Mortgaged Future

Bailout Demands Reach New Levels Of Lunacy

November 24, 2008 by admin Leave a Comment

As reported in the RepublicanAmerican newspaper, the demand for a piece of the $700 billion bailout fund has reached new levels of lunacy. Originally, the bailout was passed by Congress to rescue our banking system from collapse, but the idea of being bailed out with taxpayer money has apparently become very appealing to anyone who might have made a bad financial decision. Apparently, some of those individuals who locked in home heating oil at $5 a gallon earlier in the year feel some sense of entitlement for their bad call now that the same oil can be had for $2.40.

The RepublicanAmerican reports that:

“In July, when heating oil was approaching $5 a gallon and the so-called experts were saying crude was headed to $200 and beyond, millions of homeowners were flipping coins. Heads, they’d commit to pay $4.50 to $4.75 a gallon for heating oil this winter; tails, they’d gamble it wouldn’t going to $6 as predicted.

In Connecticut, heads came up about 200,000 times. And as soon as those homeowners signed contracts with their suppliers, crude prices crashed 60 percent in less than four months.

Today, heating oil can be had for as little as $2.40, c.o.d. As awful as those contracts are, they were signed by willing sellers and willing buyers. Legally binding contracts are fundamental if we are to have faith in our economy and the rule of law.

Heating-oil contracts have an excellent track record. In the last 20 years, for example, customers of Wesson Oil of Waterbury who signed oil contracts saved money in every year but two, including one in which they broke even. Last winter, when the average retail price was $3.31, those who reserved 700 gallons saved about $500.

The Independent Connecticut Petroleum Association and eight other energy associations want Treasury Secretary Henry Paulson to redirect some of the $700 billion allocated to ease the credit crisis to allow them and their customers to get out of their contracts.

Their hearts may be in the right place, but the feds already have bailed out the lending, financial and insurance industries.

Congress is poised to spend billions more to rescue borrowers who through stupidity or duplicity got mortgages they couldn’t afford.

The auto industry got $25 billion and this week was back in Washington for $25 billion more. Spendthrift states are asking for upward of $30 billion.

The list goes on. The retail, construction, electronics and tourism industries are reeling. The service sector is shedding jobs left and right. Should the feds bail them out, too? Where are they getting the money? Between deficits, long-term debt and unfunded entitlement liabilities, they (present and future taxpayers) are in hock for nearly $100 trillion.

Comparatively speaking, no person or company is in worse financial shape than the government, yet pain-averse Americans continue to go to the government for handouts or bailouts to indemnify their mistakes.

We don’t doubt that heating-oil retailers and customers would love to get out of their costly contracts. But what about investors who bought stock in AIG this year for $62 a share, people who three years ago purchased flat-screen TVs for twice what they’re selling for today, and millions of Americans who suffer buyer’s remorse every day?

Where does it end?”

Excellent article and there is no need to answer the last question posed by the author since it is obvious, as manifested by our collapsing stock market and economy. A sovereign nation’s credit rating and ability to pay its bills is no greater than the sum of its citizens earnings capacity. If member A of our society receives some sort of entitlement, by definition it must be paid for by some other member B. Member C, the government brings no money to the table; they merely sit at the table and divide the wealth between A and B.

A national government does not have an unlimited ability to borrow and spend without eventually defaulting on its debts and impoverishing its citizens.

Filed Under: Bailout, Economy

Where Have All The Stock Buybacks Gone?

November 23, 2008 by admin 3 Comments

Given the magnitude of the stock markets decline, one would think that there would be major announcements from companies announcing stock buybacks. I recall after the crash of 1987 when numerous companies announced major stock buyback programs in an attempt to inspire confidence and shore up stock prices.

As reported in Barrons this week, stock buybacks declined by 90% from last year during the latest 10 day period, this despite the fact that the average stock has declined by around 50%. So one may certainly be inclined to wonder why corporate America would be heavily buying back their own stock as the market was at all time highs but not now when, arguably, the stock is a better buy due to price declines. Maybe some shareholder will ask this question of management at the next annual stockholders meeting. Perhaps a better time to have asked about stock buybacks was when corporate management was spending hundreds of billions to buyback stock when times were good.

I have never been a fan of stock buybacks for these reasons:

– studies have shown that over time, share price performance of companies buying back stock does not exceed those of companies that do not repurchase shares.

-if management cannot intelligently invest funds back into their core business at a greater return than the cost of capital, then they should instead pay dividends to the shareholders, who will at least have something to show for their investment, since as stated above, stock buybacks do not lead to share price gains. Microsoft was one of the few major corporations that actually paid a substantial dividend to shareholders a few years back instead of repurchasing stock.

-unless a company is debt free, would it not have been better to have paid down debt instead of dissipating funds buying back stock? As mentioned in a previous post, GE spent billions on stock buybacks at high prices and now has to borrow money at 10% rates. I don’t see how this makes sense as a long term strategy.

-how many of the companies buying back stock have their long term compensation plans and bonuses tied to the EPS performance? Quite a few I would imagine, which makes the decision to buy back stock all the easier since it directly increases management’s pay while the shareholders get nothing. (Buying back stock decreases the outstanding shares used in computing the earnings per share, so a stock buyback will serve to increase the reported EPS.)

-how hard is it to conceive of the possibility that someday, markets will decline and cash will be dear, so why not pay down debt or simply increase your cash holdings to be used in an opportunistic manner at some point in the future? Apparently, not too many members of corporate America ever thought about this or else we would now be hearing about a lot of stock buybacks and company buyouts.

-Exxon Mobil has spent billions buying back stock as their oil reserves shrink year after year. With prices of oil and gas companies selling for a fraction of the price of a year ago, why are they not opportunistically reinvesting in their business by buying cheap oil and gas reserves via cash acquisitions?

-Merrill Lynch announcing a $6 billion stock buyback in 2006 – one for the history books of poor timing and inept management, although it may be topped by Merrill’s prospective owner, Bank of America, who despite needing taxpayers funds from the TARP, decides to invest $7 billion in the China Construction Bank. I think BAC has a real problem here and the stock price reflects management’s decision making. BAC’s
“investment” in China, GM executives flying on their plush corporate jet to Washington to beg for taxpayer funds – I think the pattern here is part of the reason for the economic crisis that we are in.

My conclusion is that a shareholder should carefully evaluate an investment in any company engaging in major stock repurchase plans.

Filed Under: Bailout, Economy, Stocks Tagged With: BAC, MER, MSFT, XOM

Loan Modifications – Salvation For Former Mortgage Brokers?

November 22, 2008 by admin 1 Comment

From my industry contacts and investigation of the loan modification “business” there are several conclusions easily reached:

– The Internet is extremely crowded with unknowledgeable, coarse idiots who are all attempting to haphazardly create businesses doing loan modifications. Very few of them have thought through whether or not they can be profitable, or the long term destination of the new industry.Many of the new loan mod businesses are being started by unemployed members of the mortgage brokerage industry who helped to create the very problem that they are now offering to cure. In fact, the very same people who were “helped” by the mortgage industry by getting them approved for subprime and Alt A mortgages are now on the top of the calling list as potential “loan mod” customers.

– The press is highly critical of anyone who tries to assist homeowners with loan modifications. Beyond news driven stories, the only loan mod stories are about bad providers who charge huge upfront fees and deliver little or no results, or others who are simply defrauding customers outright.

– The press and the government, for lack of a real solution, see the idea of loan modifications as THE solution to the housing crisis. If payments are lowered for 2 million of the country’s biggest financial losers, the economy will snap back immediately, job losses will cease and all will be well. The consensus seems to be that the government should pay for this, and make rules about which people are “distressed” enough to receive a lower rate and mortgage payment through a loan mod. The cost of all of this, as you may guess, will be borne by those who handled their finances responsibly and did not borrow themselves into oblivion speculating on the certainty of eternal home appreciation.

Here is where I think things are going:

– In response to concerns about fraudulent or unknowledgeable companies assisting with loan modifications, most states will implement licensing requirements, as is already happening. Among other things, to maintain the license, you will be subject to strict guidelines on how much you can charge for loan modifications. The fees will be low enough to make any business which exclusively performs loan modifications unprofitable; the theory being that people behind on their mortgages should not have to pay since they are in financial difficulty. Several states have recently created licensing requirements. Colorado was the latest: http://www.rockymountainnews.com/news/2008/nov/20/loan-modifications-require-mortgage-broker/ .

– As more of our nationalized banking system is pressured/required to do loan modifications, certain universal standards and calculations will develop. These will eventually evolve into a simple calculation that will require only a few inputs to determine exactly how a loan will be modified. This may even reach a point where banks routinely modify loans without even taking an application. This technology provider for the mortgage industry just released an early version of such software: http://www.marketwatch.com/news/story/Lender-Processing-Services-Announces-New/story.aspx?guid={58FCD216-F636-4EF9-8B93-5C1C1A41AD2F}

– The government will eventually fully endorse the idea of loan modifications for troubled homeowners and subsidize the losses. Of all the problems the country faces, for some reason the politicians will decide that keeping 2 million “homeowners” (who should be renters) out of foreclosure is the most pressing issue, instead of letting the free markets, via time and price solve the problem. With the government involved, the criteria will become even more formalized and systematic. Loan servicers or banks will be encouraged or required to deal with borrowers directly. The entire process will become formulaic and there will be little need for an outside party to assist with the loan modification.

– As modified loans default again and further borrowers fall into distress, whatever small scale plan the government implemented will be expanded dramatically. The government will increase pressure and incentives for banks and loan servicers to perform loan modifications en mass. Getting a loan modification will become as easy as it used to be to get a loan. Of course, one may wonder when it last occurred, that a government solution to a problem actually worked. Nonetheless, as home prices continue their inexorably decline for years and given the inability to find a better solution, this program will continue and expand, attempting to artificially arrest the decline in home prices that will occur anyways. Someone should clue in the powers to be that unless we want to totally socialize our economy, the free market, if left to do its work, would quickly solve the housing crisis by bringing prices to the point where they are worth investing in again and at a ratio of family income to cost that is sustainable for qualified borrowers.

Conclusion

Loan modification as a stand alone business is transitory since circumstances will change to make the current business models obsolete. At the same time, the fees that will be legally allowed will be too small to allow most businesses to be profitable. To turn this into a business, one would need to align his strategy to be way ahead of the curve and I have only seen one business model for loan modifications that would work if applied by an industrious and ethical entrepreneur.

In the meantime, potential customers who are solicited to have their loans “modified” would be well advised to do a complete background check on the firm that they may chose to deal with. In addition, under no circumstances should anyone pay a nonrefundable fee upfront (other than a modest processing fee). Guidelines vary with each loan depending on the investor, but if you are dealing with a knowledgeable firm, they should be able to determine from an initial prequalification if someone qualifies for a loan modification and accordingly, should only charge a fee if the loan is successfully modified.

As to the financial cost and moral hazards of the loan modification scheme, one should consider the words of Representative Ron Paul, when speaking out against the original $700 billion bank/homeowner bailout bill:

“It is neither morally right nor fiscally wise to socialize private losses in this way. The solution is for government to stop micromanaging the economy and let the market adjust, as painful as that will be for some. We should not force taxpayers, including renters and more frugal homeowners, to switch places with the speculators and take on those same risks that bankrupted them. It is a terrible idea to spread the financial crisis any wider or deeper than it already is, and to prolong the agony years into the future. Socializing the losses now will only create more unintended consequences that will give new excuses for further government interventions in the future. This is how government grows – by claiming to correct the mistakes it earlier created, all the while constantly shaking down the taxpayer. The market needs a chance to correct itself, and Congress needs to avoid making the situation worse by pretending to ride to the rescue.”

Filed Under: Bailout, loan modification, Mortgages

Treasury Officials Announce Mortgage Holiday

November 20, 2008 by admin 7 Comments

News Release: Sometime in 2010.

The United States Treasury Secretary is expected to release details today of the Government’s plan to suspend for one year all payments due on mortgages secured by single family residences. The Government announced that it was taking this action due to unprecedented conditions in the economy and record numbers of mortgage delinquencies. With close to half of all mortgages in arrears, a jobless rate approaching 20% and retail sales collapsing by double digits for the third consecutive year, the latest government move to boost the economy was applauded by analysts as the best direct method of putting funds in the pocket of cash starved consumers.

Government officials noted that since most of the mortgages affected had already been purchased or guaranteed by the US Government, there would be no direct cost to the taxpayer. Analysts noted that this latest move was necessary after a long series of loan modifications for many borrowers had failed due to the continued decline in housing prices and incomes. Brushing aside suggestions that this program was unfair to those who had no mortgage debt, Treasury officials stated that the program was initiated to help those most in need and that those without mortgages might be eligible for funds under the latest rebate stimulus plan.

In response to questions as to whether or not the Mortgage Holiday Plan might be extended beyond one year, Treasury officials stated that the Government would do everything in its power to assure that affordable housing was available to every citizen and that every measure would be taken to prevent homeowners from losing their homes due to unaffordable payments.

The Treasury Secretary noted that while many sovereign nations had become insolvent due to the ongoing financial crisis, the United States remains “fiscally strong”.

So there you go; congratulations to the Federal Reserve and our fiscally imprudent leaders who have brought this nation to the brink of economic collapse.

Filed Under: Bailout, Economy Tagged With: mortgage, US Treasury

Loan Modification – Someone Forgot To Ask The Investors

November 18, 2008 by admin 3 Comments

Purchasers of mortgage debt, formerly known as investors but now known as bag holders were distressed that Bank of America (BAC) did not consult with them prior to deciding to modify customer mortgages, as reported by the Wall Street Journal. The problem was not with the mortgages actually owned by BAC, but rather the mortgages owned by others and merely serviced by BAC. Apparently so enamored with the idea of saving the banking industry by reducing the rate and loan balances of the lucky mortgagees, BAC decided to apply their therapy to mortgages that they merely service but do not own.

The problem with attempting to modify mortgage loans en masse is that many mortgages originated over the past 5 years were sold to investors as mortgaged backed securities. BAC maintains that they can modify these investor owned mortgages based on “delegated authority” per the loan servicing contract they have with the investors. Obviously some of the investors in the serviced mortgages don’t see it that way and are looking to BAC to make them whole on any write downs given to the borrowers at their expense. These are the types of issues confronting the industry in their attempts to modify mortgages.

Mortgage modifications are seen as a win/win situation by the FDIC, many banks and some of the mortgaged backed securities investors since it appears to offer the ideal solution – homeowners get to keep their homes, foreclosures decrease and the ultimate loss on the loan modification theoretically is less than foreclosing on the property. This may all be work out to every one’s advantage unless property values continue their decline which I consider to be a likely scenario. Home prices won’t stop dropping regardless of government efforts until the economy stabilizes and until the ratio of family income to cost of ownership reaches an affordable level.

The issue with loan modifications that I and others see is one of moral hazard; this program is institutionalizing the repudiation of debt on a national scale and the cost and negative consequences of this rationale are open ended. In an excellent article by Peter Schiff, he describes loan modifications as “the mother of all moral hazards” as follows:

“No doubt prodded by the administration, Fannie Mae and Freddie Mac announced a new attempt to stop the fall in home prices and foreclosures through a loan modification program that would cap mortgage payments so that a homeowner’s total housing expenses would not exceed 38% of household income for home owners who are 90 days delinquent.

In a classic case of unintended consequences, the plan will encourage a massive new round of delinquencies and household income reduction as homeowners will jump through hoops to qualify for the program and maximize their benefit. Those who could conceivably economize to meet their existing obligations will now have a strong reason to forgo such sacrifices. Those who are not 90 days past due will intentionally become so. In many cases, dual income families may decide to eliminate one job altogether as reduced mortgage payments combined with lower child care and other work related expenses will likely exceed the after-tax value of the lost paycheck.

Unfortunately, the last thing our economy needs is falling household incomes and even more bad debt. But that is precisely what this plan will give us.”

Transferring all the losses of homeowners, automakers, banks, insurance companies, credit card companies, mortgage companies etc etc onto the balance sheet of the US Government does not correct the incredible excess of leverage that has been ongoing in this country since the early 1980’s; it merely transfers the losses to the US taxpayers and shortens the day that the US Government itself will need to be bailed out.

Filed Under: loan modification, Mortgages, Stocks Tagged With: BAC, loan modification

American Express – A Single Digit Stock?

November 18, 2008 by admin 6 Comments

Despite the horrendous 72% sell off in American Express this year, I would still not be a buyer at the recent price of $19 for the following reasons.

From my personal experience in the mortgage business, I have seen many people turn to their credit cards once the home equity cash out loans were no longer available to them. The credit cards were used to maintain a now unsustainable life style or to bridge the gap between income and living expenses. Now that credit card lines are being reduced or simply maxed out, the last option for many people is now closed. Since AXP gets around half of their revenue from the fee charged to merchants when a credit card is used, this income is obviously going to see a reduction.

Moody’s recently cut AXP’s investment grade by one notch to A2 (still very respectable) but the trend is clear. Moody’s is expecting the recent earnings decline at AXP to continue, especially in view of the broad economic weakness and overleveraged consumer.

The fact that AXP decided to request $3.5 billion in capital from the Treasury’s TARP fund also raises many red flags – if AXP wasn’t expecting further problems in its basic business they would not be requesting theses funds. In any event, AXP needs to refinance approximately $24 billion of debt over the next year; if the credit card securitization window remains closed, AXP may be back in line very soon for another TARP injection.

AXP expanded its business during the peak of the credit boom, expanding their credit card loans by some $26 billion over the past 4 years – an increase of 68%. Timing is everything and they definitely got this one wrong, possibly by assuming that an overextended credit card customer would simply pay off his unmanageable credit card debt with his next cash out mortgage refinance. Unfortunately for AXP, the days of constantly borrowing more money to pay off past borrowings has come to a halt.

Also, extremely unfortunate for AXP is the consumer attitude that debt that cannot be easily paid off should be easily forgiven, either by the company that lent the money or the bankruptcy courts. If AXP needs proof of this, they can check out the Bank of America, Citibank, JP Morgan etc loan modification programs for mortgages. At a time when collarteralized debt is being forgiven, unsecured credit card debt will be easily walked away from as well, as evidenced by the 100,000 plus (and increasing) personal bankruptcy filings each month. Overleveraged consumers forced to borrow for years to bridge the gap between incomes and expenses will no doubt have no trouble being approved for a Chapter 7 debt liquidation instead of the Chapter 13 payment workout resulting in zero recoveries for AXP on outstanding credit card debt.

If you apply conventional, historical valuation metrics to American Express, the stock looks ridiculously cheap. Unfortunately, I don’t thinkthe present economic disaster is going to end anytime soon and if that is the case, AXP will be facing a bleak future not only in its future earnings but also in its ability to refinance their 6/1 leveraged balance sheet.

Filed Under: Economy, Stocks Tagged With: Add new tag, American Express, AXP-single digit

Some Borrowers Will Need Very Large Loan Modifications

October 11, 2008 by admin 2 Comments

As discussed in a previous post, Bank of America agreed with the state attorneys general to offer concessions to 390,000 sub prime and pay option arm borrowers by reducing both the principal owed and/or the interest rate to a level that allows these borrowers to have a an “affordable and sustainable” monthly mortgage payment. An affordable and sustainable payment was determined to be a mortgage payment (including taxes and insurance) that would not exceed 34% of gross monthly income. With this agreement apparently setting a standard for future concessions to homeowners, consider some recent mortgage transactions/applications that I have seen.

Woman wants to refinance her Connecticut home which she bought in early 2006. The home today would probably sell for no more than $260,000. Home was purchased for $305,000 with 95% financing; the current interest rate is at 11.625% and she owes $285,000. The negative equity is only $25,000. Borrower has a gross monthly income of $3780 per month and her current monthly payment of principal, interest, taxes and insurance is $3682 giving her a debt ratio of 97%. She is currently in arrears on the mortgage and obviously not capable of making the payment. In order for her payment to become “affordable and sustainable” with a 34% debt to income ratio, the lender would have to reduce her loan balance to $158,000 with an interest rate of 1%.

If the home owner gets this deal, not only would her payment become affordable, she could also sell the house and reap a gain of $102,000. The applicant’s income is about the same today as it was when she purchased the home, so there was no drastic decline in income. Obviously, this woman should have never been approved for a mortgage in the first place; both the bank and borrower knew this.

A self employed carpenter applied for a mortgage to purchase a home for $185,000. Applicant has no credit score since he pays for everything “in cash”. The yearly income reported on his tax return for the past two years averaged $5500. When I told the applicant that he did not qualify he became indignant and arrogantly proclaimed that his bank told him they would approve him; I wished him good luck. This guy hasn’t been reading the papers lately but the days of borrowing based on what you say your income is are over. The applicant understood his situation; his income averages $458 gross per month according to his tax return and the monthly mortgage payment with taxes and insurance would have been at least $1650 per month which he insisted he could afford. I would say that the IRS should conduct more audits of self employed individuals.

Borrower with very good credit and working two jobs has a sub prime mortgage and applies for a lower rate under the FHA mortgage program. Borrower gets approved with with a debt to income ratio of 56%. At this point, instead of bringing his lunch to work everyday, he might be better off to stop paying on his mortgage and ask his bank for a loan modification once he is delinquent. The interest rate would need to be reduced from 6.25% to 1% which would put him at the recommended 34% DTI. Although most loan modifications are currently being offered only to sub prime and pay option arm customers, I am certain that in the name of equitable treatment, the offer will expand to include the multitudes of other borrowers with a debt ratio over 34% . Why discriminate against better credit borrowers?

Borrower with fair credit purchases a home with 100% FHA financing with the help of a down payment assistance program. Borrowers debt ratio at time of approval was 48%, which is extremely high and not affordable or sustainable for very long. Why is the FHA approving loans at this ridiculous debt ratio when the state attorneys general are forcing Countrywide to modify loans to a debt ratio of 34%? I suggest that a state attorney general be named Head Underwriter for the FHA.

I could go on and on, but one thing is for certain; there are millions of home owners currently in a stressed income situation with negative home equity who would like to refinance but can’t due to low credit scores/lack of home equity or both. As word spreads of the great deal that Countrywide borrowers got from the recent Bank Of America settlement, there will be many indignant and angry home owners demanding the same treatment. Can the banking system, already insolvent, handle huge new write downs?

Filed Under: Bailout, Economy, Mortgages Tagged With: bank of america, loan modification, mortgage

World Economies Burn, Politicians Debate

October 9, 2008 by admin Leave a Comment

As the world economies implode the presidential candidates debate who is the angrier man; doesn’t seem to be inspiring very much confidence in the marketplace.

Smaller countries world wide are collapsing – Bulgaria, Estonia, Romania, Turkey – we will find out how interlinked the world really is. Iceland couldn’t have set itself up better for bankruptcy than if they had deliberately planned it.

The GAP sales plunge 25% – expect to see massive layoffs as companies dramatically cut costs starting with labor. Very few businesses can sustain a 25% sales drop without either closing the doors or slashing costs.

AIG burns through the original $85 billion in Fed funds in a week and comes back for $38 billion more; does anyone believe that they won’t need more? We may find out what the US Treasury lending limits are before this is over.

Where is the mighty (mythical?) plunge protection team when you really need them?

A 20% plunge in stock values over 7 days is a crash. These types of declines usually do not stop until one day we are lock limit down and the selling burns itself out.

On the bright side, if you have any spending money left after the Crash of 2008, a vacation to the Caribbean is getting cheaper by the day: A Silver Lining for Vacationers in the Caribbean

Filed Under: Economy, Stocks Tagged With: Economy, politics

World’s worst borrowers given astonishing concessions

October 8, 2008 by admin 2 Comments

Bank of America agreed with the state attorneys general to offer astonishing concessions to 390,000 subprime and pay option arm borrowers that will cost upwards of $9 billion, as reported on by the Wall Street Journal.

Summary terms of the settlement with borrowers for loans made by Countrywide Financial include the following:

Mandatory loan modifications are required due to “unfair and deceptive” practices.

Supposedly this action will keep borrowers in their homes, support local communities and the general economy. Some background here: loan modifications, still off the mainstream press, have over the past year grown into a sizable cottage industry, manned mostly by ex loan officers and former lenders, who for a fee, will negotiate with the borrowers bank to try and obtain a reduction in either or both the interest rate and the principal balance.

Many lenders are now and have been proactively contacting borrowers and offering them a loan modification where it was obvious that the borrower was in over his head. The biggest impetus to loan mods was by Indy Mac after being taken over by the FDIC where 38,000 borrowers were sent letters offering to reduce their payments by either rate and/or principal reductions.

Loan mod results to date have been uneven, and each lender has been individually offering concessions where they see it to be in their best interest. To date, most of the loan mods have been an interest rate reduction since the mortgage investors are hoping that eventually property values recover and their write downs will be limited. In cases where only an interest rate reduction was offered, initial stats suggest that only 20% of borrowers are still current six months later thus necessitating either a foreclosure, recovery, or another loan mod.

I recently spoke to a woman in Massachusetts who had a subprime mortgage with Chase at 12%; after months of phone calls and sending paperwork to Chase, she was given a fixed rate of 1% for 5 years, with the rate to rise in steps to 6.25% at the end of 10 years. The lender did not, however, adjust the loan principal and she has negative equity of around $80,000. Whether or not this loan mod works out for both parties is subject to debate.

In an excellent post by Mr Mortgage, a very compelling argument is made that negative equity is one of the prime motivators for payment default by the borrower, regardless of the rate. Apparently the attorney generals read Mr Mortgage, since the loan mod mandate settlement requires that changes be made to the borrowers loan so the that loan payment is “affordable and sustainable”; thereby necessitating in most cases both a rate and principal reduction.

A Credit Suisse study of subprime loan mods, however, indicated that over 20% of subprime mortgages in which a principal reduction was granted were 60 days delinquent on their mortgages within eight months of the loan mod, so the success rate is not much different were only a rate reduction was granted. Keep in mind that all the statistics on loan mods are preliminary and based on small sample numbers over short periods of time since there have not been a great number of loan mods done to date.

Borrowers’ monthly PITI (principal, interest, insurance and property taxes) should not exceed a 34% front end debt ratio.

This means the PITI should not exceed 34% of the borrowers’ monthly gross income. See my post on Mortgages still being approved for unqualified borrowers) and Unsound lending policy.

For borrowers who took out pay option ARMs, Bofa will reduce the loan amount so that borrowers have as much equity, if not more, than when they took out the loan.

Borrowers will not be charged for the loan mod and any prepayment penalties will be waived.

The mandate that no fee be imposed on the borrower for modifying the loan will make it very questionable from an ethics and business standpoint for the nascent loan mod industry to try and attempt to charge a Countrywide mortgagor a fee to modify their loan, since Bofa will be contacting all the Countrywide customers with no cost offers to modify their loans.

In those cases where the loan is serviced by Countrywide but owned by an investor, Bofa will work with the loan servicer to get the necessary approval for a loan mod.

BofA will send offers of a loan mod to qualified borrowers by December 1 and stay any foreclosure action until a borrower’s eligibility has been determined.

Bofa will provide $150 million to refund some closing cost on the original loan if the borrower is in foreclosure and also provide $70 million of “key money”, cash payouts to help with moving costs.

It is only logical to conclude that since one of the largest banks in the country has agreed to this type of settlement that virtually every other lender and loan servicer will also be required to participate, either by invitation or legislative decree. Indeed, banking regulators are now calling on every subprime loan servicer “in the strongest possible terms” to adopt a similar loan mod program as possible.

In the rush to “do something” to address the foreclosure problem, it appears that there is a collective rush to judgment that loan mods are the best manner in which to address the problem. Superficially, it appears to be a compelling solution to the problem; make the payments low enough so that the homeowners can easily make their mortgage payments. Every easy solution, however, seems to create unanticipated adverse consequences.

Specifically, the following issues may cause adverse consequences that outweigh the presumed advantages:

1. Moral hazard may be a significant factor. I talk to many people who would like to refinance but cannot due to insufficient or negative equity in their homes. Most of these people have good credit and sufficient income to pay their mortgage but many of them (especially with negative equity) bring up the question of whether or not they should stop paying their mortgage and mail the keys back to the bank and to what extent this would impact their credit.

As publicity about the loan mods programs grow, the flood gates could open here especially since there are around 12 million households that now owe more than their house is worth according to Moody’s Economy.com. Modifying a loan may sound like an easy solution, but the reduction of a loan amount equates to a loss for someone else – a bank, pension fund, insurance company etc. A reduction of only $25,000 on 12 million homes means another bailout of $300 billion – someone gets burned by this loss and our government does not have an unlimited ability to borrow money.

2. The social backlash and resentment from the 40 million households who have a mortgage but still have equity, as well as from the 24 million households that have no mortgage is going to be tremendous; the consequences will not be positive.

3. Every borrower who has a subprime or pay option arm loan was not a victim; I am sure some did not understand the terms of their loans and there were abuses, not to mention that many of these borrowers should never have been granted a mortgage approval in the first place. However, most people of reasonable intelligence normally ask about the terms and details of their mortgage and are given numerous disclosures during the loan process and at the closing table.

Why should someone else pay for another’s carelessness with their financial affairs and failure to properly evaluate their actions? There is plenty of blame to go around here, both on the borrowers part and certainly on the part of the lenders who knowingly made loans that they knew could not be repaid.

4. For a nation that has a tremendous debt burden on every level, loan mods could encourage debt repudiation on a massive level which will cause a further destruction of asset values on a scale too large to contain, which is what is already happening. Every loan represents an asset to someone else; debt destruction and asset price destruction reinforce each other; the evaporation of wealth (assets) on a massive scale will not help anyone.

5. Many of the buyers of properties in the past 4 years purchased with 100% financing. To the extent that they now have negative equity, what have they really lost? They received a free call option on future price appreciation of the property that they bought. Now that the property didn’t go up in value, they are entitled to walk away from their loan obligation or simply default and then be given huge concessions? I have seen many people that purchased a home with 100% financing come back a year or two later and then take out as much cash as possible with a new first or second mortgage. My math puts these people way ahead of the game.

6. I have also seen many people do 100% cash out refinances in the past four years, often times using the money for trips, new cars, consumer goods etc. Many of these refinances occurred at the peak of the market meaning that they effectively sold their properties at peak prices. For those now walking away or getting their loan balance reduced, it is their gain and the banks’ loss.

7. To modify the loan so that the borrower has a 34% front end debt ratio is extremely generous. Most of the new first time homebuyers and mortgage refinances that I see approved have debt ratios above 34%, but the borrowers work hard, struggle and pay. How is this equitable to them??

8. To reduce the principal on a pay option arm borrower back to his original principal or lower is equally inequitable to those borrowers who borrowed in a more conservative manner with a 30 year fixed rate loan. Many of the pay option arms had initial payment rates based on a rate of 1% or 2% for a period of years; the real rate fully indexed was typically 6 or 7%, but the borrower was allowed to pay a very low payment based on 1% and the balance of the interest that was due was added to his loan balance. The pay option arm borrowers reap a windfall here since they effectively were given a 1% rate compared to the conservative borrower who took out a 30 year fixed rate and paid the full payment on a 6% mortgage. Obviously, the pay option arm customer had a lot more cash left in his pocket at the end of each month; by my math they came out way ahead.

9. Many of the loan mods proposed will probably not work out since a significant number of the subprime and pay option arm loans were done with inflated stated income (liar loans). Many of these types of loans would have to have a massive reduction in the loan balance for the borrower to have a comfortable payment since his income was never even close to what was needed to service the loan from day one. The result would be a ridiculous situation whereby we are rewarding those who falsified their income to qualify for a loan. How inequitable would this be for the financially responsible borrower who bought a home for $250,000 with a $50,000 down payment next door to the guy who also buys a $250,000 home, “states” his income to receive a 100% loan and now receives a loan reduction down to $150,000??

10. The impact of loan mods on future mortgage lending in this country will be incredible negative. The government can subsidize rates and we can all pay for this, but investors who previously bought the loans or mortgage backed securities (which support the mortgage market) will either have no interest in this type of investment going forward or require a properly risk adjusted rate which is obviously going to be very high. No one is going to lend out money when they face a substantial risk of large losses by having their original loan amount and interest rate reduced by a loan mod every time there is a price pullback in housing. Mortgages have become and will remain an asset class of “extremely dubious value” (see 7. above).

11. Not Everyone Should Own a Home, Wall Street Journal, Janet Albrechtsen. In an excellent article that explains why Australian banks are not bankrupt entities as in America, the author points out the weaknesses in our banking system and the lack of responsible behavior by borrowers and lenders which helped propel us into the banking, housing and credit crisis.

Instead of prolonging our property market declines with constant costly bailouts, it may be wiser to follow the RTC example in the 90’s when the market was cleared by selling foreclosed properties for whatever bid was offered. Anything will sell quickly at the right price.

Filed Under: Bailout, Mortgages Tagged With: lending, Mortgages, WSJ