Tuesday, October 07, 2008

Mortgage Bailout 202

Ochuk has a good 40,000 ft. rundown on the cause of the present credit crisis. I agree with everything he has written, so I thought I'd fill in some of the additional layers. This will be dry as toast, so I will accompany my post with pictures. For example:

I'll begin by stating that every relevant person knew that the housing bubble would pop. Given the market's immunity to price swoons, however, the risk was deemed reasonable enough by investors. In other words, it was a low-risk, high-reward proposition. Under ordinary circumstances, the markets could have sustained a fallout.

The reason the bottom fell out of the market so precipitously was fraud. Markets cannot account for fraud, almost by definition.

The most dramatic example of mortgage fraud is straw-buying, wherein a mortgage servicer sells someone (of modest income) a group of properties, usually accompanied by an offer to manage those properties. Conveniently enough, the properties in question just happen to be those owned by the mortgage broker (and possibly his real estate partner).

So they sell some poor sap five properties at greatly inflated value, securing the funding by sending documentation to five different banks simultaneously. Since each bank doesn't know what the other is doing, they approve the loan. Further, these loans were so-called "stated income" loans. Under normal circumstances... Wait, you're getting bored. Um...

But yeah, stated income loans. This is where banks offer a higher rate in exchange for not verifying your income. As preposterous as that sounds, these loans did once have a purpose, allowing farmers and self-employed folk to purchase land and property based on reasonable expectations of income.

In our straw-buying scenario, all the each bank knows is that some freelance graphic designer (which, apparently, had become the countries most popular profession overnight) is interested in buying a three bedroom home in Rogers.

In reality, a janitor for Cub Foods just took out $1 million worth of loans. The brokers immediately bailed on their promise to manage the property, so as to locate their next victim, er, investor.

And these are not small ticket fraud items. We can conservatively estimate that each of these brokers probably found twenty or so victims. So if 50 brokers are running similar operations in the Twin Cities, that's $1 billion in bad loans in one metropolitan area resulting from a single fraud tactic.

Oh, right, pictures... Um, take look at the Kutch...

Handsome fellow, isn't he? Too bad he can't act.

Of course, there are plenty of safeguards against fraud. Could you imagine someone trying to pull this crap on an insurance company? Have you seen Double Indemnity?

But banks weren't worried about mortgage fraud. Why would they be? They were packaging and selling their risks to someone else (see Ochuk's post). Further, their efforts were focused on eliminating identity theft and the like. Besides, while foreclosure was undesirable, the bank still had a hedge against outright loss.

Many homeowners made good faith efforts to restore their loan. These homeowners were met by loan servicers (hired by banks to deal with the proles) whose only goal was to extract more and more payments. Thus, instead of using savings to, say, put money down and restructure a loan with more favorable terms, they sent good money after bad in an effort to catch up on payments.

And why would the banks renegotiate loan terms? History has shown that people will do everything in their power to keep their homes. Home ownership was part and parcel of achieving the American dream, and to lose one's home was a one-way ticket to shame.

Well, until people started moving every two years and buying rental properties and such. Then, not so much. Banks failed to adapt their methodology to changing attitudes toward home-ownership. For younger generations, home ownership was an entitlement, not an achievement.

The penalty for losing one's home is a three year blight on one's credit. Any further punishment exists solely in the penumbras of the American dream. By ceasing to require homebuyers to put money on the line in the form of a down payment, banks eliminated any leverage they might have had.

Oh, and they failed to mention any of this to the people buying their bundled loans. So they had that going for them.

Now that the government has stepped in, the question now is how to value these bundles of loans. What is the expected return on a three bedroom home in Rogers, Minnesota, owned by a self-employed "graphic designer". See the problem?

Finding a solution to the mortgage mess will call for an end to the (literal) buck passing and ignorance. The institutions that win (i.e. stay solvent) during this crisis will be those that take the time to sit down with mortgage holders and determine their financial circumstances.

Widespread calls for homeowner bailouts, "regulation" and an end to golden parachutes are not going to cut it. Reviving our economy depends on reviving the housing market. That means empowering our financial leaders to forge creative, contextualized solutions to contend with the widest variety of risks.

That can only happen if and when the government realizes that it is not an economic savior. Or, at least, when we recognize that it isn't.


Anonymous Guy Incognito said...

Nice pictures!

3:21 PM  
Blogger Adam Omelianchuk said...

Bush is worse than Hitler!

8:09 PM  

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