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Friday, July 25, 2008

Dodd/Frank + Mortgage Crisis= Match + Flame

I have been pointing out just how corrupt the Dodd/Frank bill is. That said, when corruption is used in the abstract, it usually doesn't hit home as much. So, let's see just exactly what this corrupt bill will do to an already troubled market.

Now, here is what the mortgage market looks like right now. As most people already know, about this time last year, the sub prime portion of the market crashed. This popped the real estate bubble. It also destroyed the sub prime niche of the market indefinitely if not forever. After sub prime tanked, Alt A was next. This niche of the market tanked several months later but it disintegrated just as quickly. After this, jumbo loans took their turn in the guantlet. Jumbo loans haven't disappeared. They are now simply priced so badly that their rates are totally unattractive as a result of holding onto too many loans in default.

At this point, the only loans left were conforming loans done through Fannie Mae and Freddie Mac. Of course, their malaise is now also well known and they are now both about to be bailed out as well. In fact, over the last couple months, the two have both been changing their guidelines so much that one expects a new rule change every single day. The only nich left is FHA. FHA is also going through some upheavel however that isn't as well publicized. Take a look at this chart that shows an alarming increase in defaults on FHA loans.

In other words, there is currently no niche of the residential mortgage market is not going through some turmoil.

This is the backdrop for the CORRUPT Dodd/Frank bill. What this bill will attempt to do is bail out some of the most troubled borrowers and back those borrowers with $300 billion in new FHA loans. Now, as I mentioned already, FHA is beginning to experience defaults at an alarming rate.
As a result of Dodd/Frank, $300 billion in new loans to troubled borrowers are about to be guaranteed. Despite the politically correct spin, most of these borrowers are irresponsible and they would never qualify for an FHA loan without this bill. What this bill will attempt to do is to provide much needed liquidity to the market. Now, because at their current mortgage balance these borrowers wouldn't have any equity or qualify, these new loans will be artificially reduced to 85% of the current value.
As such, not only will borrowers get much needed relief, but banks will get many of their most troubled loans off their books. This is the portion of the bill that Countrywide and Bank of America wanted badly. Of course, in a sense, all that will really happen is that these bad loans will simply be turned into new and unblemished FHA loans. In other words, most of the same irresponsible borrowers will hook up again with most of the very same irresponsible banks to create a whole new set of transactions. Only these transactions will be insured by the Federal government through FHA. In other words, FHA, now on the brink of disaster, is about to take on all sorts of credit risk it really shouldn't be taking on.
Furthermore, two very irresponsible entities just got a bailout with no consequences. In fact, the borrower will receive even better terms. As a result, all sorts of moral hazards are created. Looming behind all of this moral hazard is the prospect of a trillion dollars and more in Adjustable Rate Mortgages that still need to adjust. The bulk of so called option arms will adjust in the next two years. These loans allowed for negative amortization payments for the first five years, and once they re adjust to a normal payment, the borrower will face an enormous payment shock, (when the monthly mortgage payment shoots up)
All of these folks will now see others get bailed out and likely many of them will expect their own bailout once their rate and payment adjusts. That's one of the problems with creating a moral hazard. Keep in mind, it isn't as though Dodd/Frank will create an liquidity so that these folks can be saved. Dodd/Frank is supposed to save those already in trouble.
The worst part maybe that for a few months this bill may even create the appearance of settling things down. After all, one troubled borrower after another will simply be able to trade in their bad loan for a brand new one. Keep in mind that when a loan subset like FHA begins to take on too many loans that will go into default, as this clearly will end up doing, either the loan's interest rates go up, or they tighten their guidelines for future borrowers. In other words, soon enough either FHA will see its rates go up, or it will simply make it more difficult for future borrowers to qualify. Either way, in the not so long term, this will tighten the market even more and create even less liquidity.
So, now we have a mortgage market already on the brink of disaster. We combine that with a bill that will make it appear to be better only it will make it worse. There is no question that Dodd/Frank WILL bankrupt FHA. The only question is when and how badly.
Keep in mind that in order for this to work, the federal government will need to maintain strict oversight and FHA will need to maintain strict discipline and make sure not to expand their guidelines so that they take on too much risk. Since the creator of this bill did it only for a quid pro quo, and the recipients are all irresponsible, what are the chances of that? In other words, we are lighting a match to a lit flame.

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