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Sunday, July 19, 2009

President Obama's Foreclosure Nightmare

Let's make some stipulations. President Obama didn't create the foreclosure nightmare. Instead, he walked in while it was unfolding. That said, it will be his nightmare because among the first things he did was create loan modification program that he, himself, said would save nearly ten million people from foreclosure. The president held a press conference, and he said it would cost about $75 billion. As soon as he did all of this, he took ownership for the rising foreclosure crisis. The opinions of what to do about rising foreclosures are plentiful. For instance, those like me would say that you do nothing. Let the homes get foreclosed on naturally because that's the only way the market can bottom out. Then, there are those like ACORN and the Center for American Progress that say not enough is being done. For instance, earlier this year the so called cramdown rule, championed by Dick Durbin, was filtering through Congress and didn't get passed. Cramdown would have allowed bankruptcy judges to force loan modifications on any homeowner in bankruptcy.

What is clear now is that so far the administrations efforts have been akin to putting a band aid on a heart attack. To understand just how corrosive this problem is you must first understand that it is very layered. Second of all, even while the president's efforts have so far been largely useless all of the negativity of the efforts are in play.

Right now, there are four main drivers of future foreclosures: continuing resetting of adjustable rate mortgages, continued growth in unemployment, resetting of Option Arms, and balloon payments coming due on commercial mortgages. So far, the president has done a little bit to limit the first problem and nothing to limit the other three.

ARM's Resetting:

Here's a graph that illustrates the problem.

In this Politico piece, a Harvard economist makes this assertion.

Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies, said that while the Obama plan was well-crafted for the issues at hand in February, the cause of foreclosures has changed. Now they are less about the
creative, variable-rate loans that buried many homeowners and more about an
unemployment rate that has even those with fixed-rate loans struggling to keep up.

“The issues have changed, and in some ways the solutions haven’t kept up with the problems,” Retsinas said. “The most effective intervention would be to put people back to work.”

At this moment, he's right, however that's sort of a misleading assessment. Right now, the main foreclosure problem is unemployment. People can't pay their mortgages because they don't have work. ARM's resetting is NOW not as big a problem because in 2009 there aren't that many resetting. What will happen in 2010? There will be a lot more. So, in fact, come 2010 resetting ARM's will again become a driving force in the foreclosure mess.

The president's foreclosure prevention plan was mainly supposed to deal with resetting arms. That's because those getting a loan modification were supposed to show a "hardship". There's a built in hardship when you see your payment go up several hundred dollars monthly. It's also supposed to deal with the problem of underemployment. There's also a built in hardship when you see your income go down a few hundred dollars monthly.

The problem is that the president's plan was implemented very haphazardly. Banks are confused. The rules are unclear. Their departments aren't equipped for hundreds of thousands of struggling borrowers all demanding loan modifications all at once. As such, very few have been done compared to the growing numbers of foreclosures. Now, everyone is pointing fingers at everyone else.

The White House realizes the stakes. Treasury Secretary Timothy Geithner and Housing and Urban Development Secretary Shaun Donovan took the 27 participating servicers to task in a July 9 letter to their CEOs, telling them to add more staff, improve training, create an appeal path for borrowers dissatisfied with the service and fulfill other measures to do more modifications, better.

The servicers were told to designate a liaison with the administration who will meet with Treasury and HUD on July 28. The servicers have to tell the administration by July 23 what specific steps they’re taking to improve performance.

In addition, the administration announced that next month it will start publishing company-by-company results, including how many modifications each servicer has made and how quickly. At the least, that will give policymakers ammunition to shame recalcitrant lenders.

“We think that that type of disclosure, servicer-by-servicer, will be important to spurring greater activity on their part,” Herbert Allison, assistant treasury secretary for financial stability, told Dodd’s committee.

It speaks to how terribly chaotic the system is when the administration puts a gun to bank's heads and still loan modifications aren't getting done. since I've begun to analyze the failures of Obama's loan modification program, I've identified the main culprit that this is a whole new industry being created from scratch. It's going through the same problems that any industry would in its infancy, growing pains. Up until this year, there were a few thousand loan modifications done yearly. Now, the administration wants there to be several million. Such a revolutionary change doesn't happen overnight and without serious problems. Of course, the problems of foreclosures can't wait until everyone involved figures out how to work them.


I think everyone has heard that our unemployment rate is 9.5%, but in the context of the foreclosure problem, that number is misleading. It doesn't include those that took on less paying jobs, part time jobs, and those that quit looking. When you figure out underemployment, the number approaches 20%. Many of those folks are property owners and thus all in danger of being unable to pay their mortgage.

There is little the government can do to make sure that someone unemployed pays their mortgage on time short of creating an environment conducive toward job creation. Right now, things are bad and getting worse. That's why Mr. Retsinas was so focused on jobs. In that respect, he's right. If job losses continue to grow with no end, that will spill into a foreclosure mess and there's nothing the federal government will be able to do. While, I believe that unemployment benefits can be included in loan modification income, almost no one that relies on unemployment would qualify for a modification. The stunt in income would be too great.

So, unless jobless rates are curbed soon, that will continue to spill into higher foreclosure rates. All of it is a vicious cycle. If foreclosures are exploding that is a cancer to the rest of the economy. Unemployment works much the same way. Most expect unemployment to cross 10%, some 11%, and others into the teens. Foreclosures will be a variable of that.

Option ARMs

Here's a loan that most have never heard of. How about this? The three biggest players in option arms were: Bank United, Washington Mutual, and Countrywide. It's NOT a coincidence that all three are no longer in existence. That loan product brought all three to their knees.

That's a graph of Option ARMs, specificially, adjusting. You'll notice that a fair few have adjusted so far but that is about to change with its zenith happening in 2011.

First, Option ARM's no longer exist. They were a gimmick loan who's fatal flaw was exactly the current economic climate.

It worked like this. For the first five years, the borrower was allowed to make a payment that had no relation to the interest rate they were charged. The payment wasn't merely small but tiny. For instance a $300,000 mortgage would have a payment of just over $1000. (the small payment is made up at the end of the loan with a concept known as negative amortization) After five years, it adjusted and reset to track the rate and the current payment. Since the first five year's payment didn't track the rate, that payment almost always built negative equity. As such, the borrower would owe more after five years than they started. So, any option arm that adjusted would have an obscene payment shock. (payment shock is when payment adjusts up. Obscene is when it adjusts up a LOT)

Well, starting in 2010, all of 2011, and most of 2012, we'll have at least $10 billion monthly adjust. While that is a relatively low number, an enormous amount of these will go into default unless drastic measures are taken. Remember, the president's play is only $75 billion. Most of it is supposed to run out at the end of 2010. Furthermore, Option ARMs aren't even a part of the plan. So, starting in a couple months, we'll see about $10 billion in foreclosures monthly that no one has been paying attention to. There's about $500 billion in Option Arms that will adjust in total. Most of those borrowers are stuck. Their balances have gone up while their values have gone down. As such, they can't sell. They can't refinance either. It's unclear if they can modify. That's what Bank United attempted to do on a mass scale and still went under.

Commercial Mortgages:

The most underreported looming problem is that of commercial mortgages. Congress woman Maloney recently held a hearing on the problems faced in commercial mortgages. The numbers are frightening. In 2007, $488 billion in commercial loans were financed, $143 billion in 2008, and $15 billion year to date. Furthermore, there have been ZERO commercial mortgages securitized year to date. As such, there is no commercial mortage securitization market. If you were to do a commercial mortgage, the bank would have to hold it. Imagine asking a local bank to finance a hundred million dollar property. That's just far too much to put into one loan. That's why financing of $50 million and more are nearly non existent.

The problem isn't simply that multi units, warehouses, and office buildings aren't financed and sold. The problem is much bigger than that. Many commercial loans are done as balloon loans. That means that while they are calculated as though it is a 25 or 30 year loan, they are due after 3,5, 7, or 9 years. At that time, there is a massive, or balloon, payment for the remaining balance. So, the holder of a commercial mortgage needs to sell or refinance before the balloon is due. If not they either face a massive payment or foreclosure.

Of course, commercial loans are NOT part of the president's loan modification program. In fact, it's problems have almost been entirely ignored. I'd challenge anyone to even find a time when someone in the administration even talks about the problems in commercial mortgages. According to testimony, starting in 2010, commercial mortgage balloons will come due with the zenith in 2012. (an estimated one trillion dollars of balloons coming due in that year)

Let's think about that. Normal ARM's will increase their adjustment in 2010, Option ARM's will have their adjustment zenith in 2011, and commercial mortgages will have their zenith in 2012. So far, his plan is a largely impotent $75 billion program to modify mortgages and a stimulus package that has done little to stem joblessness. That's what I would call a NIGHTMARE.

Moral Hazards:

I first heard about loan modifications last fall. I immediately had a problem with them as a matter of policy because there is an inherent moral hazard. What I mean is that loan modification reward exactly the sort of behavior we want to punish. Here's how loan modifications work. You are struggling to make the payment on your mortgage. As such, the bank modifies your payment to something you can afford. The rates on these modifications can be as low as 2%. As such, if you have a modified loan, your rate is very likely to be better than that of someone with perfect credit. How's that for fair?

Banks are very aware of this built in moral hazard. That's one reason that loan modifications have been slow in coming. They don't want word spreading that loan modifications are a legitimate option for struggling borrowers or soon everyone will want one and suddenly everyone struggling is demanding their 2% mortgage. Suddenly, everyone is figuring out how to be struggling to get their 2% mortgage.

In fact, that's the Obama vision. He may not say it but if his plan works out 7 million people who have mortgages they can't afford will get mortgages better than those that can afford them. Remember, loan modifications are based on hardship. That means if you can afford your mortgage, you have no hardship. Isn't getting an affordable mortgage what we want to encourage? If your credit is perfect, mortgage is affordable, you have plenty of money in the bank, see if you can get a 2% mortgage. Remember, Obama doesn't go as far as want. Some want modifications to include a reduction in balance. In other words, if you're really struggling, then you won't owe $300,000 but say $250,000. See if you have perfect credit and ask if your bank will reduce your balance as a result.

That creates an upside down and perverse mortgage market. The most irresponsible are the ones rewarded the most. That's a moral hazard.

Now, moral hazard is a legitimate problem, but if we avoid a foreclosure crisis, some would say it's worth it. That's not what's happening. Instead, foreclosures are exploding all while the administration ramps up efforts to reward bad behavior. Remember, both Treasury and HUD are about to put extra pressure on banks to hurry up and approve more loan modifications. So, lot's more irresponsible borrowers will be rewarded all while foreclosures explode anyway. The administration will create a massive moral hazard with hundreds of thousands of homeowners being saved from themselves all while doing little actually solve the foreclosure crisis. I'd call that a nightmare.


Anonymous said...

Rather than reduce rates and principal, what about turning 30 year mortgages into 40 year mortgages?

Anonymous said...

In this brave new world of Quantitative Easing, is it possible these loans could adjust downward?

mike volpe said...

Let me take both at once. Extending the term is a common thing done in modification however that doesn't make as much of a difference as you'd think. It helps but if that's all it took, the person probably wouldn't even need a modification.

As for quantitative easing, that question is impossible to answer. They are all tied to different interest rates and were all done at differen times. Some might be. That said, that's one small problem in a series of problems. First, Option Arms don't have that problem but a much bigger one. Second, commercial loans aren't adjusting but ballooning.

Christopher said...

In my opinion, President Obama is doing a great job about foreclosures. Only what we have to do is trust on him and wait, because this crisis will not stop instantaneously.

By the way, great blog!!!