There was a time when the main purpose of this blog was to explain just how some government policy or other official action was designed to benefit some large bank under the cover of the public interest. In a bit of nostalgia, I wrote this week’s Atlantic column on the Freddie Mac–Bank of America story reported on by Gretchen Morgenson. It’s clear that Bank of America got a sweetheart deal from Freddie. The question is why. Did Freddie Mac’s people, some of the most knowledgeable people in the country when it comes to mortgages, not realize they were giving away money? (Hint: Probably not.) Did FHFA examiners, some more of the most knowledgeable people in the country when it comes to mortgages, not realize that Freddie was giving money away? (Hint: See above.)

It’s amazing that after three full years of our government trying to give Bank of America money at every possible opportunity, it’s still a basket case. Now it’s charging people $5 per month to use their debit cards. Yes, this is a predictable response to new Federal Reserve regulations limiting debit card fees. But it’s easily avoidable: just find another bank. (Neither of mine charges me debit card fees.) Not every bank out there is still trying to pay for the Countrywide acquisition.

Many commentators who want to blame Fannie and Freddie for the financial crisis base their arguments on analysis done by Edward Pinto. (Peter Wallison bases some of his dissent from the FCIC report on Pinto; even Raghuram Rajan cites Pinto on this point.) According to Pinto’s numbers, about half of all mortgages in the U.S. were “subprime” or “high risk,” and about two-thirds of those were owned by Fannie or Freddie. Last year I pointed out that Pinto’s definition of “subprime” was one he made up himself and that most of the “subprime” loans held by Fannie/Freddie were really prime loans to borrowers with low FICO scores. Unfortunately, I made that point in an update to a post on the somewhat obscure 13 Bankers blog that was mainly explaining what went wrong with a footnote in that book.

Fortunately, there’s a much more comprehensive treatment of the issue by David Min. One issue I was agnostic about was whether prime loans to people with low (<660) FICO scores should have been called “subprime,” following Pinto, or not, following the common definition. Min shows (p. 8) that prime loans to <660 borrowers had a delinquency rate of 10 percent, compared to 7 percent for conforming loans and 28 percent for subprime loans, implying that calling them the moral equivalent of subprime is a bit of a stretch. Min also shows that most of the Fannie/Freddie loans that Pinto classifies as subprime or high-risk didn’t meet the Fannie/Freddie affordable housing goals anyway — so to the extent that Fannie/Freddie were investing in riskier mortgages, it was because of the profit motive, not because of the affordable housing mandate imposed by the government.

Min also analyzes Pinto’s claim that the Community Reinvestment Act led to 2.2 million risky mortgages and points out that, as with “subprime” loans, this number includes loans made by institutions that were not subject to the CRA in the first place. Of course, the CRA claim is ridiculous on its face (compared to the Fannie/Freddie claim, which I would say is not ridiculous on its face) for a number of reasons, including the facts that only banks are subject to the CRA (not nonbank mortgages originators) and most risky loans were made in middle-income areas where the CRA is essentially irrelevant.

Mainly, though, I’m just glad that someone has dug into this in more detail than I did.

In the Times, Neil Barofsky, Special Inspector General for TARP, performed the admirable feat of fitting a clear, comprehensive, sober critique of how TARP was implemented and what its long-term impact will be in fewer than 1,000 words. It’s a perspective I mainly agree with,* and it highlights the different priorities that the administration put on aid to large banks and aid to homeowners, even though both were goals of the bill.

Back in late 2008 and early 2009, there was a lot of talk about how a true solution for the problems of the banking system would require a solution for the problems of homeowners, since the banks’ losses were largely the result of mortgage defaults. One of the major technical achievements of the administration was showing that it was possible to stabilize the financial system and restore the banks to short-term profitability without doing much for homeowners. As Barofsky says, and as the Times reports in yet another article today, the administration’s programs to help homeowners obtain loan modifications had little impact on the behavior of the banks that service mortgages and foreclosures continue unabated. Real housing prices have fallen below the previous lows of 2009 and now look likely to overcorrect on the downside.**

Housing modifications are admittedly more difficult than bailing out banks. It’s administratively easier to write a few $25 billion checks and create unlimited low-interest credit lines for a few of the Federal Reserve’s existing customers than to intervene in millions of mortgages. But the financial crisis was a time of bold action on other fronts. Treasury and the Federal Reserve were willing to push the limits of the law, for example in J.P. Morgan’s takeover of Bear Stearns. (See the chapter in Steven Davidoff’s book Gods at War for the details.) Henry Paulson threatened to declare the nation’s largest banks insolvent if they didn’t agree to sell preferred stock to the government. By contrast, as law professor Katherine Porter says in the Times article, “The banks were so despised, and TARP was so front and center, you could have actually done something. In the midst of real boldness in bailing out the banks, we get this timid, soft, voluntary conditional program.”

The lesson we learned learned is that homeowners were only a priority insofar as their health mattered to the banks’ health. When those two things became unmoored, the administration was willing to declare victory.

* The main thing I don’t agree with is Barofsky’s implied criticism of the Bush administration for using TARP money to buy preferred stock from banks rather than buying mortgage-backed securities directly. While I have often criticized various aspects of the preferred stock purchases, I think it was a more direct way to stop the panic of September-October 2008, and at that point a program to purchase MBS would probably have been an even more blatant transfer to the banks.

** I’m all for prices falling from bubble levels, but the policy goal should have been preventing them from falling through the long-term trend.

By James Kwak

My previous post on Fannie/Freddie had two major parts. In the first part, I questioned whether the thirty-year fixed-rate mortgage would really go away (or become much more expensive) without Fannie/Freddie, as some people have argued. In the second part, I said, who cares?

The first part has gotten a fair amount of good criticism, for example from Arnold Kling and John Hempton (by email), and also in comments. My position, simplified, was that a thirty-year fixed-rate mortgage includes three kinds of risk: credit risk, interest rate risk, and prepayment risk. Credit risk can be diversified, interest rate risk can be hedged, and Fannie/Freddie didn’t do anything about prepayment risk anyway. This is the kind of theoretical argument people make all the time, and the obvious question is whether the world actually works that way.

I think there are two important criticisms. One, which Kling makes, is that while there are thirty-year fixed-rate bonds (like Treasuries) floating around out there, there just aren’t that many compared to the volume of U.S. thirty-year fixed-rate mortgages. So there might not be enough buyers, and without enough buyers the yields could go way up. One response is that the interest rate risk can be hedged, but that means you have to find a lot of people willing to take the other side of the interest rate swaps, and maybe that would be too hard. So the real question is how much demand there is for thirty-year fixed-rate assets.

The second criticism, which Kling and Hempton make, is that the big issue isn’t the thirty-year maturity; the big issue is prepayment risk. A thirty-year fixed-rate mortgage gives the borrower the right to refinance and pay off the loan at any time, which means that even if you want a thirty-year asset, you can’t count on it. When interest rates go down, you’re likely to get your principal back, and then you’ll have to reinvest it at lower rates. Now, the classical response is that this is just an embedded option (for the borrower), and you should be able to price the option into the mortgage. So the real question is how many people are willing to write those options, and maybe the markets just aren’t deep enough.

I’m not completely convinced by this, though, because Fannie/Freddie didn’t actually hold onto most of their mortgages. Instead, they created pools that issued mortgage-backed securities, and those things had both interest rate risk and prepayment risk (see pages 11-16 of this prospectus for a long list of prepayment risk factors). So people buying the MBS issued by Fannie/Freddie ($5 trillion of them), it seems to me, were happily taking on both interest rate risk and prepayment risk. This seems obvious to me, so I’m almost certainly missing something.

For this reason, I’m still not entirely convinced that the private sector couldn’t take this on. Sure, interest rates would have to be higher because the private sector wouldn’t have the Fannie/Freddie implicit government guarantee* (although, as one commenter pointed out, part of the private sector has something like it). And with higher interest rates, thirty-year fixed-rate mortgages might become less popular compared to adjustable-rate mortgages. But that’s not the end of the world.

Relatedly, John Hempton has another proposal for Fannie/Freddie: simply raise the fee they charge for guaranteeing credit risk. At some point the private sector will step in and take on the job, and in the meantime the government will lose less money and distort the economy less.

* Without the implicit guarantee, the credit risk would be properly priced into the MBS issued by Fannie/Freddie, because Fannie/Freddie already charge a fee for guaranteeing the MBS.

(Yes, I know that isn’t saying much.)

Most people think that Fannie Mae and Freddie Mac had something to do with the financial crisis. Some people think that they were the major reason the crisis happened, which (to them) proves that activist government policy was the cause of the crisis. Other people, including me, think they were a modest contributing factor because they did buy a lot of securities that were backed by subprime loans, but they were well behind the curve when it came to mortgage “innovation” and the creation of toxic assets. But that’s not the question here.

The question now is what to do about them. Although they had been private, profit-seeking companies for forty years, they were taken over by government regulators in September 2008 when they had become clearly insolvent, and are still being operated in conservatorship. Because Fannie and Freddie were very, very long housing, they have suffered massive losses since the financial crisis began. But because the private mortgage securitization market has collapsed, they are the bulk of the secondary mortgage market at the moment, which means the housing market could collapse without them.

On Planet Money a couple of weeks ago, Bethany McLean and Joe Nocera took the cutely counter-intuitive position that the most bizarre mortgage product is the thirty-year fixed mortgage — and that it wouldn’t exist without Fannie and Freddie. Basically, their argument goes like this: Borrowers like thirty-year fixed-rate mortgages, but lenders should hate them. Because of the fixed rate, they carry interest rate risk, meaning that if market interest rates rise the value of the mortgage asset will fall. (If you hold it to maturity, you will still get the cash you expected, but if you are a traditional lender you are funding the mortgage with short-term liabilities, and the interest rates you pay on those will go up — as happened to the entire S&L sector in the 1970s.) Furthermore, they carry credit risk, since lots of things can happen to borrowers over thirty years, and as a result they might not pay you back.* So, according to McLean and Nocera, no banker in her right mind would sell such a product — not, that is, without Fannie and Freddie there to buy the mortgage and take the risk off her hands.** Their punch line is that although Americans like to complain about government intervention in the mortgage market, Americans also want their thirty-year fixed-rate mortgages, and you can’t have one without the other.

But this argument doesn’t make complete sense to me. If thirty-year fixed-rate assets are bad, that means no one would buy thirty-year U.S. Treasury bonds, yet people do (at 4.53 percent). A bank could originate a thirty-year fixed-rate mortgage and just buy an interest rate swap to hedge the interest rate risk. And if banks didn’t lend money to people because lots of things can happen to them that might interfere with their ability to repay, then they would never make business loans. Most businesses have much more volatile cash flows than someone with a good job. The first hedge against credit risk is the fact that you’re making lots of different mortgages to lots of different people, so you diversify away the specific risk in any given household. Now, it’s harder to hedge market risk — in this context, macroeconomic factors — especially if you do your lending in a local market. So the second hedge is that the mortgage is secured by the house, which means that as long as you have a reasonable loan-to-value ratio the bank is probably safe. And in any case, if you’re in traditional banking, macroeconomic risk is just part of your business.

The above also assumes that lenders are holding onto their loans. If they can sell their thirty-year fixed-rate mortgages on the secondary market, then the “problem” is completely off their hands. Yes, Fannie and Freddie are big players in the secondary market. But there’s no law of nature that says you can’t have a secondary market without them. What you need are standards, so that mortgages (or mortgage-backed securities) can be traded without investors having to look into every single mortgage. (For example, the development of standards for corn in (I think) the nineteenth century made it possible for different farmers to dump their corn into the same bin at one end of the railroad and for different buyers to take their corn out of the same bin at the other end — without every buyer having to verify her seller’s corn.) That’s one thing Fannie and Freddie provided with the conforming mortgage standards, but again, there’s no law that says that standards have to be set by companies with implicit government guarantees.

In fact, until recently we had a big secondary market for mortgages that didn’t rely on Fannie and Freddie — private mortgage securitization. Now, yes, I know as well as anyone that this turned out to be a big disaster. It turned into a disaster because the “standards” were set by credit rating agencies. But instead of setting strict criteria for underlying mortgages and then verifying that the actual mortgages met those criteria, the rating agencies used statistical models that attempted to predict how new, varied bundles of mortgages would perform, and they didn’t even do a very good job of verifying that the actual mortgages were consistent with the models. So in the end you had a secondary market that was vastly overpaying for crappy mortgages, and when everyone realized that, the market vanished.

So let’s think about what might happen if Fannie and Freddie didn’t exist. People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them. That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. Banks held onto the credit risk during the postwar boom. [Fixed, see below.] In 1960, for example, banks and thrifts held about $116 billion in home mortgages; government-sponsored enterprises held about $3 billion, with about zero in mortgage pools.***

Alternatively, that bank might try to package and resell mortgages on the secondary market. It doesn’t really matter if they are sold as packages of loans or as tranched mortgage-backed securities. The important thing is that there are verifiable and verified standards so that investors don’t have to inspect all the mortgages. That could be a private sector function, or alternatively there could be a government agency to define conforming mortgage standards and verify that the loans in a given pool comply with those standards. But the government agency doesn’t also have to be buying the mortgages. If investors can be sure that mortgages are what they say they are, then someone will buy them: pension funds, insurance companies,**** hedge funds, rich people, etc.

Now, the question is, how much will they pay? The Planet Money episode with McLean and Nocera cited Bill Gross of PIMCO saying he would demand an extra three percentage points in yield for a mortgage without a Fannie/Freddie credit guarantee. Although Bill Gross is no doubt one of the smartest investors in the world, there are a couple of reasons to doubt this.

There are at least two ways to estimate what mortgage rates would be without Fannie and Freddie. First, we can look at Fannie and Freddie themselves. Until 2008, they were profit-seeking companies, meaning that they were already paying as little for mortgages as they could. Their competitive advantage in the market was their implicit government guarantee — people thought that, in a crisis, the federal government would bail them out and protect them from default — which meant they could borrow money more cheaply than, say, banks. Without Fannie and Freddie, the new replacement buyers would have higher funding costs, so the increase in the yields they demand should be roughly the same as the difference between their fundings costs and those of Fannie/Freddie. Major banks these days have credit ratings around A, which means they pay about 80 basis points more for seven-year debt than do Treasuries. (I use seven years because that’s roughly the average time before a mortgage is paid off.) Even if Fannie and Freddie were paying the same yield as the Treasury Department, that means that mortgage rates would only be about 80 bp higher without them.

Second, we can look at the spread between conforming mortgages and jumbo mortgages (which are too big to be bought by Fannie and Freddie). A quick search yields this paper by Anthony Sanders, which cites several other studies (see Table 1) that show the spread to be between 16 and 40 basis points.

(Now, Bill Gross might still be right. In today’s market, if a mortgage isn’t guaranteed by Fannie or Freddie, there must be something wrong with it, so maybe you should demand 300 bp more to buy it. But that’s an adverse selection problem that wouldn’t exist without Fannie and Freddie.)

So according to the back of the envelope at least, a world without Fannie and Freddie would not send mortgage rates into the stratosphere. But more importantly: so what if it did?

The immediate response is usually that middle class families wouldn’t be able to buy houses. But this isn’t quite right. Higher mortgage rates mean buyers can’t spend as much on houses. But that means the demand curve would shift down and housing prices would come down; people would still need to move, they would still need to sell their houses, and the market would clear at a lower price level.

The market would also clear at a lower quantity, which means that over time the homeownership rate could go down. But this isn’t as big a problem as it sounds. It’s not like a consumer product market where lower quantity means less stuff. We’ll still have the houses we have; they’re not being destroyed. In fact, the current problem with the housing market is that we have too much housing stock for the number of households in the country (a point often made by Calculated Risk). Since housing at the margin can shift between homeownership and rental, whether a housing unit is used for one or the other doesn’t matter from the standpoint of total production. If we want to soak up the glut of housing, we need new household formation (e.g., people moving out of their parents’ houses). That is more likely to occur if the price of housing comes down. And only when the glut is soaked up will there be a reason for developers to build more.

Instead, one major effect of higher mortgage rates would be distributional: lower housing prices would hurt people who own houses (like me) and help people who don’t. In general, this means hurting the rich and helping the less rich, and that sounds like a good thing to me from a simplistic Rawlsian perspective. But that’s probably the main reason why our government has spent so much effort subsidizing mortgages and propping up the price of houses.

Then there’s the wealth effect, which is fictional on the one hand but unfortunately real on the other. If you have $100,000 in cash and a $300,000 house, and tomorrow the value of your house falls to $250,000 because all housing prices have fallen, you are exactly as rich as you were the day before for most practical purposes, assuming you still want to live in a house. You still have $100,000 and one house.(There are exceptions, like if you plan to move someplace where houses are cheaper, in which case you will end up slightly worse off.) But unfortunately, you feel $50,000 poorer, and that may crimp your consumption, hurting the economy. So if we’re going to move to a world where the government doesn’t suppress mortgage rates, we’ll have to do it gradually.

So here’s my not-very-thought-through proposal: Fannie and Freddie should continue doing what they are doing, as wards of the federal government. But every year, for each $1 in assets that get paid off, they should only invest $0.50 in new mortgages (the rest should reduce net debt). So gradually, over the next 15-20 years, their balance sheets should shrink to small fractions of what they are today, and then they should be shut down as borrowing and investing institutions. As I said above, I think it’s possible and perhaps preferable to keep them in the role of defining and verifying conforming loan standards so that investors have some confidence in securities backed by those mortgages.

Yes, this would be a big experiment. But we’ve had a big experiment in subsidizing homeownership, and I’d say it hasn’t worked out too well.

Now, to reassure regular readers of this blog, I’m not against subsidized mortgages because I’m against government subsidies in principle. I just think government subsidies should be saved for things that are worth subsidizing — like fruits and vegetables, for example. I should add that I’m no expert on Fannie and Freddie and I’m willing to be talked out of this position. But it seems to make sense to me.

* Actually, there’s a third kind of risk: prepayment risk. If interest rates go down, borrowers will refinance and pay off their mortgages. As a lender, you still get your principal back, but now you have to reinvest it at a lower interest rate. But Fannie and Freddie didn’t do anything about prepayment risk anyway — that was still the principal risk faced by investors in mortgage-backed securities.

** In fact, for the most part, Fannie and Freddie don’t buy and hold the mortgages outright. They create mortgage pools that issue mortgage-backed securities that have a Fannie or Freddie guarantee. At the end of 2009 the government-sponsored enterprises had $700 billion in home mortgages, while the pools had $5.3 trillion in mortgages, according to the Fed’s Flow of Fundszy report. Since the beginning of 2010, most of those pools are now consolidated on the Fannie/Freddie balance sheets, presumably because they are still on the hook for losses.

*** The originate-and-hold model did run into problems in the 1970s, but that was primarily because of volatile interest rates, not because of credit risk. Interest rate risk can now be hedged using interest rate swaps, which weren’t invented until 1980.

**** In 1960, life insurance companies held $42 billion in mortgages.

Update: Arnold Kling caught a mistake above. Originally I said “That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. This is what banks did during the postwar boom.” I meant to say that banks used to hold onto the credit risk, not that they used interest rate swaps. I know that interest rate swaps didn’t exist back then (that’s a point made elsewhere in the post). My point was that banks used to hold onto both interest rate and credit risk, and that model broke down because of the interest rate side, not the credit side. And on the interest rate side, you can use swaps today. Now, maybe there aren’t enough people who want to take the other side of that swap, but there are plenty of pension funds and life insurance companies who need thirty-year assets.

Adam Levitin and Susan Wachter have written an excellent paper on the housing bubble with the somewhat immodest title, “Explaining the Housing Bubble” (which has been sitting in my inbox for a month). My main complaint with it is that it’s eighty-one pages long (single-spaced), which is most likely a function of law review traditions; had it been written for economics journals, it could have been one-third the length. I also have some quibbles with the seemingly obligatory paean to the importance of homeownership, which I think is an assumption that deserves to be contested. But overall it presents both a readable overview of the history and the issues, and a core argument I have a lot of sympathy for.

The argument is that the motive force behind the credit bubble was an oversupply of housing finance—in other words, the big, bad, banking industry. Levitin and Wachter’s key evidence is that the price of residential mortgage debt was falling in 2004-06 even as the volume of such debt was rising. As Brad DeLong’s parrot would say, that can only happen if the supply curve is shifting outward, not if the demand curve is shifting outward (which is what would happen if it were all the fault of greedy borrowers who wanted to flip houses).

This oversupply of housing finance happened because of banks’ desire to keep the securitization pipeline flowing after the 2001-03 refinancing wave tapered off. Private mortgage-backed securities were their preferred instrument because they are both complex and heterogeneous: complexity means they are impossible to price based on fundamentals, and heterogeneity means that comparing prices between private MBS is meaningless or misleading. And this was possible because there were no regulatory standards governing the private MBS market. The “market regulation” beloved of Alan Greenspan also didn’t work because, among other things, short pressures were soaked up by synthetic CDOs that were willing to sell CDS protection on MBS at artificially low prices.

A lot of the story will be familiar to financial crisis junkies, but you will probably learn something new (about the difference between the CMBS and RMBS securitizations, for example). And most importantly, with all the misinformation floating around about the causes of the crisis, Levitin and Wachter isolate the importance of our deeply flawed financial system.

I’ve been largely sitting out the foreclosure scandal/crisis. Partly I’ve just been too busy, and partly the coverage on other blogs has been great. Mike Konczal in particular has been providing the “beginners” posts–here’s part one of five–that were my niche during the earlier part of the financial crisis, basically putting me out of a job, and Yves Smith has also been all over the issue.

I want to ask one question, but for those who are not economics blogs junkies, let me get you up to speed. It first turned out that in their haste to foreclose on houses, the law firms filing for the foreclosures (in many states, you have to get a judgment from a court in order to foreclose) were cutting corners and sometimes filing fake documents. Then it turned out that sometimes they were filing fake documents because the real ones didn’t exist. In particular, it is possible that many of the trusts that issue mortgage-backed securities never had properly-endorsed copies of the notes that underlay those mortgages. (See this Yves Smith post. Highlight quote, from the CEO of a mortgage originator: “We never transferred the paper. No one in the industry transferred the paper.”)

The question is this: Why, just weeks from an election in which Democrats are probably going to get clobbered, is the Obama administration sitting on its hands, writing this off as a bunch of technicalities, and opposing a foreclosure moratorium?

Not only would it be good politics for an administration that has a hard time establishing credibility with ordinary people, but you would think a halt to foreclosures is actually what the Treasury Department wants. Over the summer, Steve Randy Waldman pointed out that Treasury essentially confirmed what many had suspected all along–the main point of HAMP (the mortgage modification program) was not to help homeowners, but to spread out the foreclosure wave over time in order to prop up housing prices and therefore protect the economy. A foreclosure moratorium, by temporarily halting the flood of foreclosed houses onto the market, would be even better.

The scary possibility is that what they’re really afraid of is systemic risk: the possibility that, as Konczal and others have pointed out, the mortgage securitization trusts (the entities that bought mortgages and issued mortgage-backed securities) could sue the investment banks, forcing them to buy back the underlying mortgages at the original cost. Since those mortgages are now worth far less than before, this would impose huge losses on the Big Six banks.

Big banks losing money isn’t what’s scary. What’s scary is that the administration may be pooh-poohing the foreclosure fraud crisis because it wants to protect the big banks once again. In other words, it’s minimizing the problem because it’s hoping that the banks will finish “reviewing their procedures,” say that everything has been fixed, and go on with their business; in that situation, it would be awkward for the administration to have come out strongly on the side of homeowners. This would basically be the operational equivalent of “it’s just a liquidity problem.”

But why? If this really could damage the big banks, why not let them take the hit and clean up afterward–especially if “orderly liquidation authority” is really the bazooka they claim it is? Why protect them now after being stabbed in the back repeatedly during the financial reform debate and in the current campaign finance cycle? Why not take this opportunity, if there really is one, to undo the mistakes of 2009?

Let’s hope there’s a better explanation than “we have created [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle.”

Since most of you probably read Calculated Risk, you’ve probably seen the Sun Sentinel story of the man in Florida who paid cash for a house–and still lost it in a foreclosure. Not only that, but he bought the house in a short sale in December 2009, the foreclosure sale happened in July 2010, and only then did he learn about the foreclosure proceeding.

Even after that,

“Grodensky said he spent months trying to figure out what happened, but said his questions to Bank of America and to the law firm Florida Default Law Group that handled the foreclosure have not been answered. Florida Default Law Group could not be reached for comment, despite several attempts by phone and e-mail. . . .

“It wasn’t until last week, when Grodensky brought his problem to the attention of the Sun Sentinel, that it began to be resolved.”

Bank of America now says it will correct the error “at its own expense.” How gracious of them.

If the legal system simply allows Bank of America to correct errors, at cost and with ordinary damages, after they happen, this type of abuse will only get worse. There’s obviously no incentive for banks not to make mistakes, and as a result they will behave as aggressively as possible at every opportunity possible. Yes, this was probably incompetence, not malice, on the part of the bank. But if you don’t force companies to pay for the consequences of their incompetence, they will remain willfully incompetent, and the end result will be the same.

Mike Konczal did some more great work earlier this week in two posts on the not-so-exciting topic of second liens. I don’t have much in the way of new insight or analysis to provide, so let me just summarize.

A second lien is a second mortgage on a house. The second lien is junior to the first mortgage, meaning that if the borrower defaults and the first lender forecloses, the proceeds from the sale go to pay off the first mortgage; the second lien only gets paid back if the sale proceeds exceed the amount due on the first mortgage. You can see where this is heading.

Konczal’s first point was that in the stress tests almost a year ago, the big four banks held $477 billion of second liens and estimated that these assets were worth 81-87 cents on the dollar, so they would take $68 billion in losses (under the “more adverse” scenario). Konczal estimated that they were instead worth 40-60 cents on the dollar, implying $191-286 billion in losses.

After Ryan Avent questioned whether second liens were really in such bad shape, Konczal came up with this great chart from Amherst Securities:

Here’s how to read it:

“The second to last column is the current loan-to-value, LTV, of the first lien. If it is greater than 100, it is underwater on the first mortgage by itself – the loan is greater than the value of the house. . . . The last column is the current CLTV, or combined-loan-to-value, which is the loan to value on all the debt of the property. . . . These are averages – the data sources aren’t more specific.”

So, for example, looking at the third line, the borrowers currently owe $32.1 billion on first liens and $6.0 billion on second liens. The LTV of the first mortgage is 105%, so the current value of the property is $30.6 billion. In other words, the first mortgages are underwater, so the second liens are more or less worthless. (In practice, the second liens do have some small value, based on three things: (1) the hope that some borrowers will continue to make payments on second liens, even though would do better (financially) to walk away; (2) option value, since housing prices could rise enough to make the second liens worth something; and (3) the possibility that the government will start paying off second lienholders to stop blocking short sales.)

So, looking down the chart, the problem seems obvious: the second liens are not worth very much, so the big banks are sitting on major unrealized losses. What’s more, these second lienholders are blocking the principal writedowns that would make sense if there were only one lender involved (a single lender would often rather lower the principal and keep the borrower in the house making payments than foreclose), because those writedowns would wipe them out; but they don’t want to foreclose, either, because that would also wipe them out. So instead we get “extend and pretend,” and possibly servicers pressuring borrowers to pay off their second liens before their first liens.

Now, John Cassidy doubles down on his defense of the stress tests in a blog post that responds to Konczal. Cassidy says:

1. Banks have to write down loans that are delinquent for six months, and we haven’t been seeing this in bulk.
2. “Most second mortgages aren’t piggybacked on first mortgages that are underwater. . . . according to one official I spoke to, roughly thirty per cent of second mortgages are in this dire predicament.”
3. “About one in five second mortgages aren’t really second loans at all. Typically, they are home equity loans taken out by people who have fully paid off their first mortgages. . . . The monthly payments on such loans are usually relatively small—a few hundred dollars—and the likelihood of default is relatively small.”

Not surprisingly, I’m not very convinced. As for 1, a lot of this is probably people who are underwater but are still making payments–but might decide to stop. Some of it is probably people who got trial modifications on their first mortgages, so they can still make payments on their second liens. (The servicers who are in charge of those modifications are often the same bank that hold second mortgages.)

As for 2, this seems to directly contract Konczal’s data, which I would trust over “one official I spoke to.” Now, Konczal’s data are originally from LoanPerformance; I believe they get their data from securitizations, but I don’t know if that means that the second liens in their sample were securitized, or just that the first liens were securitized. (My guess is the latter.) It is likely that loans that went into securitizations were more toxic than those that didn’t. So if the banks in question are holding onto whole second liens where the primary mortgage was not securitized, then that could lean in Cassidy’s favor. (If on the other hand they are holding onto ABS based on second liens, then that would lean against.)

As for 3, what we care about is not the number of second liens that are underwater, but the dollar amount. If a HELOC is small and hence easy to pay off, by the same token it is relatively insignificant to the question at hand. More importantly, as Konczal says in a comment to his second post, citing Amherst Securities: “many borrowers are not paying their 2nd, but most of those are unpaid 2nds are home equity lines of credit. The unpaid interest is simply added to the balance, and the loan technically remains current.” So the default rate on HELOCs is artificially low.

Did under-regulated lending to consumers play a big part in destabilizing the financial system? Many knowledgeable people say yes, but Professor Todd Zywicki disagrees. (“Complex Loans Didn’t Cause the Financial Crisis,” Wall Street Journal, February 19, 2010).  He claims that the present troubles resulted from the “rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity.”

Professor Zywicki’s argument enjoys, at least, the modest virtue of technical accuracy, because many objectionable misleading sales practices and agreements that lenders used were, and continue to be, unfortunately, quite legal.  Lending practices may have been regularly misleading and confusing and reckless-but fraudulent?  Well, no, usually not unlawful by the remarkably low standards of the day.   But that in itself is an argument for saying consumer protection laws failed.

Professor Zywicki’s case for denying that better consumer protection rules would have mattered quickly becomes technical and rather disingenuous, hinging as it does on the difference between denying that there were inadequate restraints on imprudent lending, on the one hand, and insisting that there were definitely “misaligned incentives,” on the other.  If the lassitude of the government agencies who were responsible for financial consumer protection is not to blame, then who was responsible for all the euphemistic “misaligning”?  Zywicki manages to blame the financial crisis on “extraordinarily foolish loans” that created incentives for borrowers to borrow unwisely, but absolves the regulators who could have prevented those foolish loans from being made.

Zywicki’s research leads him to conclude that the onset of the foreclosure crisis “was [initially] a problem of adjustable-rate mortgages, whether prime or subprime.”  It might have been useful if he recalled that even if true, it was still the case that inadequate disclosure of the implications of potentially exploding adjustable-rate mortgages was a matter of serious concern to consumer groups.  In the second phase, he says, “falling home prices provided incentives for owners . . . to walk away from their houses.” It might have been useful to recall that if the carrying cost of mortgages had been more closely supervised as a matter of consumer protection, the problems would not likely have been as severe.

And so the broad claim that the financial crisis has nothing to do with fraud or consumer protection dissolves in the face of the facts: the crisis can be attributed to failures of consumer protection, including those that enabled lenders to make the loans Zywicki decries. Consider the following examples of consumer protection failures:

First, lenders made loans that virtually invited default.  Thus, Countrywide’s manual approved the making of loans that left consumers as little as $550 a month to live on, or $1,000 for a family of four.  And lenders qualified borrowers for loans based on a temporary low teaser rate even though they knew that borrowers would not be able to make the higher payments required when the teaser rate expired.   Of course, when loans became unaffordable, lenders could anticipate that borrowers would refinance, triggering a new round of fees for lenders-but they gave too little attention to the possibility that the loans could not be refinanced.  Consumer protection laws failed to prevent this disaster-in-the-making.

Second, the Federal Reserve’s disclosure rules made it impossible for adjustable rate mortgage borrowers-and 80% of the subprime loans were adjustable–to understand the risks they faced. Since the eighties, the Fed has mandated that the disclosures for such loans state figures for monthly payments that are simply wrong.  That may have led consumers to believe their loans would be more affordable than they were.  One of us recently presided over a survey of mortgage brokers that revealed that many borrowers spent little time reviewing those disclosures and never changed what they did because of them-something that ironically makes sense when the disclosures are misleading.  Better consumer protection laws would have enabled borrowers to know when they risked getting in over their heads.

A third consumer protection failure connects to Zywicki’s claim that borrowers “rationally switched to adjustable-rate mortgage when their prices fell relative to fixed-rate mortgages.”  The problem is that many adjustable-rate borrowers did not realize that their loans were adjustable.  Thus, a study of borrowers in certain Chicago zip codes found that “the overwhelming majority” of those who received adjustable-rate loans had thought their loans were for fixed rates.  The authors explained that “In every case where borrowers were surprised to be told they were receiving an adjustable rate loan, the Loan Originator had told the borrower that the rate was ‘fixed’ but neglected to mention that the terms for which the rate was ‘fixed’ was limited to 12 to 36   months.”  It was not until 2008 that the Fed reined in this practice.

These problems could have been forestalled by an agency focused on consumer protection. Why weren’t they?  We believe that Zywicki is right to focus on incentives but wrong to ignore the incentives faced by regulators themselves.  The economic crisis was caused in part by incentives built into our consumer regulatory structure that encourage regulators not to protect consumers.  A CFPA would have different incentives.

For example, in 1994 Congress gave the Federal Reserve the power to bar unfair or deceptive mortgage loan practices and abusive lending practices in connection with mortgage refinancing-powers that would have enabled the Fed to prevent the foolish loans Zywicki complains about, and the practices described above.  Yet the Fed did not use that power until 2008, long after the subprime loans had tanked.   And it was only last summer that the Fed proposed to change its misleading adjustable-rate mortgage disclosures. Perhaps the reason lies in the fact that the Fed is primarily an agency devoted to monetary policy, where consumer protection is reportedly seen as a backwater.  The leaders of the Fed are chosen not because of their expertise in consumer protection, but because of their mastery of economic policy.  Thus, the Fed’s incentive is to focus on monetary policy.  An agency with protecting consumers as its sole mission would surely not have waited almost twenty years to act while lenders provided borrowers with false and useless disclosures.

A second problem with the current structure of consumer protection regulators stems from the fact that because lenders have some power to  choose which agency will regulate them, agencies have an incentive to go easy on consumer protection regulation to avoid chasing lenders to other agencies.  For example, four days after the Connecticut Banking Commissioner examined one Connecticut lender, the lender notified the Commissioner that it was becoming a subsidiary of a national bank, thereby excusing it from compliance with Connecticut banking law.  The incentive to retain lenders to regulate is especially strong for regulators, like the OCC, that depend on fees provided by their lenders to finance their operations.   That may explain why the OCC took the position that state anti-predatory lending laws did not apply to the lenders within its jurisdiction-laws which might have prevented some of the lending that led to the subprime crisis.  But if lenders could not choose their regulator, regulators would lose the incentive to compete to protect lenders from consumer protection laws.

Zywicki is right that we need “simplified and streamlined regulation.” The problem is that the existing structure, with consumer protection split among an alphabet soup of agencies, such as the OCC, OTS, NCUA, FDIC, HUD, FTC, and, of course, the Fed, among others, is not likely to produce simplified and streamlined anything.  We share Professor Zywicki’s concern that the Truth In Lending Act needs pruning, for example.

The best way to attain simplified and streamlined regulation is to simplify and streamline the agencies that produce it-by reducing them to one.  Doing so would concentrate consumer protection expertise in one place and enable accountability.   And, we assert, if it had been done a few years ago, the financial crisis might have been averted.

The failure of the Obama administration so far to come up with a working solution to the problem of mass defaults and foreclosures may be due to practical barriers, such as lack of capacity among mortgage servicers or legal uncertainties regarding securitization trusts. Alternatively, however, it may simply be that the administration doesn’t care that much. Perhaps the primary goal of homeowner assistance all along was to detoxify the toxic assets on large banks’ balance sheets; now that those banks are off of life support, maybe the mortgages themselves don’t matter that much.

Congressman Brad Miller’s proposal in The New Republic should put that question to the test.*

Miller says we should stop expecting the mortgage lenders, securitizers, and servicers who created this mess to be the ones to clean it up. Instead, the government should create a new Home Owners’ Loan Corporation, modeled on the one created by FDR in June 1933 (three months after taking office), to buy up mortgages and modify them. The HOLC could pick and choose the mortgages it buys and modifies, so it could focus on mortgages that could be successfully modified to keep the homeowner paying something and give the HOLC a small profit. I spent half the article wondering how the HOLC cold avoid overpaying for the mortgages (since the banks would try to hold it up for a high price), and then Miller suggested the solution: eminent domain. (The idea would be to take market data about mortgage prices and force banks or trusts to accept that in exchange for the mortgages, instead of letting them demand the inflated prices they may be keeping those mortgages at on their books.)

Both administrations, and the Federal Reserve, took absolutely extraordinary measures to rescue the financial system, simply shoving the private sector out of the way and, for example, buying over one trillion dollars of agency bonds and mortgage-backed securities in order to prop up prices in the market. By contrast, the homeowner assistance measures have been tentative, based on “nudging” private sector actors to do the right thing through small cash incentives. Those measures have largely failed; the cash incentives seem to be motivating mortgage servicers to “extend and pretend,” stringing homeowners along to keep them paying something without ever making the principal reductions that are necessary for a real solution.

Will the administration take bold measures — either those suggested by Miller, or something else commensurate with the steps taken to save large banks — to keep homeowners in their houses and stop the wave of foreclosures? Or is it content to pretend that its half-measures are working?

* Note that as far as I can tell Miller actually writes his own articles (and blog comments, even), as opposed to many public figures.

Update: Paul Kiel at ProPublica has yet another story on the challenges facing homeowners trying to get their mortgages modified through the government’s program. Among other things, modification trial periods were supposed to last only three months, yet 475,000 homeowners have been in trial periods for longer. That’s a lot of people. This is the problem that Miller is trying to fix. The administration may not agree with his solution, but I think something similarly bold is necessary.

Unemployment is always a lagging indicator, and given the record low number of average hours worked, it will turn around especially slowly this time. Until then, people will continue to lose their jobs and wages will remain flat, and any small rebound in housing prices is unlikely to help more than a few people refinance their way out of unaffordable mortgages. So unless the other part of the equation – monthly payments – changes, the number of foreclosures should just continue to rise.

Calculated Risk provides this great chart from Matt Padilla (see the CR post for definitions of the categories):

The foreclosure problem has gotten a little more press recently as the Treasury Department attempts to follow through on its “name and shame” campaign to pressure mortgage servicers to modify more loans.

There seem to be two main explanations for why more loans are not being modifyied. The New York Times recently reported that for the servicers at the center of the process, it is simply more profitable to make fees off of delinquent loans than to foreclose on them and give up that stream of fees. On this theory, the cash incentives being provided by the government are simply not big enough to change their financial incentives.

The servicers prefer to argue that their hands are tied by the investors who own the mortgage-backed securities that have swallowed up the mortgages. On this theory, the Pooling and Servicing Agreements that govern these securitization trusts restrict the ability of servicers to modify mortgages. However, an article by Karen Weise in ProPublica yesterday casts serious doubt on this claim. Weise follows a household that is trying to get a modification of their mortgage, serviced by Wells Fargo, under the Making Home Affordable plan. Wells Fargo claims that it cannot modify the mortgage under those terms because “the investors need their money,” and instead proposed a different modification, which would increase the loan principal by $80,000. However:

researchers at UC Berkeley’s law school looked at the contracts covering three-quarters of the subprime loans that were securitized in 2006. The researchers found that only 8 percent prohibited modifications outright. About a third of the loans were in contracts that said nothing about modification, and the rest set some limits but generally gave the servicers a lot to leeway to modify, particularly for homeowners that had defaulted or would likely default soon.

And that is the case with the loan in question, for which the servicer need only make a “reasonable and prudent determination” that the modification is in the investors’ interests. What’s more, in this case, “Deutsche Bank [trustee for the securitization trust] spokesman John Gallagher said servicers are ‘solely responsible’ for deciding all modifications.”

According to Weise’s article, the administration anticipated servicers’ fear of being sued by investors, but a key phrase in the proposed legislation was removed by Congress as a result of lobbying efforts. Servicers would probably have preferred the phrase be left in, but the end result is it gives them a convenient excuse for failing to modify mortgages – which, as the Times pointed out, is often in their own financial interests.

It will be interesting to see if the administration chooses to take serious action to reduce foreclosures, or whether it sticks to a “name and shame” strategy that is likely to be ineffective.

By James Kwak

Wolin firmly rejected the argument made by American Bankers Association chief executive Ed Yingling in recent congressional testimony that responsibility for consumer protection should not be separated from the responsibility for safety and soundness. . . .

The industry has argued that prudential regulators are careful to preserve a profit margin on financial products, to keep financial institutions sound.

This is a staggeringly cynical argument. Basically it says that you should combine prudential (solvency) and consumer safety regulation because otherwise the consumer safety regulators will reduce profits to the point where banks will not make enough money to be healthy. This logically implies that if there is a banking product or practice that is unsafe for consumers, but whose elimination would threaten banking profits, you should allow that product or practice. Is this really what the industry means?

I couldn’t believe anyone would actually say this, so I tried to find a source. I looked in the most obvious place, which was Ed Yingling’s July 14 testimony before the Senate Banking Committee. To his credit, I couldn’t find that argument in all its brazen glory. However, I did find torrents of partial truths like this one attempting to make the same argument:

Consumer protection and financial system safety and soundness are two sides of the same coin. Poor underwriting, and in some cases fraudulent underwriting, by mortgage brokers, which failed to consider the individual’s ability to repay, set in motion an avalanche of loans that were destined to default. Good underwriting is the essence of both good consumer protection and good safety and soundness regulation.

Note in passing that the spokesman of the American Bankers Association places all the blame on “mortgage brokers.” More importantly, what Yingling leaves out is that from the perspective of the individual bank there is no contradiction between fleecing customers and making lots of profits (which is what makes you safe and sound). (a) Originate bad loans; (b) pocket fees; (c) sell bad loans to an investment bank for distribution; (d) repeat. What threatened to bring down banks was the fact that they held on to too much of the risk of those loans, either on their balance sheets or in their off-balance-sheet entities.

Yingling’s testimony is page after page of that. This is going to be a real battle.

By James Kwak

I’m in favor, although I don’t think it will be enough to simply make the vanilla offering available; in that case nothing would stop lenders from paying higher commissions to brokers in order to steer customers toward exploding mortgages.

By James Kwak

So what gives? Do the rating agencies see some new perils in the economy that are being overlooked? Or are they just stretching out a writedown in their forecasts over several quarters? Under the latter theory, they should have known what would happen to subprime and Alt-A loans the same time people like Calculated Risk did – that is, several months ago – but it would be too embarrassing to do a massive writedown all at once, so they are spreading it out over time for respectability.

By James Kwak