The Cost of Delaying Foreclosures
With State AGs and the Federal Government pushing to further extend the mortgage foreclosure process for late borrowers, one might assume that these government officials believe that further delay has no costs, and is at most a transfer from the lender to the borrower. Judging from the results of a recent working paper, by economists Shuang Zhu and Kelley Pace at Louisiana State, they would be wrong. Further foreclosure delays impose significant costs, not just on the economy and lenders, but also on other borrowers.
Zhu and Pace start with the observation: “The longer the period between first missing payment and foreclosure sale, the more valuable the default option becomes. The borrower preserves the option to either keep defaulting or cure the default in the future. Since this option value grows with the foreclosure period, longer expected foreclosure periods increase the propensity to default on mortgage loans.”
As state and local law govern the foreclosure process, the authors examine differences across areas to see if such differences in delay impact the rate of foreclosures. Interestingly enough, they do find that the longer are delays, the greater is the foreclosure rate.
Given that lenders understand that delays are costly, this is likely to show up in the price of the mortgage. Zhu and Pace find that with each additional six month delay in foreclosure, mortgage rates increase by 10 basis points. As delays are running an extra year or so now, mortgage rates are higher by about 20 basis points due to government efforts to extend the foreclosure process. This might seem small, but its also the amount many claimed Fannie Mae and Freddie Mac lowered rates by. Clearly the costs of delaying foreclosures are not borne just by the banks, but by anyone hoping to get a mortgage. For those who would respond “but mortgages are cheap” – they are only cheap due to cheap money. The spread of mortgage rates over Treasuries is actually about 20 basis points above its historical norm.
Also of interest is that Zhu and Pace, using S&P/Case-Shiller house price futures, find that in cities where borrowers have lower future home price expectations, they default at a greater rate. I believe this lends some support to the notion that we should stop trying to hold up prices and let them hit a point where up is the only direction. The paper is full of interesting findings, and also includes a useful literature review of the default literature.
What Caused the Crisis?
Last night National Government Radio promoted a documentary on National Government TV about the financial crisis of 2008, which concludes that the problem was . . . not enough government.
If the “Frontline” episode mentioned any of the ways that government created the crisis — cheap money from the central bank, tax laws that encourage debt over equity, government regulation that pressured lenders to issue mortgages to borrowers who wouldn’t be able to pay them back — NPR didn’t mention it.
For information on those causes, take a look at this paper by Lawrence H. White or get the new book Financial Fiasco by Johan Norberg, which Amity Shlaes called “a masterwork in miniature.” Available in hardcover or immediately as an e-book. Or on Kindle!
And for a warning about the dangers lurking in Fannie Mae and Freddie Mac, see this 2004 paper by Lawrence J. White.
Housing Bailouts: Lessons Not Learned
The housing boom and bust that occurred earlier in this decade resulted from efforts by Fannie Mae and Freddie Mac — the government sponsored enterprises with implicit backing from taxpayers — to extend mortgage credit to high-risk borrowers. This lending did not impose appropriate conditions on borrower income and assets, and it included loans with minimal down payments. We know how that turned out.
Did U.S. policymakers learn their lessons from this debacle and stop subsidizing mortgage lending to risky borrowers? NO. Instead, the Federal Housing Authority lept into the breach:
The FHA insures private lenders against defaults on certain home mortgages, an inducement to make such loans. Insurance from the New Deal-era agency has enabled lending to buyers who can’t make a big down payment or who want to refinance but have little equity. Most private lenders have sharply curtailed credit to those borrowers.
In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.
And what is the result of this surge in FHA insurance?
The Federal Housing Administration, hit by increasing mortgage-related losses, is in danger of seeing its reserves fall below the level demanded by Congress, according to government officials, in a development that could raise concerns about whether the agency needs a taxpayer bailout.
This is madness. Repeat after me: TANSTAAFL (There ain’t no such thing as a free lunch).
Mortgage Mods: Congressman Prefers Coercion over Cooperation
The recent focus in Washington on mortgage modifications once again illustrates one of the most fundamental flaws in current political debate: the notion of using government to threaten or force the “voluntary” transfer of wealth from one group of citizens to another.
Just this week Rep. Barney Frank warned the banking industry if they don’t “voluntarily” do more to reduce foreclosures, Congress will step in and make them do so, by allowing bankruptcy judges to re-write mortgage contracts. This proposal is really nothing more an ex poste transfer of wealth from investors in mortgage backed assets to borrowers.
Of course, Rep. Frank and others respond that they are only trying to “bring lenders to the table” in order to keep negotiations going. In the words of many “consumer” advocates, this is just a “stick” to the motivate the lenders. I could think of few things more offensive to a free society. In a government truly constituted on the notion of the common good or general welfare, it would be no more appropriate to use the stick of the state on lenders than it would be on borrowers. Government quite simply should not take sides in purely private disputes.
One would think that if anyone could understand the principle that government should not interfere in the private, voluntarily entered relationships of consenting adults, it should be Mr. Frank.
Obama Financial Reform Plan Misses the Mark
The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crisis. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.
Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of the TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.
While the Administration plan recognizes the failure of the credit rating agencies, is appears to misunderstand the source of that failure: the rating agencies government created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the out-sourcing of their own due diligence to the rating agencies.
Instead of addressing our destructive federal policies at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.
The Administration’s inability to admit to the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.
Congress “Helps” Credit Card Customers
One of the best laugh lines always has been “I’m from the government and I’m here to help you.” Certainly that’s true when it comes to consumer protection.
In the name of saving customers from the evil, rapacious credit card companies Congress plans on limiting access to credit. It also is working to hike costs for people with good credit.
Now Congress is moving to limit the penalties on riskier borrowers, who have become a prime source of billions of dollars in fee revenue for the industry. And to make up for lost income, the card companies are going after those people with sterling credit.
Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.
“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”
This makes a lot of sense. We’re worried about bad debt, bad mortgages, and bad loans. So Congress is going to penalize people with good credit who carefully manage their financial affairs. Of course!
It has long been evident that Congress has the reverse Midas touch. Everything congressmen touch turns to, well, this is a family-oriented blog. You can fill in the blank.
If Congress wants to help consumers, the best thing it could do is take an extended recess.
Two Terrible Tastes That Taste Even Worse Together
Few things irk me more than human-interest anecdotes parading as objective journalism, or college students/graduates complaining about how much money they owe – and think someone else should pay – for their educations.
Perhaps in a bid to break some sort of irritation record, yesterday the USA Today combined these two odious phenomena into one wretch-inducing article about how just cruelly difficult it can be to rid oneself of the student debt one freely entered into.
I won’t go into a detailed dismantling of the piece. Read it for yourself and you’ll see that it really is nothing but a long series of anecdotes delivered with way too little information to have any idea why the debtors shouldn’t, you know, take responsibility for debt they freely incurred. I’m just going to highlight one vignette that sickly typifies just how rationally and morally bankrupt (pardon the pun) both the sentiments of some debtors, and the article, are:
Lenders often fail to offer relief to the neediest borrowers, says a report issued last month by the National Consumer Law Center.
“I feel like it’s a real shame that people like me are coming out of college, weighed down by all this debt,” says Austin Light, 24, a journalist for The Mecklenburg Times in Charlotte. He and his wife have $100,000 in student loans. “My dream is to be a full-time children’s book author and illustrator, and if I wasn’t shackled with this debt, I would be pursuing that.”
In how many ways is this galling?
- We don’t know anything about why Mr. and Mrs. Light have $100,000 in student debt, but we are supposed to become morally indignant just because they feel “weighed down” by it? Did they go to very expensive schools? Did it take them each seven beer-soaked years to graduate? Who knows, but since average student debt for graduates who have any debt is only about $20,000, the rational conclusion must be that they did nothing to control their costs.
- We don’t know what these two studied, but we do know that Mr. Light really wants to be a children’s book author and illustrator. Well, you don’t need to go to college for that, especially one so expensive you incur a debt that even Stephen King — much less a neophyte kiddie lit author — might have trouble paying back.
- Given the overall context of the article, readers are presumably supposed to feel that it should be easier for the Lights to discharge their debts in bankruptcy. But why should people who lent them the money, especially taxpayers who have no choice but to back federal loans, have to take losses on loans that these two freely agreed to pay back when they took them? Isn’t the word for that “stealing”?
Unfortunately, this seems all-too representative of the growing sense of entitlement exuded by many student interest groups. Students should get all the benefits of an education, but someone else should pay for it! And their will is being done in Washington, with several pieces of aid-enhancing, loan-forgiving legislation (which I sketch out here) having been passed in the last couple of years; the Serve America Act – which includes taxpayer-funded education stipends for qualifying “volunteers” – enacted in April; and Senator Dick Durbin (D-IL), according to the USA Today article, planning to re-introduce legislation that would allow private student loans to be discharged under bankruptcy.
And we wonder why higher ed costs, among other things, seem to be out of control…
Obama’s Broken Toaster
Recently on Leno, President Obama compared some financial products to an exploding toaster. His words:
When you buy a toaster, if it explodes in your face there’s a law that says your toasters need to be safe. But when you get a credit card, or you get a mortgage, there’s no law on the books that says if that explodes in your face financially, somehow you’re going to be protected.
So this is — the need for getting back to some common sense regulations — there’s nothing wrong with innovation in the financial markets. We want people to be successful; we want people to be able to make a profit. Banks are critical to our economy and we want credit to flow again. But we just want to make sure that there’s enough regulatory common sense in place that ordinary Americans aren’t taken advantage of, and taxpayers, after the fact, aren’t taken advantage of.
While I think we would all like to get to “common sense” regulation – arriving at such is unlikely if one’s understanding of the very problem is flawed, as seems to be the president’s.
Unlike broken toasters, mortgages and credit cards do not fail to pay themselves – borrowers fail to pay, almost always for a reason that has little to do with the characteristics of the loan itself. There is a wealth of empirical data documenting the causes of bankruptcy, mortgage and credit card default – much of which has been assembled by those on the left (take a look at any of Professor Elizabeth Warren’s work on bankruptcy). The fact is that the number one cause of all of these events is job loss. If the president has a plan for a mortgage that protects you from losing your job, I would love to see how that’s going to work. After job loss, comes unexpected health bills and divorce.
My hope had been that Obama’s talk about broken toasters was just a little pandering and could be safely ignored. However, judging from the structure of his foreclosure relief plan, he appears to believe that if we just lower the borrower’s rate, all would be saved. The sad truth is that his foreclosure plan does nothing for those really in need – who have lost their job for instance – they are simply out of luck. But then helping people who have lost their job would undermine the argument that it is all the fault of the product.
Shocking News: Fannie Mae Is Losing More Money
Yes, I know. It’s hard to believe. Fannie Mae continues to lose money and, even more surprisingly, isn’t likely to ever pay taxpayers back for all of the billions that it already has squandered. Rather, it says it will need more bail-out funds — probably another $110 billion this year alone.
Fannie Mae reported yesterday that it lost $23.2 billion in the first three months of the year as mortgage defaults increasingly spread from risky loans to the far-larger portfolio of loans to borrowers who have been considered safe.
The massive loss prompts a $19 billion investment from the government to keep the firm solvent, on top of a $15 billion investment of taxpayer money earlier this year.
The sobering earnings report was a reminder of the far-reaching implications of the government’s takeover in September of Fannie Mae and the smaller Freddie Mac. Losses have proved unrelenting; the firms’ appetite for tens of billions of dollars in taxpayer aid hasn’t subsided; and taxpayer money invested in the companies, analysts said, is probably lost forever because the prospects for repayment are slim.
But the government remains committed to keeping the companies afloat, because it is relying on them to help reverse the continuing slide in the housing market and keep mortgage rates low.
Even as the government bailout of banks appears to be leveling off, the federal rescue of Fannie and Freddie is rapidly growing more expensive. Fannie Mae said that the losses will continue through at least much of the year and that it “therefore will be required to obtain additional funding from the Treasury.” Analysts are estimating that the company could need at least $110 billion.
Freddie Mac, which has been in worse financial shape than Fannie Mae and has obtained $45 billion in taxpayer funding, will report earnings in coming days.
The response of policymakers in the administration and Congress to this fiscal debacle? Silence. No surprise there, since many of them helped create the very programs that continue to bleed taxpayers dry.
Alas, this isn’t the first time that the federal government has promoted a housing boom and bust. Instead, writes Steven Malanga in Investor’s Business Daily:
This cycle goes back nearly 100 years. In 1922, Commerce Secretary Herbert Hoover launched the “Own Your Own Home” campaign, hailed as unique in the nation’s history.
Responding to a small dip in homeownership rates, Hoover urged “the great lending institutions, the construction industry, the great real estate men … to counteract the growing menace” of tenancy.
He pressed builders to turn to residential construction. He called for new rules that would let nationally chartered banks devote a greater share of their lending to residential properties.
Congress responded in 1927, and the freed-up banks dived into the market, despite signs that it was overheating.
The great national effort seemed to pay off. From mid-1927 to mid-1929, national banks’ mortgage lending increased 45%. The country was becoming “a nation of homeowners,” the Times exulted.
But as homeownership grew, so did the rate of foreclosures, from just 2% of commercial bank mortgages in 1922 to 11% in 1927.
This happened just as the stock market bubble of the late ’20s was inflating dangerously. Soon after the October 1929 Wall Street crash, the housing market began to collapse. Defaults exploded; by 1933, some 1,000 homes were foreclosing every day.
The “Own Your Own Home” campaign had trapped many Americans in mortgages beyond their reach.
Financial institutions were exposed as well. Their mortgage loans outstanding more than doubled from the early 1920s to 1930 — $9.2 billion to $22.6 billion — one reason that about 750 financial institutions failed in 1930 alone.
The only serious option is to close down all of the money-wasting federal programs and laws designed to subsidize home ownership. A stake through the hearts of Fannie Mae, Freddie Mac, Federal Housing Administration, and Community Reinvestment Act, to start. Otherwise the cycle is bound to be repeated, again to great cost for the ever-suffering taxpayers.
Mortgage ‘Safe Harbor’ Anything But Safe
After the Senate’s rejection last week of allowing bankruptcy judges to re-write mortgage contracts, the so called “cramdown” provisions, it was starting to look as if the Senate cared about respecting private contracts. Sadly, such concern has been short-lived.
Tucked away in the mortgage bill is a provision that gives servicers of mortgages, that is, the entities that collect payments and perform modifications on behalf of the actual investors in mortgages, a “safe harbor” from any litigation by investors if the servicer chooses to follow the interests of the borrower or the government, rather than fulfilling their fiduciary duty to the investors.
Supporters of the safe harbor claim that too many foreclosures have taken place due to contractual restrictions on the ability of servicers to modify mortgages in a manner that would allow borrowers to stay in their homes. Most pooling and servicing agreements allow mortgage modifications without the investors’ approval if the modification increases the net present value of the mortgage. However, if the mortgage modification resulted in a loss to the investor, over what they would recover in a foreclosure, then they are not allowed under current contracts. The safe harbor intends to fix this “problem” by allowing the servicer to impose additional losses on investors, as long as that servicer follows President Obama’s foreclosure plan.
Allowing parties to a contract to ignore their contractual obligations as long as they sign-on to presidential initiatives is a dangerous precedent, and one that will ultimately raise the cost of entering into and enforcing contracts.
As these costs will have to be borne by someone, it is likely in the future that these efforts at undermining contracts in our credit markets will result in higher interest rates for all borrowers.
Love the Cards, Hate the Card Issuers
God hates the sin but loves the sinner, we are told. Americans have a similar attitude towards credit cards. They love the cards but hate the card issuers.
Naturally, President Barack Obama has picked up on this sentiment and wants the credit card companies to be “fair.” Reports the Washington Post:
The Obama administration yesterday called for an end to unfair credit card industry practices such as retroactive interest rate increases for any reason, late-fee traps that penalize borrowers with weekend or middle-of-the-day deadlines and teaser rates that last less than six months.
In a written statement released by the Treasury Department, the administration outlined practices it would like Congress to reform as it considers two bills that would crack down on the industry. One proposal would force card companies to apply payments above the minimum amount to the highest interest rate debt. To crack down on over-limit fees, the administration would also like Congress to require card companies to get customers’ permission to set up accounts so transactions over the limit can still be processed.
There are lots of reasons to criticize the practices of credit card companies, but many of the rules are simply mechanisms to charge riskier borrowers more. If you pay off your bill every month, you don’t pay the extra fees and interest. If you are more disorganized, short on cash, or both, you pay more.
Higher charges make it possible to provide more credit to more people. Of course, politicians believe in the latter but not the former. Banks should provide credit cards, make loans, and issue mortgages to everyone, irrespective of credit standing, at rates akin to those charged Bill Gates. Anything more is viewed as a variant of “predatory” lending deserving condemnation.
Maybe it would be best for some people not to buy so much on credit, but that isn’t — at least so far — the government’s decision. However, it would be more honest if government branded people with the Scarlet C and banned them from borrowing than prohibiting companies from charging higher rates and fees to reflect higher credit risks.
The credit card debate is stranger than most in Washington. Listening to critics you’d think that the card companies were dragooning people off the streets, forcing them at gunpoint to sign up for cards, and demanding that they spend money else their children will be kidnapped and sold into slavery. Precisely who was forced to accept and use these terrible cards with their terrible terms? No one.
Instead of posturing as defenders of the body politic, crusading politicians should, as my friend Don Boudreaux of George Mason University suggested, give up their day jobs and start credit card companies. These entrepreneurs then could offer consumers better cards with less onerous terms, making everyone better off.
Any takers?
Solve the Financial Crisis (and Make Some Serious Money)
Peter Van Doren and I have been puzzling over this very interesting NYT op-ed on home foreclosures by Yale economist John Geanakoplos and Boston University law professor Susan Koniak. If G&K’s story is right, then shouldn’t there be an opportunity for some clever financiers to help struggling homeowners keep their houses, help banks and other investors repair their balance sheets — and the financiers could help themselves to piles of cash in the process?
G&K argue that all three parties to a home mortgage — the homeowner, the lender, and the loan servicer who works as a go-between — currently face grim financial prospects:
- Many homeowners are “underwater” — that is, they owe more on their mortgages than their homes are now worth. According to First American Core Logic, some 20% of mortgages were underwater as of December 2008. The percentage varies greatly from state to state, with 55% of mortgages underwater in Nevada, but only 7% in New York. The homeowners who are underwater include not just those who purchased with little down payment, but also many people who put down the traditional 20 percent when they bought in 2005 or 2006, at the peak of the real estate bubble. According to Case-Shiller index data, house prices nationwide have fallen 27% (as of December) from their May 2006 peak. Some local markets have experienced more dramatic declines, highlighted by Phoenix’s 46% slide. Rental prices are now far below many homeowners’ monthly mortgage payments, and lots of underwater homeowners will have to make payments for years before they have some equity stake in their homes. Many of those homeowners would rather default and risk foreclosure. G&K’s op-ed includes this figure showing that defaults increase dramatically as homeowners sink further and further underwater. Given their current options, default is rational.
- The mortgage lender faces heavy losses if the home enters foreclosure. According to G&K, ”the subprime bond market now trades as if it expects only 25 percent back on a loan when there is a foreclosure.”
- The servicer also is at risk. According to G&K, the servicer is obligated to continue paying the lender its monthly payment even if the borrower is in default. That obligation only lifts at foreclosure.
Because of the servicer’s obligation, the servicer has strong incentive to push for quick foreclosure. However, the homeowner and the mortgage lender would likely benefit from a loan modification — even a significant write-down of principal — because that would keep the homeowner in his house and it would deliver a better return to the lender than the 75% loss from foreclosure. G&K thus argue that government, instead of continuing to bail out the banking industry and struggling homeowners (and putting taxpayers on the hook for hundreds of billions of dollars), should simply require that the lenders write down the mortgage principal.
But is government action needed? Couldn’t some private actors accomplish the same thing — and make some serious scratch in the process?
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