Part 7 – How to wipe out $4 trillion of excess mortgage debt

By May 21, 2009Economy

Part seven of a nine-part series

After significant internal debate, I’ve concluded that repudiation of excess mortgage debt is the only workable solution to the current crisis. I don’t suggest this solution lightly as it has not only national, but also geopolitical implications since foreign central banks hold so much U.S. debt. While some people believe debt repudiation would lead to a complete lack of confidence in U.S. obligations and, in turn, lead to a total financial collapse, I believe the opposite is true. Our failure to mark the value of investments to current market prices and take necessary losses only increases the fear of investing in these instruments. Our refusal to see the plain simple truth that we cannot repay these obligations has frozen our credit markets and, as counter-intuitive as it first seems, debt repudiation is likely the only way to restore lender confidence and get credit flowing again.

Repudiating debt won’t mean the end of lending due to a loss of investor confidence if the debt repudiation acknowledges the mistakes that were made, shares the pain among all involved to minimize the moral hazard and is accompanied by a clear plan to prevent those mistakes from being repeated. If debt levels are restored to sustainable levels and protections for investors are put back in place, then credit markets will return as investors compete for safe debt investments. By taking a proactive approach, we’d be far more likely to minimize losses then we would be if we continued to deal with the problem on a reactive basis. That’s especially true since those reactions, like foreclosure moratoria, only delay the inevitable.

Unfortunately, we currently lack the political will to take this step. It would take incredible leadership to convince not only Americans, but also the rest of the world that debt repudiation was not only necessary, but also in everyone’s best interest. Homeowners who have negative equity would get a second chance. Homeowners who have equity would gain stability in their home’s value. Creditors would gain by seeing losses minimized, risk reduced, and new opportunities to invest. Governments would gain by stabilizing tax revenue. And everyone would gain as the economy would regain health and again be capable of growth.

If we found the political will, I think it would be important to share the pain. Taxpayers should bear a portion of the losses because they allowed their elected representatives to enable this crisis through the Taxpayer Relief Act of 1997, the Financial Services Modernization Act and the Commodities Futures Modification Act. Loan originators and investors, including foreign central banks, should bear a portion of the losses because they made obviously bad loans, despite whatever assurances they may have received from ratings agencies or the U.S. government. All borrowers who were a part of these transactions should proactively help to resolve the issue, rather than walk away from their obligations, and those who used their house as an ATM should be held to a higher standard of accountability.

To that end, a carrot-and-stick approach for both lenders and borrowers should be brought to bear:

Lenders

Carrots:

  • The federal government should offset a percentage of investors’ losses to encourage them to proactively reduce loan balances for borrowers who qualify for a loan modification and allow short sales for those who don’t. The offset should vary depending on the loan position and tranche in accordance with the level of risk for which the lender signed up. AAA-rated first mortgages should have as much as 70 percent of the loss protected while second mortgages likely should have only 10 percent of the loss protected. On a blended average, taxpayers should be on the hook for less than was spent on bank bailouts while this time addressing the real problem.
  • Even without government credit, lenders would see higher returns on loan modifications and short sales since they can return 90 percent of current market value compared with 65 percent or less (after expenses) from a distressed home sale.
  • Lenders should be allowed to foreclose without delays or moratoria on loans of borrowers who choose not to participate in a short sale or loan modification.

Sticks:

  • Lenders should be required to review and either accept or reject short sale offers within 15 days and loan modifications within 30 days of receiving a complete application. If they fail to do so, they should be ineligible for any government relief.
  • Bankruptcy cramdowns should be available to bankruptcy judges if and only if the homeowner has first fully cooperated with the lender to try to resolve the problem though a loan modification and short sale.

Borrowers

Carrots:

  • Borrowers who qualify should receive a reduction in debt to 90 percent of the current value of their home. This carrot would essentially bring homeowner to the break-even point and allow them to reset and move forward. To qualify, the homeowner must be able to afford to repay the resulting principal balance with a 30-year fixed-rate loan at a market interest rate.
  • Borrowers who don’t qualify for a loan modification, but cooperate in a short sale should have their exposure to deficiency judgment under state tax law limited to $10,000 and the impact to their credit limited to two years.

Sticks:

  • Borrowers who refinanced and pulled out cash should have to carry a personal note to repay taxpayers for the portion of the loss born by the government. That debt shouldn’t be dischargeable in bankruptcy, except in cases of significant hardship.
  • Borrowers who won’t cooperate with a loan modification or short sale and thus force the lender to foreclose should owe income taxes on the amount of debt forgiven and remain liable for any deficiency judgment that may be allowed under state law. Any taxes received should be used to help defray taxpayers’ losses under the program.

This approach is admittedly a rough sketch and many variations on this theme likely would work. The key is to elimintate the excess debt without creating moral hazard. Programs shouldn’t provide incentives to make the wrong choices–and the only right choice is to return to sustainable levels of debt in as orderly a fashion as possible.

Next: How to prevent another housing bubble

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  • richard_1 says:

    Political tinkering got us into this mess. It is hard to trust that more political tinkering can get us out the mess.  Capitalism is said to be the most efficient economic system known….. but it is also the cruelest.  I watched the changes in the 80s to the rust belt of the northeast. Some would say it was the greedy corporations, yet others would place blame on the unions. Both would be right.  Looking back with what I know now, it seems that it was inevitable. The tech boom and global growth of capitalism has created competition, people hungry for a better life, will work in China or India for a fraction of what the same jobs pay here.

     

    Fraud was rampant in the mortgage business. But it was on both sides. Brokers and underwriters turned a blind eye to the borrowers’ facts as they collected their commissions.  I purchased an REO earlier this year. As it turns out, the house next door is in default.  I contacted the owner to discuss a hew fence. The folks living in the house gave me her phone number. She is a housekeeper at the Embassy Suites. The house has $600K in loans, I assume that was also the selling price in 2006. Now who in their right mind would lend her that much money? Yet, should we forgive her debt in an attempt to let her keep a house she cannot afford at ½ the monthly payment? I know people who bought their homes in the 90s, then ran up big credit card debt with cars, vacations, a life style they could not afford. Then I watched them refinance  to pay off their credit cards with option mortgages. I recall commenting at the time that I thought they should do something about their lifestyle, that what they were doing was not sustainable. Of course there are people who were honest and well intended and simply wanted a home. When the realtor and loan broker told them they could move in for no money down and they would have a payment they could make, they were on cloud nine. The American dream had come true for them. Yes, they may be victims and deserve our charity.

     

    So, who is going to be in charge of deciding what is the right thing to do? So far, what has been done has been political and has not really fixed the problem. Should my friends who are loosing their home because of their credit card debt be bailed out? I love them, but tough love would have them loose their house and maybe they would get the message they were responsible for their problems, not the rest of us.

     

    The US is a country of laws. Contracts including mortgages are part of the foundation of our country. Allow the parties to these contracts to work through them one at a time. That is how they were made, and that is how they will have to be resolved. If there was fraud, then enforce the laws regarding fraud. But don’t though the baby out with the bathwater.

     

    The constitution does not guarantee happiness. It does, however, guarantee the right to the pursuit of happiness. This is a very big right and is envied by much of the world. I personally have a great deal of satisfaction knowing I have earned what I have.

  • Sean says:

    Hi Richard, I appreciate your position – you certainly represent the majority at this point. I wish you had read my earlier posts, but a couple of quick thoughts:

    1. Your nuts if you don’t think we are doing the most significant financial tinkering in our nations history RIGHT NOW. It appears things are so out of control that the fed has lost track of the $9 Trillion in off balance sheet transactions its conducted to date.

    2. Its popular to point to subprime loans and mortgage fraud as the culprits, but give me a break. There was something far bigger going on to get us to a point where 35% of Californian’s with a mortgage are now underwater.

    3. I love this “contracts are part of our foundation” line. Actually one of the things that makes the U.S, most unique in the world is our bankruptcy laws which allow companies and individuals a second chance, and are largely why we are so much more entrepreneurial than the rest of the world. We take big risks, and if they don’t work, we move on.

    4. Given that we have 3 Million upside down homeowners in CA, and only 13,500 were foreclosed on last month, are you really prepare to spend the next 10 years in economic hell as we let these things work through one at a time? Especially when our government is already running $1.2 Trillion dollar deficits just to keep things from unravelling faster?

  • richard_1 says:

    I understand the paradox. I used to think that Greenspan’s “soft landing” 1/4 point rate change approach was smart. But I can see that the soft landing really mean taking the pain out of the economy. I have come to beleive that pain is a part of the process. But my bigger point is who gets to decide who is deserving of the debt relief? This is the moral hazard. I for one think that pedaphiles should be locked up for life. But the bleeding hearts think we should try to rehab them. Only to see them molest or rape again.

    I do respect your knowledge of the mortgage and foreclosure markets, so what are the details of who gets the break?

  • Sean says:

    Unfortunately at this point I don’t think it is possible, or even useful, to try and analyze each deal for “deservedness”. Instead as I oultine above it will have to be done in broad strokes. I’m all for limiting moral hazard – though that can also be accomplished by putting in place tougher laws going forward (like removing implicit guarantees to fannie, freddie debt). Do note above that I think it is worth making a distinction between those who pulled cash out, and those who bought at the peak. The folks who pulled cash out actually received something of value and should be held accountable for it. I also don’t think we should adjust payments to whatever is affordable for the current owner (as we are doing now under the Obama plan) – instead we should adjust price to be affordable given area incomes. This subtle difference resolves your issue of a hotel maid getting to keep a $600k house, as they would still have to qualify for the adjusted price at market loan terms.

  • stock trader says:

    The sub prime mortgage crisis was born in a decade-long housing boom fueled by low interest rates and excess liquidity. During these ‘boom’ years, mortgage brokers enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without proper tax documentation and credit checks. And so the groundwork was established for the coming mortgage meltdown.

    These loans, usually adjustable rate mortgages (ARMs) were known as subprime mortgages. They typically cost two or three points above those with less-risky credit reports and carry interest rate structures with low ‘teaser rates’ for the first couple of years, followed by a reset to much higher rates. This reset or jump, frequently resulted in raising the borrower’s monthly payment by as much as 100% and thereby making it financially impossible for him to handle.

     

    That’s why now we have world financial crisis, where all institutions across are involved. Hope this will end in 2-3 years, but home loans practice will chenge somehow in future, because nobody wants financial bubbles any more

  • Most of the burden for incurred losses should fall on the investors who purchased the mortgage backed securities – investors have to accept risk with other investment vehicles – why should these be any different?

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