A central reason that Fannie Mae and Freddie Mac have not played a bigger role in rescuing homeowners, or otherwise handing out “freebies,” is that these two companies are in conservatorship.

Conservatorship is almost like a bankruptcy proceeding, or a receivership in the banking context, but without the power to impose losses. I’ve been criticized for believing that a conservatorship requires Fannie’s regulator to “conserve” the company, and not simply allow it to be used as a slush fund. The basis of said criticism is that FHFA, Fannie’s regulator, has a broad public mission, which could include handing out freebies to underwater borrowers.

Matt Yglesias suggests that “clearly the purpose of creating the FHFA and taking Fannie and Freddie into conservatorship can’t have been to minimize direct taxpayer financial losses on agency debt.” Now, Matt makes a lot of Congress being vague in the statute. And he is correct about it being vague, in some areas, but it isn’t here.

As one of the two people (the other being Peggy Kuhn) who actually drafted that section of the Housing and Economic Recovery Act (HERA) during my time as staff on the Senate Banking Committee, I can clearly say the purpose of the drafters, in terms of conservatorship, was to nurse those companies back to health. Again, how do I know that? Because I was there.

Of course, if one simply read that section of the statute, Section 1145 of HERA, which amends Section 1367 of the 1992 GSE Act, one would clearly see what the purpose, duties, and role of a conservatorship actually is. For instance, what does the law say the powers of a conservatorship are? They are to ”take such action as may be—(i) necessary to put the regulated entity in a sound and solvent condition; and (ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.”

Now, I don’t see anything in there about handing out freebies to underwater borrowers. Citing an agency-written mission statement or a vague “purposes” at the beginning of an act is no substitute for actually reading the provisions of a statute.

What’s a Conservatorship Good For? is a post from Cato @ Liberty - Cato Institute Blog

Five years ago, in the landmark property rights case of Kelo v. New London, the Supreme Court upheld the forced transfer of land from various homeowners by finding that “economic development” qualifies as a public purpose for purposes of satisfying the Fifth Amendment’s Takings Clause.  In doing so, however, the Court reaffirmed that the government may not “take property under the mere pretext of a public purpose, when its actual purpose was to bestow a private benefit.”

State and federal courts have since applied that pretext standard in widely differing ways while identifying four factors as indicators of pretext: evidence of pretextual intent, benefits that flow predominantly to a private party, haphazard planning, and a readily identifiable beneficiary.  Moreover, since Kelo, 43 states have passed eminent domain reform laws that constrain or forbid “economic development” condemnations.

While many of these laws are strong enough to curtail abuse, in at least 19 states the restrictions are undercut by nearly unlimited definitions of “blight.”  The state of New York has seen perhaps the most egregious examples of eminent-domain abuse in the post-Kelo era, and now provides the example of Columbia University’s collusion with several government agencies to have large swaths of Manhattan declared blighted and literally pave the way for the university’s expansion project.  In this brazen example of eminent-domain abuse, the New York Court of Appeals (the highest state court) reversed a decision of the New York Appellate Division that relied extensively on Kelo’s pretext analysis and thus favored the small business owners challenging the Columbia-driven condemnations.  The Court of Appeals failed even to cite Kelo and ignored all four pretext considerations, instead defining pretext so narrowly that even the most abusive forms of favoritism will escape judicial scrutiny.

Cato joined the Institute for Justice and the Becket Fund for Religious Liberty in a brief supporting the condemnees’ request that the Supreme Court review the case and address the widespread confusion about Kelo’s meaning in the context of pretextual takings.  Our brief highlights the need for the Court to establish and enforce safeguards to protect citizens from takings effected for private purposes.  We argue that this case is an excellent vehicle for the Court to define what qualifies a taking as “pretextual” and consider the weight to be accorded to each of the four criteria developed by the lower and state courts.

The Supreme Court will decide whether to hear the case later this fall. The name of the case is Tuck-It-Away, Inc. v. New York State Urban Development Corp and you can read the full brief here (pdf).  You can read more from Cato on property rights here.

Eminent Domain Shenanigans is a post from Cato @ Liberty - Cato Institute Blog

Two articles in today’s Wall Street Journal deal with the housing sector.  They complement each other. Journal reporters note that “Industry Speeds Recovery, And Housing Slows It Down.”  The story notes that that “ground-breaking for new homes and applications for building permits both plunged last month.”  Meanwhile, U.S. industrial output showed strong growth in May.

Bravo for both numbers, which are inter-related.  The headline (over which reporters have no control) reflects conceptual confusion.  U.S. industrial production is strong at least in part because construction of new homes is weak.   The bloated home sector is no longer absorbing a disproportionate share of economic resources.  The new homeowners tax credit has mercifully expired, ending that bit of misguided stimulus.

David Wessel’s article, “Rethinking Home Ownership,” further clarifies the reallocation of resources taking place in the U.S. economy.  Beginning in the 1990s, the federal government adopted a number of policies to stimulate home ownership.  As Wessel makes clear, it was a bipartisan effort.  Home ownership rates rose from around 65% to a peak of 69.4% in 2004.  It was an unsustainable policy, a true asset bubble.

Home ownership rates have now fallen back to where they began, or even below.  The experience of the 1990s and early 2000s in housing demonstrates why government stimulus is not a permanent source of demand, nor the path to sustainable economic growth. Lest we forget, the folly of these programs is measured not just in housing numbers, but in shattered dreams and hopes and ruined lives. And the terrible financial crisis to which these programs contributed

Two Cheers for the U.S. Economy is a post from Cato @ Liberty - Cato Institute Blog

The state of Maryland wants more people to have affordable housing — at least if they’ve already got it. Concerned that the owners of mobile home parks might sell the land for other uses, “affordable housing advocates” succesfully lobbied Maryland legislators this year for

legislation that, they say, discourages owners of mobile-home parks from selling their properties. If the landowner does sell, it provides the homeowner with some protection.

Under the law, which was passed earlier this year, a mobile-home park owner who wants to sell and change land use must give written notification to the residents and provide displaced homeowners with a relocation plan and relocation assistance that equals 10 months’ worth of rent. The legislation applies to mobile parks with more than 38 sites.

Now the first thing to be said about this is that it is theft. That’s become so common in legislatures that we’ve become accustomed to it. But we shouldn’t lose sight of what happened here: Some people spent their own money to buy land. They rented that land to people with mobile homes, who knew that they were not buying the land, they were just renting a place to park their mobile homes. (The word “mobile” might be a tipoff that they’re made to move.) And then the government took away the owner’s right to change the use of his land. The owner could still sell it, of course, as long as he gives written notification of his plans, provides the renters with a “relocation plan,” and pays them 10 months’ rent to leave his land. That’s a huge burden; the government has simply appropriated much of the value of the owner’s land.

But there’s an obvious long-term consequence here, too, one that the Washington Post didn’t get to in its 1000-word story. What’s going to occur to a landowner as she reads this story? She’s going to think, if I allow anyone to park a mobile home on my property, I’ll be permanently harnessed to that tenant, like a medieval serf. So maybe I’d better not rent any space to a mobile home owner. But then she’s going to think a bit further: What about other kinds of affordable housing? If I build inexpensive apartments or bungalows, and rent them to people who need affordable housing, will the state of Maryland decide that I shouldn’t be allowed to change the use of the land or sell it? After all, wealthy Montgomery County, Maryland — which doesn’t have many mobile homes — does have a 20-page handbook of rules and restrictions for any owner who might want to convert an apartment building to condominiums, including the county’s right to buy the land and a guarantee of lifetime tenancies for low-income elderly tenants. William Tucker pointed out in a 1997 Cato paper how rent control laws usually had to be followed by condo conversion restrictions, as building owners tried to find some way to make a profit on their buildings. And then of course the whole series of attempts to “protect” affordable housing leads to housing shortages and sky-high rents.

If you want people to supply affordable housing, it’s probably a good idea not to pile taxes, restrictions, and threats of confiscation on the backs of those who do.

Short-Sighted Rules for Affordable Housing is a post from Cato @ Liberty - Cato Institute Blog

In a recent speech to real estate interests, former Clinton HUD secretary Henry Cisneros preposterously claimed that the recent housing meltdown “occurred not out of a governmental push, but out of a hijacking of the homeownership process by some unscrupulous interests.”

The only criticisms Cisneros could muster for the government’s housing policies over the past 20 years were that regulations weren’t tough enough and it should have focused more on rental subsidies.

The reality is that Cisneros-era HUD regulations and policies directly contributed to the housing bubble and subsequent burst as a Cato essay on HUD scandals illustrates:

• Cisneros’s HUD pursued legal action against mortgage lenders who supposedly declined higher percentages of loans for minorities than whites. As a result of such political pressure, lenders begin lowering their lending standards.

• On Cisneros’s watch, the Community Reinvestment Act was used to pressure lenders into making more loans to moderate-income borrowers by allowing regulators to deny merger approvals for banks with low CRA ratings. The result was that banks began issuing more loans to otherwise uncreditworthy borrowers, while purchasing more CRA mortgage-backed securities. More importantly, these lax standards quickly spread to prime and subprime mortgage markets.

• The Clinton administration’s National Homeownership Strategy, prepared under Cisneros’s direction, advocated “financing strategies, fueled by creativity and resources of the public and private sectors, to help homebuyers that lack cash to buy a home or income to make the payments.” In other words, his policies encouraged the behavior that he now calls “unscrupulous.”

• Cisneros’s HUD also put Fannie Mae and Freddie Mac under constant pressure to facilitate more lending to “underserved” markets. It was under Cisneros’s direction that HUD agreed to allow Fannie and Freddie credit toward its “affordable housing” targets by buying subprime mortgages. Fannie and Freddie are now under government conservatorship and will cost taxpayers hundreds of billions of dollars.

Cisneros now serves as the executive chairman of an institutional investment company focused on urban real estate. Might that explain why Cisneros is now a fan of subsidizing rental housing?

“Unscrupulous” would be a good word to describe the millions of dollars Cisneros has made in the real estate industry following his exit from government.

From the Cato essay:

In 2001, Cisneros joined the board of Fannie Mae’s biggest client: the now notorious Countrywide Financial, the company that was center stage in the subprime lending scandals of recent years. When the housing bubble was inflating, Countrywide and KB took full advantage of the liberalized lending standards fueled by Cisneros’s HUD. In addition to the money he received as a KB director, Cisneros’s company, in which he held a 65 percent stake, received $1.24 million in consulting fees from KB in 2002.

When Cisneros stepped down from Countrywide’s board in 2007, he called it a “well-managed company” and said that he had “enormous confidence” in its leadership. Clearly, those statements were baloney—Cisneros was trying to escape before the crash. Just days before his resignation, Countrywide announced a $1.2 billion loss, and reported that a third of its borrowers were late on mortgage payments. According to SEC records, Cisneros’s position at Countrywide had earned him a $360,000 salary in 2006 and $5 million in stock sales since 2001.

Cisneros Rewriting HUD History is a post from Cato @ Liberty - Cato Institute Blog

Everyone in America, I presume, has just received a letter from the U.S. Census Bureau urging us to fill out our Census forms. Seems like a very expensive way to tell us to watch for the form to arrive in the mail. But I’m particularly interested in why they say we should promptly fill out the form:

Your response is important. Results from the 2010 Census will be used to help each community get its fair share of [federal] government funds for highways, schools, health facilities, and many other programs you and your neighbors need. Without a complete, accurate census, your community may not receive its fair share.

Obviously this is a zero-sum game. If my neighbors and I all fill out the form, then you and your neighbors will get less from the common federal trough. But at least we’ll be getting our “fair share,” as the letter tells us twice in three sentences.

But where does the government get the authority to ask me my race, my age, and whether I have a mortgage? In fact, the Constitution authorizes the federal government to make an “actual enumeration” of the people in order to apportion seats in the House of Representatives. That’s all. Not to define and count us by race. Not to ask whether we’re homeowners or renters. Just to ask how many people live here, so they can apportion congressional seats.

I’m not interested in getting taxpayers around the country to pay for roads and schools and “many other programs” in my community. All the government needs to know from me is how many people live in my house. And I will tell them.

More on the census and the Constitution here.

The Census Asks Too Much is a post from Cato @ Liberty - Cato Institute Blog

President Obama has announced his intention to use $30 billion in TARP funds to create a new small business lending fund.  In all likelihood, this is $30 billion the taxpayers will never see returned.

First of all, the problem facing small business, outside of the massive uncertainty being created by Washington, is one of credit availability, not cost.  For those who can get credit, its quite cheap, arguably too cheap.  So if the president doesn’t intend to lower the cost of credit, the plan must be to lower the quality; using the $30 billion to cover expected credit losses.  Of course, we tried throwing lots of taxpayer money at unsustainable homeownership, is there any reason to believe throwing taxpayer money at unsustainable businesses is going to work any better?

Using TARP funds for this program is also somewhat disingenuous.  This program adds $30 billion to the deficit regardless of whether it’s funded by TARP or by Congressional appropriations.  Taking from the TARP only allows the President to keep treating the TARP as his personal slush fund.  Nowhere in the TARP legislation can you find language authorizing the use of funds to cover credit losses on new loans.  Being a constitutional scholar, the President should know very well that the spending power rests with Congress, not the President.  If we are to have a new small business lending program, it should be designed and funded by Congress, not bureaucrats at the Treasury Department.

Historically the two main sources of small business start-up funding have been home equity and credit cards.  Clearly the availability of home equity has declined.  Sadly as well, with the passing of credit card “reform” the availability of credit card lending has also declined.  If the President truly wants to help small business, then the first thing to do is ask Congress to repeal the credit card bill and then just get out of the way.

Obama Small Business Lending Fund Likely A Bust is a post from Cato @ Liberty - Cato Institute Blog

A recent policy forum here at Cato discussed the role of the Community Reinvestment Act (CRA) in the financial crisis.  While the forum focused on the federal push for ever expanding homeownership to marginal borrowers, the analysis did not touch directly upon the question of whether CRA lending undermines bank safety.

Fortunately this is a question that one economist at the Federal Reserve Bank of Dallas bothered to ask.  While his research findings were available before the crisis, they were clearly ignored.

In a peer-reviewed published article, appearing in the journal Economic Inquiry, economist Jeff Gunther concludes that there is “evidence to suggest that a greater focus on lending in low-income neighborhoods helps CRA ratings but comes at the expense of safety and soundness.”  Specifically he finds an inverse relationship between CRA ratings and safety/soundness, as measured by CAMEL ratings.

In another study Gunther finds that increases in bank capital are associated with an increase substandard CRA ratings.  Apparently bank CRA examiners prefer that capital to be lend out, rather than serve as a cushion in times of financial distress.

Given the current attempts in Washington to expand CRA, it seems some people never learn.  One can always argue over how CRA should work, but the evidence is quite clear how it has worked, once again proving: there’s no free lunch.

Does CRA Undermine Bank Safety? is a post from Cato @ Liberty - Cato Institute Blog

Perhaps the worst feature of the bailouts and the stimulus has been that, whatever their merits as short terms fixes, they have done nothing to improve economic policy over the long haul; indeed, they compound past mistakes.

Here is a good example:

For months, troubled homeowners seeking to lower their mortgage payments under a federal plan have complained about bureaucratic bungling, ceaseless frustration and confusion. On Thursday, the Obama administration declared that the $75 billion program is finally providing broad relief after it pressured mortgage companies to move faster to modify more loans.

Five hundred thousand troubled homeowners have had their loan payments lowered on a trial basis under the Making Home Affordable Program.

The crucial words in the story are “$75 billion” and “pressured.”

No one should object if a lender, without subsidy and without pressure, renegotiates a mortgage loan. That can make sense for both lender and borrower because the foreclosure process is costly.

But Treasury’s attempt to subsidize and coerce loan modifications is fundamentally misguided. It means many homeowners will stay in homes, for now, that they cannot really afford, merely postponing the day of reckoning.

Treasury’s policy is also misguided because it presumes that everyone who owned a house before the meltdown should remain a homeowner. Likewise, Treasury’s view assumes that all the housing construction over the past decade made good economic sense.

Both presumptions are wrong. U.S. policy exerted enormous pressure for increased mortgage lending in the years leading up to the crisis, thereby generating too much housing construction, too much home ownership and inflated housing prices.

The right policy for the U.S. economy is to stop preventing foreclosures, to stop subsidizing mortgages, and to let the housing market adjust on its own. Otherwise, we will soon see a repeat of the fall of 2008.

Perpetuating Bad Housing Policy is a post from Cato @ Liberty - Cato Institute Blog

The ACORN scandal provides a good opportunity for citizens concerned about profligacy in Washington to explore some of the tools available to find out where their tax money goes.

A good place to start your research is the Federal Audit Clearinghouse on the Census website. All groups receiving more than $500,000 a year from the government are required to file a report. Just type in “ACORN” as the entity and the system pops up the group’s filings. My assistant John Nelson summarized the federal programs and amounts received by ACORN in recent years:

2003

Housing Counseling Assistance $1,168,388

Community Development Block Grants $388,273

Home Investment Partnership $8,000

Self-Help Homeownership Opportunity $204,082

Fair Housing Initiatives Program $85,000

Total $1,853,743

2004

Housing Counseling Assistance $2,209,009

Community Development Block Grants $221,007

Home Investment Partnership Program $21,092

Self-Help Homeownership Opportunity $127,183

Fair Housing Initiatives Program $105,000

Total $2,683,291

2005

Housing Counseling Assistance $2,605,558

Community Development Block Grants $367,560

Self-Help Homeownership Opportunity $153,082

Fair Housing Initiatives Program $140,917

Total $3,267,117

2006

Housing Counseling Assistance $1,955,074

Self-Help Homeownership Opportunity $59,541

Rural Housing and Economic Development $47,619

Fair Housing Initiatives Program $150,000

Community Development Block Grants $238,809

Total $2,451,043

2007

Housing Counseling Assistance $1,813,011

Self-Help Homeownership Opportunity $46,608

Rural Housing and Economic Development $30,504

Fair Housing Initiatives Program $60,000

Community Development Block Grants $372,950

Total $2,323,073

My colleague, Tad DeHaven, has discussed why these HUD programs that funded ACORN ought to be abolished completely.

Subsidy information is also available from IRS Form 990, which is filed by all non-profit groups and compiled at Guidestar and other websites. I am not an expert on this data, but Velma Anne Ruth of ABS Community Research has done a detailed analysis, which she kindly sent to me. She finds that federal funding for ACORN was about $1.7 million in 2008 and about $2.2 million in 2009.

Finally, a user-friendly website to research recipients of federal grants and contracts is www.usaspending.gov.

ACORN’s share of overall federal subsidies is tiny, but as thousands of similar organizations have become hooked on 1,800 different federal subsidy programs, a powerful lobbying force has been created that propels the $3.6 trillion spending juggernaut. ACORN’s own website touts its lobbying success in helping to pass various big government programs. So cutting off ACORN is a start, but just a small start at the daunting task of cutting back the giant federal spending empire.

Funding ACORN is a post from Cato @ Liberty - Cato Institute Blog

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 crises. 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 TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.

Instead of addressing our destructive federal policies aimed 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.

While the Administration plan recognizes the failure of the credit rating agencies, it 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 outsourcing of their own due diligence to the rating agencies.

The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.

Administration Reform Plan Misses the Mark is a post from Cato @ Liberty - Cato Institute Blog

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.

Reports the Washington Post:

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.

Shocking News: Fannie Mae Is Losing More Money is a post from Cato @ Liberty - Cato Institute Blog

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?

A financial wizard with sufficient backing could approach a troubled lender and offer, say, 50% of the original loan amount in order to take some of the toxic mortgages off the lender’s hands. Now, the lender won’t be happy with selling at a 50% loss, but that certainly beats a 75% loss, so the lender would grudgingly agree. The financial wizard would then approach the homeowner and offer to write down the mortgage principal to, say, 60% on condition that the homeowner purchase mortgage insurance. The homeowner should jump at the offer because it would put him back above water, purchasing a home that’s worth more than its debt. Finally, the financial wizard would get the servicer to release its control over the loan, because the servicer would want to be freed from the risk of having to cover the payments to the lender. The financial wizard would then pocket a cool 10% of the original mortgage’s value.

That is not chump change. G&K estimate some 8 million homes could be foreclosed upon in the coming years. Assume the original mortgage on each of those houses is $199,025 (95% of the median sale price of new U.S. homes in January 2004, about halfway up the bubble); that 10% would represent almost $160 billion.

Of course, if the bank proves recalcitrant and demands more than 50%, or the homeowner demands a write-down of more than 40% or he’ll walk away, that would cut into the profits. And the financial wizard would have to cover his costs and possible risk premiums. Still, at least in theory, there would seem to be a significant pile of money on the table.

So why isn’t this happening? Are there no money-loving financial wizards out there?

To some extent, they are. Last week, the NYT reported that some former Countrywide executives have formed a firm called PennyMac that, with financial backing from hedge funds and other investors, purchases toxic mortgages from insolvent banks at low prices, modifies the loans to increase homeowners’ likelihood of making payments, and profits from the rekindled mortgage revenue stream. In the particular case reported in the NYT, PennyMac paid 38 cents on the dollar. But PennyMac seems like very small potatoes compared to the $160 billion that may be on the table. And the banks were forced to sell the loans because they had been taken over by the FDIC.

So why aren’t there more firms doing what PennyMac is doing, or following the strategy that Peter and I have laid out above? And why aren’t banks lining up to offload their toxic mortgages (or to do the write-downs themselves and pocket the 10%)? Peter and I can think of three possible reasons:

1. As G&K note in their op-ed, banks and other investors who’re currently saddled with toxic assets may be waiting for some form of government rescue that would enable them to recoup far more than the 50% or so that would be offered by our financial wizards.
2. Banks are keeping bad mortgages on their books at values much higher than the 25 to 40 cents on the dollar observed in the rare sales of troubled assets, and so the banks are unwilling to sell the assets for 50 cents on the dollar. (Remember that PennyMac is purchasing assets from banks that have been taken over by the FDIC — in other words, these are forced sales.) The banks (and their managers) may strongly prefer to keep the assets on their books rather than sell them at a 50% loss.
3. The transaction costs involved in this scheme (e.g., analyzing the toxic assets to determine which ones to buy, negotiating with the delinquent and at-risk homeowners) are prohibitively large.

Government can address (1) by committing not to bail out the investors. Unfortunately, it’s unclear how reliable that commitment would be, especially given government actions so far in this financial crisis.

Fixing (2) is difficult. Accounting rules could be changed to force the banks to lower their book values for bad mortgages, but it would be difficult to get that accounting change passed quickly. Besides, some accounting experts argue that, in stressful times, accounting rules should have more wiggle room rather than less.

As for (3), the PennyMac guys claim that the work is difficult. But c’mon, there could be a $160 billion payday for the guys who can figure it out.

So, come on you money-loving financial wizards: your country needs you!

Solve the Financial Crisis (and Make Some Serious Money) is a post from Cato @ Liberty - Cato Institute Blog