A Government Rental Agency to Mop Up the Foreclosures

The airwaves are brimming with stories about the financial loss incurred by investors and financial firms due to the mortgage market meltdown. What is often ignored is that foreclosures also have a debilitating effect on communities. Home values fall reducing the tax receipts of local governments; empty homes become an eye-sore for the entire neighborhood and invite vagrants. Investors and owners of foreclosed homes will have to endure the pain of their imprudent financial decisions. However, the impact of foreclosures on communities can be reduced by creative planning.

In the past, mortgages were held by local banks who could work with homeowners in trouble to delay foreclosure till the hard times passed. However, in the days of securitization, the owner of the mortgage is a business entity, a trust created to buy mortgages and issue securities. There are mortgage servicing organizations who handle the book-keeping aspects, but they do not have any skin in the game. They do not have enough financial incentive to help homeowners stay in their homes.

Root Cause Analysis

Many home owners who are in trouble took sub-prime Adjustable Rate Mortgages [ARM] with teaser rates which reset after two or three years. After the reset point, the rates would go up to 500 to 600 basis points above the LIBOR rate (typically the 12 month LIBOR). Even the initial teaser rates were in the 7-9% range, much higher than what most prime home-owners pay.

The thesis behind funding sub-prime borrowers was that when the ARM reset, the owner would have built a credit history, and a rise in home prices would allow them to qualify for lower rates. However home-owners who bought at the peak of the housing bubble are now upside down and owe more than what their homes are worth. As a result, they cannot refinance and are stuck with the very high rates which they cannot afford.

Current Remedial Actions

Current efforts to address the problem are focused on keeping the monthly payments affordable. They include suggestions to freeze the rates on the mortgages for a few years. These proposals make sense for homeowners who have some equity in their homes and can afford to make the payments at the current interest rates.

However, for a large group of borrowers, the payments are not affordable even at the current level. Many of them bought their homes after 2005 at the peak of the home price bubble. Homeowners stretched themselves to get into homes in the hope that they would be able to refinance to a lower rate in the future. Further, many of them put very little money down and, with home values falling, have very little equity in their homes. They do not have any incentive to continue to stay in their homes, when they can rent at much lower monthly payments compared to what they would pay with the 7-9% rate on their mortgages.

Wide-Scale Repossession: Not a viable alternative

It is evident that a large group of homeowners will not have any incentive to stay in their homes even with frozen interest rates. Traditionally mortgage note holders would foreclose on the home and try to recover as much principal as they could. However, the housing market is currently in a big depression, which is likely to worsen as economic growth slows and mortgage availability shrinks. As a result, banks may be forced to hold on to these properties for a much longer time. Not only will the note-holder not make any money on the principal amount, they will also have to pay for home maintenance, house taxes, and other costs associated with maintaining the home. Further, an increase in the number of foreclosure sales will worsen home prices, and start a downward spiral where liquid creditworthy homebuyers will wait on the sidelines.

Typically, foreclosures were bought by investors who would then use them as rental properties. However, given the difficulty in obtaining mortgage financing, the number of foreclosed homes, and the general air of despondency in the home market, investor interest is likely to be muted. As a result, the capital recovered in foreclosure sales might be significantly less. Given the magnitude of the problem, it might make sense for note-holders to reconsider their traditional approach of selling the home in a foreclosure sale.

Interest Rate Arbitrage: Sub-Prime versus Prime

A typical sub-prime buyer is paying between 7-9% in mortgage interest. This is significantly more than what real estate investment firms would pay for the same home (5-6%). The ability of the investor to borrow at a lower rate than the current homeowner means that an investor can rent out the home to the existing homeowner at a much lower monthly rent than what the homeowner is currently paying.

The ability of the investor to borrow at significantly lower rates than the homeowner opens the possibility for an entity to become a landlord for the next few years and rent out homes at a much lower monthly payment than what the homeowner was paying. This is the reverse of what typically used to happen in the past. In the lower and middle income communities where sub-prime loans dominate, it was typically more expensive to rent than own. This was a reflection of the fact that credit was not easily available and even people with stable jobs were forced to rent, since they did not have enough savings for the down-payment.

Efforts to encourage home-ownership led to the proliferation of low or no down-payment loans, which allowed perennial renters to become homeowners. This lead to a bubble in home prices which is now deflating.

Rental Management Corporation

Given the large number and concentration of sub-prime foreclosures, there is an opportunity for a sponsored business entity to manage the foreclosed homes as rentals. In this article I will refer to it as Rental Management Corporation [RMC]. Each region will have an RMC unit, where the region could be defined at the county or state level.

The process would be as follows:
1. Properties at the risk of being repossessed will be bundled together into a group which will be open to general bidding.
2. RMC will provide a guarantee of a minimum bid for the set of properties. This price should account for the following:

• Rental yield of the properties.
• Historic prices trend prior to the rapid increase since 2004.
• I expect, on average, the backstop bid price will be around 70% of the home’s original sale price. A 30% haircut means that the final 43% of home appreciation will be recognized as a principal loss.
• Note-holders will have to sign off on the minimum bid.

3. If another solvent entity comes up with a bid greater than the minimum bid, the role of RMC will end.
4. If no other entity can meet the minimum bid, RMC will take over the property at the minimum bid price.
5. Note-holders will transfer the ownership of the property to RMC at the bid price. The note-holders will recognize a principal loss; RMC will obtain financing to pay off the note holders.
6. RMC will manage and rent the properties out for the next few years, till the housing market stabilizes.
7. The original homeowner will get preference to rent the home from RMC at the prevailing market rent.
8. RMC will start selling the property once the housing market stabilizes in the area. Two years of non-negative home price changes can be the trigger used to start the sale process.
9. The current renter of the property will have a chance to bid on the property before it comes to the market. It is likely that the existing homeowner will continue to rent and then buy back the property.

Is there a Moral Hazard?

There is a question of the moral hazard when a government-sponsored rescue plan comes in to the picture.

In this case, the bail-out is NOT for the note-holders or the homeowners who made poor financial decisions. Note-holders will take a principal loss. Homeowners will lose the equity, if any, they have in their home.

Further, responsible homeowners who did not stretch themselves will benefit, since there will not be foreclosed properties blighting up the neighborhood. Unlike other proposals to reduce the principal amount, irresponsible homeowners will not be rewarded.

Why RMC instead of Private Investors?

Free-market dynamics will take too long and cause too much pain; the market can remain irrational for a long time. RMC will facilitate an orderly wind-down process which ensures that the community at large does not suffer.

Specifically:

1. The foreclosure process is long and costly. There are fixed costs associated with foreclosure, which often eat up the principal recovered, especially for lower end housing. Note-holders are better served in a low cost transaction with similar principal recovery.
2. The length of the foreclosure process will keep a lot of unsold inventory on the market depressing the overall sentiment towards the housing market. RMC can guarantee that the properties move off the market quickly.
3. Distress sales will likely happen at fire-sale price, which will depress home-values and accelerate the downward negative spiral in asset prices.
4. Private investors will cherry-pick only the most desirable properties leaving behind a big overhang of unsold foreclosed inventory.
5. Foreclosures have a detrimental effect on neighborhoods.
6. Families who are thrown out of the homes have a tough time in the future since their bad credit is damaged even further.

Caveats for RMC

1. The price paid by RMC for homes it purchases should not be inflated to bail out note-holders.
2. The properties selected by RMC should have clear potential to be cash-flow positive as rentals at the specified price.
3. RMC should focus on regions with a high concentration of homes to get economies of scale and low rental maintenance costs.
4. RMC should not compete with private investors but provide a back-stop.
5. RMC should start selling properties after 2 years of non-negative home price change in the area. They will be required to sell all the properties within a 5 year period after the home prices stabilize.

What is the role of Government Agencies

1. For an entity like the RMC to succeed, multiple stake holders have to come together and agree on some rules which preserve their interest, while working towards the greater good of U.S. citizens. Federal Agencies can define the ground rules which will govern the RMCs operating in different regions.
2. Organizing Bundles of Properties: In order to move the properties off the market quickly, the properties will have to be organized in large region based bundles. Government agencies can facilitate this process and ensure that it happens at a quick pace.
3. Organizing Auctions of Bundles: Once a minimum bid price is established, government agencies can facilitate the auction process and make sure that the entities bidding are financially solvent and have the capacity to hold on to the properties for a few years.
4. Access to Financing: RMC will need financing to pay off the existing note-holders. The financing will have to be at competitive terms, to allow it to operate in a cash-flow positive manner.

Incentive for Note-Holders

1. Note-holders will have the economic incentive to take the non-performing asset off the books. The capital recovered can be invested in more attractive opportunities.
2. As a variation, note-holders can be given some equity stake in the RMC in return for a lower sale price. This will allow them to participate in any potential upside.

Conclusion

In the age of securitized mortgages, it is very hard for note-holders to work with individual homeowners in distress. Further, due to the large scale of the problem, traditional market processes will take too long and cause too much pain. An organization like the RMC can ensure an orderly wind-down of the excess, while ensuring the stability of American neighborhoods.

Comments

[Pent updemand]

Ah, you sound like a guy who never heard of a "government solution" that you didn't like. No thanks.

You're right that the traditional foreclosure model is not going to cut it anymore. However, I am certain that the market will innovate in short order. Versus this hair-brained scheme to create another bureaucracy that will never ever never die.

[Vikram]

Negative Carry:

1. It will help to read more about how the Resolution Trust Corporation, a government sponsored agency helped stabilize the makets after the S&L crisis. It also earned a profit for tax-payers; now when was the last time the government earned a profit for tax-payers?

2. What we are seeing is a fat-tail event. Something which has a very low probability of happening but can happen. The negatives of such events are well known; what people tend to forget is that after the extreme reaction, the entities left behind profit a lot.

3. The private sector is frozen right now. It needs some direction especially since securitization means that the stake-holders are not local but spread all over the world. That is why the government needs to act. All RMC needs to do is to get the process rolling, aggregate the distressed properties, and provide a back-stop. If the private-sector can find a solution the role of RMC will naturally be reduced. Its primary purpose is to instill confidence.

[REO Realtor]

Please give me a source for the "profit" the RTC made.
Thank you

[Pent updemand]

The reason that you are not seeing vultures in the foreclosure business is that prices have not fallen enough.

I see no reason why the taxpayer should step in to catch a falling knife that business people are smart enough to avoid. So easy to be brave and bold when it's other peoples' money on the line, eh?

And you are the one in need of a history lesson. The parties who got a good deal from RTC were the vultures who came to pick over the bones. In no sense did the taxpayer make out on the deal.

If we have a few more months of high foreclosures, the banks will be forced to liquidate. An unoccupied house quickly deteriorates for a number of reasons. The banks need to take their haircuts at which point the private investment money will flow into these properties to turn them into cashflow-positive rentals.

[Pent updemand]

And enough with the "stabilize the markets" new-speak. I did not fall off the turnip truck yesterday; I know corporate socialism when I see it.

[Vikram]

www.fdic.gov/bank/anal...

has a discussions on the costs involved.

The problem with RTC was initially it was auctioning off assets at fire-sale price. Once it started going in equity partnerships, the return on equity was positive.

"However, the public-sector losses were
reduced by $4.5 billion in equity held by the RTC as
of year-end 1999.22"

What I am proposing is a way to prevent a fire sale auction of assets which will have a spiralling effect; an equity based partnership in real assets is likely to return positive returns over a decade. As the dollar revalues to its true global value, the nominal dollar prices of US assets will stabilize and grow.

[Vikram]

Negative Carry:
The issue with the foreclosure vultures as you call them is that the process will take too long and be too painful.

Foreclosures result in a negative spiral of falling home prices and blighted neighbourhoods. Lack of confidence in the asset pricing environment means that availability of credit will be even more difficult (perhaps even for the vultures).

RMC is role is to manage an orderly mop-up in a quicker manner. Once RMC organizes a bundle and puts a back stop price, the vultures are more than welcome to bid on it. The vultures are likely to pay a bit more than what they would otherwise; they can also not cherry pick the best. But the overall economic effect of a back-stop will be positive.

[Pent updemand]

You think the free market will take to long? Your "RMC" will be beset by the standard cast of rent-seekers and professional victims looking for their cut of the action in the form of set-asides for the "disadvantaged&qu... and making sure that a certain portion of the business is routed through "approved clearinghouses" (owned by people beholden to the right politicians). You say "orderly mop up" as if the meaning of that is self-evident. There will be winners and losers in the mess, guaranteed. I say let the market decide which column we all fall into, not some committee on Capitol Hill. I think you're buying into the myth of the quick fix. That sort of thinking is exactly why we find ourselves at this particular juncture.

[Rong]

Here is a link to a story about Minneapolis housing problems: www.startribune.com/lo...

[Vikram]

Rong: Thank you for the link.

Negative Carry: What you need to understand that a bulk of the mortgages are not held by 'banks' any more. They are held by a virtual entity called trusts which then sell the bonds by backed by them. There is no bank to make a call to sell; there are just servicers who have very little skin in the game.

It is likely that the liquidation will be really depressed values. However unlike other markets liquidation of homes at distress values has a cascading effect on the overall national economy. It affects all other homeowners in the area. It affects mortgage rates. It affects the confidence of investors and consumers.

Measured government intervention is going to be good for a majority of US citizens; the only people who are will get a slightly less good a deal will be the vulture investors and people who are short US assets. I think they have already had their bear run; time to help Main Street.

[Realtor/formerspeculator]

Since I've contributed to this problem myself and I have been affected by it a lot more than the average I have to say that Vikram's solution is exactly what was on my mind a few days ago, but also that I totally agree with Negative carry, government internvention will most likely result in further abuse and erosion of the best (not the ideal) market economic system in existence. Vikram's solution can work if it's run and controled by a "Vlad The Impaler" kind of administrator, which is unlikely in this litigious society. I other words it's a beautiful liberal solution which looks great on paper but it will colapse under the real worls tests. Maybe I am a cynic who calls himself a realist but we only learn through our own mistakes, never through our parents'.
As a society we need to bear (sic) the brunt of our greeds results and drasticaly change the laws and regulations that allowed us to get here and build again a strong fundation for this economy as it once briefly was.

[Vikram]

I do understand the fear of abuse of a system with the government involved. However, one key difference between the past and the present is the role of the servicer.

The servicer handles the foreclosure but has little or no skin in the game. They have very little incentive to get the most out of the foreclosure process. The bank who had a vested interest to recover the most principal is no longer in the picture in most cases. This is especially true for sub-prime loans which were the first to be off-loaded in the securitization market.

The REO sale managed by the servicer is open to abuse and bid-rigging by the vulture investor and the servicer managing the sale. The huge number of foreclosed homes in the market also means that it is going to be a vulture's market to pick; scarcity of buyers means that the fire-sale price would be hard to question.

A government sponsored agency, working with local community members, can insert some semblence of oversight in the process.

There are pros and cons of everything but clearly the market has failed to resolve issues. It is time to consider alternatives. Investors betting on a doomsday scenario may not like but Main Street needs it.

[brokerbila]

How to Fix the Housing Dilema:

As buyers keep waiting to buy, due to dropping prices, the problem continues to grow. If we can help put a floor under values we can stop this costly spiral meltdown. When prices stop dropping, forclosures will stop increasing.

Lets create an FDIC sticker for a home like the one on the window at the bank. It basically insures that if you put money in youll get money back later. Lenders currently protect themselves with PMI (Private mortgage insurance). We should make this available to home buyers, that if they agree to hold the home for a least X number of years that the value will be insured if they have to sell after that time. The owners could make a small payment per month to pay for the insurance. Buyers would not wait any longer to start buying again and this would put a floor of confidence under the market.

At some point in the future a smart insurance company who is already recognizing a bottom in the market anyway could step and make a lot of money at low risk. Government could encourage the insurance industry to create an FDIC like insurance that would stop this spiral down dead in its tracks.

[User 122298]

"Government agencies" and "happens at a quick pace" in the same sentence? What have you been smokin', dude?

[the finalhorseman]

an fdic for sub prime? oh please! why doesnt the treasury just issue enough paper to buy all the mortages in the us. since we owe the money to ourselves, we didnt spend a dime, did we? then the government in its infinite knowledge and humble courage can become history's greatest slum lord.

big brother now controls just about everything and the national security agency or whatever can were black uniforms and matching armbands.

if certain parties still think national health insurance should be mandatory then why cant national mortgages be intermeshed with this theorem? why cant peon citizenry who actually own their homes be forced to take out home equity loans to stimulate the economy? if these subversive former home owners refuse to stimulate said economy, then why cant they be forced to pay rent on top of taxes, home maintenance fees, etc. turn america into one giant condo? why not? unemployed financial analysts can now be put to work in a us ccc work program, thus eliminating unemployment insurance...and...sinc... the government hires mostly temps (sans benefits) there will be no need for either social security or medicare. we can get our roads fixed, our oranges picked, etc.

final solution...here we come. i must be one of the thinking minority. i refuse to allow this...but then, who am i? hey: jefferson and franklin? where are you guys when we need you the most?

[the finalhorseman]

sorry for the typo...'wear' not 'were'

[Pent updemand]

Vikram, you need to examine your premises. You start with the premise that it is desirable to "support" (I read "price floor") the price of housing.

In my book you are off the track right there. Why are expensive homes a public good? Because financial engineers on Wall Street built an edifice of levered debt on top of them?

Humpty dumpty can not be put back together again. Anybody with a pulse can see that home values can decline and furthermore that they got way out of line with current incomes. The fact that many "smart" people bet a lot of money to the contrary is not reason for a government bailout.

[Vikram]

Negative Carry:

Markets tend to overshoot in either direction. In case of housing the effect is not just on investors and traders but your average Joe trying to earn a honest living. That is not good for anyone except for someone betting against US economic prosperity.

A bulk of subprime loans went to lower income people in lower income neighbourhoods. After you remove 43% of the appreciation, you are coming close to replacement value of the home (i.e. the cost to construct). These are not expensive homes or MacMansions. Many times these are homes bought by unsophisticated first time buyers who never thought they could buy a home; they are also dominated among minorities.

What I am trying to propose is to ensure that the markets come into an equilibrium sooner than what the private sector can bring them. Further by putting a floor we ensure that negative psychology does not destroy the world's confidence in US issued assets.

We do need to fix a lot of things including our trade balance and budget imbalance. We also need to take the excess out of housing. However letting the pain in housing linger on for longer than necessary is not the way to do it. Neighborhoods need to be preserved.

[Pent updemand]

Well then I simply disagree. I think the historical record is replete with examples of well-intentioned government cures that made the disease worse rather than better.

American society has been living beyond its means for a long time. And now we're going to learn the hard way the consequences of that. To those who propose magic wand solutions, I would only offer the words of one of my mentors about "the hard way". He always said people should just call it "the way" because there was no other path to real learning.

[brokerbila]

I agree with Vikram in that I would like to see markets reach equilibrium soon for everyones sake. The problem has grown way beyond subprime. Some peolple who put $150k down are walking awaynow and if job losses increase many more will follow. My first preference is not for government, but for a private and for profit insurance company to step in to stop the overshoot of the decline. Think of all the people who might like to buy home price protection insurance. This could be a real growth industry. Maybe we could put some of the people who have lost jobs in the real estate industry back to work? It's really a very capitalistic idea. Hedgeing a bet on spending a half a million dollars on purchasing a home is probably sounding like a pretty good idea to a whole lot of people right now. It just makes sense. It's something most skillful investors do.

[Pent updemand]

brokerbila, you are calling for some private or public entity to walk into a falling market and sell puts? Sorry, but to me that sounds like one definition of insane.

Your little proposal does sound like a good deal for buyers, but let's look at the guy on the other side of the trade. I see a lot of risk. Perhaps your "insurance premium" won't be as cheap as you think.

[johngonole]

I only quickly perused the responses to the artical by Vikram. On paper I agree it sounds like a good idea. I also strongly agree with the posters wary of more facism/socialism. One comment that Vikram made that I disagree with is that the market isn't working. I disagree because I don't believe the free market has been given a chance to work. The Federal reserve has been constantly tinkering with the market since the late 90's especially. Every time there has been even the hint of a recesssion the Fed and government start printing money and deficit spending. A free market would never have allowed us to get to this point without the artificial stimuluses that were not needed.

Vikram's proposal is just more of the same. Only government is supplanting and replacing the free market. If banks had been allowed to fail here and there all along this process we would not be at this point where we are at a "Too big to fail stage". Why were these finanical institution's allowed to get so big anyway. Anti-trust was supposed to protect the free market. Instead we have banks that are brokerages, mutual fund managers all the same etc...

Another problem is that I don't see a disorderly problem yet when we talk about foreclosures. The banks are scared yes but I'm sorry prices haven't come down a whole lot yet. Maybe in a few places like Detroit but not here in Florida. Houses are still priced like 50 - 100% more than they were just 5 years ago. Banks made huge profits now they should lose some money. Perhaps they should cancel their dividends or recapitolize by selling stock after doing all those buy backs. Every other industry must risk losses. The very idea that banks are secured by the fed and govt to not having to take losses created this moral hazard. The owners banks essentially act as if they own the government and are entitled to protection and profit. Now I don't want a bank with my money in it to fail but as I mentioned let them recapitolize by selling stock and dilute the owners who are to blame.

The point I'm trying to make is let the free market acutally squeeze some people a bit, let prices come down a bit, and see how the market handles the situation. One government solution after another is what has caused the problem. Heck even the Fed policy of target a bit of positive inflation 3% is stupid. The dollar should actually be in a slow constant state of deflation due to natural productivity gains that are constantly being made. Slow deflation would not set off the kind of deflationary spiral every one is so scared off. It would actually allow people to save for retirement without the need for medicaid, social security etc... Imagine being able to plan for retirement confident that the money you have now would be worth as much or more in the future.

Policies like this one proposed and every other central planning solution are madness. The best markets are always the ones allowed to work. The problems are governments and monopolies. Stop interfering with markets and everything will sort itself out.

So as a tax payer I say no to this! I also think the dollar should be partially backed by hard assets such as land, gold, silver, oil, etc. The idea that our dollar is backed by DEBT which is considered an asset only because the US government has the power to tax is crazy. So basically if our government goes broke we all do. So far the government hasn't shown the ability to even balance a budget. Scary scary times indeed. So what will they do to stabalize the currancy in a crisis. They will be forced to let the currancy become worthless or confiscate capitol or wealth accumulated by those who have managed to save something. I agree with the guy above if we continue down this road we will be back to Nazi germany. History, economics, mathematics, basic knowledge of human nature acquired in what religion you practice all individually and collectively point to the same conclustions. So do we get a bloody French revolution or a Halocost. Its coming if we continue with this central planning and fascism. Where those at the very very top conspire with goverment to maintain power buy promising to help the poor, while desimating the middle class. Think about it. The elite buy protection and bail outs from the government every time they fail so they stay rich. The bail outs are funded by the middle class. The poor aren't funding it. Of course the poor are held down by it. This created a demand by the poor for more government help further securing the elite's protection. Shrinking middle class no wonder.

And so vikram lets create another fascist entity. Good plan! How will you profit from it.