With all the talk of write-downs, bailouts, and stimulus packages, I came across this op-ed column in the Boston Globe by Robert Kuttner that offered a refreshing approach to the current crisis.
Kuttner says the economic threat posed by the sub-prime crisis comes from within the housing sector, and the solution must address that sector as well. He proposes a New Deal-style solution: a new government agency that would buy up bonds backed by distressed mortgages and then refinance those mortgages at lower rates. With lower rates, homeowners who can't afford their sub-prime loans could keep their homes and vacant homes could be purchased by new owners with mortgages financed by the new federal agency. Funding for the agency would come from issuing tax-exempt bonds. According to Kuttner many housing experts support the approach, but few politicians do.
On a first read, this sounds like a sensible proposal that could have a more direct impact than mailing checks to taxpayers some time within the next few months. I wonder if others have analyzed with this proposal? If so, what are its flaws?
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1. Posted by kjhkjh on January 29, 2008 @ 16:07 | Permalink
I don't understand what's good about this proposal. If someone can't afford their house, I don't understand why taxpayers should help them stay in it. The difference between someone who needs the help of this type of agency and someone who does not is that the former bought a house that was too expensive for them while the latter did not. Since the persons who did not need the help of the agency are paying for the agency, effectively this means that people who have lived within their means are paying for people who have not. This makes no sense.
2. Posted by Elizabeth Brown on January 29, 2008 @ 16:19 | Permalink
Perhaps one problem with this solution is that it is based on an over-simplified view of how the mortgages were securitized and ignores the other financial instruments that may have been created to prop up creditor confidence in those securities.
For example, the New York Times reported on a lawsuit brought by American Home Mortgage Holdings, a subprime lender that went broke in August 2007. American sued Bank of America, claiming it had reneged on a deal to take the losses if mortgages were sold for less than face value. The bank claims that some of the loans shouldn't have been made at all, but American Home says that is irrelevant.
A very simplified description of how a deal involving these entities worked is as follows: American made subprime loans and sold them to special purpose entities it set up. Those entities, in turn, financed themselves by borrowing, mostly through the short-term commercial paper market.
To reassure investors, the special purpose entities entered into swap agreements with Bank of America and other big banks, in which the banks promised to make up the difference if the loans had to be sold and fetched less than par value. The chances of such a sale presumably seemed slight when the deal was made in 2004.
American auctioned off the loans. Packages of mortgages that were classified as performing - meaning the homeowner is mailing in a check every month - sold for as little as 80 percent of face value, and none went for more than 92 percent. The nonperforming loans sold in a range of 54 percent to 59 percent.
American says it sent out bills to its swap partners, and all but Bank of America agreed to pay. The amount in dispute is just $25 million, an insignificant amount for the bank. But its refusal to pay may indicate an effort to find ways to shed what now seem to be foolish risks.
So these transactions are more complex than described in the op-ed piece. Even this deal is considerably simpler than many of the deals out there. As a result, a solution based on the mortgage markets of the 1920s and 1930s may no longer work given the wide range of financial instruments that are actually involved in many of these securitization deals today.
In addition, it is hard to see how this type of bail-out won't create a moral hazard problem that would simply encourage a wider range of financial institutions to engage in excessively risky behavior in the belief that if things go wrong that the government will bail them out.
The Home Owners Loan Corporation extended the mortgages time frame from 15 to 30 years when it refinanced the mortgages in the 1930s. Today a 30 year mortgage is the standard time frame in the United States. Would the new agency also extend the life of mortgages? If not, it might not be able to turn a profit at lower interest rates as the Home Owners Loan Corporation was able to do.
3. Posted by KipEsquire on January 29, 2008 @ 18:44 | Permalink
"If so, what are its flaws?"
Besides the fact that mortgage lending is not a legitimate function of government?
How about this: Many defaulters simply have no desire to avoid foreclosure. They owe more than the value of the house (or, in the case of speculators, houses), they are already bankrupt and have no incentive not to just walk away from the property.
Those who do want to "work it out" almost always can without any help from the government. Contrary to the stereotyping by liberal malcontents, lenders are not all Silas Barnabys waiting impatiently to evict Mother Peep from her Shoe. If the defaulter shows good faith, typicall so will the lender.
Or how about this: predatory borrowers who filed fraudulent mortgage applications. Why exactly should taxpayers bail them out?
This proposal is meant to generate warm fuzzy feelings, not to solve any extant problems.
4. Posted by Cliff on January 29, 2008 @ 20:01 | Permalink
Just what we need. Another government agency to solve the country's problems. How about responsibility for choices?
Doubtless, many have done their best to be financially responsible, but my personal impression is that issues like this are the result of overreaching on the whole, and government subsidizing of the effects of widespread overreaching is simply dangerous policy.
5. Posted by Renee Jones on January 30, 2008 @ 7:10 | Permalink
Thanks for your helpful comments. I agree that the model presented by Kuttner seems oversimplified given the complexities of the financing arrangements connected with these mortgages. Still, I wonder whether Alfred DelliBovi, the president of the Federal Home Loan Bank of New York, who is quoted in the article has worked through some of the thornier issues.
As for the moral hazard problem of bailing out investors and bankers, to some extent it is water under the bridge, they have already engaged in the risky conduct without a guarantee of a bailout, and a problem remains that must be addressed somehow.
Regarding the financial soundness of the new institution. I would want to know more. If it is not self-sustaining then some of the commenters complaints of a government bailout seem warranted, but as I understand the proposal the financing would come from tax-exempt bonds, not from the government directly.
6. Posted by Jason Kilborn on January 30, 2008 @ 9:02 | Permalink
KipEsquire, do you have any empirical basis for your observations about borrowers' ability to secure a workout? Outside California, as far as I know, most mortgage are recourse loans, so most borrowers have plenty of incentive not to just walk away and face personal liability. The reports I have seen suggest that lenders are VERY seldom agreeing to reasonable haircuts to work something out with insolvent borrowers. So, can you point to any emprical evidence in support of your comments?
7. Posted by Elizabeth Brown on January 30, 2008 @ 10:35 | Permalink
I looked at Alfred DelliBovi's orginal piece in the American Banker but it does not indicate that he has worked through the thornier issues. I also did a quick internet search but could not find a longer description of how a new Home Owner's Loan Corporation (HOLC) would deal with the complexity of today's deals.
In his American Banker piece, DelliBovi noted that the HOLC was set up in 1934 with $2 million in federal government funds and authority to issue up to $2 billion in tax-exempt bonds in order to refinance a little over 1 million mortgages. In today's dollars, that would be equivalent to $30 million in federal government funds and the authority to issue $30 billion in tax exempt bonds.
Some current estimates put the number of homes potentially facing foreclosure at 2.2 million with mortgages worth $164 billion. So a new HOLC would probably need at least $80 billion to refinance half of the mortgages on homes currently facing forclosure, which would make it considerably larger than its 1930s counterpart.
While HOLC could refinance loans up to $14,000 (or $224,000 in today's dollars), the average mortgage that the HOLC refinanced in the 1930s was worth $3000 or about $48,000 in today's dollars. Less than 15% of the mortgages refinanced by the 1930s HOLC were worth over $5000 (or $80,000 in today's dollars). The HOLC had considerably more problems with the mortgages that were over $5000. Even with refinancing, the HOLC had to foreclose on 194,500 homes, or about 20% of all the loans that it refinanced.
Given that the loans needing to be refinanced today are for much larger amounts and are much riskier than the loans refinanced by the HOLC in the 1930s, it is unlikely that a new HOLC would achieve the same happy results that the orginal HOLC was able to achieve.
One could argue that some relief is better than no relief. I guess, however, that I am not as quick to discount the moral hazard problem that a bailout would create. There is evidence that banks deliberately merge to get to a size where they would be deemed "too big to fail" in order to enable them to enter into riskier deals with the comfortable that the federal government will bail them out. I am not sure that a bail out for financial institutions now would not embolden them to even riskier behavior in the future, unless such behavior was expressly prohibited by government regulation.
Part of the reason that the subprime mortgage crisis was created was due to the absence of federal and state regulation, particularly of mortgage brokers. The financial services industry seems reasonably adept at preventing government regulators from pro-actively adopting regulations and very innovative in thinking up newer, riskier products that work around existing regulations. A bail out now would give a clear signal to financial institutions that they will not have to bear all, or perhas even most, of the downside risk for any new products that they create.
8. Posted by Renee Jones on January 30, 2008 @ 10:53 | Permalink
Thanks for your insightful and impressive analysis. It appears from your figures that this would be a significant government undertaking that would provide only a partial solution to the current problems. More problematic for its proponents, however, is that it seems to be a political non-starter.
9. Posted by art byrne on February 20, 2008 @ 23:33 | Permalink
A page of history is worth avolume of blogs. What the HOLC did wasbuy mortgages.They were selling at a fraction of what their face value was The typical mortgage was for 5 years at 10%. NO amortization[think bob cratchett],The home applied the HOLC appraised the property-Houses went down alot- it then offered to buy the mortgage for the appraisal.If it aquired the mortgage it refinced it for the lower amt for 20 years-amortorized. The holc was would up in 1951 at a profit. Mrs roosevelt wrote about it in her column MY DAY-you can look it up.
10. Posted by artbyrne on March 3, 2008 @ 19:51 | Permalink
One of the commenters pointed out that HOLCs limit was $14,000 which in CPI terms is $ 214,000.BUT in many places the house that sold for !4,000 sells for more than a million.E.G in 1931 kathreen hepburn bought her house in Kips Bay manhattan for $25,000 when she died it appraised in the millions.But then again in n.y.Ipicked a zip code and looked at the first 27 listing for properties in distress --REALTY TRAC>COM the median mortgage was $490.000 and the average $512,000. Then I went to MELISSA >COM and looked up the adjusted gross income reported to the IRS in 2005 It was $28,926 Q.E.D.