I have a lot of respect for Chris Whalen and the folks at Institutional Risk Analytics. I think of them as being sort of centrists on some of the critical economic issues. They don’t support the Fed, they most certainly are not supporters of the big banks. They are no fan of “kick the can down the road” plans. On the flip side they are not in the camp that says that all must be torn down before we find a sensible base that we can move forward with.
So when IRA came out with, “A Brady Plan for Fixing the Mortgage Mess” I got excited. Then I read it and got disappointed. I think the plan has warts. That said, something along these lines is probably what we will see from D.C. in the coming months. Some of the blemishes:
On the general concept of a “Brady Plan” IRA had this to say:
Remember that the Brady Plan was mostly about acknowledgment of huge losses at the big banks.
While it is true that back in the 80’s the US and global banks took some big losses on their exposure to busted developing country debt the Brady Plan was (and still is) the biggest “extend and pretend” accounting gimmick in history. The solution for Brazil and Mexico (and others) back then was to eliminate the obligation to pay back the principal on the debt. The plan split the old loans into two pieces. An interest only and a principal only (IO/PO) security was created. The principal of the loan was secured by a 30-year zero coupon bond issued by the US Treasury. The only obligation of the borrowers was to pay interest at the reduced rate of Libor +13/16ths for 30 years.
The accountants were leaned on. The banks were able to put the new Brady Bonds on the books with no haircut as the principal repayment was assured. A clever solution (that worked very well), but extend and pretend was born from this deal. Suggestions on what do with mortgages from the IRA report:
Lower interest rates/duration in existing mortgage through new or expanded GSE guarantee programs.
The conforming loan size limit should be made permanent at $729,750, going up to 130% of this limit in high cost areas.
Subsidize already low interest rates? Make the ridiculous GSE high limit of $730K permanent? Increase the already ridiculously high limit to $950K in high cost areas?
These recommendations represent a massive increase in the federal commitment to the mortgage market. The 730k limit was established with the 09 HERA bailout.
It was supposed to end a week ago. But it has been “temporarily” rolled over to September 30, 2011. What has been the consequence of the steps taken two years ago? Easy answer: Washington has become 95%+ of the new mortgage market. The mortgage market has been totally socialized as a result. Do we really want to take additional steps that cement D.C. into the mortgage business? Forever?
IRA points to the problem:
The private label mortgage security market will never come back.
I ask, “Why is this the case?” The answer is that with Washington lending money under terms and conditions that private investors can’t compete with (and terms that would result in losses for “real” lenders if they did) there is no hope that a private market will resurface at anytime soon. More from the proposal:
Allow for discounted payoff of underwater mortgages so that homeowners have at least 5% positive equity.
So here is the debt relief. Anyone with an underwater mortgage gets a write down so that the new debt is equal to, at most, 95% of current appraised value. This is a very big deal. Something like 25% of all homeowners currently are in this terrible position. By waving a wand IRA makes the problem go away. But what about the 75% who are not underwater? They get nothing in this plan? Where is the fairness to that? What about all the renters out there who will be kicking in for the cost of this? Why should they have to pay?
Second liens should be written off in the case of principal reduction on the first lien.
This should (and will) happen. Cleaning up the sub-debt is part of the process of wiping out the dreck. But hold on to your socks as to the implications of this. The “second” that IRA refers to is actually a critical component of housing finance. Without it, residential RE is dead for as long as the eye can see.
The second mortgage is the airball between a conventional mortgage (80% LTV) and the purchase price. There was a time that you had to put up 20% of money out of your pocket to buy a house. Second mortgages eliminated the need for equity. With no restraint on buying a home too many people did it. It first caused a boom and then a bust.
But if we legislatively wipe out all seconds where will the new seconds come from? Once legally "nicked" this money (high risk capital) will be gone for a very long time. If we revert back to a sane policy that requires a big down payment (and results in a good borrower) you can kiss off the housing market. So who will provide the money given that private capital will be forever gone? Washington of course. Fannie (OTCQB:FNMA), Freddie (OTCQB:FMCC) and FHA are all providing 97% LTV loans today.
A technical point. The CBO has recommended that the D.C. lenders take a haircut at the time a new mortgage is written equal to the difference between "market" and actual terms. Under this approach, if a mortgage is written at 98% LTV (an embedded 18% second) the GSEs would have to take a big current hit. This would flow directly back onto the federal budget (where it should be). But the cost of subsidizing new issuance would explode (as it should). Other budget priorities will dominate coming years. This conflict will result in many less supercharged (+80%LTV) mortgages.
Cleaning out old seconds solves an old problem. But the absence of new seconds is going to hurt more than the problems that are solved. Let's face it. If the terms to buy a home required the buyer to pony up 20%; RE would fall by 30%. It's all well and good to take the rotten seconds out back and shoot em. But don't think there is no cost to this. Another recommendation:
The losses from the write-down of principal of the first and second liens would be borne by the bond/loan holders.
Okay, I like this. Whack the bondholders. But who are these bondholders? The biggest is the Federal Reserve. Last I saw they were sitting on 1.1 Trillion of dodgy mortgage paper. The losses could be in the 20% range. So the Fed would suffer a hit of $200b or so. But the Fed is the Treasury and the Treasury is the taxpayer so really this just ends back up being a socialized loss shared by all.
What about the losses for private sector holders of mortgage bonds? IRA has an answer:
These losses should be treated as full tax credits, accounted for as a Treasury Strips on the balance sheets of the institutions who take the principal loss.
Hold on a second. A tax credit is a much different thing than a tax loss. By creating a credit the holder of the bad mortgage paper never feels any pain. The credit creates an asset that is equal to the loss. As future tax liabilities come due the credits are used to offset dollar for dollar the prior losses. Under normal circumstances a lender who suffers a loss can shelter that with other gains and reduce taxes. For our big financials the average federal tax is around 20%. A tax credit is therefore 5Xs more valuable than a tax loss. With a tax credit, the end result is that 100% of the losses are born by unsuspecting tax-payers.
The lenders get off Scot-free. Where is the fairness in that?
To address this concern IRA suggests:
Non- US taxpayers (like German Landesbanks and Cayman Island hedge funds) get nothing. This should cut the cost to the Treasury by 30% (estimated) and spread it out over 7 to 10 years.
Read this differently. PIMCO, Citi (NYSE:C), Wells (NYSE:WFC), BoA (NYSE:BAC), JP Morgan (NYSE:JPM) and the others would get to write off their losses against $ for $ credits (no loss) while the bad boys at the Landesbank and the white spats guys at hedge funds eat the losses. What kind of plan is that?
If you wanted to put a dent in the US financial position and cripple future capital formation the best way to do it is to drive foreign capital from our shores. A plan that had an asymmetrical result, where one class of investors got significantly better treatment than another, would result in money moving away. Exactly what we don’t want. While it is nice to put up a proposal that saves the taxpayer 30% of the cost, one has to look at the broader implications related to those “savings”. I’m no lawyer, but I doubt that an asymmetrical result like this is even legal. It most certainly would produce some of those dreaded, “unintended consequences”.
IRA recognizes the various inequities of their plan. Their solution:
As a matter of equity, homeowners with written-down mortgages would be subject to higher taxes.
Okay, that sounds good, but from the report:
Principal reduction will count against taxpayer's $500,000 exemption from capital gains tax on the sale of the primary dwelling. If you get a principal reduction, you have to pay capital gains taxes until the IRS gets the amount of the principal write down back. Reduction of capital gain exemption will last for 20 years and apply to the gain from the sale of any residential real estate, not just the home associated with the principal reduction.
The assumption here is that RE is going to explode in value and all of the losses today will be gains (and tax income) tomorrow. I’m sorry. This is smoke and mirrors. Everything will work out fine, provided we have another bubble. As IRA concludes:
This scheme may not work for every homeowner; some will die before the gain is repaid.
I think we will all be dead before it is repaid. It's too easy to shelter RE gains. The IRS will not see much from this. So really this is just a, “kick it down the road and hope” kind of approach.
I pick apart the IRA thoughts to make a point. There is no “solution” to the mortgage mess. Every approach has costs, inequities and long-term consequences. This effort is the best that I have seen and I believe a number of features in this plan will be adopted. But let’s face it. This “good” plan sucks. We are going to hate it.
It's too bad Chris Whalen isn't involved with this. He should be. 2011 is the year when key choices on the GSEs will be made. As of right now the only voices that are steering the ship are all saying that we need to return to what we had in 07. A (series of) privately owned (AKA: Wall Street) mortgage providers who live off the taxpayers with a government guarantee of their debt. Absolutely the dumbest thing we could do.
We need a few fresh faces with better ideas. I wish the 'deciders' would ask Whalen to the party. I (and many others) would feel just a tad more comfortable if he were involved.