September Foreclosures Top 100,000

September Foreclosures Top 100,000
by The Freeman on Thursday, October 14, 2010 at 10:22am

"The number of homes taken over by banks topped 100,000 for the first time in September, though foreclosures are expected to slow in coming months as lenders work through questionable paperwork, real estate data company RealtyTrac said on Thursday." ( Reuters, Thursday)

The hidden cost of regulation?

FEE Timely Classic:
" Can the Feds Save the Housing Market" by Robert P. Murphy


Can the Feds Save the Housing Market?
Numerous Government Policies Caused or Exacerbated the Crisis
Robert P. Murphy
June 2008 • Volume: 58 • Issue: 5 •

It seems each passing week we are treated to yet more record-breaking dismal housing news. As of this writing, the latest report of the respected S&P/Case-Shiller Home Price Indices reveals that in February 2008, its ten-city composite suffered the largest year-over-year decline ever of 13.6 percent. Perhaps more troubling, February's drop of 2.9 percent was the largest monthly decline in the index's history, going back to January 1987. (Data are available at http://tinyurl.com/3c8uag.) So not only is the housing market continuing to fall, its drop is arguably accelerating.

In this environment, it's natural that the government­and in particular the presidential candidates­are offering their "solutions." As we'll see, most of these proposals would only make things worse. To see why, we first need to understand what went wrong in the housing market.

To put it simply, there was an unsustainable bubble in home prices. From June 2001 to June 2006, the ten-city composite index mentioned above rose a whopping 89 percent. Now an average annualized return of over 13 percent isn't bad, especially when you can live in the investment or rent it out for income. Consequently, more and more people entered the housing market. Some bought more expensive homes than they otherwise would have, and others even began buying homes purely as investments to "flip" once they had appreciated. As in any market, when prices exploded producers began cranking out more product­homebuilders were very busy, and their stock did very well during this period.

Another important part of the story is the revolution in financing that blossomed at the same time, which both benefited from and exacerbated the housing boom. In a traditional arrangement people in a community deposit funds with the local bank, which pays them a low interest rate in return. Then the bank takes this large pool of individual deposits and grants mortgages to qualified applicants, charging them a higher (but fixed) interest rate to compensate both for the bank's overhead and the possibility of default. To make sure its loans went to responsible borrowers, and to align everyone's incentives, the bank would insist on a hefty down payment, often 20 percent of the price of the house.

Yet things didn't always happen this way during the recent housing boom. Rather than conventional fixed-rate mortgages, eager buyers were granted adjustable-rate mortgages (ARMs) that offered low upfront rates, which would then reset down the road. This allowed people to buy much more expensive homes, because they could handle the monthly payment at the "teaser" rate. Many buyers figured they could either flip the house before the ARM reset, or they could refinance at that time into a fixed mortgage.

Besides ARMs, other unorthodox practices occurred. People might be granted interest-only mortgages, where the borrower treads water with each payment, or even "negative amortization" ones, where the principal owed to the bank actually grows over time. Naturally, people signing up for all of these low-pain mortgages didn't have money for a down payment, and here too the banks were very obliging. Before discussing the innovations on the mortgage-holder side of the market, I should stress that the above patterns aren't as crazy as they now appear in retrospect. If home prices had continued their double-digit rates of appreciation, these practices all made perfect sense. It was only when the housing market collapsed that the borrowers were caught with their pants down.

On the banking side, here too practices deviated from the old ways. Rather than keeping mortgages on their balance sheets, local banks would sell them off to middlemen, who would ultimately pass them on to the giant investment banks headquartered on Wall Street. These organizations would turn to their "financial engineers" to bundle pools of mortgages into a new entity, broadly classified as a collateralized debt obligation (CDO). Outside investors could then buy bonds issued by the CDO. The flow of monthly mortgage payments into the CDO funded the flow of coupon payments to the bondholders. In the event of defaults, there were pre-determined rules for which CDO bondholders took the hit first. Naturally, the riskier classes (or "tranches") of CDO bonds offered higher rates of return at the outset.

The growth in popularity of CDOs allowed institutional investors to participate in the booming housing market. Someone managing a pension fund didn't have to do research on employment and default rates in Sacramento to gain exposure to real estate; all he had to do was buy bonds issued by the relevant CDOs. The high ratings granted by Moody's and other agencies satisfied contractual and regulatory requirements, and reassured these outside investors that such investments were safe. Sure, any individual borrower could default, but the Ph.D.s at the investment banks had quantified the risks so everybody (apparently) knew exactly what he was buying into.

Of course, the party ended once housing prices peaked, and things turned ugly when prices began falling sharply. Most obvious, homebuilders were caught flat-footed, with more inventory in the pipeline that now had no buyers. But the fall in prices also   devastated those borrowers who had been banking (literally) on the opposite expectation; with negative equity and no buyer, they were stuck with mortgage payments (especially those with resetting ARMs) they couldn't afford.

As is well known, the housing bust wreaked havoc in the credit markets as well. CDOs involving real estate were suddenly dangerous. The mathematical models that had previously been used to value them were obviously deficient, yet market prices weren't available because nobody wanted to purchase the securities. Thus beginning in August 2007 and continuing to this day, banks have been reluctant to lend to each other because they couldn't really trust the solvency of their counter-parties. (A bank asking for a short-term loan might have $1 billion in mortgage-backed securities on its books to pledge as collateral, but how much were those assets really worth?)

Because of banks' reticence to lend not only to regular people but also to each other, the housing bust led to a much broader credit crunch. The process was a vicious circle. Spooked by the debacle, banks became much more stringent in their standards when evaluating new mortgage applications. This has only intensified the fall in house prices, as willing buyers can't obtain financing.


How Government Caused the Trouble

Now that we have a better grasp of exactly what happened, the next issue is, "Why?" The typical answer is greed, on the part of investment banks, real-estate brokers, and speculators. But unless someone can explain why financiers and speculators were greedier in the mid-'00s than at other times, this explanation isn't too helpful.

The free-market economist has learned from many different examples that when individuals and firms systematically make boneheaded decisions that lose them gobs of money, there is usually a government policy driving the madness. And in the housing bust, the pattern holds.

First and most obvious, the Federal Reserve had an easy-money policy to try to rescue the economy from the dot-com crash. In 2001 alone, the federal funds target rate was slashed from 6.50 percent down to 1.75 percent; the target eventually reached an incredibly low 1 percent by June 2003, where the Fed held it for an entire year. Then from June 2004 through June 2006, the target was steadily hiked back up to 5.25 percent. Although the correlation isn't perfect, when the federal funds rate is cut, other interest rates­including mortgage rates­generally fall with it. Given the close connection between mortgage rates and home prices, even mainstream analysts have blamed the Fed for its role in the housing crisis.

Another obvious government distortion resulted from the actions of the Federal Housing Administration (FHA), which provides insurance for mortgage holders in the event of a default by borrowers. To see the connection between the FHA's activities and the housing boom, we need only quote from the main page of its website: "Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios."


Implicit Government Guarantees

Freddie Mac and Fannie Mae, major participants in the secondary market for mortgages, also share a portion of the blame. They buy mortgages from originators (banks, thrifts, credit unions, and so on), package them into bundled securities, and then sell the new assets to outside investors. As so-called government-sponsored enterprises, they do not directly receive tax dollars or explicit government assistance. However, many investors believe there is an implicit federal guarantee behind these agencies, and their regulatory requirements are also looser than for their purely private-sector counterparts.

Because of these advantages, when mortgage originators know a loan will be eligible for purchase by Freddie Mac and Fannie Mae, they can charge home buyers lower rates than would otherwise be profitable. Indeed, part of the official mission of these companies is to make the dream of homeownership attainable for millions of low- and moderate-income families. When trying to understand why so many obviously unqualified people were able to obtain financing during the housing boom, we shouldn't ignore the role of large intermediaries explicitly designed to "soften" the strict requirements of the pure market.

Pressure to loosen underwriting standards was placed on private lenders as well in the name of avoiding discriminatory "redlining." Stan Liebowitz, an economics professor at the University of Texas at Dallas, has been a critic of such political correctness for over a decade. In a February 5 New York Post op-ed (http://tinyurl.com/2ahdkd), he explains how beginning in the 1980s, activist groups such as ACORN (Association of Community Organizations for Reform Now) agitated against lending practices that yielded fewer approvals for minority and other low-income applicants.

In 1992 the Boston Fed produced an academic study that purportedly verified this bias in lending and distributed a manual for lenders that said the use of "arbitrary or outdated" criteria could be evidence of discrimination. Some of these criteria included income verification and the credit history of the mortgage applicant.

In 1995 the fuzzy-sounding 1970s Community Reinvestment Act (CRA) was strengthened. Henceforth, all banks and thrifts that enjoyed deposit insurance had an affirmative duty to lend throughout the regions in which they accepted deposits, notably including poor neighborhoods. If they received bad marks on this score, they could be subject to direct or indirect sanction, such as having merger plans held up by the Department of Justice. Studies by both the Federal Reserve and Harvard's Joint Center for Housing Studies found that the CRA achieved its goal­namely, higher rates of homeownership in poorer communities.

Although some defenders of the CRA have pointed out that half the subprime loans were made by institutions outside the law's purview (http://tinyurl.com/3sjcfj), surely government and activist efforts to shame lenders into loosening standards must play some role in our story. To quote Liebowitz:

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed "the most flexible underwriting criteria permitted." That lender's $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why­Countrywide, the nation's largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide's chief executive bragged that, to approve minority applications that would otherwise be rejected "lenders have had to stretch the rules a bit." He's not bragging now.

Finally, there is the matter of the ratings agencies. Had they done their job properly, and given more accurate estimates of the riskiness of the rather exotic CDOs with which many investors were unfamiliar, then the housing boom would not have gained so much momentum. As usual, critics of capitalism attribute their mistakes to simple greed or even corruption.

Yet we have to ask: Don't agencies such as Moody's and Standard and Poor's have an incentive for honest and accurate reports? Aren't they suffering now for their wildly overoptimistic ratings, the way Countrywide and other lenders have either gone bust or are on the verge of doing so?

The answer is no. State and federal regulations of entities such as banks, insurance companies, and broker-dealers often rely on the creditworthiness of the bonds on the books of these organizations. Naturally the government then has to specify which ratings agencies are legitimate for this purpose; a banker can't simply get a letter from his brother-in-law declaring his bonds to be "investment grade." Although space does not permit a full treatment here, suffice it to say that the major ratings agencies are largely shielded from open competition (http://tinyurl.com/5akgq3). Consequently they will not be ruined by the housing bust, and it is no wonder then that they were so reckless with their profitable (at the time) evaluations.

Now that we understand the problem with the housing and credit markets, and how misguided government policies caused or at least greatly exacerbated the mess in the first place, we can quickly evaluate the likely effectiveness of some of the recent and suggested moves to fix things:

Cutting the federal funds rate. From September 2007 through April 2008, the Fed cut its target rate from 5.25 to 2 percent. Not surprisingly, things are still awful in the housing market, and the credit markets are still unsettled. As we've seen above, it was arguably Fed rate cuts that caused the housing boom in the first place. At this point, everyone is spooked; newly created dollars won't flow into housing, but rather some other sector, such as commodities.

Bailouts of firms judged "too big to fail." The Federal Reserve Bank of New York notoriously assisted with JPMorgan's rescue of Bear Stearns in March on the grounds that its collapse would have led to widespread panic and further failures. As many critics have argued, such rescue attempts lead to a "moral hazard" that will only further encourage risky practices in the future. For a market to work, we need to rely on the profit-and-loss mechanism. Bear Stearns was heavily invested in mortgage-backed securities (MBS) and should have been left to suffer its fate on the open market. The only way to reward firms that wisely eschew hot items during a boom is to allow their competitors to go bust.

Accepting mortgage-backed securities as collateral for short-term loans. On March 11, the Federal Reserve announced the Term Securities Lending Facility, authorized to lend up to $200 billion of the Fed's holdings of Treasury securities to primary dealers in 28-day loans. The Fed agreed to accept MBS as collateral for these loans. The move promoted "liquidity" because it is much easier to raise cash in the market with bonds issued by the federal government (Treasuries), rather than securities tied to mortgages at risk of massive defaults.

There are several problems with this arrangement and others like it. First, it obviously puts taxpayers on the line if the primary dealers default and the Fed is stuck with (grossly overvalued) MBS. Second, it intensifies the moral hazard discussed above; it benefits those who hold a large amount of MBS­precisely the investors with poor foresight. Finally, it perversely encourages holders of MBS to keep them off the market, since the Fed will accept them at an unrealistic book value.

To repeat, the problem in the credit markets isn't simply the massive losses from bad loans. It's also the uncertainty caused by the large holdings of derivative assets tied to mortgages. Only when institutions bite the bullet and begin selling these assets, presumably at large losses, can realistic market prices be established. Only then will banks be able to assess each other's creditworthiness, and only then will they begin lending freely to one another. Government efforts to prop up the MBS market perversely stall this shakeout.

Rewriting contracts in favor of the homebuyer. Senator Hillary Clinton has been the most aggressive in this area. In December she called for a 90-day moratorium on certain types of foreclosures, and a five-year moratorium on ARM resets. Although these measures would help some existing homeowners in the short run, they would make it harder for newcomers to obtain financing to purchase a house. After all, the reason a bank is willing to lend out such large sums to a young couple is that the loan is secured; the bank can take possession of the house if the couple defaults. As far as ARM resets, it obviously doesn't help the beleaguered holders of MBS to be told that the government has codified their fears of nonperformance.

A federal "loan substitution" program. In a March 7 op-ed in the Wall Street Journal (http://tinyurl.com/2zo6nm), economist Martin Feldstein proposed that the federal government pay off 20 percent of the mortgages of homeowners who opt into the program. They would repay the government over 15 years at the rate earned by two-year Treasurys (1.6 percent when Feldstein was writing). The point of the plan would be to encourage homeowners­especially those with negative equity­to continue making their monthly mortgage payments, rather than walk away.

Feldstein said the plan would be financed "by issuing new two-year debt until the loans are fully repaid, thus eliminating any net cost to the government." It is rather shocking that Feldstein, chairman of the Council of Economic Advisers under President Reagan, didn't consider that some of the participants in the plan might default on their debt to the government. As usual, the taxpayer would ultimately foot the bill for this massive handout to the mortgage industry.

Enhanced regulation. Almost every "serious" commentator on the housing crisis, including the allegedly laissez-faire Treasury Secretary Henry Paulson, has called for enhanced government oversight of the financial sector. It is ironic that in February the constraints on Freddie Mac and Fannie Mae were considerably loosened to allow them greater leeway in buying mortgages­and this just as the companies were reporting losses in the billions of dollars in the fourth quarter alone of 2007.


Where Do We Go from Here?

There are two distinct approaches the government can take to discourage institutions from engaging in reckless financial transactions. One is to let them do whatever they want (subject to prohibitions on outright fraud and theft) and let them go bankrupt if they screw up. The other is to hold their hands every step of the way, bailing them out of trouble but also second-guessing every decision they make.

In light of the complex and quickly moving financial system, as well as the politicians' own dismal record on matters of honest bookkeeping, I think the first approach is far more sensible.

Unfortunately, even some nominal friends of markets have argued the housing crisis is too serious to ignore. If the government sits back waiting for prices to hit bottom, we are told, there will be unacceptable ripple effects throughout the rest of the economy. Yet as we have seen, most of the proposed interventions would make the housing crisis worse; any alleged ripples would turn into tidal wives. Beyond that observation, we should also remember that prices really do serve a function in a market economy. The politicians have already caused real damage, and people need market prices to know how to make the best of a bad situation. Propping up home prices at unrealistic levels will simply waste tax dollars and hamper the correction.

Our current housing and credit crises are quite serious­perhaps the worst since the Great Depression. As usual, the free market is not to blame; numerous government policies caused or exacerbated the situation. The host of "solutions" being implemented or  recommended will only make matters worse.


http://www.thefreemanonline.org/featured/can-the-feds-save-the-housing-market/