I came across a research paper published by the Boston Federal Reserve Bank where the researchers looked into among other things a mathematical formula that demonstrates subprime lender have little financial motivation to modify mortgages facing default.

This research I thought was interesting because I am caught between wanting the government or the lenders to “help” foreclosure victims, especially if they were tricked or lied to (a typical practice among subprime mortgage sellers). Of course, everyone on the planet knows best how to accomplish this “helping”. I on the other hand don’t. Nor do I have the arrogance or stupidity to believe just throwing money at defaulted homeowners will work any better than burying the banks in mountains of cash thawed a “frozen” credit market.

So are we stuck with the alternative…do nothing?

Maybe that is the best answer. Do nothing and let the real estate market absorb all the foreclose homes at depressed prices. This will eventually mean a bottom in home price gets hit or what economists call an “equilibrium”. The theory goes this will happen anyway and the only thing the Feds or lenders can do with too much “help” is slow down the inevitable. If that’s true, well-meaning “help” turns out to be “hindrance”. Not good…

I don’t know…this “free market equilibrium” rationale sounds very self-serving for the banking and mortgage servicing industries. Am I biased against it just because it aligns with the wants of an obviously crooked couple of industries?

Probably…

When I get caught in a “bias debate” with myself it can go on forever, so I seek out facts and figures to make the differences. Enter this new report…

Subprime Mortgages, Foreclosures, and Urban Neighborhoods – Authors: Kristopher S. Gerardi and Paul S. Willen

In the report, I found a few nuggets of gold to help me break the logjam.

First, the reason for the subprime lenders do NOT want to help is the fact that according to fairly simple “risk vs. reward” calculation, lenders know that most underwater borrowers will in fact pay!

Did you get that?

The worst hurt by this subprime meltdown, the lowly subprime borrower…those horrible folks who “took advantage”…even after losing a ton of equity…those folks will find a way to pay. Under this scenario the banks lose nothing…so why modify a loan with a costly principal or rate reduction.

We all forget to ask for the numbers in a fervor to “act” or “help”. In the case of subprime borrowers, the numbers show most will pay even when you or I might walk away.

Here’s a chart …

The chart shows even with a negative equity of 20% a prime and subprime borrowers’ chances of foreclosure are 4 and 33 percent respectively. Yes, subprime borrowers will default at a much higher rate than prime borrowers, but we should still remember if 33% default, that leaves 67% who don’t. That reflects a majority who don’t default under the same conditions.

A quote from the report,

“Specifically, many commentators have recently argued that lenders should eliminate negative equity for borrowers in such a position by writing down a portion of the principal balance on their loans. The argument runs that such a plan benefits the lender as well as the borrower because the new principal balance exceeds the yield from foreclosure, once one takes into account the costs of foreclosure. Many commentators have argued that this solution is so obvious that one wonders why lenders do not implement it on a large scale. In the following discussion we show why lenders have not engaged in such a policy as a matter of course, but we also argue that for multi-family properties in the inner city, such a scheme
might work.

There is a serious flaw in the logic of principal reduction. To see why, it is useful to think of two mistakes a lender could make. One mistake is to not offer assistance to a borrower in distress. The lender loses here if the increased probability of foreclosure and the high costs incurred by foreclosure make inaction more costly than assistance. We call this scenario “Type I Error.” But there is another mistake, often overlooked, which is to assist a borrower who does not need the help. The lender loses here because it receives less
in repayment from a borrower who would otherwise have paid off the mortgage in full. We refer to this case as “Type II Error.”

Type II error is precisely the reason that lenders rarely engage in principal reduction. One lender summed it up this way, “We are wary of the consequences of being known as a bank that forgives principal…we have not to date forgiven any principal.” Some have suggested that principal reduction would benefit investors, but that complex agreements between servicers and investors make such a policy infeasible. However, the evidence for this explanation is severely lacking. For example, Freddie Mac, which retains credit risk when it securitizers a mortgage, and thus has complete discretion over the disposition of troubled loans, rarely grants any loan modifications. Furthermore, for the instances in which it does offer assistance, few involve any “concessions” like principal or interest rate reductions.”

Why don’t we have more meaningful foreclosure asistance…prinicpal and/or rate reductions? Because lender’s …”are wary of the consequences of being known as a bank that forgives principal…”.

But is this because the banks are simply horrible, evil people with no compassion…or is it due to some macro-economic theory of hitting bottom unimpeded?

Nope…on both accounts!

The real interesting part of the study comes when the algorithm gives both types of credit borrowers back a 10% percent equity stake in the home and recalculates the foreclosure probability and the “Net Gain” between Type I and Type II Errors.

Looking at this we see the probability of foreclosure on the prime borrowers barely move but on the subprime borrower it drops considerably…from 33% down to 9%. One the surface, you’d think that would support the idea lenders and policy makers could benefit from a “principal reduction” strategy.

But wait…

We still have a negative net gain number even after simulating a principal reduction for all home-owner borrowers. The authors define the chart this way…

Type I error measures the cost of not assisting borrowers who need help. Type II error measures the cost of assisting borrowers who do not need help. The net gain to the lender, as shown in Section 6, equals the difference between Type I and Type II error.

So the researchers factored in the cost of the “accidental helping” of those who didn’t need it…which does occur when you do en mass loan modification ala Sheila Blair’s method. With this factored in, the subprime borrower now shows a negative “Net Gain” of -12.7%. The bank loses money even after reducing the principal amount…a no-win situation.

Combine this fact with the fact that 67% of subprime home-owner borrowers were going to pay in full without any help whatsoever, we get a reluctant banking industry when it comes to principal reduction loan mods.

It appears to me it’s a double standard for us to ask the banks to “help” subprime foreclosure victims in a way that loses them money. At the same time, preaching “Be smarter next time”. They are just trying to ‘be smart’ right now.

Of course, it really won’t matter because Congress and other politicians are already geared up to spend about $100 billion at last check to “help foreclosure victims”. I feel I can now say with certainty, no scheme of “helping” homeowners with principal “cram downs” or government investing in the “underwater” portion of their home will solve a thing.

I say this with equal parts relief that the debate is over…and overwhelming sadness the only logical conclusion means, in this case, “help” turns into hindrance.

I really wanted it to go the other way….

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Fed Research Sheds Light On Reluctance Of Subprime Lenders To Modify Loans

Ho! Ho! Ho! boys and girls (and real estate investors) — it’s that time of year again–Christmas –when the holiday spirit is in the air. Jingle those bells! You know you want to. But, there is a slight problem this Yule time season (well, okay, a big problem) that just may dampen your good cheer.

Santa is facing foreclosure!

I know, this has not been widely reported in the news because, frankly, Santa thinks it’s none of your freaking business . . . but, the mortgage on his North Pole residence is about to go South since it was financed with one of those subprime loans we keep hearing about.

I know, you are asking yourself, why did Santa need a subprime loan? Well, come on, if you only have a job that requires you to work one night a year, don’t you think it might be hard to get a bank to give you a regular mortgage?

Now, don’t get me wrong . . . Santa is no deadbeat . . . a little too fat, maybe, but no deadbeat. The problem is the subprime mess that led to the credit crunch has led to fewer people buying toys for their tots this Christmas. This is impacting Santa in a BIG way. He’s almost doing as badly as FedEx.

Santa Learns From Fannie, Freddie, the Banks & Big 3 Autos

Santa was heartened at first by the federal takeover of Fannie and Freddie. But the sad fact is, it’s done zero for him. His elves are being laid off. His reindeer have taken to crystal meth to cope. And Mrs. Claus is moving to Miami cause she can’t take living in the North Pole now that the heat has been turned off.

Last week, Santa did try one last thing. He secretly went before a Congressional committee to ask for a small loan–something like $4 or $5 trillion dollars, I think (come on, overhead is high at the Pole).

Congress is thinking of giving Santa a loan in exchange for strict controls over the elves and his promise to develop a more fuel efficient fleet of reindeer.

Santa is sort of okay with this…he actually can’t stand the elves anyway…they are so—well—height challenged!

The fact is, if Santa doesn’t get the dough, he will default on his mortgage payment and probably have to give up his abode and workshop.

Santa is not exactly in a holiday spirit, boys and girls (and real estate investors) — Truth is, he’s a bit drunk right now. Not to worry. He’s a pro and he will be fine when the time comes.

Just please keep this in mind–when Santa comes down your chimney–he will be in a foul mood. Whatever you do, don’t talk to him, look at him or question the toys he’s brought your kids. Santa is believed to be armed and could be dangerous considering his mental state.

So, have a merry Christmas . . . keep the faith…believe in miracles and send Santa a few bucks because he’s too fat to fail!

BREAKING: BiggerPockets Conducts Follow-Up Interview With Santa!

Check out the interview

Photo Credit: Homeless Santa by azrainman

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Santa Faces Foreclosure; Victim Of Subprime Debacle; Seeks Christmas Government Bailout

I call the Bernanke – Paulson twosome the Dynamic Duo because what they devise to solve our financial crisis is no more ridiculous than the far-fetched ways Batman and Robin used to escape sure death in the campy TV show. Unlike the TV show, I’ve stopped rooting for this financially bungling Dynamic Duo to succeed.

They don’t deserve to succeed…and I’ll prove it.

Dynamic Duo At It Again

Their latest “brainstorm” was to float a story about “putting a floor under home prices by driving conventional mortgage rates to 4.5%”. This would ostensibly be accomplished in the FNMA/FHLMC MBS market place where Hank and Ben could use their freshly printed $$ Billions to buy up the MBSs like no tomorrow. As we all know, increasing demand drives up the prices and down the yield (read rate) so mortgage rates drop from say 5.5% where they were before the story leaked to around 4.5%.

It is believed by the Dynamic Duo this lowering of prime mortgage money would increase demand for housing and home prices would stabilize.

Housing Crisis Solved…Right?

Wrong!

First, it won’t work. Ben and Hank forget the prime credit folks were not the problem…and by definition then cannot be the solution.

That’s what makes the “subprime mortgage” crisis a crisis of the new species called “subprime”. Once you introduce a “new species” into the eco-system…if things go wrong, tweaking the old players in the system won’t help. You have to eradicate the new addition and hope the old players can recover once the threat is gone.

This is the same thing. The subprime players increased demand for housing and drove prices sky-high. Those players need expunging for real estate price to stabilize. Foreclosure gets rid of most of them and sadly, the sooner the better.

Secondly, this plan could actually backfire. As I’ve written before, we are in not so much a financial crisis as a CONFIDENCE crisis. If these two technocrat idiots try this and nobody steps up to buy a house….say “bye, bye” to what remaining confidence Americans have in their financial markets and those running them.

Don’t laugh…this could happen. After all Hank said once he gave the nine mega-banks $250 Billion a few weeks back, they’d start lending to each other unfreezing the credit markets. Those banks got the money and either sat on it or used to pay executive bonus packages.

Oh, Hank…you’re such a sucker!

Anyway Possible To NOT Help Homeowners

Lastly, this is just another in a long string of end-arounds so as to NOT directly give any money or relief to struggling home owners. There is a small percentage of “savable” foreclosure victims who can afford their home if they get a temporary restructuring of their loan. Paulson and Bernanke won’t consider for a second any proposal which gives them any help.

Every time Barney Frank or another member of Congress yelps there should be some relief for home owners, these two guys head for the door.

Now, I know I just said the “subprime threat to the eco-system needs eradicating” or whatever, and this sounds like a contradiction. It’s not. I’m not talking about those subprime folks…subprime borrowers are all but gone.

What is left is that small percentage of borrowers who were not “turned into a home buyer” due to lax credit standards, but simply got roped into the wrong loan. This group needs and deserves our help, but thanks to the Dynamic Duo will never get our help.

Saving this small worthy group would do a lot to jump-start the recovery of the eco-system. It would also go a long way toward restoring confidence. Confidence that even if those in charge of the system don’t always know exactly how to fix things…they, at least, care.

These two over-privileged mega-jerks…don’t care…and we all know it. Their fate is not ours. We will all come out of this, but they don’t deserve to succeed because of this fact alone.

I’ll see you all on the other side of this…

…but I’m afraid this is “curtains” in my eyes for this Dynamic Duo.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

The Latest Dynamic Duo Disaster In The Making

The scuttlebutt amongst conservatives since the beginning of the subprime mortgage mess has been that the Community Reinvestment Act (conveniently expanded during the Clinton years) was the source of the troubles in the capital markets. Being a housing economist with a fiscally conservative disposition (although not a registered republican or democrat) I always found this hard to swallow. Particularly because having been in the mortgage finance arena for over a decade, I knew intimately how the secondary market worked. Subprime mortgages are not purchased by Fannie Mae and Freddie Mac–although they DO have an expanded approval program that could be considered “subprime”. Now, admittedly the world of mortgage backed securities, collateralized debt obligations and credit default swaps is highly convoluted. Exactly where certain traunches are housed can be very difficult to untangle. But just looking at my company’s own numbers, we never had a statistically significant difference between default rates on our “low income” mortgages and our “prime” mortgages.

Turns out, that hunch proved to be right. Yesterday, John C. Dugan–the comptroller of the currency appointed by President Bush (hardly a patsy for the dems) released a statement that categorically disagrees with the argument that the CRA is at least partly to blame for the ongoing credit crisis. In fact, during  the second quarter of 2008 loans offered in partnership with NeighborWorks Organizations actually have a lower default rate than even conventional conforming mortgages. “Foreclosure rates within the NeighborWorks network were just 0.21 percent in the second quarter of this year, compared to 4.26 percent of subprime loans and 0.61 percent for conventional conforming mortgages,” said Dugan.

The fact of the matter is that affordable housing is a good thing. It helps lift communities all over America and for real estate investors who ethically focus on Section 8 properties, affordable housing multifamily developments and low income housing, it can be quite profitable. Many of my own clients are some of the most successful residential and commercial real estate investors in the world. Almost without exception, they all have at least a portion of their real estate portfolio allocated towards affordable housing. Programs like the CRA are a wonderful example of public-private partnerships.

Photo Credit: George the Geek

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Community Reinvestment Act NOT Source of Subprime Mess

Bond insurers are virtually never discussed as a pivotal and responsible party in the subprime mortgage meltdown. Companies like Ambac and MBIA this week used a new accounting rule to post deceptive earnings gains after multiple quarters of multi-million dollar loses. The duplicity of the bond insurers in earnings reports and the over-all “asleep at the wheel” subprime insurance they issued deserves an airing out…so here goes.

Wall Street knew they’d need a form of insurance to entice pension funds, foreign banks, and other investors to buy the subprime mortgage backed securities they created called CDOs or collateralized debt obligations. A CDO is a form of bond and therefore the bond insurance companies would need to be recruited to complete Wall Street’s high risk scheme to help make CDO investment look less risky.

Was Wall Street trying to pull a fast one on the bond insurers?

Sure, but that’s to be expected. Bond insurers job is to ferret out the bad bets and only lend their stamp of approval to investments that pass muster.

But before we continue let’s look at bond insurers in general. This is a bond insurers business model…insure investors against loss – both principal and interest. Bond insurers typically make their money from truly low risk state and municipal bond insurance. Rarely do those types of bonds default, so the insurance a company issues to cover any losses to investors rarely needs a claim paid.

However, when Wall Street came calling on subprime CDOs, the bond insurers got blinded by their greed seeing a whole new, much more profitable market. They used their AAA rating to issue insurance on obviously risky financial instruments knowing full well if defaults mounted they’d be on the hook for both principal and interest payments to the investors.

Wall Street could now sell billions in subprime CDOs with the bond insurers on board.

If the bond insurers had simply said, “No, we won’t rubber stamp your crappy subprime mrotgage CDOs ruining our name, our balance sheet, and our AAA rating just so you can fleece investors around the globe.”…there would have been no subprime secondary market.

No subprime secondary market…no subprime mortgage meltdown…no subprime mortgage meltdown…no real estate bust…or so the story goes.

If the bond insurers had done even the least amount of “common sense underwriting” of the risk these subprime CDOs held the country could have avoided the creation of the subprime secondary market and the subsequent destruction of said market taking the economy with it. The bond insurers were our last line of defense…and they went AWOL when we needed them most.

With Ambac and MBIA back in the headlines, I thought you should know these type of companies are back playing games with numbers. This time instead of turning a blind-eye to risks, they are using newly passed accounting rules which magically allow them to show earnings gains (at least on paper) where none existed before.

Whether bond insurers are deceiving subprime mortgage CDO investors or their own stockholders, they seem to have no problem acting immorally. With morally indifferent companies having such a powerful position in our financial markets, a better case for a complete overhaul in regulation can’t be found.

Maybe Congress could spend a little more time focusing on regulating the bond insurers and a little less time passing so many forms of new regulation on mortgage brokers most of them will go out of business trying to comply.

Right…who am I kidding?

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Bond Insurers – The Hidden Conspirators of the Mortgage Meltdown

Yesterday in a special session the Senate passed the Housing Economic Recovery Act of 2008, H.R. 3221, with a 72 to 13 vote. This measure received such overwhelming bipartisan support so politicians could point to this legislation and say, “We are doing something to mitigate the foreclosure crisis”.

They aren’t.

This bill once converted to law with President Bush’s signature next week can’t and won’t do a thing to stem the drop in home prices which is what home owners and landlords need desperately. But with over 1.5 million households in foreclosure and elections in November, politicians did what politicians usually do…too little, too late.

I found the perfect quote to describe this new bill…

“Politics is the art of looking for trouble, finding it, misdiagnosing it and then misapplying the wrong remedies.” – Groucho Marx

Grouch had H.R. 3221 in mind when he made that statement. This bill is nothing more of a blank check to the Treasury Department to bail out the GSEs, Fannie Mae and Freddie Mac. Sure the Democrats slipped in a $5 Billion measure allowing states to buy and repair foreclosure properties. However, you and I both know this money will never reach the market in time and it’s a drop in the bucket anyway.

Paulson pushed hard for this legislation for the last 2 weeks telling every Congressman who would listen how our national credit worthiness with the world was at stake…our honor no less. It just goes to show how ill-equipped Congressmen are to spot a conman in action. Since when does bailing out two of the most profitable NYSE traded companies in recent history a national priority?

Paulson now has the power to grant unlimited credit to the GSEs and the power to buy their stock directly. This over-reaching power has never been given to the Treasury. The GSEs, especially Fannie Mae, are known for accounting scandals, huge campaign contributions to Congress, and multi-million dollar incentive-based compensation packages for top executives.

This is how we want to spend tax payer money?

Wall Street firms can’t seem to determine the extent of the subprime damage in their own portfolios, so how is Paulson going to it at the GSEs? The bad loans buried in the mountain of GSE owned debt – over $5 Trillion – could easily be well over $100 Billion at Fannie Mae alone.

My guess is this new law will cost the tax payers over the next few years about $200 Billion and not one dime will stop the slide in home values. Not one dime will go to help a family save their home from foreclosure which would help stabilize home prices.

Groucho…when you’re right, your right.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

New Housing Bill Will Not Stabalize Home Prices

Last week I opened my big mouth and said I’d present another solution to the foreclosure problem we are facing today. Before I do, I happened across this law:

“every insolvency of a bank shall be deemed fraudulent, and the president and directors shall be severally punished by imprisonment and labor in the penitentiary . . . provided that the defendant . . . may repel the presumption of fraud by showing that the affairs of the bank have been fairly and legally administered, and generally with the same care and diligence, that agents receiving a commission for their services are required and bound by law to observe. . . .”

as I was researching information on bills of credit. I thought a few of you might like to see that law on the books today. I know I would. I bet the CEOs of IndyMac Bank, Countrywide, Freddie Mac, Fannie Mae and a few others would have done business a bit differently if this law actually existed and was enforced.

By the way, it did exist as Section 28, Art. XX, of the Georgia Banking Act [State Banking Act of 1919 (Acts Ga.1919, p. 219)]. I say did in the past tense because as you might guess, it has been watered down over the years by the courts. Today defaults and insolvencies are blamed on the borrowers and especially the sub prime borrowers.

But that is a different tale and I’m not marching down that avenue today. I posted the above because I thought you would like to see what life used to be like for irresponsible banksters.

Here is what life is like now for irresponsible banksters. It is a snippet from an online AP story of July 14, 2008:

Brian Bethune, chief U.S. financial economist at Global Insight, called the troubles at Fannie and Freddie a “potentially dangerous turn of events” for the U.S. economy. He said they needed to be addressed quickly with an infusion from the government — read “taxpayers” — of as much as $20 billion in new capital for both institutions.

Notice who the goat is in the second paragraph. You and me, laughingly called the taxpayer. The jokesters running these two scams draw not only their paychecks but bonuses. Every year they go before Congress and weep and whine about how tough they have it and Congress keeps letting them run barefoot through the treasury.

My solution for today is to have the U.S. Marshals do to the banksters what they do to organized crime bosses. Haul them away in handcuffs. I’m not totally heartless. I’d give them $300 to put on their books in the joint. That way they can at least visit the commissary once a month.

I don’t believe it will ever happen because it appears all of the marshals, US attorneys and the like are really cloned Mike Nifongs. But, I can still hope it will happen.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Commentary: How to Really Handle the Foreclosure Problem