Wednesday, March 19, 2008

Foreclosures

Anti has accused the Bush administration of doing nothing to help those facing foreclosures. I guess the question left unasked is whether the administration should be doing anything to prevent foreclosures, leaving aside the macroeconomic questions (also, the administration has been strongarming industry to renegotiate loan terms as part of the hope alliance, which i think is an awful idea, Barack Obama to his credit hasn't said a peep about preventing foreclosures). All of the discussion of preventing foreclosures boils down to one basic element: keeping people in homes they can't afford. Is this a desirable policy goal? I don't think so. It certainly does present a considerable moral hazard.

Over the last four years there have been those of us that have sat out the housing market because we have seen what looked like, and was in fact a bubble, but also, simply couldn't afford to buy. What's the responsible thing to do when you can't buy a place, well, not to buy the place. The responsible thing is not to get a no-document loan, or an interest only loan on the hopes on that appreciation will build equity for you. For a good many of the folks whose houses have gone into foreclosure they entered into mortgages with low teaser rates where they were paying interest only for a year and once the reset set in discovered that their house had depreciated and that they couldn't afford the new rate. Who is somebody that doesn't have any equity in a house, a renter. Why not just accept this reality rather than maintaining the fiction that these folks are actual homeowners.

If the administration were to put a moratorium on foreclosures it would essentially be taking money from fairminded folks who decided to live within their means for deciding not to enter into a mortgage that they couldn't afford and giving it to the profligate and stupid. At least with Bear Stearns what we are seeing is basically an orderly liquidation of the firm. JP Morgan is taking their good assets, though, along with the attendant litigation risk (they have purportedly set aside $6 billion for lawsuits) and the fed has become the speculator of last resort.

I think there is one other aspect though that needs to be fleshed out here. I think people are under the impression that foreclosures are good for the banks. They are awful, they truly are the last resort for the bank. The banks have every incentive to renegotiate the loan terms with the "homeowner". Mortgages are non-recourse loans. So if I default on my payments and can't negotiate new terms with my bank my home goes into foreclosure. Let's say the value of my loan was $500,000 but the bank can only get $350,000. As a mortgage is a non-recourse loan they can't pursue me for the $150,000 difference. They are stuck with the loss. So a foreclosure is a pretty shitty deal all around. I think the reason that you aren't seeing renegotiations en masse is that so many of these mortgages were so insanely stupid. The rule of thumb with a mortgage is that you want have a 1:4 ratio income to mortgage with 1:6 as the outerbound. You are seeing on a lot of the foreclosures, especially in Florida and California, trends where the ratio was closer to 1:9 or 1:10.

3 comments:

Anti-Everything said...

I have to agree, I don't necessarily think that the Federal government should enter the business of saving those suffering from foreclosure. I was merely pointing out how as of now the Fed really hasn’t done a whole lot in regard to the individual suffering from the subprime collapse (rightly or wrongly), but when it comes to a major investment bank who gambled on subprime loans and lost the Feds worked feverishly through the weekend to bail them out.

The New Yorker had a great article back in August that discussed the Fed cutting the discount rate by half a point which basically sums up my opposition to the Fed stepping in and taking actions similar to the ones we saw over the weekend:

“Money managers created the current turmoil by failing to take risk seriously, enabling borrowers with sketchy credit records to borrow money nearly as cheaply as blue-chip companies. In the past weeks, managers had been paying for their folly. The Fed’s decision to flood the system with cheap money will create a textbook case of what’s usually called moral hazard: insulating fund managers from the consequences of their errors will encourage similarly risky bets in the future.”

xtra said...

I am not sure that it is fair to consider this a bailout. I am still wrapping my mind around this. But Bear Stearns is getting liquidated. The Fed is putting in a sweetener for JP Morgan to take Bear Stearns on but Bear Sterns will cease to exist. The shareholders wealth will be effectively wiped out, and the managers gone (and for that matter without a severance). This seems more akin to a chapter 7 (i think, or is chapter 11) bankruptcy proceeding, except the fed is stepping in to speed along the process.

Anti-Everything said...

The key part of the "bail out" as I see it is that the Fed will be guaranteeing Bear Stearns riskiest investments (i.e. their subprime loans), thus alleviating JP Morgan from accepting that risk.

That in essence sounds like a bail out to me since it ultimately becomes a low risk sweat heart deal for JP Morgan.

It might not be a bail out for Bear Stearns, but some rather good corporate protection for JP Morgan.