Monday, June 29, 2009

Hedging Real-Estate Risk (Fabozzi, Shiller & Tunaru)

Abstract:
Real-estate assets represent more than one-third of the value of all the underlying physical capital in the United States and the world. The relationship between the level of interest rates and housing prices does not always follow one direction and a shock event in one market may trigger deep repercussions in the other. With the spread of the securitization process, the risks rooted in these two fundamental markets can have far reaching outcomes. The paper can be downloaded here.

Saturday, June 27, 2009

Canadian Residential Mortgage Markets: Boring But Effective?

Summary: Klyuev (2008) concluded that the Canadian market for housing finance is highly advanced and sophisticated, but financing options were somewhat limited, particularly at terms longer than five years. This paper argues that the paucity of longer-term loans is caused by a five-year maturity cap on government-guaranteed deposit insurance, and a prepayment penalty limit on residential mortgage loans in the Interest Act. That said, the availability and cost of residential loans for prime borrowers are comparable to those in the United States.

Download the paper here.

Thursday, June 25, 2009

Can pay, won't pay

Posted in the Economist:

HOUSE prices in America have fallen so far that as many as one in five households have mortgage debt greater than the value of their homes. In a few states, borrowers are not liable for the shortfall between an unpaid loan and the resale value of the home it is secured upon. Even where borrowers are on the hook, lenders often find it too costly to pursue unpaid debts. So some homeowners may be tempted to default and escape the burden of negative equity.

How widespread is this practice? New research* based on a survey of 1,000 homeowners suggests that one in four mortgage defaults are “strategic”—by people who could meet their payments but who choose not to. The main drivers of strategic default are the scale of negative equity, and moral and social considerations. Few would opt to renege on their mortgage if the equity gap were below 10% of their home’s value, the authors find, partly because of the costs of moving. But one in six would bail out if loans were underwater by a half.

Four-fifths think strategic default is wrong. Those in the unethical minority are four times more likely to renege on loans (allowing for other influences) when their negative equity reaches $50,000. But morality has its price. When the equity gap reaches $100,000, “immoral” homeowners are only twice as keen to walk away from their debts as “moral” ones. People under 35 or over 65 are less likely to believe that default is wrong. So are the well-educated.

Anger about bail-outs of banks or carmakers does not weaken the moral barrier to default. But people who live in neighbourhoods where home repossessions are frequent are more likely to welsh on loans. Homeowners who know someone who has defaulted strategically are 82% more likely to say they would do so, too. The likelihood of strategic default rises more quickly once the rate of local home foreclosures reaches a critical level. That hints at a vicious cycle of foreclosures that both depress home prices and weaken the social and economic barriers to further defaults. To break the cycle, policymakers need to address the problem of negative equity, not just unaffordable interest payments.

* “Moral and Social Constraints to Strategic Default on Mortgages” by Luigi Guiso, Paola Sapienza and Luigi Zingales, University of Chicago Working Paper

Sunday, June 14, 2009

Inaction on the Mortgage Crisis Will Hurt All of Us

Posted in the Washington Post by Jack Guttentag:

I don't ordinarily publish long letters, but this one is worth the space because it captures the mood of a sizeable segment of the population:

I'm upset by your recent article advising people having trouble with their mortgage on how to get it modified. In my view, they should be allowed to take their lumps.

My first home was a single-wide trailer that cost $18,000, which was all we could afford at the time. We have upgraded three times since then as our family and our income have grown, but we never paid more than we knew we could afford. . . . We have never missed a mortgage payment. I am tired of hearing the sad stories of people who overbought because they thought that house prices would rise forever and they would get rich. Their garages were full of boats and other toys that I don't have because I can't afford them.

It drives me nuts that these people can now take advantage of programs that reduce their mortgage payments, and I'm paying for it with my tax dollars.

The government should aim to promote good behavior, with programs that benefit homeowners who have played the game of finance the right way. Instead, government is helping the ones who were greedy or stupid or who lived beyond their means. I'm also tired of the media, including your articles, supporting these bad government policies by playing up how rough it is for these people whose lavish lifestyles have gone awry.

It is hard not to have some sympathy for this view. The measures the government has taken to deal with the financial crisis are indeed unfair, rewarding people who don't deserve it while burdening the many innocents who must finance it. So why do we do it?

In large part, we do it because inaction -- allowing the crisis to run its course, along with the major depression that would accompany it -- would not punish the guilty alone. It would also destroy the livelihoods and disrupt the lives of millions of others who have done nothing to deserve having their lives disrupted.

Every foreclosure we can prevent now, even if the borrower we help is a greedy speculator or a profligate spendthrift, means one fewer house being thrown on the market, which ultimately will prevent the layoffs of three people. Note: The number three is my guess; any econometricians among my readers are invited to correct it.

Furthermore, many consumers having mortgage troubles today were not greedy or extravagant; their only character deficiency was a lack of foresight, which afflicts most of us at one time or another. In particular, they didn't anticipate that house prices would plummet as they have. I didn't anticipate it, either. The price drop has been an underlying or contributing cause of most mortgage problems.

It is interesting that the issue of deservedness does not often arise in connection with aid to banks, auto companies or other firms. Most would agree that the firms getting the aid are the least deserving, but there is a grudging acceptance that this is a necessary price to pay for maintaining the viability of the system. When it comes to individual borrowers, however, the systemic implications are ignored, perhaps because the fate of any one borrower will not affect the entire system.

Policies that attempt to limit assistance to deserving borrowers, however, do affect the system because large numbers of borrowers in trouble are denied help. This is certainly the case with the government's program of assistance for loan modifications, which excludes investors -- those who don't occupy their homes. The rationale for viewing investors as undeserving is extremely weak -- most are small-business owners or members of the armed forces. But even if investors were not deserving, foreclosing on the homes they own has the same negative impact on the system as foreclosing on the homes of the deserving.

There is another reason to help homeowners with mortgage problems, even when the problems are of their own making. When we replaced debtor prisons with bankruptcy laws, we became a forgiving society that offered people who had erred second chances and fresh starts. It is a long-standing tradition that has served the country well.

In my view, the valid rap against the current government programs to curb foreclosures is that they have been too timid to have the major impact we need. That timidity seems to reflect a misplaced concern by policymakers that government not appear to be assisting undeserving borrowers. As a result, many deserving people are going to lose their houses.

Monday, June 8, 2009

How to rebuild US home prices and fix the economy

Posted in the Financial Times by Ross DeVol and Michael Klowden:

There are tentative signs that the US housing market is approaching a bottom but it is premature to declare that recovery is under way. Mortgage rates are low and tax credits to first-time buyers and lower prices are raising interest in home buying.

But as long as home prices keep plummeting, many potential buyers will sit on the sidelines. And homeowners who are underwater, with negative equity, might throw in the towel and default, putting more homes on the market – thus pulling down prices even more. Foreclosures and distressed properties already accounted for more than half of existing home sales in March.

If we want to create a broad-based housing recovery we must stop this downward spiral in prices. A number of government programmes have helped but have not yet stopped the bleeding. We suggest a new approach: give homeowners who owe more than their house is worth a financial incentive to stay in their homes and keep up repayments, by offering them a path to positive equity. Call it the homeowner principal forgiveness vesting plan.

More on this in a minute. But first, let’s look at what’s being done right now. The Obama administration’s homeowner affordability and stability plan is a step in the right direction to slow home-price declines. But it does not go far enough in addressing one of the fundamental problems: millions of homeowners owe more than their homes are worth. We estimate that 16.3m were underwater at least 10 per cent at the end of March; 6.5m more than 20 per cent; and 1.3m more than 30 per cent.

The first part of the administration’s plan allows homeowners to refinance with a loan-to-value ratio of up to 105 per cent through Fannie Mae. If you have negative equity of more than 5 per cent, you don’t qualify and must move to part two of the plan – loan modification. If stringent income and credit guidelines are met, the interest rate can be reduced to as low as 2 per cent. This will lower monthly payments and help many stay in their homes.

The drawback is this plan is unlikely to reduce foreclosures by as much as anticipated. Why? Because more than half of foreclosures are in California, Las Vegas, Phoenix and South Florida, and most homeowners who are severely underwater live in those areas. According to the home-valuation website Zillow.com, 67 per cent of homeowners in Las Vegas would need to bring cash to the table if they wanted to sell their homes and 51 per cent of homeowners in Modesto and Stockton, California find themselves in a similar position.

Let’s say you’re one of these homeowners. Even if you qualify for a loan modification and can afford the new lower monthly mortgage payment, why would you keep paying it if you don’t have any hope of having equity in your home for at least a decade? Only those who are compelled by an old-fashioned sense of obligation might continue making payments.

To fix this conundrum, the Obama administration should add the homeowner principal forgiveness vesting plan to its program. Here’s how it works: After a valuation of the property and proper income and credit verification, two separate loans are made. The first loan, from Fannie Mae, would be for the current value. A second, interest-only loan, from the Treasury Department, would make up the difference between the current home value and the original mortgage.

The Treasury loan would be the ”vesting” element of the program. For each year that the homeowner maintains their payments on the Fannie Mae mortgage and the Treasury loan, one-fifth of the Treasury loan would be forgiven. This gives homeowners the incentive of returning to a positive net-equity position before their hair turns grey – maybe even in time to pay for their children’s college education.

Yes, this plan would be expensive. If 1.5m homeowners were kept from foreclosure, it would cost the Treasury an additional $75bn (€53bn, £46bn) to $100bn. Many Americans might criticise rewarding people who made bad decisions, thereby creating a moral hazard. But it’s not just homeowners with subprime mortgages who are suffering. More than 60 per cent of homes that have been purchased since 2004 are underwater. Sure, the market could correct these problems on its own in time but it would be painful and disruptive. Besides, the moral hazard issue has been thrown out of the window thanks to troubled asset relief programme funds being issued to banks that originated or securitised many of these bad loans.

There would be major economic and financial benefits offsetting most of these costs. For every 100,000 foreclosures avoided, home prices would be 0.5 per cent higher. So, if 1.5m foreclosures were to be avoided, home prices would be 7.5 per cent higher than without the plan.

Assuming the plan were implemented in July, home prices would stabilise by the first quarter of 2010 and begin to recover thereafter. By the end of 2010, household holdings of property and other non-financial assets would be boosted by $1,800bn. Consumption spending and real gross domestic product growth would go up 1.1 and 1.6 percentage points, respectively, by the second quarter of 2010. Most importantly, 1.8m more jobs would be created by the end of 2010 than without the plan.

This is a win-win programme that allows homeowners to keep their homes, raises home values, increases GDP and creates jobs. Even the biggest critic of government bail-outs can forgive those results.

Saturday, June 6, 2009

Do these homeowners deserve help?

Posted on the OCRegister Mortgage Insider by Mathew Padilla:

Homeowners who treated their houses like cash machines, tapping the equity as home values rose, are among the most likely to end in foreclosure, even more than those who bought at housing’s peak, a new study finds.

Often homeowners have had second, third and even fourth mortgages at time of foreclosure — a trend not adequately addressed by any of the federal or state foreclosure avoidance progams, said Michael LaCour-Little, a finance professor at Cal State Fullerton who authored the study.

LaCour-Little tracked all houses and condos set for foreclosure auctions, known as trustee’s sales, in the first two weeks of November 2006, 2007 and 2008 in Orange, Los Angeles, Riverside, San Bernardino and San Diego counties. He is presenting his study today in Washington, D.C. at the mid-year conference of the American Real Estate and Urban Economics Association.

I plan a bigger story on his findings, but wanted to share a few results now.

For example, for the early November 2008 data sample, he tracked 2,358 properties. Here’s what he found:

  • They were purchased at an average price of $354,000 and average year of 2002 (long before the housing peak of 2005).
  • Total debt on the properties averaged $551,000 at time of foreclosure. That’s 56% more than the properties were worth when purchased, meaning at least that much was cashed out!
  • An automatic valuation model estimated average value at time of foreclosure was $317,000, which suggests a combined loan-to-value at foreclosure of more than 170% ($551,000/$317,000). And that is a conservative estimate. Properties that banks later sold had an average resale price of $271,000!

LaCour-Little is, well, diplomatic in his conclusion that “borrower behavior, rather than housing market forces, seems to be the predominant factor affecting outcomes.”

More telling is a rough calculation the professor did, estimating that for all properties in his study homebuyers made downpayments of $262 million and cashed out $2 billion, for a 40% return on their money over six years.

The professor stops there. But my inference is — are these people government officials should be trying to help keep their homes?

Lending 'Reform' We Don't Need

Posted in the Washington Post by Jack Guttentag:

Reading proposed legislation designed to "reform" the mortgage market is usually a depressing experience for me. Most of the proposals would take us further from a competitive system that works for borrowers. This is certainly true of HR 1728, called the Mortgage Reform and Anti-Predatory Lending Act, which passed the House and was winding its way through Senate when this was written.

Virtually every section of the House bill, an amendment to the Truth in Lending Act, bears the fingerprints of consumer groups or mortgage lenders. Legislators and their staffs operate under the illusion that by refereeing between these groups, they can achieve a balance between the interests of borrowers and those of lenders. This is an illusion because most of the policies espoused by consumer groups further the interests of consumer groups, not those of consumers. Consumer groups look to entangle lenders in a maze of complex rules and potential liabilities, which provide opportunities to counsel and litigate for borrowers, and make special deals with selected lenders.

Unfortunately, neither lenders nor consumer groups want to make the market work more effectively because a well-functioning competitive market would both force down prices and reduce the need for consumer groups.

The mortgage market works poorly because borrowers know so little relative to the loan originators they deal with. Economists call this the problem of information asymmetry. There are two major tools for overcoming information asymmetry: mandatory disclosures, which are discussed below, and transaction simplification rules, which I will discuss next week.

Under mandatory disclosures, government requires that lenders disclose what borrowers need to know to negotiate on an equal basis. We have had mandatory disclosure for three decades, however, and it has not helped borrowers in the slightest. Mandatory disclosure has raised lender costs and lengthened transaction periods, but for the most part has left borrowers as confused and overwhelmed as before. Indeed, judging from the many hundreds of letters I have answered on the subject, the required disclosures in many cases have created more, rather than less, confusion.

The reasons are well known to everybody familiar with the process, including many consumer groups: The total volume of disclosures is excessive, overwhelming borrowers; a large proportion of disclosed items is garbage of no value to borrowers; some disclosed items are irreconcilable with others because they originate with different agencies; and none are abreast of the current market.

The major source of these problems is the early decision by Congress to make itself the source of many of the items subject to disclosure. The garbage disclosures all come from Congress. As just one example of many, the requirement that every transaction must show the sum of all scheduled monthly payments over the term of the loan, which is a completely useless number, is in the law.

Congress is also responsible for entrusting the two most important disclosures -- truth in lending and the good-faith estimate of settlement -- to two agencies (the Department of Housing and Urban Development and the Federal Reserve) that have never succeeded in reconciling them. And of course, there is no possible way to keep disclosures up to date when substantive changes require new legislation.

The remedy is obvious: Congress should remove itself from disclosure operations and eliminate all existing congressionally mandated disclosures. Sole responsibility for all mortgage disclosures should be entrusted to one agency, which would have the legal authority to set and revise the rules as needed. This is the approach taken a few years ago, to good effect, in Britain.

The approach taken by HR 1728, in contrast, leaves the current disclosure system in place and adds a new set of mandatory disclosures to the pile. Under one of them, lenders will be obliged to disclose "the comparative costs and benefits of each residential mortgage loan product offered, discussed or referred to by the originator." Compliance with this rule alone, ignoring extensive other new disclosures stipulated in HR 1728, would probably double the size of the garbage pile dropped in the lap of hapless borrowers. Needless to say, none of the existing garbage disclosures would be eliminated.

The cardinal sin of any disclosure system is overload because borrowers have limited time and attention span. Disclosing too much is the same as disclosing nothing because nothing is absorbed. Adding even a badly needed and well-designed new disclosure to an existing pile of garbage disclosures does nothing but increase costs. An agency whose sole business is disclosure would quickly learn this, but Congress never will.

There's still room to improve foreclosure rules

A competitive mortgage market that would work for borrowers requires an effective system of disclosures and transaction simplification rules to equalize the playing field between borrowers and loan originators.

As indicated BOVE, an effective disclosure system would require the end of all existing congressionally mandated disclosures, which are largely useless, and entrust sole responsibility to one agency that would set and revise the required disclosures as needed.

Transaction simplification rules are needed to separate third-party service transactions from the mortgage transaction, to sharply reduce the number of lender charges that can vary from loan to loan and to assure the validity of price quotes. These rules would empower borrowers to protect themselves from abuse by loan providers.

-- Rule 1, as simple as it is obvious, is that any third-party service required by lenders must be paid for by lenders. The cost of these services would be embedded in the mortgage price, in the same way that the cost of automobile tires is embedded in the price of an automobile. But the price would be much lower because lenders can buy the services for less than borrowers, and it would no longer needlessly complicate the mortgage transaction.

-- Rule 2 would limit lender charges to points, expressed as a percent of the loan amount, which are traded off against the interest rate, and one fixed-dollar fee that must be posted and the same for all transactions. This rule would eliminate fee escalation, which is common practice.

-- Rule 3 would require that the prices that lenders lock be the same as the prices they quote to a borrower shopping the identical loan on the same day. This rule would eliminate low-ball price quotes, which pervade the market.

Not surprisingly, none of these rules is found in the current bill, which is aimed not at empowering borrowers to protect themselves but at replacing private decision-making by lenders with government-imposed rules.

Some of the rules in the bill are sensible, such as the requirement that mortgage originators be licensed. It would also prohibit the sale of single-premium credit insurance, which would be barred by my more comprehensive Rule 1. But other rules -- essentially knee-jerk reactions to abuses that arose during the go-go years before the crisis -- are toxic.

One involves mandating detailed underwriting rules and procedures, which is in effect Congress telling lenders how they must assess risk. This is the same kind of legislative overreach that Congress embedded in Truth in Lending, where it specified the items that had to be disclosed, with the disastrous results discussed last week.

A second toxic rule requires that lenders be responsible for assuring that borrowers who refinance obtain a "tangible net benefit." In every refinance, the net benefit depends on something known only to the borrower. Making the lender liable for what is in the borrower's head is bad policy.

A third rule would require that all mortgage lenders retain 5 percent of the credit risk on any loan they sell. I am not sure whether this rule will prove toxic or not, but it will raise costs, especially those of the smaller lenders who sell all the loans they write.

The current bill provides an escape hatch from these three rules, in effect waiving them on "qualified mortgages." A qualified mortgage has an annual percentage rate no more than 1.5 percent above that of a "prime" transaction, on which the borrower's total payment obligation does not exceed some maximum to be prescribed by regulation, has a 30-year term and fully documents the borrower's financial status.

The qualified mortgage escape hatch from these rules will divide the market between qualified and nonqualified mortgages. The nonqualified group will be larger, because it will include all loans with terms other than 30 years; loans with debt-to-income ratios above the level deemed prime by the regulators; loans to borrowers with FICO scores below about 660, who pay a rate premium of about 1.5 percent in the current market; most loans to self-employed borrowers; most loans for investment purposes or on properties other than single-family houses; and all loans with risk variables that in combination require a risk premium of more than 1.5 percent.

In the current market where risk premiums are extremely high, that covers a lot of ground.

The bill in Congress says nothing about the down payment, the most important risk variable of all. If prime loans are viewed as having down payments of 20 percent or more, which is consistent with the concept of "prime," mortgage insurance on loans with smaller down payments will increase their APRs, pushing many of them into the nonqualified sector as well.

Borrowers taking nonqualified loans will pay a price increment charged by lenders to cover the additional liabilities they assume under the bill. This will be an addition to the large risk premiums they already pay in a highly risk-averse market. Prime borrowers get a pass.

Tuesday, June 2, 2009

Mortgage Investors Fear Safe Harbor Law

Posted in Forbes by Maurna Desmond:

Big pension funds and other mortgage investors scored a huge victory earlier this year when they were able to kill the push for mortgage cramdowns, but the quiet passage of a so-called servicer "safe harbor" law this week has them worried.

As part of a larger housing bill, President Obama signed a provision granting special legal protection to mortgage servicers that modify loans under the administration's Making Home Affordable plan and the Federal Housing Administration's foundering Hope for Homeowners program.

Advocates say giving servicers more legal protection will decrease the number of unnecessary foreclosures, mitigating the next wave of defaults that are expected to hit in the next few years. Safe harbor "ensures a more efficient process for assisting troubled borrowers," says John Courson, president of the Mortgage Bankers Association.

Mortgage investors don't like modifications because lower interest payments for borrowers means less money or even losses for them. These investors, including major pension managers, mutual funds and life insurance companies, recently stepped up lobbying efforts to curb Washington's modification push.

Servicers have inherent conflicts of interest, they say. The four biggest U.S. banks, Bank of America, Wells Fargo, Citigroup and JPMorgan Chase, underwrote more than half of the second liens guaranteed by FDIC-backed banks. They also service 60% of first-lien mortgages in the U.S.

Modifying a first-lien mortgage so borrowers can avoid default increases the likelihood that the second lien will also be repaid, which is, of course, good for the bank, never mind the losses investors take when the loans are modified.

Portfolio managers are practically stomping their feet about this. "The incentives of the servicers are very misaligned," says Scott Simon, who manages Pacific Investment Management Co.'s $500 billion mortgage book. "All the seconds [liens] are held by the banks who are the servicer's parents."

Bill Frey, a principal of Greenwich Financial, represents a consortium of nameless mortgage investors in a court battle with Bank of America. They are demanding the Charlotte bank buy back every loan it agreed to modify under a $8.4 billion predatory lending settlement. (See "Bondholders To BofA: 'These Mortgages Must Be Yours.'") Frey says his group is "seriously contemplating" challenging the safe harbor legislation in court.

Loan modifications are "a multi-hundred-billion dollar wealth transfer from pension funds and IRAs and 401(k)s to large banks," Frey says. "This is a backdoor bailout of the banks."

Managing directors and principles at several multibillion-dollar money management firms privately expressed concerns about safe harbor during interviews in recent weeks. These investors insisted on anonymity in order to avoid being cast as advocates of foreclosures.

So far, only a handful of investors, including TCW and T. Rowe Price, have been outspoken about their objections to loan modifications. (See "T. Rowe Price Calls For Halt To Obama Mortgage Bill.")

Activist groups like the Neighborhood Assistance Corp. of America have gone further, attacking respected investors like Pimco's Mohammed El-Erian and Freddie Mac's David Moffett, as "predators" for their positions on housing issues.

How successful safe harbors will be in getting banks to modify more loans remains to be seen, given the litigation risk. Loans were being modified even before the bill passed, as banks tread gingerly on the lines separating their duties to borrowers, investors and the government, which has pumped trillions into the system to bail them out.

"Both sides are right," says Josh Rosner, a managing director at Graham Fisher. The new legal protection will definitely bring about lawsuits down the road, even though that is exactly what it is supposed to prevent. "As much as the government wants servicers to be aggressive, servicers aren't stupid."