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.
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.
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.
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.
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