Thursday, December 6, 2007

Federal Policies for Mortgage Crisis Contradict Each Other

With today's announcement of a freeze on adjustable mortgage rates, we see federal policy for the mortgage crisis moving in contradictory directions. The federal freeze on rates focuses on mortgages whose monthly payments would adjust between Jan. 1, 2008 and July 31, 2010. Eligible borrowers would include those that cannot afford the increased payments, but can afford the initial rate. If you're more than 30 days late on a payment at the time the mortgage would be modified with a frozen rate, or were more than 60 days late with a payment in the 12 months before that time, you're not eligible for a rate freeze. The rate freeze is aimed at borrowers who would be able to stay in their homes if their rates are frozen, but not if monthly payments are increased. Borrowers who cannot afford even the initial rate are out of luck. Those that can afford the payment increase get the privilege of making increased payments (consider it a character building experience). Those lucky enough to be poor enough to be eligible would get a five-year freeze.

Press reports indicate that well over a million mortgages will reset in the time period covered by the rate freeze, but only somewhere between 145,000 and 240,000 borrowers would satisfy the criteria for a freeze. In other words, the rate freeze would benefit about 20% or less of the borrowers facing resets.

The rate freeze is, in essence, a shifting of losses. Homeowners who would have very possibly lost their homes get to stay in them, at least for the five-year duration of the freeze. The owners of the mortgages that are frozen--who are likely to be banks or investors in mortgage-backed investments--lose some of the value of their holdings.

A problematic question for investors and the mortgage markets is what impact the rate freeze will have on the values of mortgage-backed investments. Mortgage-backed investments are based on pools of individual mortgages, and one would have a difficult time figuring out which individual mortgages in a particular pool might reset. Determining eligibility for a reset requires reviewing the borrower's income, assets, liabilities, payment history and perhaps other factors. This kind of detailed review is exactly what wasn't done when many of the mortgage loans in question were first made. So figuring out how many mortgages in a pool might reset would be difficult or impossible.

But knowing the answer to that question is crucial to determining the impact the rate freeze will have on the price of mortgage-backed investments. In effect, the rate freeze creates more uncertainty for mortgage-backed investments at a time when they are already highly uncertain. This uncertainty extends from AAA-rated CDO tranches to the depths of the subprime sewer, and detracts from other policy goals of the federal government.

The Treasury Department has been working with major banks to create a super conduit or super SIV to bail out troubled bank-affiliated SIVs that invested heavily in mortgage-backed securities. The potential efficacy of the super conduit is hindered by the rate freeze, since the investments it was supposed to buy from the bank-affiliated SIVs may now be harder to price. Banks may be more reluctant to sink capital into the super conduit, now that there is less certainty it won't turn out to be a dog of an investment.

The Federal Reserve has been working to maintain the stability of the banking system. The lending and investment exposure of banks to mortgage-backed investments is Brobdingnagian. The increased illiquidity of these investments caused by the rate freeze would likely produce more losses to banks. That would detract from banking stability.

Banks that have been trying on their own to work through their mortgage problems will have a harder time. Investors have had their nerves frazzled by repercussions of the mortgage crisis in myriad nooks and crannies, including unpleasant surprises with money market funds and the municipal bond markets. The increased uncertainty in valuations of mortgage-backed investments caused by the rate freeze will make investors less willing to buy these puppies from banks in distress. With fewer buyers available, banks will have to dance with the ones they brung, and become long term mortgage investors and financiers. Less bank credit will be available for other purposes.

The rate freeze, like the super conduit proposal and the Fed's reactive interest rate cuts and discount window lending, is a means of treating the symptoms. The government has yet to tell us how it proposes to deal with the causes of the mortgage mess and prevent anything like this from happening again. With the Fed set to ease interest rates again next week, one suspects that their strategy (witting or unwitting) is to re-institute the easy money policies that created the mortgage mess in the first place. But you can't just keep throwing money at people and expect them to spend and invest as recklessly as they did in the past. The Silicon Valley learned prudence from the tech bust of 2000. $90-100 a barrel oil hasn't led to the speculative boom in oil and gas exploration of the early 1980s. The Japanese central bank learned in the 1990s and 2000s that simply throwing money at consumers after a real estate and stock market bust doesn't revive an economy.

Franklin Delano Roosevelt's New Deal included a variety of measures that treated symptoms, such as the National Recovery Administration and the Works Progress Administration, and utilized policies such as price controls and limits on competition. The New Deal also included measures to deal with underlying problems, such as the FDIC and the SEC. It is not coincidental that the measures that treated symptoms are largely gone today, while the measures that treated underlying causes remain actively involved in today's financial markets. The mortgage rate freeze, with its contradictory impact on other federal policies, has all the hallmarks of policy making by scribbling on the backs of envelopes in the coffee shop of a Washington hotel. It's at times of crisis like this that public servants distinguish themselves--or not. Having sound proposals for dealing with the causes of the mortgage crisis is essential to restoring the public confidence in the financial and real estate markets. With bated breath, the citizenry continues to wait.

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