Author Archives: Mike

How To Kill OTC Derivatives Reform in Two Sentences

The post below, which looks like it could be extremely important, is by Mike Konczal, author of the popular (for those in the know) Rortybomb blog, a previous guest blogger on this site, and now a fellow at the Roosevelt Institute – James

Have lobbyists snuck another major loophole into the OTC Derivatives bill? This week the final touches are being put on Barney Frank’s financial regulation bill – H.R. 4173 – “Wall Street Reform and Consumer Protection Act of 2009.” One of the centerpieces of this reform is Title III: Over-the-Counter Derivatives Markets Act. And one of the goals of this reform would be to get as many derivatives as possible to trade on exchanges.

An initial hurdle for Barney Frank was what to do with an “end-user exemption.” This would exempt certain types of derivative buyers who use derivatives, say corporations hedging interest rate risk without speculating, from the extra scrutiny and regulation that comes with the exchange/clearing system. One of the narratives of financial reform so far has been that this initial end-user exemption was too large a loophole at first, and instead of just handling 10-20% of the market, it would let a large majority of the market sneak through, but ultimately Barney Frank was convinced by consumer groups and people pushing for stronger financial regulation and fixed this issue. See Noah Scheiber here in “Could Wall Street Actually Lose in Congress?” for this story, and it shows up as well in a recent profile of Barney Frank in Newsweek.

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One Last Thought on FDIC and Political Will

So this is Mike Konczal signing off for the week – I’d like to thank James and Simon for giving me the opportunity to guest-blog here. And I’d like to thank all the readers and commenters for sparking discussions and refining my thoughts about many of the issues here.

You can follow my blogging at the rortybomb blog, and I’m also on twitter.

I want to close on one last note about where we, as a country, need to go from here. As a longtime fan of The Baseline Scenario, I read that there’s a project here to show the way in which capture by the financial industry has taken place in this country; through regulatory capture, through social networks and connections, etc.

There’s another element to it as well, and that’s what we as a country expect our government to be able to do about it. I want to point out this netroots nation video of Chris Hayes, an editor at The Nation, talking about The New Deal versus today (5m20s start):

Think about FDIC, how would we design FDIC today?…What we would do is, we wouldn’t set up an independent government agency which works very well, has worked smoothly, has prevented bank runs, since the bad old days of bank runs…we wouldn’t do that today. The banks would be like ‘what? you are just going to step into this market?’ What we’d do today if we were designing FDIC is we’d choose a bunch of the banks and we’d subsidize them insuring other banks…

The Home Ownership Loan Corporation…we have a lot of foreclosures, a lot of people underwater on mortgages. What are we doing? We are subsidizing the lenders with public dollars and telling them ‘if we give you guys some money, will you go help those people?’ And surprise, surprise, they have not really gotten their asses to do it. Now the Home Ownership Loan Corporation was faced with the same exact problem…and it went out and bought the mortgages and directly re-negotiated the terms of the mortgages, and it was very, very successful.

This is a massive conceptual problem.

I find this fascinating because I completely agree that, if we were to encounter bank runs for the first time today, this is how we’d try to set up FDIC. FDIC is an example of a government program that works, and the banks-insuring-one-another-with-public-money is exactly the kind of operation we’d expect to fail. I also find it fascinating because I believe part of what happened in this crisis is that we started a banking system in the capital markets, a ‘shadow bank system’ if you will, that collapsed in a new 21st century style bank run, and going forward we need to find a way to regulate it properly to make sure it doesn’t happen again (here’s interview I did with Perry Mehrling about it).

It’s one thing to identify the problem – finding the will to conceptualize the problems, and begin to fix them, is the other half of the solving the problem. And that is what this country needs more of, less hoping that the problems will fix themselves if we shove enough public money to private parties, and more of working to find the solutions ourselves.

Thanks for the great week all!

The Best of Behavioral Finance Anomalies

And before I go, my two favorite Behavioral Finance anomalies. Learn them, because next time someone tells you that the market is perfectly efficient all the time, bring these up.
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The Limits of Arbitrage

Wow, it’s already Friday. I’ll feel that I’ve short-changed you if we don’t do some Finance Theory before I go.

Did you see this roundtable about the state of macroeconomics in The Economist’s Free Exchange? Fascinating stuff; in particular it became a bit of an odd defense of the Efficient Markets Hypthosis (EMH). A representative comment was made by William Easterly, in defense of EMH:

The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.

This is not true, and I want us to walk through why it isn’t. In March of 1997, Andrei Shleifer and Robert Vishny published a paper titled The Limits of Arbitrage (pdf) in the Journal of Finance. I think it’s the most important finance paper of the past 15 years, something everyone even remotely connected to financial markets should become familiar with. It builds on and summarizes a decade long research project, research they conducted with people such as Joseph Lakonishok and Brad Delong. In it they say that arbitrageurs, the very smart and talented traders at hedge funds who will take prices that are out of line and bring them back into line, making a good fee and making prices reflect all available information, the very building block necessary for EMH to work, can’t do their job if they are time or credit constrained. Specifically, if they are highly leveraged, and prices move against their position before they return to their fundamental value – if the market stays irrational longer than they can remain solvent – they’ll collapse before they can do their job.
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Dean Baker’s Right To Rent

There’s another problem with trying to deal with the foreclosure problem – the most obvious solution, mortgage cramdowns, are very unpopular. They failed to pass last spring, and are probably even less likely to pass now. People don’t like thinking that they are rewarding those who made bad mortgage decisions. Very few people have ever come close to trading a credit default swap – every adult has had to make a choice about mortgages over the past 10 years, and rewarding, in the words of CNBC, “the losers” is a political no-go in the United States.

What is another choice? How about “Right To Rent”? Here’s Simon Johnson back in November of 2008 calling what would happen over the next 10 months and then suggesting a version of Right To Rent:

Washington is beginning to turn its attention to housing, and there is progress on plans to make it easier to modify delinquent mortgages where there is a win-win solution for the borrower and the lender.

At best, though, this is only a partial solution. Many homeowners will be unable to afford any mortgage that lenders will accept. Complicated relationships between servicers and secondary-market investors will make it difficult, impossible or illegal to restructure many mortgages…

In addition to limiting the number of foreclosures, it will be critical to manage the flow of foreclosed properties onto the market. Otherwise, the mounting wave of foreclosed condos and single-family homes threatens to push housing prices far below long-term sustainable levels, inflicting unneeded pain on homeowners and the economy…. Here are some ways to facilitate an orderly unwinding of real estate…

The borrower turns over the deed to the servicer and rents the property back from the mortgage investor for some period of time. At the end of the period, the renter can get a new mortgage from the investor at prevailing market rates if the borrower qualifies; if not, the property goes on the market.

I want to take that idea and flesh it out further. I think the best approach is the version suggested by Dean Baker’s, who also originated the idea, described here:

There is an easier route. In recognition of the extraordinary situation created by the housing bubble and its collapse, Congress could approve a temporary change to the rules governing the foreclosure process. This change would give homeowners facing foreclosure the right to stay in their homes, paying the market rent for a substantial period of time (eg seven to 10 years).

This change would have two effects. First, it would immediately give housing security to the millions of families facing foreclosure. If they like the house, the neighbourhood, the schools for their kids, they would have the option to remain there for a substantial period of time.

Also by keeping homes occupied, this rule change can help prevent the blight of foreclosures that has depressed property values in many areas. Vacant homes are often not maintained and can become havens for drug use and crime.

Dean Baker has had this proposal out there for a while, since at least 2007. Felix Salmon had it as one of his Fixing The World Ideas in The Atlantic Monthly. Some conservative economists, including Andrew Samwick have signed on, and there’s a version of a bill floating out there.

So what are the advantages? The foreclosure is avoided, keeping pressure off the community and not displacing a family. The rent is set by an appraiser to the neighborhood renting value, and reassessed whenever either the lender or borrower requests it at their cost. This prevents it from becoming a de facto form of rent control, while the externality effect of people losing the value of being able to sell their home because of foreclosures down the block has gone away, not to mention the more general social cost of abandoned housing.

Now is this a gift to those who made terrible decisions? No. As opposed to a normal foreclosure in most states, it is purposely designed so that any equity built up in the loan isn’t transferred over to the consumer. Normally if the bank sells your house for more than the loan outstanding plus fees in a foreclosure, you get the remainder. Not so with Right to Rent, the bank gets all that upside and the other party gets their equity wiped out.

Some versions of similar plans are designed so the bank is required to sell back to the renter first at a later date; I see no reason for this, as the bank will almost certainly offer it first to the people at the property if they can afford it. If they sell it to someone else however, the person still gets to rent their home. Personally I’d like to see the timeframe for the home rental to be on the order of 3-5 years, though that is debatable. Ideally it would also have accelerated eviction rules, so that people who couldn’t even afford the rent aren’t still living in said property.

This requires no taxpayer funding, and can be done in our very efficient bankruptcy courts. How great of a deal is that?

What are the downsides? It is an intrusion onto the property rights of the lender. The lender can still sell, but will sell with a tenant attached to the property. For the time being, the social costs being accumulated by neighborhoods as properties sit vacant is devastating, enough so that we need to take action. Lendors will become landlords, though there are a lot number of civic groups, third parties, businesses, etc. who can contract that labor out if it can’t be done in-house.

What are your critiques? Thoughts? Personally, in terms of our current political dialogue, I wonder if the type of social conservative who is willing to lock up large segments of the population to prevent a “broken window” from forming would be willing to ask a lender to take a small haircut to save the entire house from rotting in foreclosure, windows included. Nothing increases the “disorder” of a neighborhood than having foreclosed houses rotting away on them…

Has Mortgage Modification failed?

Obama’s mortgage modification plan, HAMP (Home Afforable Modification Program), isn’t working very well. Designed to help prevent foreclosures by incentivizing and giving legal protection to previously indifferent middle-men servicers it isn’t producing anywhere near the number of modifications that were anticipated. Is it likely to work in the future? My guess is no. Let’s discuss some reasons why.

Servicers Gaming the System Over the past few months, more and more stories have come out about servicers finding ways to line their pockets while consumers and investors are getting shortchanged. The one that brought the gaming issue to everyone’s attention is Peter Goodman’s article in the New York Times. Here are my favorite three since then:

Story One, Financial Times:

JPMorgan Chase, one of the first mega banks to champion the national home loan modification effort, has struck a sour chord with some investors over the risk of moral hazard posed by certain loan modifications.

Chase Mortgage, as servicer of several Washington Mutual option ARM securitizations it inherited last year in acquiring WAMU, has in several cases modified borrower loan payments to a rate that essentially equals its unusually high servicing fee, according to an analysis by Debtwire ABS. Simultaneously, Chase is cutting off the cash flow to the trust that owns the mortgage. In some cases, Chase is collecting more than half of a borrower’s monthly payment as its fee.

Story Two, Credit Slips

Countrywide Home Loans (which is now part of Bank of America) has been the subject of proceedings in several bankruptcy courts because of the shoddy recordkeeping behind their claims in bankruptcy cases. Judge Marilyn Shea-Stonum of the U.S. Bankruptcy Court for the Northern District of Ohio recently sanctioned Countrywide for its conduct in these cases…The resulting opinion makes extensive reference to Credit Slips regular blogger Katie Porter and guest blogger Tara Twomey’s excellent Mortgage Study that documented the extent to which bankruptcy claims by mortgage servicers were often erroneous and not supported by evidence. Specifically, the court adopted Porter’s recommendation from a Texas Law Review article that mortgage servicers should disclose the amounts they are owed based on a standard form. Judge Shea-Stonum found that such a requirement would prevent future misconduct by Countrywide.

Mary Kane, Washington Independent

Even as the Obama administration presses the lending industry to get more mortgage loans modified, the practice of forcing borrowers to sign away their legal rights in order to get their loans reworked is a tactic that some servicers just won’t give up on…

In a dramatic confrontation last July, Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, told representatives of Bank of America to get rid of waivers in their agreements. His pronouncement came after Bank of America representatives denied they were using the waivers – and Julia Gordon, senior policy counsel at the Center for Responsible Lending, produced one from her briefcase.

Check out those stories. The first has the servicers set the payment to maximize their fees, and not anything beyond (to make sure very poor and desperate mortgage holders are able to pay each month), making sure their interests are above the lender’s ones. The second one shows that it is very difficult to determine incompetence from maliciousness with the way that servicers are handling their documents on the borrowers end. And the third would be a great piece of classic comedy if it wasn’t so terrible. I bet these guys sleep like babies at night too.

The servicer’s interests are their own – and if they can rent-seek at the expense of the parties at either end, ‘nudging’ them with $1,000 isn’t going to make a big difference.

Redefault Risk There’s another story where the servicers aren’t modifying loans because it isn’t profitable for the lenders. There’s a very influencial Boston Federal Reserve paper by Manuel Adelino, Kristopher Gerardi, and Paul S. Willen titled “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization.” They point out that, according to their regressions, redefault risk is very high – the chances that even under a modification there will still be a foreclosures, so why not foreclosure immediately?

I’d recommend Levitin’s critique (Part 1, Part 2), notably that the securitization regression doesn’t control for type of modification, specifically they don’t variable whether or not the modification involved principal reduction, which is probably does for the on-book loans and not for the off-book loans.

But regardless, this is a valid argument as U3 unemployment starts its final march to 10% we are going to see consumers become riskier and riskier, and that will be a problem for modification that will get worse before it gets better.

General Inexperience Servicers were never designed to do this kind of work; they don’t underwrite, and paying them $1,000 isn’t going to give them the experience needed for underwriting. It’s hard work that requires experience and dedication, skills that we don’t have currently. (Isn’t it amazing with the amount of money we’ve put into the real estate finance sector over the past decade we have a giant labor surplus of people who can bundle mortgages into bonds but nobody who can actually underwrite a mortgages well?)

But isn’t it at least possible that as the sophistication of the servicers increase, they’ll become equally good at learning how to game the system? I don’t mean this as a gotcha point, because I think it is the fundamental problem here, and there isn’t any way to break it. The servicers get paid when they have to get involved, and learning the contracts better will give them more reasons to get involved.

It’s been know for several years now that this was a weak spot in the mortgage backed security instruments. In the words of the creator of this instrument, Lewis Ranieri in 2008: ” The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is ‘who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?’ … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy.”

He’s right of course; the people we are trying to ‘nudge’ into acting as the fiduciary are going to be more than happy to rent-seek these instruments while they crush the consumer economy. This ‘gordian knot’ has to be broken, but it’ll need to be done outside the instruments – in the bankruptcy court.

Vermont, Texas, and Subprime Loans

The Wall Street Journal has a story about Vermont and subprime loans:

…For the past five years, as home loans went to even Americans with poor credit and no proof of steady work, Ms. Todd couldn’t get a mortgage in spite of her good credit and low debt. Vermont banks told the self-employed landscaper that her income stream was unreliable. The 32-year-old changed careers, taking a permanent job as a teacher, to boost her chances.

Vermont’s strict mortgage-lending laws largely prevented the state’s residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S…

These tendencies help explain how, in the 1990s, the state moved to rein in mortgage lenders based on just a few instances its chief regulator says raised red flags. According to Vermont’s Department of Banking, Insurance, Securities and Health Care Administration, one broker solicited customers through newspaper classified ads, charging up to $5,000 for referring customers to a lender. Another searched property records for owners’ tax liens, a town clerk reported, searching for what the department believes were people who could be desperate to borrow….

In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors’, with notices printed on “a colored sheet of paper, chartreuse or passion pink.” And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers’ fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour…

Vermonters didn’t see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting — and keeping — a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.

Daniel Indiviglio follows up it with an in-depth comparison to Florida, while Tim Duy goes through the article and ends with this fantastic note: “according to the article, the ‘pitfalls’ amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some ‘pitfalls’ – truly, greater consumer financial protection would spell ruin for us all.” Ha!

Two additional things:

Prepayment Penalties To go back to an old soapbox of mine, it’s worth noting that Vermont has outlawed prepayment penalties. Why is this important? My own thoughts, and the research is finding this as well, is that “lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.” The prepayment penalty is what made these bad-faith loans profitable to the lenders, and with house prices increasing, prepayment penalties allowed lenders to bet directly on this housing appreciation.

To put it a different way, banks, instead of underwriting borrowers, were betting that house prices would increase, and paying consumers to sit in the houses. The fees and prepayment penalties were the payout that made this bet profitable (with that consumer getting what’s left over in housing appreciation). Banks don’t normally bet on house prices – they have exposures, but they are secondary exposures related to recoveries and risks – they bet on consumers. Getting rid of these prepayment penalties keeps them from taking that side bets. It also helps markets actually do their job, by allow borrowers to shop between outfits and products while reducing this transaction cost – and allow the innovation of interest rate risk management to make things a little easier for the consumer.

Texas Like Vermont, Texas has some of the strictest mortgage regulations on the books. No prepayment penalties, no balloon mortgages, etc., and as a result of the Homestead Act of 1839 and subsequent laws strict rules on Home Equity Loans (pdf).

I mentioned earlier in the year, that these consumer protection laws may have played a major role in keeping Texas from having a major housing bubble. I did not know at the time that there was a study at the Dallas Federal Reserve, Why Texas Feels Less Subprime Stress than U.S., that also came to the same conclusion:

Due to the state’s strong predatory lending laws and restrictions on mortgage equity withdrawals, a smaller share of Texas’ subprime loans involve cash-out refinancing, which reduces homeowner equity and makes default more likely when mortgage payments become unaffordable….

State data on subprime mortgage delinquencies suggest that housing prices and local economic factors are still the primary drivers of subprime default rates. Even so, mortgage characteristics also matter—from the incidence of ARMs to the purpose for which the loan was taken out. In general, cash-out refinancing loans are more prone to delinquency than loans for outright purchases.

Recent tightening of credit standards in the mortgage market has put a lid on the growth of subprime and exotic mortgages. Nevertheless, a sharply deteriorating economy, weak home sales and a continued downward trend in housing prices suggest that delinquencies and foreclosures will continue at a high level.

I find it very ironic that places like the AEI are using Texas as the role model for The Way States Should Conduct Themselves in the future, which is by association bootstrap-tugging laissez-faire financial capitalism. The research produced at the Dallas’ Federal Reserve, by economists on the ground, points out the exact opposite – consumer protection is a major reason why Texas isn’t Arizona or California or Florida. Consumer protection allows a baseline of financial safety, a net where the work of building our real economy can take place.