Friday, December 7, 2007

Update on the Rate Freeze

Several business journals have recently come up with editorials that echo what I have been saying about the rate freeze. Here is a snippet from IBD...

The flaws of the plan are many and fatal.

First, the deal will reward irrational behavior and encourage such behavior by homebuyers in the future. It was not logical for people to take out mortgage obligations they couldn't afford, but it will become logical for them to do so in the future if they can reasonably expect that the government and their lender will later bail them out when the going gets tough.

Second, the deal will thwart the market by keeping home prices artificially high. In recent years, laughably easy credit has let many people "buy" homes who otherwise could not have done so, pushing up prices.

We've had "liar" loans, in which people could just state their annual income without fear that their mortgage lender would call their employer to check. We've had "Nina" loans, for "No Income, No Assets." And we've had "Ninja" loans, for "No Income, No Job or Assets." Consumers, armed with the easy money provided by these silly terms, have pushed home prices to record levels when they're measured against personal income, making falling home prices not only inevitable but healthy.

Here is the view from Forbes...

Decried as a bailout of irresponsible borrowers by some and a financial industry wrist slap by others, the plan is not mandatory for the financial industry, though more than three-quarters of lenders and servicers say they embrace the idea. The biggest, Countrywide Financial, Wells Fargo, Citigroup and JPMorgan Chase, who collectively service $4.3 trillion in mortgage loans, all support the plan.

Still, independent mortgage-servicing firms, some of which are not overseen by federal banking regulators, could opt out, leaving their borrowers still vulnerable to foreclosure.

And investors may not like it. The financial industry lobby worked aggressively to make sure the plan included indemnification for them so investors of bonds backed by these mortgages won't sue them after lenders change the terms of the loans. The more lenders who volunteer to join the program, the less vulnerable they'll all be to lawyers, saying it had become industry practice.

Another issue: The plan only applies to those who are current in their mortgage payments but who are determined to be unable to afford higher reset rates. It won't apply to those who are already faltering, and it won't apply to those who face resets but are deemed able to afford it.

That raises the inevitable moral hazard question. "I'm very skeptical of this," says Bert Ely, a banking regulation consultant in Arlington, Va., who was among the first to say in the 1980s that there would be a taxpayer bailout of the federal deposit insurance fund in the midst of the real estate lending crisis of that decade. "It's government-sponsored collusion."

Finally, here is the word from the Wall Street Journal

The next time we suggest that the government give advice to the private sector, tie us down until the fever passes. A couple months ago, we endorsed the idea of mortgage service companies voluntarily negotiating with subprime borrowers and investors to avoid a wave of defaults next year.

Now come the politicians to wrap their arms around the idea, and maybe give the U.S. a reputation for forcibly rewriting financial contracts. Don't cry for us, Argentina?
Both Treasury Secretary Hank Paulson and the White House are touting a plan to freeze interest payments on up to two million troubled mortgages.

This one from the New York Post falls into the category of why don't you tell me how you really feel...

Yet this plan, bad as it is, has little chance of helping most of the people who face the possibility of foreclosure - after all, 1.5 million Americans will see their mortgage rates "reset" to higher rates next year.

So Treasury Secretary Hank Paulson will propose to Congress to let cities and states issue tax-exempt debt to bail out even more borrowers.

Cities and states would borrow billions and lend the money to "homeowners" (in fact, these borrowers don't actually "own" their homes; they only own the mortgage). The "homeowners," in turn, would use the money to pay off the mortgages they can't afford - and take out new, more affordable mortgages with their city or state government. (Not all tax-exempt debt is guaranteed by the city or state that issues it, but this debt would have to be - no private investor will touch this risk right now for an interest rate that would be "affordable" to these borrowers.)

The whole idea is disastrous - and not simply because it is massive government interference in the private markets. The problems are almost too painful to describe:

Finally, in response to to my previous work on this, I received this ANONYMOUS comment...

As a threshold matter, I treat any comment that begins by citing a politician with a healthy dose of skepticism. I'm not knocking politicians for doing their jobs. I'm just stating the obvious--their views are extremely skewed.As for freezing Rates, while I respect the poster's opinion, it is built on a false premise. One artificially jaded by his admitted "insider" position. In plain English, the arguments seems to be as follows: Capitalism depends on freedom to contract. When this freedom is interrupted, the system breaks down and everyone suffers the consequences for a few bad decisions. In the poster's view, the present mortgage crisis was largely created by a few economically and intellectually inferior individuals taking on financial burdens they should have known they could not carry. Now, according to this view, the government is interfering with an important moral and intellectual lesson that the gullible, but benevolent lenders are poised to teach. Moreover, because of this, the banks will be forced to retaliate by raising everyone's rates.As previously stated,
this position is replete with foundational flaws. First, lenders may be gullible, but they are far from innocent. Brokers, Banks, and title companies have, for several years (at least), colluded to mislead so-called sub-prime consumers who approach them from a bargaining disadvantage due to their, again, so-called spotty credit profiles.

Tellingly, the prime/sub-prime distinction is a banking industy invention intended to allow banks to charge usurious interest rates. And, hidden finance charges, fees and penalties have increased the number of technical defaults (via hidden universal default provisions) and (along with other predatory practices) have resulted in an increasingly small prime consumer population. But, as of late, the mortgage industy has taken deception to a new low. Which brings me to my next point. Other than credit histories (many of which--despite the Fair Credit Reporting Act and consumers' diligent efforts to update the information--contain vague and/or incomplete negative references many years old), the vast majority of sub-prime homeowners are just as financially able as prime consumers. They are doctors, lawyers, accountants, CEOs, etc. The average sub-prime homeowner pays his mortgage, his HOA, and his taxes on time, despite paying, in many cases, twice as much as his counter-part for the same home.

Contrary to the most prevalent explanation, it is not their ability to pay for the house they purchased that is at issue. Instead, it is their ability to pay the concealed premium on that house that neither they nor their counter-part can afford.

Take for instance, the Jumbo two-year interest only ARM. If you believe the poster, these people were fully informed about the affect of the LIBOR index (or, at least, knew what it was) on their loans after the 2-year interest only period. They knew that the interest capped out at, say, 12.7% from a teaser of 7.0% and that the rate would reset multiple times (every six months). They were also informed that very few if any finance companies would refinance such a loan. I think not.

This characterization strains credability and common sense. No one would knowingly agree to such terms. The Brokers and the lenders with their secret kick-back deals assured these consumers that, though the loan would reset (giving no mention of multiple resets or the actual dollar value of the payment increase), the consumer would refinance before then. They also routinely fail to explain the variabl interest rate provision of the contract, in part, because they can't understand the LIBOR themselves. If they do understand, they know that the deal would be dead on the table if they told the customer that his payments would go from $3700.00 per month to $5000.00. So, instead, they point to the page and vaguely reference a reset at the end of the 2-year period, skipping any details. If, by chance, they are selling to an attorney, they simply let the person read it. But, unless you work within a lending institution and regularly deal with such provisions, even an attorney will be completely lost (One does not usually have the final documents until he is sitting at the table at the title company). So, most will rely on the broker's interpretation, thinking, "at worst, I will have to refinance at the end of the term." So, the customer is a little gullible too.

Finally, as to the legal implications--and I'm an insider on this issue--this country has not seen the magnitude of litigation against major banking institutions that is currently in in the pipeline since Worldcom.

Now, this is naive and misleading on several levels. First, clearly this poster hasn't read all of my work, but just this piece. Had they read this piece, they would have known that I blamed five entities working in cohesion: the banks, Wall Street, the mortgage broker, the borrower, and the Legislature. Had they read this piece, they would have known that I even laid much blame for starting this crisis on Alan Greenspan.

Now, since the poster naively claims that my claim is flawed because I only blame the borrower, which I don't, I can stop now in the analysis, however I won't. They falsely claim that sub prime and prime don't have any difference in terms of income. While it is true that income is, in and of itself not the factor that determines prime or subprime (debt to income is), it is just a plain lie to claim that sub prime is not much more skewed towards the poor. Through logic and experience I have learned that while sometimes wealthy people have as poor a credit profile as poor people, I have learned that on the whole wealthy people have a much easier time paying their bills and thus have better credit.

They claim that it is the hidden part of the contract that sub prime borrowers can't pay. Again, in my six years, I know that overwhelmingly people buy homes at a higher price than they intended. That is my back up for my supposition, the poster gives no evidence for their hypothesis. They also claim that the paperwork is too difficult and thus the borrower is then not held responsible for the signature they gave to it. First, I pointed out that Congress has created an atmosphere in which it is easier to rip someone off. Second, that is pure hogwash. If you can't understand what you are signing, don't sign it. I had a twenty three year old that spent nearly six hours at the closing because he literally read and understood every word in every document before he signed. Good for him because he wasn't "gullible". To claim that the language was to complex and thus people agreed to things they wouldn't have is not only fellacious but irrelevant. They agreed to them and their signature is proof.

Then, he claims that sub prime is nothing more than a means for banks to charge outrageously high rates. While the rates are much higher, this poster would be surprised to learn that banks use a sophisticated manner in which to reach those rates. For the most part, borrowers get what they deserve. While sub prime is higher, it also excuses such things as bankruptcy, foreclosure, multiple mortgage lates, low credit scores, and sparse credit history. No one is forced to take on any rate, however if someone gets a sub prime loan it is almost always because that is exactly what they deserve.

Finally, they claim that my concern of the litigation nightmare in unwarranted because it won't rival Worldcom. That absurd statement speaks for itself and needs no counter.

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