As the treasury continues to figure out how to use their $700 billion, there seems to be a real conversation about how to directly assist troubled mortgage holders. I have yet to hear an effective structure for any of these programs, and have heard even less about averting a moral hazard. When John McCain talks about economics the only thing he can be sure about is the need to “renegotiate mortgages.” His speeches frame a program that sounds roughly like the Home Owner’s Loan Corporation (HOLC), a great depression era government program, but the details of McCain’s plan are more than a bit scarce. A different approach was outlined in yesterday’s New York Times. This Treasury/Bush plan seems to be more of a loan guarantee program. This 3 part series will explore both of these options in Parts one and two, then explore the moral hazard issue in part three.
Part I – The Loan Guarantee
There are some fundamental flaws in the loan guarantee program outlined in the Times article. The guarantee promises a government backing after a loan is “modified according to standards established by the government”. A guarantee will add collateral to a loan, and should in theory reduce an individual’s risk factor, thereby inducing the bank to restructure at a lower rate. But the guarantee does not address a core issue, a sub-prime lender will never be able to afford a restructured payment because the borrower is over leveraged. In a loan guarantees the borrower still carries all the principle debt. In this lending climate any successful program must address the issue that the typical troubled mortgaged holder is overextended and must deal with some management of their unaffordable principle.
First we must identify what it means to be over leveraged. In December of 2007 Henry Paulson identified this as a key problem and suggested abandoning rate based initiatives because they would not work, recommending instead to freeze teaser rates to buy time to create a comprehensive policy. Secretary Paulson understood that an over leveraged borrower can only afford their principle based on a “Teaser Rate”. The borrower had planned on refinancing their mortgage before it adjusted to a higher rate, which allowed a borrower to afford a much higher principle in the short term. If the borrower planned on continually refinance before the mortgage is adjusted they could perceive this teaser rate to be the long term rate of their loan. This borrower was able to obtain this mortgage based on extremely lax underwriting standards which aligned the lender’s incentive structure to support this reckless mortgage planning. My analysis in “You would have been an idiot not to take a teaser rate, adjustable mortgage in 1999” showed how tempting it was for someone to become over leveraged using the above described method.
A loan guarantee will not help the over leveraged mortgage holder by reducing their principle debt burden, the core problem noted above. The best a guarantee program can do is effect the interest rate. To be effective the guarantee must be able to lower it enough to make debt payments affordable. I think a suitable benchmark target rate (and Henry Paulson would agree) would be the last rate an over leveraged borrower could afford, which was likely a teaser rate of approximately 3%. With a bank’s cost of obtaining capital around 5%, (the current LIBOR rate) I would argue it is impossible for a sub-prime applicant to receive 3% in today’s market, even with a government guarantee.
As LIBOR begins to come down a guarantee becomes more feasible but it seems that the risk level of a sub-prime borrower will only become worse. The guarantee will have to overcome all market risk factors that are working in the opposite direction of keeping a rate artificially low. This means the government will have to take on more risk to induce a low rate as: (1) housing prices (the asset the mortgage is secured against) continue to fall further (dropping 14% in the spring), (2) unemployment continues to rise and (3) recession fears continue to deepen. It would be impractical to assume given these factors a risky borrower would be able to obtain a rate anywhere near their former teaser rate, even with government backing.
I also want to note a guarantee may actually hurt the foreclosure problem by putting an incentive structure in place for more foreclosures. A guarantee does not prevent the bank from foreclosing on a property and selling it at auction. I present the following scenario: A bank will restructure the loan, the homeowner will still default because they cannot afford debt service on such a high principle (as shown above), then the bank will still foreclose, capture the government’s guarantee and auction the property for whatever it might still be worth. The government backing gives a higher payoff for foreclosure. This additional reward for foreclosing may provide enough incentive for a bank to cut their losses.
The Times article was light on detail, but it seems the guarantee will be working against market forces that are making these borrowers more risky and do not provide a solution to reduce an unsustainable principle. Any way this program is designed the targeted troubled homeowner is still without a home. Not a very promising solution.
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