The issue of mortgage ‘cram-downs’ – allowing bankruptcy judges to reduce principle on primary residential mortgage loans – is in the news again as a version of legislation passed in the house of ‘representatives’ yesterday. This is an extremely important issue and the passage of such legislation would be an unmitigated disaster for our economy.
Where does the money come from?
First, it is important to understand that banks do not directly loan the majority of the mortgage money in existence. This money comes from secondary market investors in the form of their purchase of mortgage-backed securities (MBS). While securitization has taken a beating in the media over the past year, it is important to remember that not all MBS are collateralized debt obligations and exotic derivative products. Today, the overwhelming majority of secondary market investment comes from investor purchases of government-backed MBS in the form of FHA and GSE (Fannie Mae and Freddie Mac) loan pools. Already, such securitizations are under a considerable amount of strain – and for obvious reasons. The international economy continues to operate under extreme stress. Potential purchasers of MBS have greatly reduced capital access and are under pressure to make sound investments that will perform well in the short-term, as well as over time. The American economy, upon which the strength of MBS ultimately rests, continues to face a variety of challenges. Specific to MBS performance, continued job losses, declines in home values and questions regarding the underlying strength of major financial institutions are drawing ambiguous answers from even the most astute observers and analysts.
Understand, next, that secondary market investor purchases of MBS are the source of funding for mortgage loans. Absent these successful securitizations, the flow of money stops. Today, these securitizations are made possible only due to the now-explicit guarantee of such securities by the federal government. Absent this guarantee, purchases of MBS are simply too risky to attract the prerequisite capital. If you think things are rough now, imagine an economy where the flow of mortgage dollars simply stops, cutting off any possibility of mortgage refinance, purchase and, therefore, of sale. In this worst-case scenario, all citizens are equally impacted up and down the economic spectrum. Need to refinance to lower your monthly payment or move from an adjustable rate to a fixed rate loan? No option. Looking to purchase a home? No option. Pay your mortgage just fine, but need to sell your home due to a job transfer or downsizing? Sorry, no option if prospective purchasers cannot obtain financing.
Just like your father said, money does not in fact grow on trees. It has to come from somewhere. It can come from investors in the secondary market, or it can come from the taxpayer in the form of a completely nationalized mortgage finance market. Today, the market is partially nationalized in that MBS are explicitly backed by taxpayer dollars. Again, absent this explicit guarantee, the flow of investment dollars into mortgage-backed securities, and hence residential mortgages, would grind to a halt. Take a moment to ponder the repercussions.
Question for our Congress
Ironically, and perhaps I should expect nothing better at this point, the mainstream media has labeled this proposal as ‘help for homeowners’. In reality, this proposal would be a disaster for homeowners. Which leads me to pose this question to Barney Frank and other members of congress:
Do you understand the consequences of passing this legislation into law?
The first and immediate consequence would be a dramatic surge of bankruptcy filings, clogging the courts and further delaying any hope of bottoming out the decline in home values or in the overall financial economy. Debtors and creditors alike would be put into a state of suspended animation as the courts worked through this tsunami of new filings.
The next repercussion of passing this poorly thought out legislation into law would be a dramatic increase in mortgage rates, and therefore a big increase in monthly mortgage payments for new home buyers or those looking to refinance. In other words, we would get exactly the opposite of what these same ‘representatives’ have been working towards for over a year now. Instead of ‘affordability’, we would see the opposite – and with increases in mortgage rates, the deflation of home values would continue unabated. The reason for this is simple. If investors’ principle can be written down arbitrarily in court, these same investors must seek a higher overall return to compensate for increased principal risk. If the increase in principal risk is perceived to be dramatic, increases in overall yield must be equally dramatic. If the increase in principal risk cannot be quantified, overall yield demanded will likely be higher than anything we have seen in a generation. As with any security, an investor expects lower return with a low-risk investment, but seeks higher return for greater risk. Allowing bankruptcy judges across the country to reduce principal owed on primary residential mortgage transactions injects unpredictable risk into the risk/reward calculation of investors.
Worse still is this same congress’s likely reaction to rapid increases in mortgage rates and/or declines in securitizations. More than likely, in reaction to contracting supply of investment capital, congress will step in to make investors whole. Recent trends would support this hypothesis. In very simple terms, if a $150,000 mortgage obligation is reduced by a bankruptcy judge to $80,000, congress will step in with the difference. The difference, of course, will come from your tax dollars. Remember once again that government does not really have any money. The only money government has is that which is confiscated through taxation, or that which is borrowed. Either way, this is paid for by the tax payer – either through increased rates of taxation, or through inflation: the ‘stealth tax’ on every dollar held or earned. Once these economically illiterate career politicians realize they have just killed the market for mortgage-backed securities, they will need to revive it. As we have seen, they will feel compelled to ‘do something.’ The thing to do will be to prevent investors from taking losses on risk that was added after the fact. In other words, when investors bought these securities, they did so with the understanding that principal could not be written down in court. They are unlikely to throw continued good money after bad. To keep the secondary market dollars flowing into mortgages, government will have to make these investors whole, or at least severely limit the haircut they will take. Whether that means paying out $70,000 in our example above, or perhaps only paying out $50,000, it is clear that secondary market investors will get something or the flow of investment capital will stop.
And this leads to the third repercussion. Unless government steps up with further guarantees, the flow of investment capital into the mortgage-backed securities (which serve as the feeder mechanism for mortgage loans and therefore mortgage lending as we know it) will shut down. This will have a devastating impact on the overall economy and greatly exacerbate all of the negative dynamics already in play. Home sales will grind to a halt. Mortgage delinquencies will skyrocket beyond anything we have ever seen. Both bank and non-bank lending operations will be out of business. The foreclosure rate and all of the associated problems that go with it will climb to uncharted territory.
A lose/lose for taxpayers
Either way, this is a lose/lose proposition for tax payers. If mortgage funding dries up, the repercussions for the overall economy in which we live and work as both consumers and producers will go from bad to much, much worse. If government steps in to keep investors whole and subsidize the flow of capital into mortgage-backed securities, it will be taxpayers who bear the ultimate burden not just in the short-term, but for generations to come.
The case for deflation
Clearly our ‘representatives’ have a very limited understanding of how finance works. But what is the answer? The only way out of this capital markets crisis is the exact opposite of the efforts of our government for the past two years. Instead of supporting measures to reinflate a debt and credit bubble, and to recreate price and credit inflation that was unsustainable, we must support the deflationary dynamic and allow the market to weed out the inefficient and the unsustainable. Prices simply must deflate to sustainable levels if we are to reach a transparent bottom. Only from this bottoming-out can we seek to rebuild a healthy, functioning and sustainable financial economy with rational flows of capital and sustainable levels of debt. As we have seen virtually every day for the past two years, all efforts of the federal government to reinflate are doomed to failure. Worse, however, is that the efforts of the government to reinflate create a variety of long-term unintended and unpredictable consequences.
Within this great deflation there will be pain. There will job loss and home loss. There will be bank failures and bankruptcies of inefficient business models in a variety industries. But these will come at a rapid pace and the pain will be over quickly. Strong businesses will absorb the weak. Creditors will be punished for their lack of due diligence. Stockholders will be punished for their casino mentalities. But as the strong devour the weak, the end result will be finding a transparent bottom and a solid foundation upon which to rebuild a sound economy. Current government policies only exacerbate the problem and make finding a bottom more elusive. Efforts to forestall the inevitable only drag out the bottoming-out and recovery process, creating more pain for all.
Perhaps the best case of the real-world consequences of government propping up failed business models is the recent announcement by Sheila Blair that the FDIC risks insolvency in the coming year if the premium fees banks pay into the fund are not increased. This is a case of the strong being pillaged to support the weak. Instead of allowing market forces to work on failed business models – in the case of banks this would be investors and depositors moving their funds to solvent institutions – government, through the FDIC and outright capital injections, will support the flow of capital into insolvent institutions by guaranteeing it. This disproportionately affects smaller, move nimble banks by increasing the fees they must pay to prop up the bloated, non-transparent and virtually insolvent institutions such as Citi and Bank of America. Further, investor capital is induced based on explicit guarantees of large bank debt. Why invest in a healthy but smaller bank when your capital will be guaranteed by the government even when invested in an international zombie bank? Why move your deposits away from a Citi or Bank of America when the government will guarantee them? Thus are perverse incentives injected into the market through government policy. The end result, in simplistic economic terms, is the inefficient use of capital. Understand that this is not the market failing, or making a poor decision. This is government injecting incentive into the market in favor of inefficiency. And it will not end well. Not even government can guarantee a failed business model or an insolvent bank indefinitely. Sooner or later, reality hits. And the longer this reality is forestalled, the harder it hits.
Sadly, the long-term, unintended consequences of government’s injection of incentive into the market are often very difficult to predict. In the case of bankruptcy ‘cram-downs’, however, the consequences are quite clear: a dramatic increase in cost, followed by either the disappearance or nationalization of mortgage finance. Support for such a measure suggests profound ignorance of how the financial market in general, and mortgage financing specifically, works. Or, such support suggests ulterior motive. The events of the coming weeks and months will point to which motivates our congress.