Has Roubini gone to the Dark Side?
Nouriel Roubini, normally the voice of prudence, makes a marked shift in his latest post, “Fiscal versus Monetary Solutions to the Subprime Crisis. ” He sympathizes with those like Bill Gross of Pimco who call on the federal government to rescue mortgage borrowers at risk of losing their homes:
Bill Gross…is now proposing the creation of a fiscal institution …. to resolve the subprime credit problems. While this may sound as a fiscal bailout of borrowers (and by default of lenders) the alternative… is destructive home price deflation (as much as 10% fall in home prices…) and million of homeowners ending up in foreclosure. Folks at Goldman Sachs are actually predicting that home prices will fall as much as 15%…
Larry Summers… correctly argues ..that in situations of severe credit distress it is important to be pragmatic rather than religious on issues of moral hazard…
Dean Baker wants to help the victims (the subprime borrowers in his view) rather than the reckless lenders (the “bloated bankers); so he is suggesting changes in foreclosure rules to allow moderate and low-income homeowners to remain in their homes indefinitely as renters.
A number of authors – including analysts at BNP – have argued a fiscal solution is needed and that government sponsored agencies should be allowed to purchase more conforming loans.
Even the Bush Administration, that has opposed suggestions to have Fannie and Freddie expand their mortgage portfolios, is now suggesting that Federal Home Administration could help distressed borrowers….
[T]here is now a new and increasing recognition that severe credit and financial distress problems cannot be resolved with monetary policy alone…. The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue.
Now let me stress I have a great deal of respect for Roubini and normally am on the same page as he is. And he may well be correct that the political consensus is moving in the direction of Throw Money At This Problem.
I am probably being harsh because I have read too many calls to action, most of which have not given much (any?) thought to how their proposals might work on a practical level.
But Roubini lumps a whole variety of ideas together, some of which (Gross’s in particular) are just plain barmy (and for the record, the RTC bears little resemblance to what Gross is suggesting, except that it required a ton of money).
Before we discuss these recommendations, let’s address the big flaw in Roubini’s argument:
The prospect of home prices falling 10 to 15% and two million plus home owners losing their homes is – rightly – becoming a political issue
First, I had searched the logical suspect financial news sites, plus Google News and Google Blogs, and haven’t found a source for this “two million will lose their homes” factoid (this is the only reference I’ve seen besides Gross, which is hardly a well recognized source and cites unnamed studies).
I’ve seen other formulations, such as The Center for Responsible Lending saying that 2.2 million ARM mortgages will reset in the next two years. “Reset” does not mean “lose your home,” and “2.2 million” is clearly the high end of a range of estimates. Senator Christopher Dodd may be responsible for the recasting of The Center for Responsible Lending data. The Financial Times reported that he stated that 2.2 million (hhm, the very same number) could lose their homes in the next few years.
It’s one thing for a politician to take liberties with data. I would hope Gross and Roubini would hold themselves to a higher standard. And if I am wrong and there is a source that says over two million are likely to lose their homes (as opposed to face a reset and accompanying financial stress), I’d like to see it. I could have missed something, since I don’t have access to certain databases and search tools, but information like this usually shows up on the Web.
Nevertheless, the specter of “two million plus” losing their homes has become established fact.
The most granular analysis I’ve seen on mortgage resets (and I stress granular, it’s a very detailed analysis using two massive mortgage databases) is by one Chris Cagan of American CoreLogic, which projected 1.1 million foreclosures over 6-7 years. That’s bad but not catastrophic. Admittedly, things have gotten worse since the time of his estimate (March, when subprimes had already been under stress for a while), but I doubt if they are 2 times as bad. And most important, these losses are spread over time. Even if the total in the end is 2 million, it’s one thing if that happens in 2008-2009 versus over 6-7 years. The housing market will be better able to absorb the impact, as will the greater economy. But that 2 million number is becoming fact, and it’s being treated as if those defaults will hit all at once like a financial tsunami.
In keeping, the prospect of a 10% to 15% fall in house prices is being treated as if it would constitute the end of the world. Yet as we pointed out, quite a few economies have endured 25% or more housing price falls. They did not go into an economic black hole. They had short bad recessions.
The fear of recession in this country has gotten so bad that the Economist ran a story this week arguing that America needs a recession. I have no doubt they did that mainly to be provocative, but the horrified reactions from some quarters proves the point. This fear of recessions, and tendency to paint a recession in the dark colors of a depression, is dangerous and distorts policy decisions.
Now it would be fair to argue that a housing recession, given how leveraged the financial system is, will deepen an already careening deleveraging and could do real damage to the financial system. That would be consistent with Roubini’s world view, and would justify more radical measures. However, he didn’t make that case.
Now mind you, I am not saying we should do nothing, but a large scale bailout of homeowners, as I’ve argued elsewhere at considerable length, is a bad idea from the standpoint of equity and efficiency.
But there are some things worth doing. The real problem is that the thing that would be the most effective and surgical (the numbers 4 and 5 on this list) are the most difficult to implement (but vastly easier than acquiring 2 million mortgages and renegotiating them!).
1. Borrowers who were defrauded by lenders should get relief, ideally from the perp (and it is probably easiest if it also comes out of the hide of investors who bought securities with assets originated by the perp, although I am open to comments and ideas on this front. This notion would encourage much greater investor due diligence on sourcing methods).
I am all in favor of severe punishments. Organizations that institutionalized fraudulent activities should be fined out of existence. If four of the former Big Eight accounting firms perished due to their misdeeds, why should mortgage lenders get better treatment?
2. I have not thought about it deeply, but having Fannie and Freddie step up their activities is probably a good idea. Banks swing wildly from overoptimism to excessive caution, and there are signs they are now overly stringent with creditworthy borrowers.
3. Mortgage brokers and other consumer mortgage originators need to be regulated on the same footing as banks, as far as their disclosure standards are concerned, and all should be subject to tougher consumer protection requirements.
4. The best way to salvage financially stressed homeowners is via loan modifications. In the stone ages of finance when banks not only made loans but kept them, banks would when possible restructure a mortgage rather than foreclose (note that all borrowers cannot be salvaged, but banks in general were pretty good at judging who could make it).
What has screwed that up in our Brave New World of finance is that mortgage servicers are now responsible for managing the relationship with borrowers on behalf of the investors in the mortgage paper. Because the servicer has every reason to keep the borrower alive (they keep earning their servicing fees), most indentures on mortgage securitizations restrict the servicer ability to do loan “mods.” Some prohibit them altogether; others limit them, say, to 5% of the pool, which if a pool has a lot of subprime and/or Alt-A, is too low a ceiling in the current environment
The problem is that it isn’t easy to waive a magic wand and lift mod restrictions across the board. I am told the mortgage indentures are governed by state law, which means you’d need new legislation in the states where the big servicers are domiciled.
5. The last bit of borrower relief is to treat the mortgage debt of individuals who declare bankruptcy the same as corporations. As Credit Slips explained:
If a corporation can no longer afford the mortgage on its factory, it has powerful tools to rewrite the mortgage in bankruptcy. But if a homeowner is in exactly the same trouble following an interest rate hike, those same tools are unavailable….
MA company that cannot pay its mortgage can declare Chapter 11 and do two things: 1) separate the mortgage into its secured and unsecured portions (called bifurcation), and 2) pay the secured portion at current market rates under a new mortgage and discharge the unsecured portion. So, for example, a $1.2 million mortgage at 12% on a factory worth only $1 million will be bifurcated into a $1 million secured mortgage at, say, 7% interest, and the remaining $.2 million can be discharged. The economic insight behind permitting this move is that the mortgage company will get 100% of the value of the property paid over time, which is a LOT better than the much lower amount it would get in foreclosure. The second insight is that this is precisely the risk the lender took: that the property would decline in value and the debtor couldn’t pay. The Chapter 11 bankruptcy forces the lender to revalue the mortgage to the actual market value of the collateral.
But notice: If a homeowner can no longer afford her mortgage, the homeowner can declare bankruptcy and get rid of the credit card debt and doctor bills, but she cannot force the lender to write down the mortgage to the value of the home or to accept payments at the current market rate. All the homeowner gets is the right to make up past-due payments–in full, with interest. So, for example, a $120,000 mortgage at 12% on a home worth only $100,000 must be paid in full at 12%. In other words, homeowners get a lot less protection in bankruptcy than do businesses.
Giving individual mortgage borrowers the same treatment as corporations would reduce the need for federal bailouts, make sure right people took the pain (investors who chose to buy in mortgage paper, rather than taxpayers) and be vastly cheaper than creating a new federal bureaucracy.
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The Risk of Doing Nothing By Elizabeth Warren
The comments are worth reading too.
This was a self-made mess by the banking industry to loosen or eliminate regulations that would have screened out bad borrowers. This time it boomeranged on the bankers and they should be beyond sympathy.
Financial literacy for people these days is sad, but overall when you consider the fact that 2 million or more homes could go back to the banks, the ripple effect is worth addressing. And that doesn’t even include the fact the US reputation is in tatters globally because of this in addition to everything Bush-related such as Iraq.
Thanks for the link, but please note what I said above: I have yet to see any substantiation of this “2 million may lose their homes” factoid.
I hate to hector a reader who otherwise made a very good comment, but don’t dignify this (at this point) dubious statistic unless you can offer some proof!
Yes, even at a lesser level of distress, it’s worth doing something to help borrowers, and I suggest remedies. But brandishing scary numbers tends to make legislators jump first and think later. And per Warren’s point, one of the culprits is the workings of the bankruptcy code. Getting some correction on that front is more effective and more equitable than massive bailouts.
I think the 2 million number is easy to come up with for the whole US based on these numbers of the Top 100 metro areas.
California cities fill top 10 foreclosure list
A couple of points.
The numbers quoted in the link are for the first six months of 2007. Roubini (if I remember correctly) has been writing about this for awhile (2 years?)
It’s hard to tell how much of this is above the “average” rate of foreclosures. But like a wave, it’s all collected and viewed in the same bucket now. And I’m not sure how the US territories are accounted for, but I’m almost certain they have the same finance companies as the mainland. Even Mexican tv has plenty of ads for home fi/re-fi (same second-third tier lenders) if I remember correctly.
Anon of 3:41 PM
Your link points to RealtyTrac data. As we have discussed before, in “Foreclosure Stats: Pick a Number, Any Number,” citing an article in the LA Times, RealtyTrac vastly overstates the level of foreclosures.
RealtyTrac reports every step in the foreclosure process (notice of default, scheduling of the action, actual foreclosure are the minimum number) as a separate foreclosure AND fail to correct for the fact that some properties have multiple liens (RealtyTrac would report each lien as if it were a separate home). So if an owner gets a notice of default and gets current, RealtyTrac would count that as a foreclosure.
For example, the CNN article in the table, using RealtyTrac data, showed roughly 38,000 foreclosure filings for LA in the first half of 2007. The LA Times article reported that there were only 2,453 foreclosure auctions scheduled for the first quarter The site that complied that figure estimated that half had been postponed or cancelled. Now admittedly, the owners might have sold the property themselves; that’s the rational thing to do if you have any equity in your home and can’t find a way to make the payments. But the point remains that the RealtyTrac numbers are way out of line with obtainable measures of foreclosure sales.
RealtyTrac’s foreclosure figures are over 10 times larger than that of DataQuick. Now the Times tells us there are reasons DataQuick’s figures might be too low (and we agree), but RealtyTrac’s numbers clearly are badly inflated.
Since foreclosure rates have averaged just under .7% over a long period of time then around 1m homes are “lost” every year in US.
Sorry scratch that source not a percentage of properties
Tanta at Calculated Risk had an interesting suggestion:
Create a federal organization to buy loans in bulk (both the good and the bad). Lower the loan amounts such that the borrower can actually make payments (based on a fixed multiple of their income). When the house is next sold, the government gets first crack at the proceeds, to the tune of whatever the loan was lowered by.
So if one’s 600k loan is split in half, when the house sells the fed gets 300k off the top.
Properly done this results in no net cost to the taxpayer (in the long run) – possibly even a gain.
Lab Rat,
Hhm. I looked at her recent posts (I must confess I am behind on keeping up with other blogs these days) and didn’t see it. Can I trouble you for a link?
Although her idea is economically elegant, I see it as also unworkable.
We still have the basic problem that under current law, mortgage servicers are constrained in what they can do with the pool, such as substitute collateral (I think technically you can’t substitute; you might have to prepay with the proceeds of the new loan). If you do anything other than what was contemplated in the original indenture (generally not very much), it takes the approval of a certain % of the interests in ALL classes. An example I saw was 2/3; I can’t imagine it would ever be less than 50% (this is Tanta’s turf, not mine).
Moreover, per the Bear failed hedge fund liquidation, attempts to substitute collateral led to threats of lawsuits (Tanta was unable to get to the bottom of the issue, but it appeared Paulson & Co., the hedge fund that threatened the suit, had a derivative exposure that would benefitted if the mortgage securities, probably CDOs, did badly).
And the federal government can’t do this by fiat. These agreements are governed by state law. This creates big time Constitutional issues. By the time this got through the Supreme Court, the houses in question would have already been lost.
In addition, all these proponents vastly underestimate the difficulty and costs involved in setting up a new bureaucracy to deal with INDIVIDUAL loans. Even though Tanta says “in bulk’, the underwater mortgages have to be fished out of various pools. I don’t see how this is an “in bulk” activity. You are not buying out an entire mortgage securitization. Despite the bad press, most subprimes are current.
The RTC, the new agency that worked out failed S&Ls, had assets fall in its lap, and it was wholesaling them. Completely different situation.
Yves
In March, Cagan estimated that 1.1M homes will be foreclosed on AND that an additional 70K will go down for every one percent decline in the average national price of homes. YOY we are at what, negative 3%?, so that would make another 210K foreclosures. A 10% decline and Voila, you have your 2M foreclosures.
Thanks for the report link; was the most rational and thorough of anything I have read. btw – love the use of the word “granular.”
Martin,
Touche.
Recall that Cagan sees the foreclosure as more protracted, over 6-7 years. The calls for action make it sound as if this is all going to hit the fan in 2008.
One reason I am being somewhat contrary on this one (even though I do agree things are bad and Something Should Be Done, just not a massive Federal purchase of doggy mortgages) is that the tone in the press and among commentators has gone from complacency to gloom and desperation.
For instance, that Cagan study was out in March. The Economist (hardly a bastion of bearish thought) declared the US housing market to be 20% overvalued in 2005. Yet people seem shocked, shocked that things are playing out as some experts predicted.
But that’s what you get when the association that represents industry salesmen manages to establish itself as the primary source for information.
Yes Yves,
Given that IMF World Economic Outlooks in February 2004 and I believe also in late 2003 reported that house price rises in ‘many industrial countries do not seem to be fully explained by fundamentals’, no doubt that 3 1/2 years later people seem shocked to discover what became progressively more evident, but conveniently ignored. Perhaps mentalities conditioned by the prior rapid rise in equity prices and the historically misinformed notion that ‘real estate never loses value’.
I favor your perspective with its comprehension of generally ignored but certainly real technical difficulties.
Thank You
And also Cagan just looked at resets. That’s in addition to normal flow of foreclosures via divorce, job loss etc. as well as various other foreclosures as home prices slide, i.e. investor dumping.
I’m interested in these mysterious other economies enduring 25% or more home price declines. I assume we are talking Japan…I’d like to see your list with dates.
I am also intrigued by the idea of what’s so bad about a recession, would like to read more.
Matt,
I had a long discussion of steep housing market declines towards the end of the Pimco post (I imagine many readers got tired). The “mysterious economies” include the UK, Finland, Sweden, and Hong Kong. As discussed, the fall in Japan was WAY worse than 25%.
There are links in the text to both the Bill Gross/Pimco post and the Economist story on recessions.
Yves,
She proposed her idea in a comment section. CR has been overrun today by the “let em burn” crowd and she was bemoaning the lack of a solution that avoided moral hazard or taxpayer abuse.
I didn’t really do it justice above (or, likely, below). I requested that she form a CR post around it, but we’ll see.
I think the idea was that the agency WOULD be buying out entire mortgage securitizations. This allows the agency to come out neutral or ahead by acquiring the good loans along with the bad. If the children can’t play nicely with their toys, take them away. Yes, this is pretty unworkable, but it’s a better starting point for practical solutions than any of the others I’ve seen.
I’m certainly no finance guy, I just sort of stumbled into this mess after the hedge funds imploded and I got curious about what was going on.
Lab Rat,
I give you credit for trying to sort this out as a non-finance type. The nomenclature and concepts take a while to get down. And a lot of people out there are imprecise in how they present things, which doesn’t help either.
Not to put an ad in a comment, but the post I just put up has a very good article by the FT’s Martin Wolf in which he says pretty bluntly that people, particularly Bernanke, are panicking and pulling the policy trigger way too fast.
I’m sure a 15% drop in home prices will be painful for many. But it still won’t bring us to the mean in many cities. And I don’t see any reason we shouldn’t expect a reversion to the mean, even if it takes several years.
If one can make a coherent argument that such a drop in prices would be a financial calamity that we must struggle to avoid, that should be balanced against the point that sustained high housing prices is a significant ongoing burden to our economy. Does our economy really gain anything of lasting value from expensive housing?
Thanks for responding. BTW, I went back to the December report from the Center for Responsible Lending and this graph with the 2.2 million figure:
“Our results show that despite low interest rates and a favorable economic environment during the
past several years, the subprime market has experienced high foreclosure rates comparable to the
worst foreclosure experience ever in the modern prime market. We also show that foreclosure rates
will increase significantly in many markets as housing appreciation slows or reverses. As a result,
we project that 2.2 million borrowers will lose their homes and up to $164 billion of wealth in the
process. Further, we find that many features of typical subprime loans substantially increase the risk
of foreclosure, regardless of the borrower’s credit history.”
It’s on Pg. 3. Here’s the link:
http://responsiblelending.org/pdfs/
foreclosure-paper-report-2-17.pdf
Thanks for the link. Will have to read the paper (sadly, not likely to happen today).
Interesting that the paper made a 2.2 million forecast. The press soft pedaled that. But the $160 billion losses (not high relative to other estimates) seems low relative to the number of homes lost.
Looking forward to reading the methodology.