investors whose greed and carelessness fueled the problem in the first place. And there's nothing an individual borrower can do to control who holds his mortgage. The government could help borrowers by buying up all those bad loans, at enormous expense, then essentially refinancing on terms more favorable to the homeowners. But that would amount to an egregious bailout of some of the shadiest players in the business. Even if taxpayers could stomach that, the downstream investors all have different stakes in the mortgage-backed securities they hold, with no motivation to agree to a single bailout plan. And so far, nobody in Washington has figured out a palatable way to help borrowers without also bailing out the downstream investors holding the securities, at a price the government can afford. Anybody who can solve that conundrum should contact Paulson and Bair immediately.

It's hard to tell which homeowners deserve to be rescued. Most people agree that the government shouldn't bail out flippers who bought and sold homes to make a quick buck or people defaulting on a vacation retreat. In real life, we might know who those people are, but the banks - and the government - don't necessarily know. In some cases, it's easy to tell from loan documentation whether the property in question is a second home, or whether the borrower was unqualified for the loan in the first place. But remember, one part of the problem was "no doc" loans that didn't require very much disclosure. In other cases, lenders or borrowers simply lied, and nobody noticed or complained. A comprehensive bailout plan might catch some of those borrowers, but others would essentially be rewarded for their cunning and hubris.

Washington wants to punt. Just writing that big $700 billion check was exhausting enough. You expect Congress and the Bush administration to bail out homeowners, too? Hey, don't rush them. Treasury and the FDIC already have enough on their plates, and Congress is looking forward to a post-election recess, not another migraine. Once the election is over and the next president takes office, there will be more enthusiasm for helping the little guy. Especially if somebody can come up with a reasonable plan by then.

Comments

[HARM:]

<i>One stipulation of a federal program, for example, is that in exchange for a loan guarantee, the government gets a big chunk of any future appreciation in the house, even if you don't sell for 25 years. But sharing your house with Uncle Sam is a strange proposition, and even distressed borrowers are reluctant to go along with that.</i>

Ahhh... the "choosy beggar" syndrome. Here's a thought: if underwater borrowers don't want to accept some taxpayer profit-sharing as part of a bailout on taxpayers' dime --F*** 'em. That alone should weed out a huge chunk of the greedbag speculator component.

2008 Oct 29 02:58 PM

[RatWatcher:]

LOL that is the comment I zeroed in on also. My traditional IRA is already shared with Uncle Sam....he is a 15% investor in it. If my taxes are more than 15% in retirement, he will make more than me on the account. And I invest in him, thru treasuries. Why not partner up on the house, too? It's just another item in the portfolio.

'Distressed borrowers' couldn't care less who bails them out or how. When the time comes to pony up, even 25 years later, they'll fudge the paperwork and walk away just as they are now.

While there is a small chance we'll see some return on our bank investments, the likelihood of seeing a dime of homeowner bailout repaid is nearly zero. Homeowner bailouts are direct welfare, nothing else.

2008 Oct 29 10:53 PM

[ksmithdc:]

HARM - great commentary. Agreed, 100%.

2008 Oct 30 09:55 AM

[akasidney:]

Rick:
While the country certainly has no interest in propping up inflated housing prices, it does have an interest in slowing to the degree possible the default rate through treatment of the disease, not the symptoms. There are different ideas out there as to how to do that, and the followng is a very simple way to do this that does not distort or 'prop up' the market, reward the financial imprudence of homeowners, cost U.S. taxpayers 100's of billions of dollars, or require all of the mortgage based financial instruments to be untangled in some fashion. Also, it allows mark to market accounting to coninue to be used, and possibly most importantly allows all mortgage based assets to be valued once again, thereby recapitalizing those who hold them, restarting the markets of them... and guaranteeing their repayment.

Sounds too good to be true, of course... but it's not. All that is required is that government enter as a 'partner' with the current mortgage holder in order to make the monthly payments. It turns out that nearly all the mortgage defaults are on adjustable rate mortgages (ARMS') after they 'adjust'. In exchange for giving up any claim to any increase in the house value over time and continuing with their original low payments, the government renogiates with the mortgage holder a new lower ARM rate in exchange for guaranteeing them the payment. If you do the math, that would amount, even in it's greatest possible value (on ALL the outstanding ARM mortgages, some 4 million homes) to approximately $1.5 billion a year... hardly even a bridge to nowhere in the national budget. When the house is ultimately sold, the proceeds would be split between the parties to the degree of their investment, with the only caveat being that the original owner doesn't share in any value above the value of the original mortgage. As houses traditionally are held for longer periods of time than that which we could expect it to take for the national economy to be rebuilt, the government should do fine... and the original owner will keep their house. If any owner chose not to avail themselves of the offer, of course they have no partner to split any increase in asset value with.

Because, as I stated above, the payments on the mortgages would be guaranteed, the value returns to all of them, and the huge Credit Default insurance market that is killing companies like AIG would disappear in a second (no defaults), restoring the asset values of companies, 're-capitalizing them' in the same way they were 'de-capitalized'... through asset revaluation.

It is absolutely in the interest of the Nation to do something like this that can quickly and completely clean up the problem caused by the bursting of the bubble. It will take possibly 10 to 20 years for many of the more hard hit markets to recover their value... but they will, and in an orderly, market driven fashion.

2008 Oct 30 10:47 AM

[kebu77:]

The limits on labor market mobility imposed by our broken health care "system" are currently compounded by the inability or unwillingness of many workers to SELL THEIR HOMES and relocate to (better) jobs.

Balance the interests of these workers (and of their employers in an efficient labor market) with those of the lenders and security holders by amending the bankruptcy code to allow insolvent people living in their homes to get loan mods in bankruptcy. This will help all homeowners by getting to the housing price bottom quicker (more folks stay in their homes and fewer REOs compete with regular existing home sales).

Lenders are not the only members of the business class.

Case-by-case adjudication and settlements from the bottom up would ripple thru the system and help correct the current structural barriers that are hindering loan mods in tens (hundreds?) of thousands of cases where - - but for the financial interests servicers and their law firms have in properties going to foreclosure vs. work-outs - - mods are in the financial interests of the lenders.

Not to mention how destructive to communities are the walk-aways, short-sales, deeds-in-lieu, foreclosures, cash-for-keys, and evictions...

There is no one silver bullet. A diversity of top-down and bottom-up solutions are needed.

2008 Oct 30 01:46 PM

[joethelender:]

It is a chain reaction we have seen recently in the market collapse. The unfortunate blind eye that our government took these last few years has compounded into the current financial crisis. These non-elected experts that run the federal reserve and other top jobs responsible for regulating the banking industry are sure to please their wealthy Wall-streeters that have disappeared into the night with billions. The new leaders will need to create a sound strategy to dig the world out of this worldwide mess. It is not a simple solution. People today are still getting into homes with no money down. Investors are still flipping homes for huge profits. FHA has not really changed guidelines for primary borrowers. The real problem is the result of investors and homebuilders being allowed to get appraisers to overvalue the homes. Appraisers continued to increase the value of a home because the interest rates were so low making the payment for higher prices affordable. The appraisal industry and the realtors have slowly corrupted the industry for years without penalty. The appraisers did not have to worry about anything, there incomes were about $300 per appraisal, five in a day, no problem! $30k a month, sounds reasonable compared to builders take and realtors commission. The banks rely on honest appraisers and realtors to guide new homebuyers and that did not happen.The mortgage companies have also taken profit from this subprime market allowed by Fannie and Freddie. That is now gone. 300 mortgage companies are now gone in less than 2 yrs. The banks have learned what? That the government will bail them out if needed. Nothing will change that. Homeowner bailout, not good for the economy. Why? The economy needs to improve on people going to work, manufacturing goods and services and spending more money. So lowering your payment doesnt help the economy, its a drag on the economy. The government could help people get work, create jobs and increase the minimum wage to a liveable wage. The retail jobs and low level jobs are unfortunately becoming the majority in this country, the tech jobs are going overseas. A 10% increase in employee wages across the board each year for the next three years should be required to help get people motivated to work. 30% increase in three years is better than we have seen in 30 years. It is better than a $500 stimulus check. People on welfare would consider working instead of sponging. Lets create this bill! Pass it on! It is fair, and tax breaks for all business would be possible since the money is coming from the employers, not the government. More tax revenue would be generated.

2008 Nov 06 07:02 PM