Monday, July 07, 2008

Housing Legislation: Short help

The Frank/Dodd housing proposal, while not law yet, looks to be headed there. While it seems the proposal will have some non-zero impact on the housing market, I'd vote against it. Quickly, here are my problems with the proposal:

  • The key element is that the government will trade a GNMA security for a troubled loan as long as the bank holding the loan agrees to write down the principal to 85% of the assessed value of the home. This could be a very large write down in many cases. Say I bought a $300,000 home at the peak and put 5% down. Let's say the appraised value has fallen by 15%, so the house is worth $255,000. Now the bank has to write the loan down to 85% of that ($216,750) in order to participate in the Frank/Dodd program. What started out as a $285,000 loan must be written down by $68,250, or 24% of the original loan amount. Banks are going to be very reluctant to participate in this program. Why not roll the dice and hope that the borrower keeps paying?
  • Given the above, any loan the bank does decide to put into the GNMA program will be of the truly toxic waste variety. So tax payer costs will be significant.
  • Even if the proposal were to be signed into law today, most analysts agree that the book on 2008 foreclosures is already written. The foreclosure process is always a lengthy one, and currently servicers are swamped, so its taking longer than usual. So the proposal won't start having an impact until 2009.
  • By that time, we'll be nearing a "burn out" on bad mortgage foreclosures. By this I mean, at some point, all the really bad loans from the 2005-2007 period that are going to default will have defaulted. By mid-2009, it will have been two full years since the sub-prime blowups started. That should be enough time for the overwhelming majority of the loans to borrowers who really can't afford the loan to be ferreted out. From that point on, loan foreclosures will probably be above average for a while because of the lack of equity, but the pace should decline.
  • By early 2009, homes in the most bubblicious areas will be down 25-40%. So the amount banks have to write down to stick these loans to the government will be very large indeed. The risk/reward may be to retain the loans and hope that most of your borrowers keep paying, or to work out a separate modification rather than participate in the Frank/Dodd program.
  • Put the last three points together, and most banks will figure they've already foreclosed on the properties they might have originally put into the Frank/Dodd program, and what remains is worth keeping.
  • I'm not even mentioning the obvious moral hazard, which is another issue entirely.

So this housing proposal, at least as far as helping home owners, is a lot of political posturing without much eventual impact. So I'd vote against it.

What kind of government intervention might actually work? What the housing market needs is a reduction in supply. We're slowly getting to a place where new construction isn't so much a problem, but as I've alluded to above, I think we're about a year to 18-months away from the peak in foreclosures. So that's going to remain a problem.

Normal household formation won't soak up the supply for a while. A recent report from Lehman Brothers indicated that there will be 4 million units which need to be absorbed by the end of 2009, both foreclosures and new home construction. About 1 million can be taken down by normal household formation. That leaves 3 million homes to sell, a pretty big nut to crack.

Demand could come from either current renters becoming home owners or investors. In both cases, prices need to drop a large degree to stimulate demand for 3 million marginal homes. For what its worth, the Frank/Dodd proposal is estimated to help 500,000 home owners. That still leaves a pretty big nut to crack!

There is actually a relatively simple way for the government to help soak up this demand quickly. Make investing in a home more attractive. In other words, make buying a foreclosed property for the purpose of renting it out a more attractive investment. It could work any number of ways: there could be a large tax rebate to the investor, FHA could offer cheap loans, etc.

It could even be structured such that the financial system was strengthened in the process. Say the government allowed anyone who bought a foreclosed property to write off 20% of the purchase price on their taxes, but in order to qualify, the buyer has to have at least 20% equity in the home. The result would be a deleveraged housing sector. Most alternative proposals involve the government helping to provide down payments. But that doesn't deleverage anything, only shifts the leverage to the government.

Anyway, my idea is politically untenable, since it would help wealthy investors make money on the back of a displaced homeowner. So it isn't likely to happen. There have been similar programs enacted in urban areas, under the auspices of reducing urban blight. So it might be that some local municipal housing agencies attempt such a thing.

By the way, while I doubt the Frank/Dodd proposal helps much in terms of housing prices, it probably will help in terms of certain sub-prime securities. As I said above, banks will most likely transfer the worst of their loans to FHA under the proposal, i.e., the ones they securitized. Most of the A and BBB-rated sub-prime bonds from 2005-2007 are toast anyway, but the senior stuff trading at 50% of par could see some significant benefit. Too bad it'll be too late for Ambac and MBIA...

10 comments:

Unsympathetic said...
This comment has been removed by the author.
Noah said...

As part of your thesis against Frank/Dodd, you bullet point...

I'm not even mentioning the obvious moral hazard, which is another issue entirely.

...but - without acknowledging the same issue in your remedy - you seem to champion instigating even more moral hazard yourself...

There is actually a relatively simple way for the government to help soak up this demand quickly(,)...make buying a foreclosed property for the purpose of renting it out a more attractive investment.

The main difference appears to be that you are arguing for more extreme government intervention (as opposed to market-based and fundamentals-based intervention), which would artificially prop up house prices even more - leading to even more moral hazard.

Accrued Interest said...

Well, I'd actually perfer the government do nothing. But if they are going to do something, I'd rather it be something that might work.

As for moral hazard... You've got to define what that means. I think of moral hazard as an adverse alteration of behavior resulting from some artificial alteration of risk. Such as people driving more wrecklessly because they have automobile insurance.

With my investor tax rebate idea, you haven't rewarded the borrower who bought more house than he could afford. Nor are you bailing out the bank by giving them a government-gtd security. Granted you are improving the price banks get on foreclosed properties. But that's a stated goal of the Frank/Dodd bill.

I'm not saying there is zero moral hazard potential in my idea. Just less than Frank/Dodd.

Noah said...

Granted you are improving the price banks get on foreclosed properties. But that's a stated goal of the Frank/Dodd bill.

I'm not saying there is zero moral hazard potential in my idea. Just less than Frank/Dodd.


It is with the banks where the behavior would, could, and should be altered. "Improving the price banks get" would alter the behavior in exactly the wrong manner (i.e. inducing them to take more risk than is prudent). I suppose this is where the disagreement is, because you mention Frank/Dodd not really having a significant impact on prices as a whole, but offer a solution where prices would be significantly impacted. To do this would require a substantial price tag (of which, you mention several possibilities). Whether the banks are being "bailed out" through "guarantees" is not a point I am trying to address. I'm simply pointing out the fact that banks would receive an artificially high price on a bet that went sour. This would induce more future risk taking, given the experience of making bad bets and not having to pay for them adequately.

The average person will always chase pretty things off the edge of a cliff, so I do not think the moral hazard discussion has nearly the importance with the less sophisticated. But I would agree, these people would take a hit - which they always do in these situations anyways.

George said...

You write:

Too bad it'll be too late for Ambac and MBIA....

Could you kindly elaborate?

tia

Accrued Interest said...

Noah:

See my next post, I elaborate more. I appreciate the well-thought out comment. I expected a ton of bone-headed comments on this post, but haven't gotten any.

George:

Ambac and MBIA both have a ton of super-senior residential mortgage exposure. Those securities will be the primary beneficiaries of any government bailout, IMO. I just think its too late. ABK and MBI's franchise is destroyed. This might help them survive as solvent companies and perhaps they eventually sell their remainder portfolios for $3/share or some such. But I don't think you can buy the common hoping for the government bailout now.

George said...

But I don't think you can buy the common hoping for the government bailout now.

So you apparently don't trust their adjusted book values and believe their marks will be permanent losses, do I get you correctly?

Are you same pessimistic about their bonds?

tia

Accrued Interest said...

I think if their credit rating didn't matter and there were not mark-to-marketing of their liabilities, they'd probably survive. But as it is, I think they are going to keep getting downgraded, which means they'll keep needing to post more collateral, which they won't have. MBI has a much better shot than ABK.

Did you see my last post comparing MBI/ABK and FSA? Take a look at that.

George said...

I read your post on MBIA/ABK/FSA.

ABK claims that upon a downgrade to A-/A3 they would face a collateral shortfall of 1.1 bn, but that

http://ambac.com/Press/070708_b.html



Ambac is in discussions with the Office of the Commissioner of Insurance of the State of Wisconsin (OCI) with respect to its strategies for managing the collateral posting and termination obligations of the investment agreement business. These discussions have been positive. Ambac believes that it will obtain OCI’s approval of its plans to address the collateral posting and termination obligations of the investment agreement business in the event of downgrades to the A/A2 rating level. AAC’s investment portfolio is valued at approximately $12 billion with over $1 billion in cash and short-term securities at May 31, 2008. At the A/A2 rating level, Ambac management would evaluate its various resources and utilize those considered most appropriate to satisfy the contractual obligations of the investment agreement business.


Not sure, why thy would only get permission from OCI until A/A2 level, difference to A-/A3 is "only" another 100m.

Do you suspect a much worse scenario, where downgrades break through the A-/A3 level, continually spiralling downwards?

Accrued Interest said...

I'm going to post more on ABK and MBIA soon, so keep reading.

Anyway, I think the most likely scenario is a downward spiral into oblivion. I do think there is a decent chance they can pull it out, if this recapitalization plan winds up working.