How To Stop The Housing Market Bleeding

Big Bailout, Day 47: Can Government Fix The Crisis Government Caused?

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Treasury Secretary Henry Paulson and Federal Deposit Insurance Corp. Chairwoman Sheila Bair testified before the House Banking Committee today.

Paulson gave a vague summary of how bailout funds have been deployed so far..  The Congressmen on the committee were dissatisfied because there has been no direct intervention to prevent foreclosures.

Paulson tried to pacify the Congressmen by listing various government initiatives that encourage lenders to voluntarily make concessions to borrowers, but Committee Chairman Barney Frank cut him off, complaining that these preexisting measures were largely ineffective and were not a substitute for using Bailout funds to directly help borrowers.

Sheila Bair described a “proactive program of loan modifications” being conducted by Indymac Bank, which became a ward of the government, managed by her agency, after it failed last June. Indymac offers borrowers a combination of temporary and permanent changes in interest rates and terms to reduce the monthly payment, but does not reduce loan balances.   Most of the Congressmen were enthusiastic supporters of this program.

As a 26 year real estate investor in a region with one of the highest foreclosure rates, I humbly offer insights the media and most of the politicians don’t seem to understand.

Foreclosures most often occur when the loan balance exceeds the market value of the home.  Borrowers who can not afford their payments and know they have to give up their properties will sell if they owe less than they will receive from a buyer.

But, when the net proceeds of a sale, after paying commissions and closing costs will be less than they owe, they have an incentive to just walk away and let the lender foreclose.  Why bother with a sale if you won’t receive any cash?

Even borrowers who can afford their payments have a strong incentive to walk away when they see neighboring homes selling for less and less and the gap between their market value and what they owe growing larger and larger.

In a speech to bankers back in March Federal Reserve Chairman Brenanke agreed with this assessment and warned his audience:

“In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure…A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50% of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10% of principal,” Bernanke said. “With the time period between the last mortgage payment and…liquidation lengthening in recent months, this loss rate will likely grow even larger.”

Brenanke added that lenders and those who own the securities backed by the at-risk mortgages are likely to lose more through the foreclosure process than they would through reducing what homeowners owe.

He was right.  Market values in the worst regions, including California, Florida, and Ohio, have fallen at least another 15% since March, and here in Northern California, values have fallen more than 50% since the bubble burst in three years ago.  Losses to lenders are indeed even larger, just as Brenanke predicted.

This is a textbook supply-demand scenario, with the continuously increasing supply of foreclosed properties for sale driving market values ever lower, leading to more foreclosures, more supply and even lower market values.

Generally, we at Liberty Works oppose any government intervention in what should be free markets and private sector business and lending relationships.  In this previous post we described how government pressure on private lenders and reckless malfeasance by the two Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, led to writing tens of millions of mortgages that can not be repaid, leading to the current, intractable crisis.

To be sure, there were also bad actors on Wall Street, abetting the process of bundling  these subprime mortgages into securities and selling them to pension funds and financial institutions worldwide.  But, had the government not thrown its massive weight behind the practice of granting mortgages borrowers could not reasonably be expected to maintain there would have been far less exposure on Wall Street and the pain would have been limited to a few of the most irresponsible of financial institutions, who would be driven out of business.  There would be no massive spill-over, and no need for Government to, in Secretary Paulson’s words “rescue the financial system from an imminent melt down.”

Reluctantly, we conclude that because government caused this crisis, government has a moral obligation to do what only government can do to stop the foreclosures.

While politicians and government officials have generated a lot of publicity around their various measures to “keep people in their homes and avoid foreclosures,” these programs have been largely ineffective because they usually increase, rather than reduce principal balances.  Thus, wave after wave of foreclosures continue, each a reaction to the most recent drop in market values.

If the foreclosures are to be stopped, government intervention must come in the form of principal reductions to a point below market values where borrowers can realize some cash after paying sales expenses.

Some officials have proposed plans that lower balances but then deprive borrowers of part or all of their equity if they sell in the future, redirecting that equity back to the lenders or to the government.  This concept, if implemented, will fail because it doesn’t solve the problem of the borrower’s incentive to walk away and let the lender foreclose.

Government currently has the power to reduce the pain it has caused, either by ordering lenders to lower loan balances to below current market value, or by changing bankruptcy law to permit the courts to order the balances lowered.  A bankruptcy law change would give lenders a powerful incentive to come forward and offer borrowers substantial balance concessions in order to avoid a worse outcome in bankruptcy court.

What’s the alternative to systematically lowering balances?  Those same lenders and millions more Americans will suffer even greater losses.

When systematic balance reductions become reality the decline in market values will cease immediately, as buyers who have been waiting on the sidelines for prices to bottom out will rush in to snatch up all the remaining foreclosures.

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