Bernanke's Message Can't Be Any Clearer

Federal Reserve Chairman Bernanke presented a harsh message in his speech Tuesday before the Independent Bankers of America (Orlando). Prodding both mortgage investors and the government, Bernanke came just short of demanding that they trade principal write downs for government guarantees. Bernanke's real audience was the Congress, the White House, large commercial and investment banks, mortgage servicers, and structured product investors.

The message:

For the lender or servicer, working out a loan makes economic sense if the net present value [NPV] of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure.

Put the "do the math" message together with Bernanke's pushing for Fannie (FNM), Freddie (FRE), and FHA to guarantee refinancing; and his message cannot be any clearer.

Adding to his argument for principal write downs, Bernanke reiterates the obvious: A homeowner with negative equity has "less financial incentive to try to remain in the home." Bernanke acknowledged that structured product investors have conflicting interests, and that servicers are restricted by the trusts. Lenders have been reluctant to write down principal because that could lead to additional principal write downs if home prices continue to fall.

Bernanke counters with two points. A principal write down could lead to the borrower refinancing, relieving the original lender of the bad investment. (Bernanke acknowledges that second lien holders would have to re-subordinate to the new mortgage.) Bernanke then cites a proposal by the Office of Thrift Supervision that would allow original lenders to participate in future appreciation.

When Bernanke concludes with "Ultimately, though, real relief for the mortgage market requires stabilization, and then recovery, in the nation's housing sector"; he loses my support. This conclusion says Bernanke's ultimate goal is to restart housing appreciation. Bob Toll, Toll Brothers' (TOL) CEO, first said this during his most recent conference call. Just as the NASDAQ never fully recovered, neither will house prices. Bernanke should be saying "go through the wrenching adjustment, and then the housing market will provide the necessary liquidity."

Bernanke also needs to acknowledge that the cost of operating a house has increased substantially in recent years, leaving less money available for mortgage payments. Consider food, energy, insurance and real estate taxes. This leaves far less money available for the house itself. Housing prices cannot increase unless incomes increase or operating costs go down.

Disclosure: Author is long FNM and FRE.

Comments

[j.lauberge:]

When the Bush adminatration asked for America to 'SUPPORT THE TROOPS" in Iraq, the people, the media and Wall Street did so..The politicians got on the bandwagon and it became the patriotic thing to
do..even if you didn't agree with the war,everybody agreed that
we should support the troops....Similiarly, President Bush has an opportunity to provide leadership to the housing market...President Bush,Fed char Bernanke, Wall Street and Freddie should suck it up, stop blaming each other on whose fault the subprime loans are, and start RAISING CAPITAL to help the companies that need it most!
America need your help now..Stop driving our Congree companies down and startlifting them up..you all could consider the following:

1. Provide and sell to Congress a Housing industry stimulas package of 300 billion similiar to Larry Summer's approach that must be temperary timely and targeted...
2. Discourage the short sale of companies that qualify for emergency
relief...and provide tax incentives to investors that would invest in our most troubled industy..
3. allow greater opportunity for public and financial companies for accelerated tax benefits...

President Bush has a major opportunity to help America solve it's
housing issues and needs to go out of office with a "SURGE"
FOR AMERICA and it's rapidly deteriorating housing sector..Come on Mr. President, can't you help the American people? Can't you
talk some of your wealthiest friends together and help the millions of people suffering from financial anxiety? After all, they've been there
for you.. Use some of the same skills you used to get the Surge in Iraq to help the American people stay in their homes? I know you can!

2008 Mar 05 10:42 AM

[capitalist54:]

RE the post above; Supporting brave men and women who put their lives on the line is totally different that providing a means to bail out banks who failed in their financial oversight obligations. If I were in uniform I would be seriously insulted by the comparison.

Question; how exactly how is the division of future appreciation regulated with variations of markets, and the homeowner putting money into repairs and upgrades? This would be a storm of lawsuits in the making.

Secondly, do the same banking executives who were paid millions while they put their businesses into this disaster have any personal accountability? No. They pocketed their millions and now want the taxpayers to pick up the tab for their bungling. So does Bernanke.

When I see the committment of management to return bonuses paid I will buy into government relief, maybe. it should not even be on the table prior to that happening.

People who bought an asset that is now upside down should have considered the consequences prior to purchase. There are no guarantees in life. I'm not crying to the fed if my stock purchases go down.

Secondly, how many of the people getting bailed out are speculators that were operating on the bigger fool theory for a fast flip? And owner occupancy isn't the right answer here, as many occupants were also looking for a fast flip and got burned.

For the fed to be even entertaining the idea of a bailout is only election year politics.

One way or another market forces will win, and Bernanke has once again shown that he is driven by Wall street, not main street.

2008 Mar 05 11:03 AM

[helplessobs...:]

First comment makes no sense, second comment hits the nail on the head. Before using my money recover the $27B in bonus money paid to GS for creating this mess as a starter.

2008 Mar 05 11:25 AM

[Christian:]

I think the housing issues are essentially fixed (tongue in cheek) - people have begun to stop buying homes as speculative investments, lenders have staved off (for the most part) loaning $$$ unscrupulously, and the never-ending debt trail known as home equity loans to finance a way-of-life is coming to an end.

What is ailing the "industry" now is the consequences of these poisons. The ailing effects like massive inventory, drop off in sales, and people up to their arses in debt. To try and "cure" these consequences and not reinforce the proper loan processes is just as many people have said: you're giving a drug to a rehabilitating addict.

The Fed needs to guide the lenders (okay, the banks - lord knows where the mortgages have gone beyond that) on what it can do and what it can't do to work out this mess. It's going to get far worse in the coming years, but throwing money at the problem isn't the solution - that's just a "get out of free" ticket for those that just need to go to jail.

Hearing things like "principal write-down" makes me wonder why I stopped house shopping in the fall of 2006, deeming the market too expensive. I should have just purchased that overpriced home back then. The Fed would have my back, forgiven the price I paid - voila! "principal write-down", and I'll end up owning just the same amount had I purchased the house now, a year-and-a-half later.... except I would have lived in it since.

You sign on the bottom line - you're liable for it. Loan sharks of yore had a more colorful way of dealing with people that didn't pay up.

2008 Mar 05 06:10 PM

[robert99:]

@ j.lauberge: Dude. Seriously. Bush sucks, and so does your plan to save the economy - Which are two reasons I expect something very similar to be enacted within the next few months. Unfortunately for free markets, no one seems to understand them.

2008 Mar 05 09:28 PM

[The Level 2...:]

The subprime issue is the main culprit in the market crash. It will lead to a major catastrophy of financial institution collapse and eventually major correction of other sectors.
This is the opportunity for traders and definitely not for investor!

2008 Mar 06 10:39 AM

[348s:]

If politicians and their minions will just let the market deal with the bubble, we'll all be better off. Things are self-correcting! We can't undo the damage done by Greenspan and asleep-at-the-switch regulators. Washington should focus on longer-term financial regulation that adds stability to our economy. Enough with the short-term fixes that set us up for punishing inflation!

2008 Mar 06 01:12 PM

[BK Mas:]

First of all, housing prices are still too high! Incomes and housing prices need to converge to historical norms before there will be any stabilization in the housing market. This process is working its way through the system now.
I could write pages and pages why Bens moronic comments would be a disaster. What is interesting however, this "debt forgiveness" option is already available in the free markets to banks and is becoming more and more common every day. It is called a real estate SHORT SALE. I will explain it further down the post.
Lets say the homeowner has a 225k mortgage and is no longer able to make the monthly payments. The homeowner can't sell the house to cure the mortgage because the house is only worth 185k. The bank has a few options and none of them are good for the bank (And shouldn't be!!!!) Let's say the bank uses Bens suggestion and reworks the mortgage to 166k (writes off 59k) and now has a performing loan on the books. The problem is the homeowner probably would not qualify for a 166k loan under normal lending standards so they still have a sub-prime loan on the books. Another problem is if housing prices continue to fall, they will be faced with the same problem again. Aside from the moral hazard and the administrative negative return on this approach, it becomes obvious this is a bad idea. Another option is foreclosure, let's look at what happens in a forclosure: The payment on a 225k mortgage is going to be around 1750 with ins. taxes. pmi etc.. The notice to foreclose is usually not filed until the homeowner is 3 months behind. Once filed the home is in preforeclosure status until the legal process is completed and the house goes to auction. In a declining market these houses are rarely sold at auction (unless the homeowner had enough equity). So the house finds its way back on the books of the bank. They hire a real estate agent and the house is listed as a REO (bank owned). By the way, the foreclosure process takes a minimum of 10 months and can take up to 2 years.
Lets analyse the cost of the forclosure option:
Equity already lost in home 40000.0
225K non performing loan 10 months 17500.00
Cost of Foreclosure, legal, admin. etc. min 25000.00
Declining Market over that period 7% 12950.00
Broker fees est. 6000.00
Discount because of REO status min. 5% 8250.00
Damage to home while in foreclosure status ?????
Total 109700.00++
So the bank eats aprox. 110k or maybe a lot more.

THE SHORT SALE OPTION:
An investor contacts the homeowner once the home is in preforeclosure status (the homeowner knows he/she is going to lose the home regardless) and the homeowner agrees to sell the home to the investor for 20% under market value for 148k. This must be approved by the bank and the bank must release the homeowner of all liabilities. (The homeowner gets to walk away) The investor puts the house back on the market for 160k, 25k under market value and basically flips the home for 12k profit.
Bank loses 77,000.00 and removes the toxin from their books forever.
Which option would you take if you were a bank?
It is obvious to me that the SHORT SALE option is superior to any other. Once the bank approves a short sale it can close in one to two weeks, The homeowner won't trash the house, market risk is transfered to the investor, and the toxin is off the books.
With Ben's option the bank will continue with a loan with a bad credit risk and they eventually will foreclose anyway.
The foreclosure option is a lose lose situation. The bank faces market risk, house damage risk, and enormous legal risk (who owns the note on a sliced CDO anyway!)
HERE IS THE PROBLEM: Banks do not like to enter into short sale deals. They do not like investors stealing their equity! Who would!
It takes banks 4-5 months to approve a short sale deal which they don't approve very often. No one likes the idea of getting bent over by a counterparty, but the banks inefficient loss mitigation departments are prolonging the housing market pain by their own policies.

ANY BANKERS READING THIS TAKE NOTE:
Stop treating short sale investors like parasites, they are actually lubricating the system and creating a market balance. Consider this;
You take a smaller risk adjusted loss on a short sale AND put a qualified buyer into the home (with realistic lending standards) that can and will endure continued weakness in the housing market. BEEF UP YOUR EXPERTISE in short sale deals and YOU WILL LIQUIFY THE HOUSING MARKET, therefore price discovery and balance will be achieved much faster. Think about it! Really think about it! Foreclosures and empty homes kill neighborhoods; further increasing your risk that the spiral continues. You are going to have to let investors (wholesalers) get a little of your flesh! No different than a broker in a bond underwriting deal or a specialist at the NYSE. The market needs liquidity, activity and price discovery. To be certain; the price of houses are going to continue to fall, but why don't we let it happen in 1-2 years instead of 5-10 years.

TAKE THE HIT YOU DESERVE AND LET THE FREE MARKET WORK!!!!!!


ps. I wrote this really fast, excuse the spelling, and other errors syntax etc.. Also, I have never done a short sale deal, I know some guys in real estate and they bitch all the time about banks not willing to work with investors, or dragging their feet forever.
I'm an S&P trader, So my take on this has a lot to do with liquidity.

2008 Mar 06 07:54 PM

[6421:]

If the government wants to bail anyone out it should be the children and families living in shelthers or make shift homes.

Everyone was happy collecting their hefty pay checks and bonus, so let them take a pay cut and no bonus.

People are being forced out of their homes not only due to the interest rate raising on their mortgage, but the price of the up keep and everyday living. Let the builders drop there prices to the property's that they have not been able to sell and the ones they continue to build should be at market rate not at a rate of greed.
Or let them fall.

I would rather pay rent for someone that has lost everything then pay more taxes to bail out a company that over paid themselfs and the employees and gave away to many big bonus.

These companies are not worrying were they are getting the money to feed their families due to the alotment of their salary's and bonus.

So tell me why our government should bail them out, bankruptcy is away for these companies that are not making it, and like Kara homes some came and brought them. So let all the rest fall someone will clean it up why must it be the government at the expense of tax payors.

2008 Mar 06 08:40 PM

[Kunst:]

"President Bush" -- the words still make me shudder. Alfred E. Newman trying to act serious.

2008 Mar 09 12:09 AM