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Monday, November 24, 2008

Will Dodd/Frank Now Rear Its Ugly Head

This past summer I wrote often about mortgage bailout of troubled borrowers championed by Chris Dodd. The bill that passed this past July was in my opinion one of the most corrupt pieces of legislation that I had ever seen. Here is a quick summary of the corruption as I saw it. Chris Dodd received two sweetheart loans from Countrywide. For about a year and a half, Dodd received campaign contributions from Bank of America that averaged to about a $1000 weekly. In the winter last year, Bank of America bought Countrywide. The deal was a potential boondoggle for Bank of America however they also bought all of Countrywide's toxic mortgage debt. Then, we find out that Bank of America helped write this bill, which would transfer most of this toxic debt to mortgages that would now be guaranteed by the federal government. Such a bill would help remove much of this debt from the books of the newly minted company and as such, it would also make the merger a financial boondoggle for Bank of America.

So far, the newly minted bill has been an abject failure.

Since October 1st, HUD reports barely 150 applications from lenders. Yep, that’s just applications. Apparently the lenders weren’t too keen on that principal write-down. So HUD announced new regulations, telling lenders that they only have to write down to 96.5 percent of the current value, and homeowners would not have to spend more than 31 percent of their monthly incomes on the mortgage. The loan could be extended to 40 years.

The reason that the bill has failed to produce much activity is that it has asked banks to take far too large a markdown on their loans. What this means is that banks would be asked to reduce the balance on loans to a balance far lower than the value of the home. In other words, if a troubled borrower owed $250k, the feds would buy the loan but only if the balance were say $200k. In the summer, I didn't see this as a problem for the banks because they would likely get a lot less on their money in the open market than what the feds would offer. At the time the bill passed, Merrill Lynch had just accepted 22 cents on the Dollar for billions in toxic mortgage debt. If banks had to only write down to 60-65%, I thought they would see this as a boon.

Apparently, I was wrong. Banks, so far, have seen the write down stipulations as far too much. As such, the feds are now requiring that loans only be marked down to just under 97% of the value of the property.

The problem with this program is that the more successful it is initially, the more destructive it will be eventually. 97% is the maximum allowed on an FHA loan, the government program that will underwrite these new loans. Furthermore, FHA has strict requirements about prior mortgage history. Most borrowers with any prior mortgage lates are immediately rejected by FHA. This new program will forgive a massive amount of mortgage lates. They will do this because they will also require borrowers to stay within strict debt to income limits of 38%. Strict debt to income limits is another bedrock underwriting guideline of FHA.

The problem is that folks that have been late in the past are significantly more likely to be late in the future. That's why it is one of the standard underwriting guidelines. Furthermore, these borrowers, with mass mortgage lates, are being given loans where the loan to value is maximized. This makes such loans far riskier than FHA ever intended them to be. The math on this isn't very difficult to figure. This means that loans under this program will have far higher default rates than anything that FHA ever intended. There is no other outcome when basic underwriting guidelines are ignored. That's how we got into this mess.

The biggest problem is of course that the federal government will now be the debtor on these new loans. When these loans finally begin to default at ratios far more than what is allowed to make the program viable, it will ultimately be the tax payer, not the banks, that will foot that bill. That's because under this program the Federal government, or the tax payers, will guarantee any loans that will go into default. By moving the risk from the banks themselves to the Federal government, they are inviting exactly the sort of irresponsible behavior that lead us here.

I have felt from the beginning that this bill would eventually take our economic malaise to a place no one can imagine. So far, the banks have resisted allowing my theory to be tested. The government appears determined to make the terms attractive enough so that soon enough we will all see if I am right.

1 comment:

Anonymous said...

More like likely Frank/Dodd will have it ugly head stuck in its rear.