A Modest Proposal for a Solution
The news continues to be bad. Economists say home prices need to decline 15% to 25% before we’ve hit bottom. A recent study said that banks need to write down assets further, leading to a potential $2 trillion asset write down (read: less ability to lend).
We also need to worry about commercial mortgage backed securities (CBS). On top of that there are about $45 trillion in credit default swaps, of which $6 trillion are securitized synthetic collateralized-debt obligations, or CDOs.
If all this stuff hits, liquidity will really dry up. I don’t think the Fed can do much about it. It’s not so much a function of (low) interest rates but the ability of lenders, whose assets are shrinking, to lend. There’s still a ton of cash out there, but traditional lenders would be hard pressed to increase lending activity with a diminishing asset base. Japan had 0% money and it didn’t help them. A write-down of assets will help.
We’re betting that the market can and will solve these problems. When? Ladies and gentlemen, place your bets.
You’ll know we’re in recovery when housing inventory starts to get back to normal (4–6 month supply vs. 10–11 month supply now). Recovery will start when buyers believe house prices won’t go down anymore. We don’t see that happening while there’s so much pending asset devaluation overhanging the market and credit is tight.
What’s the quickest route to recovery? A bust would be quickest: take the asset value hit and let the market sort it out. Unfortunately we’ll probably see the Fed and Congress jump in to stave off the problem, dragging out the inevitable hit. History has shown that the more government interference in the liquidation of assets and the reallocation of capital, the longer it will take to recover. Look at Japan or the US during the New Deal.
In the meanwhile if home prices continue to decline and borrower defaults increase, lenders have few choices. They can foreclose, evict the borrower, and sell the house. They will have a loss because it is unlikely that the sales price will be enough to repay the loan. (See Peeling Back the Onion, below, on subprime lending standards.)
Lenders could renegotiate the loan with the borrowers and accept lower payments. But, under current banking rules they have to mark to the market and write down asset values. That works until the write-downs become so large in relationship to their total asset base that they will need to raise capital to maintain enough assets to cover existing loans. They’ll sell their loans or their subprime securities.
“’You’re starting to see more signs of counterparty risk’ among companies that were on the opposite side of one another’s credit trades in recent years, said Jeff Middleswart, president of Behind the Numbers, a Dallas-based research firm. ‘It raises the possibility that some of these companies could have a fire sale to raise capital’ by slashing the prices of securities on their books, which could lead to another round of big write-downs.” WSJ, Mounting Liquidation Fears Squeeze U.S. Stock Market, March 6, 2008.
None of this seems to incentivize lenders to renegotiate loans and accept lower payments as Mr. Bernanke wishes would occur. If they have to write the loan balances down, why wouldn’t they just want to dump the loans and use the capital for something more profitable?
We don’t know how to solve the lenders’ problems, and, in fact, they aren’t “solvable.” Someone has to take the hit. But I think we know how to pick up the pieces. It will solve some of the problems for subprime borrowers: reduce their payments and keep them in their homes.
Let’s say a lender sells a portfolio of loans. The investor now steps into the shoes of the lender and can renegotiate the loan terms with the borrower/home owner. The investor has great incentive to keep the borrower in his or her home: the borrower provides cash flow for the investor. If you evict someone, the house sits empty: no income.
The reason that home owners are defaulting is because they either can’t afford the higher payment on their ARM or they had a short-term loan that they can’t refinance. Depending on the deal, the investor could accept interest-only payments, re-amortize the loan to a lower rate, change ARMs to fixed interest rate loans, extend the term on short-term loans, and so on. This would make it affordable for the borrower to stay in his or her home and give them an incentive to make the payments.
The investor has a lot at risk. He will have to wait for the market to come back: i.e., housing prices are stable to rising, credit is available with LTVs in the 80%–85% range, and the economy is not in recession. That could take three to five years. He has to take the risk that the borrower/home owner won’t default on the loan and force the investor to go through a costly foreclosure. If the market doesn’t come back, the home owner may not be able to refinance the note when it comes due in three to five years.
In order for the investor to assume this kind of risk, he will have to achieve higher than average returns. Based on our understanding of this market it would require a 25% IRR to make the deal work for the investor and his investors.
If everything falls into place the home owner has saved his or her home and has been able to make the lower payments. The home owner would be able to refinance the loan at the new maturity date and payoff the investor who helped him through this rough period.
This is where the subprime lender has to play the game. Based on the requirements of the investor, to bail out the lender, the lender will have to take a substantial haircut on the loan when it is sold to the investor. The benefit to the lender is that they get capital, they write down the asset, they’ve gotten rid of the problem, and life goes on.
Or, the lender could foreclose and end up in the same place.
Or, the lender could do what the investor does, rewrite the loan, and wait out the market, but the lender will eventually take a haircut on the loan principal in order to get paid off; it is unlikely the lender will be made whole.
The problem with lenders trying to work these issues out with their borrowers is that they may not have the manpower to deal with the problem: it’s that big. If the loans are held by one of these subprime securities, the thought of all those loans being renegotiated is an intimidating prospect for any servicer. Also, for the reasons mentioned above, the lenders really don’t have any inventive to work something out with the borrower.
Our belief is that these subprime securities will unwind at some point in the future and there will be opportunity for investors like us. But the sellers of these mortgages are going to have to respond to the market.
The market for these workout deals will be mainly local and regional investors who are familiar with the properties and economics of their area. Again, this is a manpower issue. Local investors are more efficient and will be able to attract the capital and effect these workouts. So we envision mortgages will be bundled into local and regional areas and put up for auction. This is similar to the last big real estate bust when in the early 1990’s the RTC took over properties and auctioned them off. While there was a lot of criticism of the program at the time, it rather quickly got the properties off of the RTC’s books and they ceased being a problem for the Feds.
Will the industry and government react positively to this obvious solution? As Eldridge Cleaver said, “You are either part of the solution or part of the problem.”
 “Leveraged Losses: Lesson from the Mortgage Market Meltdown,” Greenlaw, et al.; See various WSJ articles.
 “Liquidity, Monetary Policy, and Financial Cycles,” Adrian and Shin, Vol. 14, No. 1, Jan.-Feb, 2008, Fed of NY.