1. If the mortgage amount is reduced to, say, $400,000, then the government loses money (the difference between $600,000 and $400,000).

2. If the mortgage amount is kept at $600,000, the interest rate has to be reduced to keep it affordable:
(a) In that case, the government is lending money at far below-market rates, which is the same as losing money, even if the mortgage is paid back.
(b) There is still the problem that the homeowner may walk away from the house, leaving the government with the loss.

This is what I don’t understand.

Okay. So if I loaned on a house for $600,000 in the Central Valley, and $600,000 is owed on it, but it’s currently worth $400,000, I get paid $600,000? This is fine because the payments are being met.

“banks would be asked or required to purchase”

My main point in the post is that if asked, they will want too much, and so they will have to be told.

“the defaulting mortgages that are in security pools by paying off the principal of the mortgages”

Once again, are they being made whole. If so, I don’t see how this is anything but a loss for whoever buys it. It’s true, the new lender will get interest, but they’ve bought assets worth much less than they paid. I don’t see this as politically viable, but I could still be missing something.

Anyway, many thanks for the explanation. Cheers.

Allow me to take a stab at clarifying the Patrick and Taylor plan. Maybe we can get James to provide his view of how this would work.

THE PROBLEM: Over the last few years, many, many people have taken out subprime and Alt-A mortgages to buy their homes. Shoddy and fraudulent underwriting practices allowed these people to get mortgages that really should never have been allowed. Though many of these people are now meeting their requirements to make their monthly payments of principal and interest, resetting of the interest in the adjustable rate mortgages they hold will likely cause many to default on their payments in the future.

To prevent numerous future defaults and foreclosures when people cannot make their monthly payments under the new interest rates, banks are restructuring mortgages so that the monthly payment is more affordable. They can do this in three ways: reducing the interest rate, extending the term of the mortgage (from 30 years to 40 years), or reducing the principal owed. Banks such as Bank of America, J.P. Morgan Chase, and Citigroup have already committed to restructuring the subprime mortgages they own. They are also doing this for mortgages they own which are currently in default.

The problem is that the banks, as well as Freddie Mac and Sallie Mae, can only do this with the mortgagtes they own. Mortgages which have been securitized cannot be modified in this way.

Why not?

Mortgages which have been securitized are placed in a pool with hundreds or thousand of other mortgages. Various types of bonds are then sold to investors, with the pooled mortgages providing the underlying collateral and earning power of the bonds. Because there are likely many bonds sold based on the pool of mortgages, a piece of each mortgage in the pool is owned by the many bond holders. Contractural obligations which are part of the bond prevent the mortgates in the pool from being modified. Even if the mortgage could theoretically be modified, it would likely require the consent of all the bond holders. I suppose it would depend on how the bonds are structured.

THE SOLUTION: It would appear that the only way to modify a mortgage in the pool is to end it by paying off the principal.

Can this be done?

Yes, of course. Otherwise a person, whose mortgage is in the pool, would not be able to sell his or her house. When a person’s mortgage has been securitized (their mortgage is in a pool) and they sell their house, the principal on their mortgage is payed early. CMOs (collateralized mortgage obligations) are set up to take prepayment into account. Paying off a mortgage is one way, and perhaps the only way, to unsecuritize the mortgage.

Patrick and Taylor are proposing that the federal government, through Freddie and Sallie, pay off all the subprime mortgages in security pools which have not defaulted yet. This would be done by paying the principal on the mortgages. There apparently is about 1.1 Trillion dollars worth of such mortgages. The government then would create new mortgages under more favorable terms (likely a smaller interest rate) for the home owners. The net effect for the home owner is a refinancing of their mortgage. The new mortgages could then be held by the government or sold to financial institutions. If a high enough percentage of home owners of the new mortages continued to successfully pay their monthly mortgage payments, the government would turn a profit.

WHAT ABOUT SUBPRIME MORTGAGES THAT ARE DEFAULTING? The article in the NYTs states that about 400 billion dollars worth of subprime mortgages in security pools have now defaulted. According to the Patrick and Taylor plan, banks would be asked or required to purchase the defaulting mortgages that are in security pools by paying off the principal of the mortgages. The banks would then issue new mortgages on more favorable terms (smaller interest rates) for the home owners. Initially this would be a loss for the banks. But if the homeowners sucessfully made their monthly payments on their new mortgages, then the banks could turn a profit in the long run.

Why should the banks be expected to buy defaulting mortgages at a loss? Patrick and Taylor say the overall deal is a real benefit to the banks. Because the banks are the primary holders of bonds issued against the pools of subprime mortgages, and those bonds are now trading at 65 cents on the dollar, the banks will benefit greatly from the government paying off the 1.1 Trillion dollars worth of non-defaulting mortgages held in the security pools. With all subprime mortgages in security pools being prepayed at full amount, all the bonds will now pay their face value, rather than just 65 cents on the dollar. Patrick and Taylor calculate this will result in “an immediate capital infusion of $385 billion” to the banks.

WHERE WOULD THE GOVERNMENT GET THE 1.1 TRILLION DOLLARS? Fannie Mae and Freddie Mac would get this large sum of money by issuing debt (bonds). These two institutions would have no trouble selling these bonds because the bonds would be guaranteed by the government. This means the tax payer would not be responsible for purchasing the subprime mortgages.

END RESULTS:

1) Subprime mortgages in security pools are terminated early through prepayment of the principal.

2) New mortgages are issued to the home owners by the government and banks on terms that are more affordable.

3) Because the mortgage terms are more affordable, fewer home owners default on their mortgages and go through foreclosure.

4) Overall the program provides a sizeable capital injection into the financial system, thus freeing up more capital for borrowing.

5) Fewer foreclosures have the effect of limiting the drop in home prices and provide for a more stable housing market.

CAVEAT: I am not an investment banker, nor a person who is real knowledgable about economics and finance. This is my understanding of how the Patrick and Taylor plan would work.

If I have stated anything in error, I would appreciate being corrected.

The only point I would make is that I only see two real possibilities out of all these plans:

1) Let the market take care of it
2) Have the government impose a solution, which could be a legal and financial mess

The middle alternative seems to involve paying a large sum of money to the servicers and the lenders, who would need to be basically bought off. They don’t seem to want to be bought out cheaply, given the stories I’ve read, and I can’t see a political way to allow this to happen.

Maybe there should be a rule: When myriads of plans are being proposed, it’s because there’s no real political and economic solution that will actually work.

Will this not help?

The market has already written these securities off anyway.

Is this not a viable way to solve a big portion of the problem?

First of all thank you so much for the wonderful blog, also for spending your reasonable time to make awareness.There are many readers and general public out, who could not understand how FED and banks create money. Then how FED remove the money created by them from the market and control the economy between inflation and deflation. It would be great if you post a separate article on the above said topic.