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Friday, March 14, 2008

The Feds rearrange the Deck Chairs on the Titanic

Imagine if the folks at Harvard got excited one day and decided to loosen up the restrictions on entry to the school. Imagine if this lead to a influx of all sorts of new students, and the campus was buzzing. Imagine that Harvard so all of this as a good thing and saw an opportunity to extend their student base. Thus, they extended their restrictions even more. Imagine further if the folks at Harvard woke up one day and were told that many of their new students were chronically tardy, not doing their homework, generally disruptive, and even failing many of their classes. Imagine further, the folks at Harvard decided that the proper course of action was to provide these new students with extra help, much extra help, and in fact, help they would never provide the average student. Imagine the folks at Harvard decided that at all costs they would do what it took to make sure that these struggling students graduated.

Now, if you replace Harvard with banks, students with borrowers, the administration with the feds, and more tutoring with bailouts, rate freezes and mortgage balance decreases, then you would have the mortgage crisis. The proper course of action for Harvard would be to expel these students that they should have realized were never supposed to get in in the first place. The same thing is true of the mortgage crisis. The only proper course of action is to remove these folks from their mortgages and their properties. While it isn't P.C., that is the proper course. That' s because these folks should never have gotten the mortgage in the first place. If someone drives drunk chronically the right move is to remove their license. It isn't to send them to driving school over and over. Just like Harvard should have realized that they accepted students they should not have, and that the only course is to remove those students.

That is the crux of the problem with the mortgage crisis. Right now far too many borrowers hold onto mortgages they never should have been approved for. All of those fancy terms that you are reading in the paper like credit crunch, liquidity crisis, and market meltdown, are all symptoms of the problem. Because far too many borrowers hold onto far too many loans that they shouldn't, this causes all of those other fancy terms. Yet, the Fed thinks they can solve the crisis by addressing the symptoms rather than the causes.

For instance, the big financial news of today is the troubles of Bear Stearns... Bear Stearns is facing a credit crunch. They are facing a credit crunch because the mortgage backed securities they are holding onto are so worthless that they can't find anyone to take them off their hands no matter how little they try and sell them for. The reason this is happening is because far too many borrowers that make up the mortgages that back up these bonds have no business holding onto them. What is the Fed doing to resolve the problem?

Beleaguered Wall Street investment house Bear Stearns (BSC) has turned to JPMorgan
Chase (JPM) and the Federal Reserve to receive temporary funding in a bid to restore investor confidence and keep the bank from possibly going under.

The bailout plan comes after the short-term liquidity position for Bear “significantly deteriorated” in the last 24 hours, according to a statement from the firm.

Under the terms of the agreement, Bear will receive funding for up to 28 days from the Federal Reserve Bank of New York in cooperation with JPMorgan. JPMorgan said the Fed will provide "non-recourse, back-to-back financing" for the deal so it doesn't believe the transaction represents any material risk for JPMorgan's shareholders.

The Fed thinks they can resolve Bear Stearns' problem by extending it emergency credit. That will only prolong their agony because it won't solve their real problem. That problem is that they are holding onto mortgages that includes far too many bad problems.

What is the Fed doing to resolve the problem rather than the symptom? The Fed is pulling out all the stops to keep borrowers in their properties...

Fighting to stem a dangerous wave of home foreclosures, Federal Reserve Chairman Ben Bernanke pledged Friday to do all that is possible to help struggling U.S. homeowners.The Fed is "strongly committed to fully employing our authority, expertise and resources to help alleviate their distress,"

Bernanke said in a speech to the National Community Reinvestment Coalition's annual meeting here.Record-high foreclosures are aggravating problems in the housing market and for the U.S. economy, which many fear is on the verge of a recession or in one already.

Bernanke did not offer new recommendations -- as he did earlier this month -- but rather spoke of the various steps the Fed already is taking to address current problems and to prevent another crisis of this sort.

This is the equivalent of Harvard offering 24/7 tutoring to students who simply didn't belong at Harvard in the first place. The Fed is addressing the symptoms and at the same time perpetuating the cause. This will only worsen the problem. While they extend credit to banks that hold troubled mortgages, they are doing everything in their powers to make sure that the strurctural problem in the underlying mortgage remains the same...the troubled borrowers.

Here is how a recent article framed the problem...

Where are the speculators, vultures and hedge funds? Where are the big money players willing to buy the exotic but still substantial mortgage-backed securities for which markets have ceased? The Fed's liquidity rush seems only to have convinced them the time is ripe for staying on the sidelines.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won't be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic -- but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.

The reason the vultures, speculators, and hedge funds are still not buying is because they don't know how to value these products. This is another symptom of the problem. The reason these bonds can't be valued is that they include far too many troubled borrowers. The only way for Wall Street to once again start buying these bonds is for these borrowers to be removed from them. That way everyone can guage how much it cost and apply proper value.

Of course, that isn't what is happening. Instead, the Fed is simultaneously extending credit to every troubled lender and providing any and all relief to every troubled borrower. They are rearranging the deck chairs on the Titanic. These lenders are in trouble because they extended far too many loans to far too many bad borrowers. These borrowers, on the other hand, shouldn't even be in the mortgages. (Of course to add to the problem none of these borrowers would qualify for another mortgage anytime soon, and almost never in their current property) While it is painful and not politically correct, the only thing to do is to remove the borrowers, assess the damage, and move on. Instead, the Fed is doing everything but that. Thus, it rearranges the deck chairs on the Titanic.

2 comments:

John said...

Volpe,

I managed to get out of one of those 1% "pay as little or as much as you want" kind of ARMs last year. I was lucky to get out of it. Had I stayed in and let the loan adjust, I'd be in a real pickle. I was put into a fixed loan at a fairly high rate for the time (7.5%) with a second at (11%). Ironically, it's with Bear Stearns (and I think they cut some major corners to get me this loan at a premium price). My situation isn't that I bought too much home. My situation is that I used my home's equity to pay for improvements and bills. I'm upside down now and not sure if I'll ever be able to get out of this loan. How many other people are in my situation compared with the people who bought too much home? Are we wrong to have used our home equity? Don't lump me in with the rest.

mike volpe said...

I don't want to make analysis without knowing more, however if you are making your payment on time, then all is well. If you are not though, it isn't the job of the government to make your payment artificially affordable.

If you used your home's equity to pay your bills, and now your new mortgage is too expensive for you, then you did over buy because you couldn't make your payments on time along with the rest of your bills. This isn't me being judgemental. I am in no position for that. This is me speaking for what is the only right and sensible thing to do.

I assume that you got an option arm. If you got an option arm because that was the only way to make your payments on time, then yes you overbought, because an option arm has an artificially low payment for only five years.