By Martin Hutchinson
While the U.S. stock market clearly liked the Bush Administration housing bailout plan announced last Thursday – the Dow Jones Industrial Average soared 175 points on the day – investors once again got it mostly wrong.
The bailout is based on bad principles, and won't help the struggling housing market much. And that's quite possibly not the worst of it. Because a bailout – by definition – keeps free-market forces from clearing the subprime sludge out of our economic system, it could actually exacerbate the housing and mortgage mess over the long haul. Only time will tell.
The Good, the Bad, and it's Still Ugly
The good news about the housing bailout is that it doesn't involve any taxpayer money – at least not directly, and not yet. In the long term, however, it probably will: Parts of the plan involve refinancing subprime borrowers with FHA loans guaranteed by the government, and since these borrowers are at the "toxic waste" end of the subprime-mortgage spectrum, U.S. taxpayers can expect to pick up the tab for lots of defaults.
However, the worst part of the plan is the agreement by mortgage-servicing firms to allow certain borrowers – those with FICA credit scores of 660 or below, who took out subprime mortgages from 2005 to 2007 – to "freeze" their interest rate at the low initial rate for five years.
There are two things wrong with this.
First, the servicers don't own the mortgages. These firms have packaged them up into mortgage bonds and sold them to investors. When President Bush says this is not an investor bailout, you'd better believe that he's correct: Investors are being forced to give up their right to high interest payments, and to receive lower rates for five years. They weren't consulted when the bailout plan was being crafted, they're not being compensated for the lost income, and their property rights as they relate to their mortgage bonds have been violated. On the face of it, that sure seems unconstitutional [anyone remember the "takings" clause?], and I'd be willing to bet it spawns a ton of lawsuits.
Second, the plan is skewed and doesn't treat all subprime borrowers equally: It FAVORS the borrowers who couldn't afford the mortgages they took out, and DISCRIMINATES AGAINST those solid citizens who have decent credit, and who could have easily afforded a "proper" [i.e.: conventional] mortgage, but were instead suckered into subprime junk by shyster mortgage brokers.
The bottom line: This is all a huge mess.
New Business Model Needed
Once upon a time, Jimmy Stewart [George Bailey], and the friendly Downtown Bedford Falls Bailey Brothers Building & Loan made the loans that consumers used to buy new homes.
Those were the salad days for the local S&Ls. Executives used the so-called 3-6-3 strategy, which enabled them to be both highly profitable, and quite happy, at the same time. They attracted capital by paying depositors 3%, loaned it out at 6%, and were out on the golf course by 3 each afternoon.
But the 3-6-3 days didn't last. Wall Street hijacked the home-mortgage market.
Now the home loans are packaged by Wall Street and sold to borrowers by shysters using sales techniques that aren't even worthy of the used-car business. The orgy of speculative lending and dishonest selling that inflated the 2002-2006 housing bubble had to end sometime, and was bound to sting lots of innocent folks when it did so.
It's all a huge shame, but you must remember that only some of the villains were on Wall Street.
They had lots of help on Main Street.
Housing companies bought up the land they needed for future developments, expecting rapidly expanding sales. Now that land they bought in 2004-2007 is not going to be worth what they paid for it, and building houses on it only exacerbates the companies' financial problems.
The banks that lent heavily to the housing sector now have huge portfolios of mortgage loans that looked terrific at the time, but have now lost that allure.
In fact, now the prices of those houses are dropping – down 1.5% in last month alone, according to the Case-Shiller price index. And with each percentage decline in housing prices, new groups of homeowners are exposed to the reality that their house is now worth less than what they still owe on it.
Even homeowners who bought long ago – some in the last millennium, even – are often vulnerable because they extracted cash from their house via a "takeout" refinancing [as their mortgage broker advised them to do], and then spent the money on luxurious living, or other non-essentials that can't be resold to get the capital back.
The Mortgage Bankers Association reported that foreclosures are now running at record levels, with 1.7% of homes in foreclosure and 5.6% of mortgages seriously in arrears. Well, if something's a record, it means nobody planned for it. And lenders who still think their mortgage portfolio is all hunky-dory, are about to find out otherwise.
A Look Ahead
Eventually, the market will bottom out, and maybe once again mortgage banks will actually make home loans and hold them on their books. This is economically much more efficient since the incentives are in the right place and nobody is making a fee without having responsibility for the credit risk. Unfortunately, there's no way to predict just how long the mortgage malaise will last, how much worse it could get, or when it will surprise us and turn around.
Some experts believe this process will take years – that's right, not months, but years – before this financial disaster is purged from the U.S. economy, meaning housing prices are destined for additional prolonged declines before they stabilize.
Others believe that pockets of opportunity will soon start appearing – if they haven't already. In the financial sector, those will appear well before the actual mortgage market rights itself. Investors who aren't anticipating this could well be surprised when financial stocks – in anticipation of this turnaround – will head north.
Which brings me to a crucial point. The whole area of housing and housing finance is going to have to undergo a big overhaul to regain its footing and get healthy again. Because of the prolonged housing bubble, both homebuilders and housing-finance companies organized themselves for a world of perpetually rising house prices, in which most mortgages were good and most houses were saleable at a profit.
But that world is long gone. And it's not coming back – or at least not in that form. And it's not clear the Bush bailout plan is the catalyst that will take us into the needed new reality.
News and Related Story Links:
- Washington University Law School:
A Brief History of the Takings Clause.
- Money Morning Financial Analysis:
It Was a 'Wonderful Life' Before Wall Street Hijacked the Home Mortgage Market.