Stakeholders, history, and options in the mortgage mess

Who’s who?

Broadly speaking, the most important distinction is between people who own homes and people who don’t own homes. But which category someone is in may have changed during the bubble. So that gives us at least 6 categories:

cash-out owners: people that owned a home before the bubble and still own a home, but took out a larger mortgage during the bubble to obtain cash

regular owners: people that owned a home before the bubble and still own a home and did not get a cash-out refinance (or the equivalent if they moved)

buyers: people that did not own a home before the bubble but do now

sellers: people that owned a home before the bubble but have since sold it

renters: people that did not own a home when the bubble started and have not owned a home at any time since then

flippers: people that bought a home early in the bubble and sold it late in the bubble – they didn’t own a home when the bubble started and don’t now, but did at some point during the bubble

Clearly the people that gained the most from the housing bubble are the flippers and the sellers. The people who will lose the most if nothing is done are the buyers. The owners that didn’t take out equity should be fine, as they just won’t get to enjoy the paper gain in value that their house had for a few years. If they moved, they probably sold an overpriced house to buy a different overpriced house and overall didn’t win or lose very much. The owners that did take out equity through home equity loans, cash-out refis or HELOCs benefited during the bubble but may lose out now.

There were also multiple enablers of the housing bubble. They include:

mortgage brokers: companies that took your financial information and connected you with a bank that would give you a mortgage

appraisers: companies that determine a fair value estimate for a house

mortgage originators: mostly banks, but may include some other organizations. These are the companies that actually wrote your mortgage and provided the money for house purchases

investment banks: various speculative investing firms that bought mortgages to package them into securities

credit rating agencies: companies that looked at securities and determined how risking they were, then assigned a credit rating to indicate to investors how likely they were to default

investors: people that bought the mortgage-backed securities (MBS’s)

What did they do?

Before discussing how to solve the problem, it is useful to discuss how it was created. There are several things that happened with just the right timing to create the largest housing bubble in the history of this country.

One step was the creation of CDS’s. A CDS is a contractual agreement between two parties. One party agrees to pay a fixed fee periodically in return for the other party agreeing to buy a specified bond at face value if the issuer of the bond suffers a credit event (basically if they declare bankruptcy or otherwise default on the loan). Eventually this was modified so that instead of actually buying the bond, the seller of the CDS will make a payment equal to the difference between the face value of the bond and the current market value. This allows people to buy CDS’s without actually holding the bond as a way of speculating on a company declaring bankruptcy. For some reason, the government decided that it should have no part in regulating CDS’s. The current size of the CDS market is unknown because it really is just a type of contract that anyone can write without telling anyone about it. Estimates are on the order of $45T. These derivatives were called financial weapons of mass destruction several years ago by Warren Buffet (which still wasn’t enough to convince the government to regulate them).

Another step was the invention of ABS’s in general and MBS’s in particular. An ABS is an asset-backed security. The idea is that some investment bank will buy a whole bunch of similar loans and then issue a bond that is backed by all those loans. There are ABS’s available for car loans, credit card debt, student loan debt, mortgages, and probably other things too. The benefit to the buyer of an ABS is that they have lower credit risk. In normal market conditions, nobody wants to buy one mortgage because if that mortgage defaults you lose a lot of money. But you might be willing to buy 0.01% of 10,000 mortgages because then the law of large numbers allows you to make a reasonable prediction as to what percentage of the loans will default so that you can better estimate your losses. The benefit to the seller is that they charge a fee for collecting the loans and they keep some of the interest, while being off the hook for any defaults. The invention of MBS’s greatly increased the suppply of money available to people trying to get a mortgage.

After the internet stock bubble burst and the terrorist attacks of 2001, the US economy was slowing down. In an attempt to fix this, the Fed lowered US interest rates. One consequence of this is that mortgage rates dropped. With a lower mortgage rate, people could afford higher priced houses with the same monthly payment. This led to faster than normal house price increases. News stories started coming out about how much money people were making in housing. People started worrying that if they didn’t buy now, they would never be able to afford a house. The jump in demand for housing led to a self-feeding price increase that went far beyond what the fundamentals would support. In other words, housing turned into an asset bubble.

Fueling the asset bubble was the increase in MBS’s. The credit rating agencies gladly gave MBS’s their highest ratings because when house prices are appreciating, a foreclosed house still represents a profit for the lender. Somehow the ratings agencies missed the bubble in house prices and failed to account for the possibility that all house prices in the country could simultaneously fall, leading to massive numbers of defaults and a lower recovery rate on foreclosures (the recovery rate is the percentage of the principle that is recovered after the loan defaults). They assumed that despite the break from the historical trend in house prices, historical trends in default rates and recovery rates would continue.

As people kept bidding higher on houses without higher incomes, creative bankers came up with new forms of mortgages to keep the monthly payments low. It used to be that to buy a house you needed to put 20% down and get a fixed-rate fully amortizing loan, typically for 30 years. But the down payment requirement dropped. And the length of loans increased from 30 years to 40 and sometimes even 50. Loans became interest-only for the first few years and then even negative-amortizing (payments didn’t cover interest, so the principal increased every month). Low introductory rates were put on loans, so that the payments for the first few years would be affordable. Appraisers were told to appraise a house above a certain value if they wanted future business (so that the loan would be below some percentage of the house value to meet credit-worthiness thresholds).

When all the creative loans still weren’t enough, people started lying about their income. If people wouldn’t lie to buy a house, their mortgage broker would lie for them. The mortgage brokers learned what numbers they would need to get a borrower approved for a loan, and they would put in those numbers instead of the true ones. Note that some honest mortgage brokers remained who did not lie and asked for documentation. But they lost business as they had to turn away people who wanted to buy houses they couldn’t afford. Since there were plenty of dishonest banks and brokers, anyone who wanted a house could find someone that would help them lie (sometimes with and sometimes without their knowledge) and get approved for a loan. Many people who already owned their home joined in by doing a cash-out refinance – they got a new mortgage on their home that was for more than their old one, pocketing the difference.

While the mortgage originators were getting more
innovative, the investment bankers were also coming up with new ways to fund mortgages. They started buying lots of MBS’s and then issuing an ABS backed by MBS’s – a CDO (collateralized debt obligation). These were split into different segments based on how senior they were in the structure. This allowed subprime debt to be sold in part as a AAA-rated bond, providing the funding needed for the liar loans and other creative innovations the banks had come up with.

Fannie Mae and Freddie Mac provided more support for the mortgage market. These two companies bought mortgages that met their criteria (conforming loans) and issued MBS’s that they guaranteed. In other words, you could buy Fannie Mae or Freddie Mac MBS’s and even if the recovery rate was lower then expected, the companies would still pay all the interest and principal to the investors. In return for this guarantee, investors got a lower interest rate.

The CDS’s allowed people to buy MBS’s and CDO’s without worrying about the credit risk. The rating agencies told everyone there was no credit risk anyway. Many investors (probably including your pension fund and some of your 401(k) or IRA mutual funds) bought these bonds assuming that they were safe. As long as the housing bubble kept getting bigger, everyone involved was getting rich.

But eventually, even creative mortgage products couldn’t provide the necessary increase in purchasing power. People just couldn’t bid any higher for houses without an increase in incomes that hadn’t occurred. People that had gotten negatively amortizing loans couldn’t refinance, because their mortgage was for more than their house was worth. When the intro period ended, they had no options and had to default. As the foreclosures started growing in number, house prices first stabilized, and then started dropping. As prices dropped, more and more people ended up owing more than their house was worth. At the same time, the low introductory payment periods were coming to an end. People were suddenly faced with a mortgage bill that doubled or tripled. This led to more foreclosures and eventually started forcing prices to fall instead of merely staying level.

As house prices started falling, investors started worrying about buying MBS’s. With investors slowing their purchases, banks couldn’t offload their mortgages as quickly. Which meant they wouldn’t issue them as quickly. Which meant that people started actually being turned down when they applied for a mortgage. Which meant that people selling houses stopped having multiple offers and instead had their houses sitting unsold for months at a time. Which led to more price declines.

As house prices fell further and further, the recovery rate on foreclosures started dropping. The MBS’s started to pay out less than they were supposed to, so the investors were losing money. The CDO’s created leveraged exposure to MBS’s, so some of the CDO holders lost everything they had put into the CDO. CDS’s were triggered, causing banks to suddenly have to provide money they had promised but never expected to be asked for. As the banks started losing on MBS’s, CDO’s and CDS’s, some of them started to fail. This triggered further CDS’s. The credit ratings agencies started issuing downgrades on financial companies almost constantly, increasing their cost of funding and reducing their willingness and ability to make loans.

Bear Sterns was a major issuer of CDS’s. This spring, the Federal Reserve recognized that letting Bear Sterns fail would cause an unknowable effect on the financial markets because anyone who had bought a CDS from them would suddenly lose the protection they thought they had on their bonds. To prevent this, the Fed guaranteed Bear Sterns value and convinced JPMorgan-Chase to buy the failed bank.

A further complication in this whole mess is that Fannie Mae and Freddie Mac were independent private companies that were chartered by the Federal government. There was some kind of vague and unclear promise that the Federal government was guaranteeing all the debt issued by both companies. As they approached insolvency this summer, the government responded by fully taking over the companies. The MBS’s they have issued are now fully guaranteed by the federal government. The shareholders equity was wiped out completely.

Last week, Lehman brothers and AIG approached insolvency. Lehman brothers declared bankruptcy because they were not too big to fail. AIG had issued too many CDS’s to be allowed to fail, so instead the government took them over. The Lehman brothers bankruptcy caused a money market mutual fund to fall below $1, which caused a panic in other money market funds and over $100B being withdrawn from the money market in a few days. These funds are now unavailable to various businesses that need short term loans.

That brings us to where we are now. The housing bubble is deflating. Houses are still overvalued relative to incomes, so they have further to fall. There is an unknown and unknowable mess of CDS’s all over the financial system. Of the five big investment banks that existed 5 years ago, only 2 are still independent companies. The FDIC has fallen beneath its statutory capital requirements, so they are talking about raising their insurance fees. The government is talking about insuring money market funds. The various bailouts that have already happened have already promised close to $1T.

In summary, the housing bubble was caused by over-eager buyers and flippers overbidding on houses. It was enabled by mortgage brokers and appraisers willing to lie and by innovations in the finance industry that increased the amount of funding available for mortgages. An almost complete lack of government oversight meant that nobody was paying attention to the systematic risk that would be triggered by falling home prices. The private market oversight provided by the bond raters also failed to catch the systematic risk. Excessive speculation by hedge funds and investment banks created a monster from CDS obligations that can’t be met.

Now what?

Without government intervention, house prices will continue to fall. This hurts owners, buyers, and investors. It helps sellers and renters because they can more easily afford to buy a house in the future.

Paulson’s plan is to buy debts from the investment banks. This helps the investment banks. It hurts all taxpayers. In theory it also helps taxpayers because the investment banks will provide credit to keep the economy working in return for government assistance. Although the credit market freezing up has more to do with money market funds than investment banks, so it isn’t clear that Paulson’s plan actually does anything useful.

An alternative plan to the Paulson plan is for the government to directly lend in the money market. If the investment banks won’t lend money to keep the economy going, the government could instead. This would have a much lower cost than bailing out the investment banks while definitely achieving the stated goal of Paulson’s plan. It would hurt taxpayers some, but would also allow the economy to continue functioning.

A plan to bail out mortgage borrowers would primarily help buyers and cash-out owners, and to a lesser extent it would help regular owners. It would hurt all taxpayers. To the degree that it props up housing prices it would also help regular owners at the expense of sellers and renters. It would also help investors to the degree that they are repaid.

Sending out rebate checks helps everybody and hurts all taxpayers.

My proposal is to have the government hire 2-3 million people at competitive wages. Such a massive government jobs program would help everyone in a competitive job market (ie people making less than about $200k/year). It would hurt all taxpayers. By causing inflation, it would allow incomes to rise instead of forcing house prices to fall. This would mostly help renters, sellers, and flippers, who would find it easier to afford a
house, but would also help owners and buyers by making their house be worth more than they paid for it sooner instead of later. Inflation would also hurt people living on fixed incomes because their assets would drop in relative value. Inflation would have a difficult to predict, but probably negative, effect on investors.