The Government's Subprime 'Bailout' Plan Will Kill the Housing Market

Details are still a little sketchy but I'm assuming that the new subprime bailout plan will closely resemble California's plan.

Previously, I listed some unintendend consequences. Quickly, those were insufficient scale to work and keeping the "plankton" out of the housing market. Those are still valid, IMO. After getting the details about Gov. Schwarzenegger's plan in California, this plan is absolutely horrifying.

The most insidious aspect of the CA plan is that it is a lie, much like Bush's supposed tax cuts for the middle class back in his first term. In that case, the tax "cuts" were actually tax rebates, akin to payroll advances. It was zero-sum and not a cut at all -- taxpayers just got an interest-free advance and had to pay it back at tax-time.

Well, this "teaser freezer" is very similar -- it actually turns your ARM into a de-facto negative-amortization loan. Nothing is forgiven and no amount is written off from the borrower's perspective. From the investor's perspective, they may take a loss or writedown if the security holding these loans is devalued but that might be acceptable if it means staving off defaults and total loss altogether.

The intent is not to help homeowners at all. Rather, these borrowers are being treated like the human batteries in the first Matrix movie -- being kept in a virtual mortgage cell where their income can be sucked out from them, basically for life. It could be decades before these people get to a zero-equity situation, much less positive equity.

Unfortunately, most of the people this directly affects will probably not view it this way. I suspect the emotional aspect to being a homeowner will overcome any economic sense (which Americans generally have very little to begin with). If so, these people are doomed to a lifetime of financial insecurity and the stress that comes with it. The kicker is many of them will be grateful for it. This is the reason I left politics -- as much as I wanted to help people, you can't help those who won't help themselves.

For the rest of us, there's a very real possibility that this plan will only set us up for the next big leg down in the housing market and eventually, the economy. It's very simple: houses are (still) too expensive. Unless gov't officials have an ingenious plan to massively boost middle class income in real terms without knock-on effects on inflation, the only solution is waiting for housing prices to drop.

Lowering interest rates will not work because as Congresswoman Sanchez pointed out to Ben Bernanke, even good-credit borrowers can not get credit at the listed best rates. We are already seeing this at the corporate level. Only the government can borrow at low interest rates. Citigroup (C) had to pay 11% and mortgage off 5% of the company at a 40% discount to its value at the beginning of 2007. So if the Fed continues lowering rates, lenders will not pass the whole of those cuts to borrowers but rather widen the spread to help pay for the current mess.

Therefore, the housing market must be allowed to decline. Much like the banking credit crisis, anything that prevents the "discovery" process is likely to prolong the misery.

Comments

[billb]

I don't understand, are you looking for a full fledged bail out where those that made dumb decisions are supposed to be bailed out in full at taxpayer's expense? I also don't understand your parallel to the tax cuts or your spin. It sounds like you're a lefty since this sounds like a lot of emotion with no logic whatsoever.

Maybe the NY Times or moveon.org would be a better a platform for you to spew this garbage.

[jcrash]

Your article is at best misleading.

Citigroup is not exactly the best borrower in the current situation. You can expect they would pay above market rates to borrow.

As for the matrix reference, I do not see how continuing to pay a low interest rate on a loan is a bad thing. Unless you assume housing prices never recover, in which case ALL homeowners are "human batteries", the most profitable thing for anyone is to pay their home loan as slowly as possible.

You are probably one of those people getting a 15 yr loan and paying extra each month instead of investing you extra cash and tripling or quadrupling the "savings" you are getting by paying your home loan off early.

If you are in your house to live and not as a speculator, you make out like a bandit with low rates.

[Rocktex]

Good point?
Paying a low interest rate is sure a GOOD thing if we assume housing price IS recovered. But, there is a sophiscated catch?
Only a fool will argue with you that Californian housing price is never going BEYOND the peak of 2006. Sure, it will with help of inflation in the long run. Maybe it will when the owner dies at age of 65, or 100?
Good assumption to say you are right? But wait, there is a sophiscated catch I don't understand?
When it is going to recovered? With a negative amortization in the freeze plan, the loan principal keeps growing. I believe in the current situation, are you sure the subprime owner will have his home valued at the end of 5 years, more than what it is worth now?
Yes, a subprime loan owner will choose to stay if his payment is equal or lower than the local rent to take the advantage of housing subsidy.
But it is true the payment & other housing costs are lower than the rent? Not likely in California as I know.
Then what's the point to keep his house by paying more money every month and paying even more loan amount in the end? I am too fool to see your arguement valid.

O

[Bob K.]

I am sorry to say but the author is correct, these "saved borrowers" are far better off defaulting and renting through their negative credit period of seven years than being stuck in a negative amortized loan. Meaning the price of their homes continue to fall as their payments remain with little upside of an equity build. Do the math. The prime brokers set up an ingenious trap.

[outback]

The intent of this plan is to encourage lenders to do what they would do if they were dealing with a sophisticated corporate client, that is, renegotiate the loan terms. Lenders do this sort of thing all the time. I personally think it makes sense. The objective is to stop the carnage and keep people in their homes, not bail out Californians who thought prices would rise forever.

[Rocktex]

Good point?
Good, it tells the same scenario as we did to finance, re-finance and re-finance to a 3rd poor country who is always in default. That means the country gets a new loan to pay a old one. The people in the 3rd world is getting poorer and the anti-America imperialism aversion is growing.
Sure, we can't send a troop to collect the debt. Neither the debt is paid.
Do you think that will happen to our citizen in Cali?

[Davy Bui]

billb - The gov't needs to get the f^&k out of the way and let the housing correction run its course. And hey pal, it looks like I'm advocating a free-market solution unlike most supposed free-marketeers like Kudlow. Obviously, you're too blinded by ideology to "understand my parellel or my spin."

jcrash - Actually the worst borrower is the US government (being the largest debtor in the history of the world). It actually gets the best rates but that's besides the point. Congresswoman Sanchez pointed out that with her 800+ FICO and assets and her job, she could not get a mortgage at the 6% rate listed in the papers.

I haven't done the math but if you took out a $500,000 loan on a house that's now only worth $300,000 and then negatively amortize the reset interest while your rate is "frozen", how will you ever "make out like a bandit?" You're gonna pay hundreds of thousands of dollars of interest alone just on the lost equity. How long do you think it will take that house to get back to $500,000? If the government keeps trying to put in false bottoms, a hell of a long time. You'd need a hyperinflationary scenario to come out of this alive.

Full disclosure: I was a wannabe first-time homebuyer (in Sacramento -- ground zero) around this time last year. The numbers didn't make any sense and now I'm biding my time. I obviously would like to see prices come down more.

The point is that this plan is not aimed at homeowners but rather financial institutions and the markets. Anyone eligible for this should turn it down, go back to renting and start over if they can (I don't know the various bankruptcy/foreclosure laws). In most cases, if you have 3% equity, that will be wiped out by the 5-25% drop in prices yet to come. In the meantime, these people will be paying massive amounts of money on an upside-down asset that's negatively amortizing. All in the name keeping people in their homes but really in trying to stave off balance-sheet reckoning day by keeping as many loans performing as possible.

At this stage, it is too late for a bail-out. This is only the first pass. As the crisis worsens, the bail-out will more fully materialize, complete with taxpayer money.

[jcrash]

Do you think a creditor is just gonna say, oh, ok you filed bankruptcy, you don't owe me anymore?

They will repossess the house and you will STILL owe them the money they lost on the asset. They will come after you for it and you will be unable to buy your next house in a few years when you think pricing is more equitable.

I don't get the "walk away" mentality I see getting sold by a lot of "finance experts." The AVERAGE person in the AVERAGE market might see price depreciation of 5 to 10% at MOST. Here in Tulsa, Oklahoma we are doing fine, our home sales aren't quite at last year's record pace, but we are still selling homes at a good clip. Median prices are off slightly, but with the number being sold, I can promise you that the financing is not in a horrible situation. If it is, meaning some people can't get affordable financing, it by definition means we are still in a BOOMING housing market, because we would be selling even more homes.

If I buy a house for $300,000 with $0 down or 20% down, just because the market value goes down to $250,000 doesn't mean I am going to walk away from the loan. Who cares what the market value is when the value _to me_ today is the same as it was yesterday. I LIVE HERE. Why would I walk away from my loan? That'd be stupid.

The only reason it would happen is if I couldn't afford my payments. The only reason I couldn't afford my payments was if a) both my wife and I lost our jobs or B) my interest rate spike to some stupid level. Freezing the rates will prevent B and A isn't happening in todays 4.9% GNP growth economy. That said, I have a fixed rate 30 yr locked at 5.5% so I really could care less about rates.

The only way this is bad for institutions is that they are not going to earn Junk like rates on their mortgages, which they shouldn't in the first place. It is usurious to expect to earn 9+% in today's markets on a mortgage, yet that is what they are expecting to make on these sub-prime mortgages post adjustment. Too bad for them. If they simply offered affordable rates on realistic loans to the sub-prime borrower, they wouldn't be having this problem. So, excuse me if I don't cry for the banking institutions...the homeowners are the ones that need help and this WILL help them, despite what your negatively amortizing brain thinks.

[Henry Barth]

Not all States are "recourse" states for loans or mortgages. In many states, if you go bankrupt whatever you still owe above what money the bank gets on a property sale is just wiped off the books, yours and theirs.

This is what "non-recourse&quo... means.

[Henry Barth]

Not all States are "recourse" states for loans or mortgages. In many states, if you go bankrupt whatever you still owe above what money the bank gets on a property sale is just wiped off the books, yours and theirs.

This is what "non-recourse&quo... means.

[Bob K.]

JCrash, most of these loans are non recourse loans, which means exactly as you described. You can simply walk away from the debt. The lender only has a claim on the asset, in this case the house. The point the author is making is that if the prime brokers must correctly value their assets on their balance sheets, it significantly impairs their ability to lend, and in some cases their ability to survive. Go ahead and look at the level 3 disclosures and you will see they have more assets they cannot value "read" sell than the capital in their business. That is the reason for all of these bailouts. They could not care less about these home owners.

[WAKEUP]

"Houses are still too expensive" says it all. Anybody with any intelligence will WAIT, WAIT, WAIT, before buying a house. The downward pull of demand will solve the "too expensive" problem. Message: Do not buy a house this year. Do not buy a house next year. Remember, you're likely to be in that house for 30 years (if you don't borrow more money than you can afford to repay), so "house fever" will have long burned itself out by then. Be patient. Sellers are going to get the message that the free ride on escalating home prices is finally OVER.

[shodai]

Good article. Two years ago, my family and I sold our house in CA because I saw this disaster way ahead of time. When I was selling everyone was bidding on a single house, jacking up prices to ridiculous levels. I even knew of college students able to buy homes with no credit history, or recent naturalized citizens bidding and buying these expensive homes. My experience with the Japanese real estate bubble taught me one thing, what goes up, does come down, the same as the stock market. Except this downturn is going to far different from the Japanese experience. Japanese save; Americans don't know the meaning of saving for a rainy day.
Most of these people who are expecting to be bailed out, should just dump their homes and get on with their lives. Home prices will fall big time in CA because they are so overpriced compared to wages. Job creation is declining in CA, wages are declining, while healthcare, energy, and food costs are rising astronomically. Keeping a home on a bail-out as home prices decline and wages decline, is committing suicide.

[jcrash]

Good move on selling the house. Still don't think you "walk away" people are right. Using your line of thinking, people would never buy a car, because it depreciates so much while they own it. Yet cars still get sold - including expensive ones.

Just because something decreases in value doesn't mean it isn't worth owning and just because the payments go up doesn't mean people are willing to sacrifice their credit ratings and dream home - not if they can find a way to make it work.

[Rocktex]

Very good presentation!
Just reminds me of one concept in Economics: Utility, a satisfaction factor to a buyer.
Just also reminds me of one vital fact in real estate: a residence is not only an investment, but a personal pleasure.
Yes, most people in USA is accustomed to enjoy everything NOW so that we have a sale pitch: “buy it now and pay later.” It is a big difference between the rich and the poor. The rich do save and invest appreciating things, the poor spend and enjoy depreciating luxury.
That’s our current culture those “freeze loan” programs count on. They want those subprime loan borrowers enjoy the satisfaction of home ownership and pay more later in order to keep the junk loan look good as performing assets in their books.
But, there is a problem. Davy didn’t make it clear here. Subprime loans are just a small part of this bubble. Not only the major portion of subprime loans are left out. But also, there are more big mess coming from other primes loans, such as Alt-A loan, Option ARM. Those loans are not a subject to be rescued from those “freeze” plans. Then, what could happen?
The housing market is definitely fallen if we can't stop other non-freeze houses going to foreclosure. At this moment of writing, a steep discount of more than 45% are seem in some area. If you bought a house for $600K and the current value is $350K, will you say to yourself: “it worth owning. I am not willing to sacrifice my credit and dream home”?
I doubt you are so smart and arrogant!

[chancer]

Analogy: At a new store grand opening, 1st 100 people get a free tv. Is that unfair to all the people who didn't get a free tv? Does it have a significant affect on the tv market? No.
The bailout is a minor blip. The pain gets spread over a long period of time, mixed in with new transactions. But is does have the affect of restoring confidence in the market.
Considering the size of the market, I really don't think this will have much of an affect.
Some of these homeowners will sell and refinance; others may lose the house anyway- especially if we go into recession and many lose their jobs.

[tkap]

Davy......I missed the neg-am aspect of this plan. Does the proposed plan allow for ARM mortgage rates to reset in accordance with the existing loan contract while simply holding monthly payments at the current level for five years (leaving unpaid interest to accrue as added principal)? If so, this is not an interest rate freeze, but rather is a potential screw job for the "homeowner", for the benefit of the banks and holders of commercial paper. The effect is to delay (while increasing the probability of) default. And, while it perhaps buys some time for investors and banks, it encourages a homeowner with negative equity in his property to continue to throw good money after bad, while housing prices continue to fall and his loan principal grows. I think most homeowners in these circumstances will be wise enough to send in the keys in lieu of their next monthly payment......this assumes that the "homeowner" could lease a comparable property for significantly less than the after tax value of his mortgage payment. This is an important point because, if the "homeowner doesn't have a favorable leasing alternative, he will and should stay put.

As for jcrash's point about the lender going after a defaulted homeowner for the deficiency in a foreclosure, he's correct, I believe, in some states....but there used to be (and may still be) many states with anti-deficiency laws on the books which prevent the mortgage holder from chasing the defaulted homeowner in an effort to recover a deficiency. Maybe somebody more knowledgeable than me can elaborate on this legal issue.

[Rocktex]

To tkap:
Here is an article talking about theory and practice of foreclosure for your reference. Foreclosure Outcome in TD States (Not for Mortgage State) activerain.com/blogs/r...

Your opinion is much welcome.

[tkap]

To rocyeah:
Thanks for the reference...once again, I am reminded of how glad I am that I never considered going to law school.

[Rocktex]

To Davy,
The job is well-done. You are very honest to present your viewpoint and give out a practical solution.
However, so many people won't look at the truth and react to the reality accordingly. That's why a scam works: to give people a dream!
In front of God, we the human being's power is so small to defend us from Katrina.
In front of Adam Smith's "a invisible hand," what the freeze plans can accomplish? Hot money & economic activities are globalized. And the world is changing at a remarkable speed, how can we "stop" at a point of time?
US government is so powerful that can do some fine tune to the economy as we do to a airconditioner in a house. But can we deal with Katrina? Can we fine tune the globe's four seasons?
I pray our government can be humble and let Adam's invisible hand do the job. That's will shorten our pain and heal it naturally.

[Jay Jay]

Good article Davy. Wanted to point out the the bubble blew the biggest not coincidentally in the nonrecourse states. I've talked to more than one of my Cali associates about the risks of buying in the recent market have been told in effect, if it doesn't work I'll just walk. When the governemt does things like tell buyers that they don't have any skin in the game if their equity is gone, it encourages more people to take risks because they know their downside is limited to their down payment. And wth no down payment, there is no downside risk, and everybody is a buyer. Prices go through the roof, then come crashing down through the floor. This is yet another unintended consequence of medling in markets. Intervention causes strife which begs yet more intervention, etc, etc. Wash, rinse, repeat until the country is bankrupted.

I think these programs are more about slowing the rate (prolonging) the crash than stopping it, and they know it. I keep hearing noise from mortgage servicers that they aren't set up to handle so many defaults all at once. They're really staffed just to collect checks every month from 99% of the people.

[thku4grace]

While it is clear the author of this blog is aligned with those that want a huge taxpayer bailout of homeowners, some of what he is saying is true. This bailout is designed with one all-encompassing design flaw--it will only prolong the bear market in real estate. 1) Credit is going to be strict even for those that would have fairly qualified for a home loan in previous years. 2) Who is going to buy a home now that we are at record levels of homeownership? More ALT-A qualifiers? I think not! 3) While I'm not going to predict a recession in the immediate future, our economy will indeed take steps backward at some future date in the next few years which will extend the real estate bear market. 4) This plan is still voluntary, meaning banks aren't going to refinance those who are upside down unless borrowers are able to infuse more capital making their loan more consistent with the market. What this plan clearly does is push off the day of reckoning. Some will be okay due to unforseen financial windfalls, such as inheritance, landing that dream job with a fat pay increase, and winning the lotto.....but for most everyone else, there goes the credit! I believe those with an iffy situation living in California, Nevada, Florida, Ohio, or Michigan may find a better alternative to foreclosure by working out a deal with the bank to sell at a loss now, and refinancing the loss with a banking institution at a mutually agreeable fixed rate. Market values are only going to get worse later and that may make this scenario impossible. Foreclosure will all but guarantee apartment life for the next 10 years.

[Jay Jay]

I read the the article to he thought it was too much intervention, rather than not enough.

[thku4grace]

As long as no taxpayer money is used, its fine to bring together all parties so as to slow the real estate market descent, somewhat. I believe it is still going to be a hard landing but a straight nosedive is never beneficial. If the government does not go beyond their current proposal I believe the pain will fall on all those that are at fault naturally. The foolish homeowners who either failed to read their contracts or simply cast all risk aside; the credit agencies who failed to rate this risk accurately will be in litigation and will lose their credibility; the hedge funds and investment banks that either held, packaged or sold these mortgage obligations will lose billions and last of all the government in years to come will have to confront their own foolish behavior in encouraging home loans for all those that couldn't afford it. Frankly, I see few politicians admitting to their misbehavior thus guaranteeing we will see more of this in the future.

[Jay Jay]

The current crop of politicians are only guilty of being of the same ilk as their predecessors that created the climate one step at a time. In fact the seeds of this disaster were sowen by FDR following the last one of similar origin. Specifically the formation of the Home Loan Bank system. Any mechanism to artificially hedge the risk of investors only serves to raise the prices for people with good credit. The ironic thing is all these types of things are done in the name of affordable housing. And the more they intervene, the less affordable housing gets.

Regarding the idea that the government is simply orginizing the action I like this quote:

"When authority presents itself in the guise of organization, it developes charms fascinating enough to convert communites of free people into totalitarian states." from the The Times, London circa early mid 20th century

[DawnIsis]

It is wrong, wrong, wrong to not allow the market to correct itself on its own regardless of the consequences. I have been saving my down payment and building my credit for years preparing to buy my 1st house and I am just waiting for the house prices to bottom out.

This "plan" will ARTIFICALLY stabilize house prices, so unless someone wants to send me my government issued check to compensate me for the money they will be stealing from my purse they better drop this bailout idea.

[Rocktex]

To SawnIsis,

It is wrong, wrong, wrong to interpret that way.

Can you see anyone not involved in forming the dumb "plans" saying those plans will work? Almost everyone with reason know they won't change the fate. If it is true, there is no real impact on the reality, right? So look at it with a different perspective.

It is clear that housing market in some areas are "dead," i.e. without normal market function. If it was dead, how could we "kill" something dead again?

In a broader sense of macroeconomics, a "dead" is just like a winter or a trough. There is still an ivisible hand, there is an opportunity for you to profit, it as long as you can realize it in a distressed market.

Good luck!