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The Subprime Mess-- Skeel

As Obama, Clinton, and everyone else tout their remedies for the subprime crisis, I’m reminded of the old joke about a group of blind men who encounter an elephant. The man who grabs the elephant’s leg tells the others he has encountered a tree, the one who touches the trunk is sure it’s a huge snake, and so on. In the fall, subprime worries centered on the losses that banks were suffering, and the possibility that credit markets would seize up. Now the homeowners who are facing default are on center stage.

These parts are connected in ways that often get obscured.

Mortgage lenders lent money to the homeowners who are now facing default. The mortgages were immediately sold, often to an investment bank. The money for purchasing the mortgages came from investors (many of them banks), who put up cash in return for (“mortgage-backed”) securities linked to the special purpose entity that was set up to hold the mortgages. Here’s the problem with this market in mortgages: a lender who immediately resells the mortgage to someone else has very little incentive to carefully screen its borrowers. And they didn’t. A new study by several economists shows that mortgages that were securitized were 20% more likely to default later. The first test of any response to the subprime crisis should be whether it both encourages lenders to be more careful, and helps homeowners who might otherwise lose their homes.

Barrack Obama has proposed a tax credit to homeowners for 10% of their mortgage interest and $10 billion in bonds to help borrowers avoid foreclosure. This amounts to a small scale bailout. The problem with a bailout is that it provides no discipline for the lenders who shouldn’t have been making many of these loans.

Hillary Clinton calls for a 90-day moratorium on foreclosures and a five-year freeze on adjustable mortgages. This approach is more promising but still flawed. In the nineteenth century and during the Depression, moratoria were often used (even though they were unconstitutional in the nineteenth century, and everyone knew it) to help people keep their homes in a depression. Often this was the best tool lawmakers had at their disposal (the federal government wasn’t in the bailout business in those days), and it does help borrowers without letting lenders off the hook for their profligacy. But the moratorium is largely unnecessary given the current market chill; the interest rate freeze is blunt and arbitrary; and most importantly, neither would do anything to discourage the next round of overzealous lending and borrowing.

The most promising proposal, in my view, is a small change to the bankruptcy laws proposed by Senator Durbin. The Durbin proposal, which the Bush administration unfortunately is threatening to veto, would let a borrower who files for bankruptcy reduce her mortgage to the value of the property if the property is now worth less than the mortgage. (Under current law, mortgages are sacrosanct, a tribute to the influence of the financial services industry). Not only would this discipline lenders who made unwarranted loans; it also would provide an individualized solution to a homeowner’s financial crisis. And many troubled borrowers would never need to file for bankruptcy to get appropriate relief. The prospect of bankruptcy would encourage lenders to restructure these loans outside of bankruptcy, thus saving everyone the cost of bankruptcy. Both Obama and Clinton appear to support the bankruptcy change, but they don’t talk about it much these days, perhaps because technical bankruptcy reform doesn’t make for great sound bites.

As I will argue in more detail in another post, I believe that the bankruptcy approach should be attractive to my fellow evangelicals, despite many evangelicals’ discomfort with generous bankruptcy laws. Although traditional usury regulation is justly unpopular, the importance of fair lending– of a fair price and concern for the borrower’s wellbeing– is a pervasive theme in the Bible. (Exodus 22:26, for instance, instructs a lender who has taken a borrower’s coat in pledge to give it back by sunset). I have quibbles with some of the details of the Durbin proposal, and I share many evangelicals’ concern that borrowers be encouraged to repay what they owe if they can, but the Durbin proposal sure looks like the best of the current options.

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Comments ( 6 )

I've worked for many years with non-profit housing groups and, based in that experience, agree with your position on the Durbin proposal. I also applaud your reference to usury -- and humanity's longstanding legacy belief/behavior against usury (a belief system that includes and reaches beyond Christianity). A shared value that, unfortunately, does not remain strong in 21st century America. In fact, if we look at actual behavior -- at what actions say about our shared values today -- usury is acceptable: see mortgages, car loans, credit cards, payday. And, if we allow ourselves to move up one level of abstraction from lending to other economic activity, the prevailing behavior related to usury extends to pricing in other arenas: See pharmaceuticals, energy, and more.

All of this rises out of fundamentalist behavior, belief and practice. Not religious fundamentalism. But, rather, what in my book On Value and Values, I call shareholder value fundamentalism (and what others call 'free market fundamentalism'). Our concern for value (profit, share price, wealth and winning) has separated out from and now trumps our concern for other values.

The singular -- value -- is no longer used linguistically as a subset of the plural. It is unbounded by all other values. And left to its own domain, we get usury in many forms. Put differently, there is no rate of profit, no price for shares, no amount of wealth, no price of money that can be too high. Think about that. If asked, "Is there a limit to profit, interest rate, etc beyond which people just shouldn't go?", Americans today (for the most part) would not just say, "No" but look askance at the questioner, wondering about his or her sanity.

The Durbin approach sounds good -- I like it. But who picks the appraiser?

When the mortgage was first made, the lender picked the appraiser. Because the lender had lots of deals to get appraised, the appraiser tended to make the lender happy.

Under the Durbin proposal, in BK the mortgage would get marked down to 100% of current house value. That gets determined, presumably, by an appraiser selected by the court. But any appraiser, I assume, will be concerned about not just the fee he'll get today but also about the fees he wants to get in the future as well. Can he get future fees without regard to annoying the lenders today? Isn't there pressure on the appraiser to keep today's values "friendly" to lenders? (Yes, I know that current sales are a driver of valuation. But the other two drivers are construction cost and rental income. If there are no comparable sales -- or if the appraiser says other sales are not comparable, or if he adjusts those other sales to make them comparable (which he is required to do), then he can usually get the value he wants.)

The answer to my question may be that the originating lender is not damaged by the BK appraisal, only the investor who bought the mortgage from the originator, so the originator will not carry a grudge and remove the appraiser from the approved list. Maybe. Even so, I'd want to be sure that the appraisals are not influenced by the need for future business.

Will rates on new loans be higher or lower with the proposed change to bankruptcy law?

I'd guess higher.

How do we weigh the effect that will have on borrowers, including borrowers who are willing to purchase in the current market? Are we providing help to those who are already in their homes in the form of a tax on those who want to buy? Does that help stop the current spiral, or accelerate it?

Great questions, Thomas. I tend to agree that the current mortgage interest rates would be mildly inflated by this proposal, and also that it could increase the depth of the present trough in the housing market.

I was inclined to oppose such a proposal based on the belief that people who gambled on ARMs were simply getting what they gambled against, while I had been paying a higher rate all along to protect myself from just such an eventuality. Then I spoke to a friend who encounters elderly people regularly in his work in the financial services industry, and he told me of a 70+ year-old man who recently was sold a 30-year, 0-down ARM on a new construction home. Now he is in a bad way. There is no excuse for such lending practices. While I still think some of this is just rewards for folks who gambled, there are also clearly cases where people were ill served by lenders.

Using the bankruptcy process might work in theory but has major problems and drawbacks.

First, the results seem unfairly harsh on the borrower compared to the lender. If the problem leading to default was an interest rate reset on a subprime ARM, it is very reasonable to say that the lender struck an unjust contract because it trapped the borrower into what was likely to become a usurious interest rate in the future considering historical averages for the adjustment index and the unfairly high margin for the adjustments. So the lender is significantly at fault as well as the borrower. Practically everybody agrees that the terms of subprime ARMs are "toxic," and I concur. The lender merely suffers a partial loss of loan primcipal, but the borrower suffers major financial ruin for years. The borrower probably will not be able to refinance or buy another home for years, since loans to do that for low credit borrowers are no longer available. The lender will be able to write off the loss of principal and continue to collect reasonable interest on the balance. That seems unbalanced to me.

Secondly, I doubt whether there are sufficient resources in the bankruptcy court system to begin to deal with the hundreds of thousands, if not more than a million, of cases that would inundate it.

Thirdly, the judge must not only alter the principal, requiring the difficult decision as to the home value, but probabaly she must also decide on new terms for the mortgage, since the existing terms often led to the problem in the first place. Leaving the terms unchanged will likely leave the borrower equally unable to pay, or at great risk of default whenever interest rates rise. Trying to decide on new terms will be very challenging, especially if the results are to be tailored to each person's specific circumstances. BK judges will need to become underwriters and loan designers.

The subprime ARM crisis has led to a worldwide credit crisis that can easily snowball further into a U.S. depression. Starting in late 2008 there will be rate adjustments to the prime and Alt-A five year ARMs that many took out over the last five years. There are more than four times as many such ARMs as there were subprime ARMs, so the default problem could become many times worse than it is now, depending on the course of interest reaters over the next 18 months.

Currently, fully indexed rates for prime ARMs are now in the range of about 5% to 5.75%, because the most commonly used index, the one year LIBOR rate, has come down to about 2.8%, and typical margins are 2.25% to 2.75%. So the fully indexed rates are now not much different than the original "teaser" rates, many of which were in the mid 4% range. So adjustmens now would not hurt the borowers or the economy a lot. But, if rates rise over the next eighteen months, there will be a continual drain on consumer spending since adjusted rates, or presumably refinanced rates, will keep draining consumer cash flow into the depleted lenders' coffers. Of course, many borrowers will elect to sell to escape higher housing costs, if they are able to do that at a high enough price to pay off the mortgage, so the unsold inventory will rise again. Most likely rates won't fall enough to let the prime ARM borrowers completely escape higher payments, and this new phase of the crisis will worsen the housing market and the economy, putting yet more borrowers upside down on their homes.

It's long past the due time for national leaders, and lenders to admit the severity and urgency of the problem and do something bold and concrete to stop the crisis dead in its tracks at no cost to the taxpayer, and probably with a gain for the investors in mortgages. The way to do that is for Congress to declare a national economic emergency, suspend all foreclosures on defualted subprime ARMs for six months, and promulgate mandated new terms for all subprime ARMs (defined as any ARM with a margin higher than 3%, which alomost perfectly captures all subprime ARMs and no prime or Alt A ARMs). The new terms would include a rate frozen for at least three years not higher than 1.5% over the start rate, or 8.5% maximum, with new limits on the initial, periodic and lifetime rate adjustments and a limit of 4% on the margin. Payments already made in excess of those rates imputed back to the first reset would be credited to either principal or future interest, at the borrower's option. As part of the emergency act, or in a follow-up act Congress must promulgate new national regulations that limit margins and adjustments on subprime ARMs, and uniform national limits on prepayment penalties to enable a new generation of safer and more fair subprime ARMs to emerge.

The authority of Congress to dictate new terms of private contracts derives from the Supreme Court ruling of 1934 in Home Building and Loan, Ltd., vs Blaisdell, whereby the state has a right to intervene in private contracts when the general welfare is at stake. That ruling was specifically applied to a mortgage contract in relation to a Minnesota law that enable district courts to suspend a foreclosure action, so the precedent is directly relevant.

I hope all concerned citizens will begin pressuring their lawmakers to enact something along the lines I suggest, because the welfare of all homeowners is immediately at risk, not just the welfare of homeowners already in foreclosure, or those headed toward mortgage default. We must also realize that the banking system is headed closer to insolvency the longer this crisis drags on, and that will ultimately lead to an depression, since there won't be much bank lending available for growth.

The durbin approach makes sense.

Haven't heard much from obama or clinton lately, as the focus has shifted to other issues... Any ideas as to who would be best equipped to deal with this mess?