Solutions For The Housing Crisis - Backstory And A Plan.

Thursday, November 20, 2008

I have been reading many of the various proposals to solve the financial crisis that we are facing here in the United States and the rest of the globe because the securities that are tied to the values of the troubled US assets were sold all over the world.

The United States is in a period that should be ripe for an instant and tremendous boom in growth. Energy prices are incredibly low, index rates are ridiculously low... and yet nothing is moving and credit, the lubricant of the economy, is not being extended or is extended at a premium.

First, a bit of a conversation about why banks are having solvency issues and are therefore either not lending or are lending at a premium.

The largest problem that the banks have is that they are over leveraged in securities for which there is no external valuation possible.

Let's clarify... When a bank does a loan, a value for the loan is assigned by the market and that loan is counted in the assets of that particular bank. So let's say that a bank has a $100,000 loan at 6% interest. In a normal market, if that bank wanted to sell that loan to someone else, they might be able to sell it for $104,000 to an investor that would then collect the interest, which would eventually add up to much more than their $104,000 investment. If the borrower kept the loan for 30 years, the investor would see a return of something like $200,000 on that $104,000 investment (avg lifespan of a loan is about 6-8 years now, then it is refinanced, so the return for an investor in reality is probably more like $30,000 but... whatever)

A bank will keep some of these loans for themselves to see the huge returns over time, and sell some as well so that they can make $4000 returns on that single $100,000 investment over and over and over as quickly as they can sell the loan paper to an investor.

So when an accountant is doing the books on a bank, they add up these loans that are still held on the banks books and did not get sold and assign them a "mark to market" value, or what the value of the loan paper would be if they sold it to an investor on any given day.

What is going on now is that the investors don't trust that people are going to pay their bills... actually, the problem is that they cannot tell the crap loans from the one that are ok. The reason is because so many stated income loans and Adjustible Rate Mortgages (ARM's) were given out, there is no way for the investors (or even the banks for that matter) to tell which loans are solid or which ones were given to people who should not have gotten them and not going to be able to pay their bills when the loan adjusts.

Because of this issue, no one wants to invest in these loans and the banks are forced to keep them on their books or sell them at a deep discount... like 80% off, which they really prefer not to do.

So the banks keep the loans on their books, and even though that $100,000 loan is really only worth $20,000 using the "mark to market" rule discussed above, there is an exception allowed in the case of a sector that is in a "firesale" situation. If a sector is in a rapidly declining market, it becomes much more difficult to judge what the fair value of that asset would be in the market, so the federally approved accounting rules allow the banks to assign an internally judged value to the asset... translation, they get to make up a number and that is what it's worth.

And, of course, this is what EVERYONE is doing... making up numbers.

The problem is that everyone knows it, and so even though their books say that these banks are solvent because of this accounting exception, none of them are... they are all trillions upside down. Trillions.

So investors that do have money don't want to give the banks money or invest in the banks assets because the assets aren't worth a damn thing on the market and the banks themselves are all "zombies"... the walking dead.


This is why the original intent of the bailout was not a bad idea... the banks would have been able to unload a decent chunk of their crappiest, highest risk and most valueless loans... but this creates 2 problems (besides the fact that Paulson isnt using the bailout money as intended)

1. Then the banks would have to admit that a certain percentage of their portfolio was crap. Even though everyone knows it is, no one wants to admit the extent of it because admitting it would shut them down instantly. Instead, they are hiding it with accounting tricks trying to skate by for long enough to make up for what they are short.

2. It does nothing to stop the rapid devaluation of properties and so keeps even the not so risky assets valueless because the investors that buy the loans at worst retrieve the asset the loan is tied to, ie a house. But the houses are worth less than the loans on them in many parts of the country, and this phenomenon is only getting worse... so why invest in a $100,000 loan if you are unsure if you will get your payments and the asset (house) that loan is tied to is only worth $70,000? Answer: you don't.


So, while the bailout was a necessary stop-gap to keep the banks from going under in the immediate sense, it doesn't solve the problem.

Ok, so what is the problem? Well, there are three:

1. There was a very bad initial assessment of risk attached to each one of these loans because no one is even reasonably sure that the person that took out these loans is able to pay them back because so many were done with a stated and not proven income level, so many were done as ARMs where payments are likely to increase in the future, and the most toxic were the ARMs that were issued to borrowers with state incomes.

2. The free-for-all credit situation caused a value bubble in many places, but the popping of the bubble is leading to such a huge devaluation that it is likely causing a reverse/down bubble in some situations. The over supply of even foreclosures houses on the market keeps pushing housing values lower. This makes it impossible for the people that own these houses to refinance out of the dangerous ARMs and into fixed rates because the assets have to be worth more than the loan.

3. With the continuing decline in values, the number of buyers is sparse. Why would you enter the market and buy a house that will very likely be worth 5-10% less than what you bought it for within 6-12 months. Especially when rates are good but nothing spectacular.


So, how do you solve these problems? I propose the following two actions... Mandate that the following pricing collusion stay in place for a period of 2-5 years.


1. Allow anyone that owns a house to refinance that house regardless of it's current appraised value on a FHA insured loan at 5% for 30 years or a 4.75% for a 15 year, BUT the borrower would have to prove income with pay stubs, w2's, tax returns, etc and also have to pay 1% of the loan amount in cash up front which gets paid directly to the FHA. Other closing costs can be rolled into the loan, as is procedure today, but that 1% must be in cash up-front.

This does several things. First, it provides the bank with an assets where a reasonable assessment of risk can be made and that asset becomes a viable market quatity... ie: you can sell it. Second, it provides the borrower with a tremendous break on pricing and a fixed rate. Third, the risk for the FHA is minimal because of the full documentation of income and assets, so the foreclosure risk is lower and with the up front fees charged as an additional offset of risk. Fourth, this would stem the tide of new foreclosure homes streaming onto the market, giving the market values a bit of stability. Fifth, there is no basis write down of the loans, so the banks are not writing off horrendous amounts of loses. The borrower signed up for a $100,000 loan... it is not the duty of the bank to make it $75,000 now because the value of the house decreased. Imagine if car loan customers demanded the same treatment?


2. Allow anyone with 10% down in cash and full income/asset documentation to buy a new house at 4% on a 30 year fixed and anyone with 5% down to buy a house at 5% on a 30 year fixed rate. The customer would also have to provide 1% of the loan amount as an up front fee in cash to the FHA.

This would bring in all of the people on the sidelines, and who are waiting for values to hit the bottom, into the market and begin to pull the oversupply off the market. It would also start moving the values of houses back up, softening or eliminating the losses incurred by those who are currently upside down on their house. The loans would be market viable because they are not only backed by the FHA but they are based on hard numbers and fixed rates. It would also allow many people previously unable to buy houses to do so.


So, to pre-empt many of the objections... here are the FAQ

1. But those rates are below market!

Yes, they are below the market because the market is distorted. In a normal market, with index rates as low as they are, rates on 30 year fixed loans would be pretty close to 4.5% or so. Hell, the Bank of England is talking about offering money at 0% interest and the Fed will likely lower their rates to 0.5%!!!

In addition, a slight tightening of the normal profit margin is far preferable than huge losses, continued write downs, increased numbers of foreclosures, and a valueless portfolio.


2. But what about those people that can't prove their income?

They get to keep the loan they have or go into foreclosure. If they can't afford the loan they got, they should not have taken it out. Period. It sucks and I feel very badly for them, but it's an unfortunate truth. And no, you can't just give them a lower rate because there is still no way to tell if they are able to pay back the loan and that loan remains not market viable.

Banks can still offer non-FHA stated income loans if they like, but I am sure the premium would be much higher and the risk more correctly assessed this time around, so this option would still be available to those exceptionally qualified.

3. But what about the people that can't bring the 1% in cash to close?

1% of a loan amount is approximately equal to 1 months mortgage payment, including taxes and insurance, in most states. Anyone deserving of a loan should be able to come up with that. If they can't, I suggest they borrow it.

4. 10% down! That is so much... many people won't be able to do that!

Umm... if you can buy a house at a 4% rate fixed, I think you would be surprised at how resourceful people would get to find the 10%. Regardless... 10% down on a purchase is what was required at a minimum for most of the 70's and 80's, and 20% down was required before that.

5. So how does this solve our problems? well...

A. It offers those in higher risk loans a way out and a discount at that.

B. It slows the tide of foreclosures

C. It turns the non-market viable loans on the banks books into something that they can both put a real value on and sell if they want because it is insured by the FHA and the borrower qualified by proving the ability to pay.

D. Investors are more likely to invest in the banks because their balance sheets are now reflective of real values and not the invented "mark to market exception" values, and are more likely to invest directly in the loans again.

E. It shores up the financials, making their basics much more solid and reliable.

F. The lower interest rates on loans and the stabilization of values will increase consumer confidence and spending.

G. The cash influx into the FHA from the up-front fees would minimize any risk to the government and thus the tax payer.

H. With the influx of buyers into the market, the demand for housing would resume and people in housing construction and in home retail would have jobs again.

I. No more deficit spending bailout craziness and the accompanying pork barrel crap.

and so on...


So, there it is... my solution.

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