06 03 08 Moral Crisis
The Chairman of the Federal Reserve Bank is once again out front leading the charge to destroy the US financial system. Inflation is alive and well (unless you happen to live in that fantasy world called Coreland) and the currency is in the tank. Perhaps we can forgive the rise in grain prices as ethanol, a prime culprit, was the creation of our wonderful Congress. Recently, however, Bernanke has moved well beyond his disdain for sound monetary policy by jumping feet first into the sub-prime/securitized asset fiasco. Joining with Treasury Secretary Paulson, Bernanke last year advocated reducing interest rates on sub-prime mortgages to those borrowers 'in trouble' and subject to foreclosure. A number of analysts and commentators pointed out the significant moral hazard such actions would put into play: a bail-out of borrowers who borrowed more than they could service; a bail out of borrowers stuck with properties they intended to flip but had insufficient capital to carry through a downturn; a bail out of borrowers who covered their ears so not to hear the adage 'if it sounds to good to be true...' ; a bail out of lenders (banks) who would be required to provide liquidity to various other entities holding sub-prime mortgage paper and CDO's; arbitrarily changing the terms of legal agreements without the consent of all parties involved; causing potential serious harm to third or higher parties involved in derivative transactions against other investors closer to the original mortgage. The list goes on but many believe the end effect would be to raise future borrowing costs as lenders adjusted their pricing to reflect the new reality that a loan is only to be considered contractually valid when times are good and that terms may be changed adversely at a later date to provide relief to the borrower at the expense of the lender.Moral hazard was not sufficient for Mr. Bernanke as he apparently prefers to see a moral crisis. In a speech he gave to an audience in Florida yesterday Mr. Bernanke proposed that in addition to other measures, lenders should also reduce the principal outstanding.That's right - Bernanke thinks the most irresponsible borrowers should be rewarded not just with a lower interest rate (like one fixed at their introductory ARM teaser rate) but they should also be forgiven whatever negative equity their transaction has created. Have a $300,000 loan on a house now only worth $250,000? Big Ben thinks your lender should give you a mulligan either give you $50,000 against a new loan with another lender or rewrite the current loan to reflect a new principal due of $250,000. Beyond the impracticality of this idea - what on earth could be the justification?
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.So lets try to understand this. Bernanke is trying to justify cutting the outstanding loan principal because this will somehow give 'incentive' to stay in the home? Or if the principal is reduced far enough, there might be some positive equity the homeowner could borrow against!?! This is patently insane. Taking our hypothetical $300,000 loan at an introductory rate of 5.5%, after 2 years the homeowner would have about $291,690 outstanding or equity of $8,310. Now let us assume the property is only worth $250,000. This leaves the homeowner facing $41,690 of negative equity and a current interest rate reset around 8.5% (resulting in a new monthly payment of $2,345 vs the original $1,703). To date, the Treasury department has been pushing for lender accommodation to extend the introductory rate an additional five years which results in the same monthly payment and an additional $25,242 of equity. Bernanke, on the other hand, proposes a new loan at a fixed rate with the current negative equity forgiven. Using a very generous rate of 6.5% on a new 30 year fixed mortgage for $250,000 gives a monthly payment of $1,580 ($1,617 if the original maturity date is unchanged.) Will a $123 monthly reduction be sufficient to keep a homeowner from defaulting? We think not. For many of these homeowners it would take a payment impossibly low to avoid default. At origination, in most cases, the borrower was maxxed out and hoping either a rising income or a rising home value (and a subsequent additional loan against that equity) would allow him to afford the home. What was not considered was the continuing dramatic rate of increase in local property taxes as well as headline inflation (4.2% in the past year alone by the official figures). In the real world you would probably need to lower the monthly payment to $1,200 (in this example) to have a fighting chance of avoiding default. That kind of reduction is just not in the cards.
Even so, using the $1,580 example of the Bernanke plan we would propose a far more palatable alternative of a continuation and extension of the loan to 40 years at a fixed rate of 6% and a new payment of $1,605 per month. Like the Bernanke plan, it is not practical to implement - contracts would need to be rewritten and duration would be extended with uncertain effect on mortgage pools and securitized tranches. But it suffers from far less moral hazard - while the interest rate given would be better than the borrower's credit rating deserves, they would still be on the hook for the original loan amount. Another alternative is to extend the rate lock period of the current loan (as proposed already by Treasury) and also extend the duration to 40 years, resulting in a $1,504 monthly payment, about 5% lower than the Bernanke plan alternative. However, this creeps even further into the realm of moral hazard and as noted earlier, neither would be likely sufficient to prevent a default in the not so distant future.
Policy makers - in particular legislators - must consider the moral hazard in their actions. A failure to do so will have long term consequences far worse than the short term pain of a glut of houses for sale. Lenders will forever factor in these events to their pricing, both to make up today's losses as well as to offset those they are stuck with in the next bailout. In addition, by forcing 'solutions' on the industry today, the industry may tomorrow say 'never more' to anything but the most pristine credits. Of note, Citibank has already announced they will reduce their mortgage business by nearly $50 billion in the coming two years. There will be no more sub-prime or alt-A lending thus in effect shutting out a large number of borrowers, some of whom would be able to own a home and make the payments if a loan was available. After all, subprime and alt-a were around long before 2004 without any of the current crisis but irresponsible monetary policy coupled with lax lending standards created a crisis where none existed before.
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