Cui bono? is a Latin term that means, "Who benefits?" Normally it is heard in legal context to inquire, "who had the most to gain?", i.e., "who had a motive?" It can also be applied to the recently burst residential real-estate bubble to ask, "Who got the money?"
There seems to be quite a bit of populist anger right now, directed against financial executives on Wall Street and others who are perceived as being the primary beneficiaries of the housing bubble, and are now to be punished. Spillover anger leads President Obama to warn against taxpayer funded trips to Las Vegas (does that include business conventions as well?), and for Congressmen to chastise auto executives for their private flights to Washington (but Congress' use of Air Force jets for their travel is legitimate?). Amongst all this vituperation it is useful to ask, exactly who got all that money from the real-estate bubble?
In point of fact, the primary beneficiaries are those homeowners and investors who sold their properties at the height of the bubble, and those homeowners who took out loans against property that has now devalued below the amount owed on the loan. In the first case - those who sold at the height - they received money for an asset that turned out to be worth far less than its purchase price. They did nothing illegal, and are frequently lauded for their shrewdness. Yet they hold the vast majority of the weath that was gained from the bubble. Secondary beneficiaries are the various real estate and loan agents who facillitated the sales. Real estate agents earned 6% of the selling price on each transaction, pocketing tens of thousands of dollars per sale. Loan agents might earn $1000 or so at most per sale. Again, nothing illegal was done.
What about the people who purchased homes that are now worth far less than they paid? If they purchased their homes as a residence, do they not still gain the benefit of living in the house? They will have difficulty selling their home without taking a loss, but eventually their homes will appreciate. They have been financially punished for no fault except that of poor judgement. However, they also have an option of walking away from their loan. If they default on their loans they will not recover the money overpaid from the original sellers, but will rather have stolen it (even if legally) from the parties who hold their loans (many in the form of mortgage backed securities, or MBSs).
Those who took out loans against property that no longer backs their loan are in the situation of owing more than their collateral supports. If they continue to pay their debts, no harm, no foul. If they default, they will also have stolen from their creditors, no matter how legally it is done.
The creditors who will be hurt by defaults are predominately not the banks and Wall Street firms, although they do hold large amounts of MBSs. The largest group of victims are the investors who purchased MBSs: among them U.S. pension funds, mutual funds, hedge funds and insurance companies, and overseas investors.(source Wall Street Journal).
The banking and Wall Street types who made money made it by facilitating the sale of MBSs, but in so doing they only married up those who had money to lend at a profit with those who wished to borrow money (many with the intent to make a profit in real-estate). By making large amounts of foreign capital available for prospective American homeowners they were providing a useful social service. It is not directly their fault that the American borrowers would prove so untrustworthy. If they were aware of the substandard nature of their product they are complicit, but even then they are not the most complicit.
The most complicit are those who advocated and participated in the issuing of loans to people who were unqualified to repay them: those borrowers who lied on their applications about their ability to repay or their intent to reside in the property, those realtors, brokers, and loan agents who assisted the lies, and the enablers in government (Barney Frank, Chris Dodd, Franklin Raines, etc.) and business (Angelo Mozilo, Michael Perry, etc.) who opened the floodgates by lowering lending standards beyond the point of foolishness to the point of criminality.
At the price of being simplistic, it is possible to triage the participants: Who are the good, the bad, and the ugly?
The Good: Investors who put up money (perhaps foolishly) for MBSs and other securitized debt. If the U.S. economy is to ever resume growth, or the U.S. government to ever be able to sell its bonds, it is imperative that the beneficence of investors be recognized and encouraged. Investors were guilty of underestimating the risk of defaults in MBSs, and if the private markets are going to resume lending for consumer credit or mortgages, they must be able to price the real risk into new loans. But that is precisely what they are currently prevented from doing by the government's actions to keep mortgage rates low. The government only exacerbates the situation when it increases the risk to the lender by promoting unilateral mortgage modifications (called "cramdowns") or other programs designed to transfer loss from the borrower to the creditor.
The Bad: Borrowers who accepted money to purchase property that subsequently declined in value, and who now seek to transfer that loss from themselves to their creditors. Default on debt is not a victimless crime. Banks do not lend their own money - they loan their depositors' money. When debtors default they harm either investors, who lose their principle, or taxpayers, who must make up the loss for insured deposits. As more money must be put aside to cover the loss from defaults, lenders must charge higher interest rates and depositors and investors must accept lower returns. The entire economy suffers. This is why default and bankruptcy must be painful - to discourage their occurrence except for the most dire circumstances.
The Ugly: The politicians, regulators, financial executives, bankers, realtors, loan agents, and brokers who knowingly facilitated the lending of money to unqualified borrowers, by lowering lending standards to the point where borrowers had nothing at stake in the loan.
Anger directed exclusively at Wall Street executives is misplaced (unless you happen to be an investor). The real culprits are those who invested in a volatile commodity - residential housing - hoping to make private profits, and having judged the market wrongly, now seek to socialize their losses by passing them onto society at large, through either defaults without consequence or government bailouts.
Intermezzo: The vast majority of home loans in the United States are either de jure or de facto "no recourse" loans:
This means that the debtor cannot be held personally liable for the mortgage even if, after a foreclosure, the bank receives only a fraction of the total mortgage outstanding from the sale of the house.
This gives the debtor the ability to walk away from their loan obligation with little detrimental effect. It also places the lender in the situation of being completely dependent on the collateral value of the property in case of default. It is also necessary to remember that each sale of residential property pays the real estate agents 6% of the property value, and without rising property values the owner will lose money when the property is sold. It is for these reasons that lenders traditionally would lend only 80% or at most 90% of the property value (requiring that borrowers put up 10% or 20% down). These requirements served to limit the potential loses of the lender. Unfortunately, these prudent measures, along with verification of the borrowers ability to repay, were abandoned in the frenzy of the rising market (with considerable pressure from liberal Democrat congressmen Barney Frank, Chris Dodd, and Maxine Waters). (A short and informative chronicle of the political intrigue that led to the deliberate subversion of lending standards appears here: Feds Impose Loan Standards They Helped Undermine)
What Now? It is important to properly assign blame so that efforts to "remedy" the "problem" may be properly assigned. The problem is that reduced and declining home values place both investors and homeowners at risk. The money that was lost is in other hands from which it can never be recovered. At this time the only question is how to divide up the loses, or possibly, to reassign them to a third party, the taxpayers.
There is another option, albeit unwise and impossible: to reinflate property values. The government sometimes acts as if it is pursuing this option, despite its impossibility. Home prices are a function of supply and demand, and there is currently not enough demand at current market prices, and absent the government buying up property to take it off the market (which it cannot afford), the supply cannot be instantly reduced. Instead, the government is attempting to increase demand by lowering the cost of borrowing.
There is a saying on Wall Street, "Never try to catch a falling knife". Buying in a declining market is risky business, and purchasing property is an exercise in confidence, which is completely lacking at the moment. People with the means and credit to afford buying property have the circumspection to wait for the bottom. Instead, the government considers encouraging unqualified borrowers with sub-market interest rates and zero down, and even cash back financing. Wasn't it these very same policies that caused the problem in the first place?
It has hopefully been established that both investors and homeowners assumed inordinate risk: the investors that they would be repaid, and the homeowners that their investments would appreciate. Had these investments been in the stock market, instead of in property, there would be no question of attempting to remedy their loses. Neither deserves to be made good, and especially not at the cost of taxpayers. The United States has a system of bankruptcy, with laws and courts, designed to handle the problems of failed businesses and insolvent individuals. Through this system, people who bet unwisely and lost money may be entitled to a new start, but they are not entitled to have their loses made good.
The Obama administration proposes five actions (The Obama Housing Fix: 5 Things to Know - Luke Mullins, U.S.News) to address the problem:
Allow Fannie Mae and Freddie Mac to guarantee mortgages between 80% and 105% of the value of the home. Pay delinquent borrowers $1,000 a year for up to five years for paying their mortgage on time. And pay mortgage servicers $1,000 to adjust mortgage terms, and an additional $1,000 a year for up to three years if the borrower stays current on the loan. Standardize rules for modifying mortgages to limit mortgage payments to 38% of gross income, and have the government subsidize further interest-rate reductions to 31% of pretax income. Treasury Department would double, to $400 billion, its funding commitments to Fannie Mae and Freddie Mac, so Fannie and Freddie will increase the size of their retained mortgage portfolios by $50 billion to $900 billion. Allow judges to alter the terms of mortgages on primary residences during bankruptcy proceedings (the "cramdown", again).
These activities will (a) cost taxpayers billions of dollars, (b) continue or worsen the disastrous lending practices that caused this mess in the first place, (c) panic private investment from the mortgage market, and (d) reward the most irresponsible borrowers the most. With the Obama plan:
Some will pay more in taxes so that others can pay less for housing. This is redistribution based on debt rather than income. ... Subsidizing select mortgages poses a fundamental rationing problem: ... there may have to be stern but arbitrary "means testing" to decide who is most deserving of a taxpayer-supported mortgage. And that will likely provoke resentment about how winners and losers are picked. ... The third part of the plan is to get Fannie and Freddie to buy more mortgages with the hope of keeping mortgage rates down. Never mind that both organizations were considered insolvent last fall, when they held far fewer dubious IOUs than they do now. ... Any plan that compels mortgage holders to reduce the amount of money they are owed must in turn reduce the value of mortgage-backed securities held by banks, insurance companies, pension funds, Fannie and Freddie, and the Fed. By injuring the balance sheets of potential lenders, a cramdown would also injure potential borrowers.
Assessing the President's Mortgage Plan - Wall Street Journal
What will be the benefit of all this effort for government to subsidize the cost of the riskiest mortgages? If history is a guide, not much:
The recent history of mortgage modifications isn't encouraging. According to the December report by the Comptroller of the Currency and the Office of Thrift Supervision, "The number of loans modified in the first quarter that were 30 or more days delinquent was 37 percent after three months and 55 percent after six months. The number of loans modified in the first quarter that were 60 or more days delinquent was 19 percent at three months and nearly 37 percent after six months."
Said Comptroller John Dugan, "One very troubling point is that, whether measured using 30-day or 60-day delinquencies, re-default rates increased each month and showed no signs of leveling off after six months and even eight months."
Research at Credit Suisse suggests that borrowers without equity are not a good bet to stay current.
Dukes Of Moral Hazard - Wall Street Journal
Neither the markets nor the public think very much of the plan. As one wag quipped, "Obama Speaks, Market Listens, Sells Off." Polls indicate 45% Oppose Government Mortgage Help for Troubled Homeowners, with only 38% supporting the plan. Of course, those 38% are Obama's core constituency, and most of the 45% probably didn't vote for him anyway. And that is the only math that matters.
Update: Larry Kudlow, NRO's financial analyst, points out in Subsidize Bad Behavior? that the markets are already working to fix the problem. He states that "while California home prices dropped 41 percent in 2008, home sales in the state jumped 85 percent." The markets will clear this up, if only Obama would stop doing what got us into this mess: stop pumping up Fannie Mae and Freddie Mac and stop pushing mortgages to the unqualified and the irresponsible.
Last Update: Froma Harrop arguing in favor of Let[ting] Bankruptcy Courts Change Mortgages, addresses some of the concerns previously raised:
Foes of such changes warn that they would unleash a new wave of bankruptcies and reward the irresponsible .... the cost of mortgages would rise to compensate lenders for the risk of having a bankruptcy court possibly change the terms.
Some or all of the above may happen, but let's discard the notion that bankruptcy is a neat way for the indebted to save a few bucks. A bankruptcy seriously impairs one's ability to borrow for 12 or more years. Bankruptcy is a particularly irrational choice for high-income people who can afford their monthly payments. They'd still have to repay the written-down part of the mortgage balance out of income earned for up to five years, to the extent possible, after paying back secured debt.
As for banks, the prospect of a court-ordered change in mortgage terms -- inelegantly called a "cram-down" -- would prompt them to focus on loan applicants' ability to repay their debt. They would check a borrower's income and require a reasonable down payment -- like they used to.
A bill to allow mortgage modifications does offer protections to lenders, setting many limits on what judges may do. And if someone still in bankruptcy sells a house that has appreciated in value, the law guarantees lenders a piece of the gain for the first four years.
Empowering courts to change the terms of a mortgage may indeed mean higher mortgage interest rates and fees for everyone, but I see the tradeoff as follows: Borrowing costs may go higher, but future housing markets won't crash, taking our jobs and 401(k)s with it.
Requiring bankrupt borrowers to repay all or part of the written down balance addresses some of the moral hazard concerns, which may at least discourage irresponsible borrowing in the future. The argument for "cram downs" then becomes one of the tradeoff between higher mortgage rates and a potentially stabilizing influence on home prices. There is still the issue of breaking the "sanctity" of contracts, but I read that this is already possible in bankruptcy, so maybe "cram downs" are worth considering after all. In any case, it is a choice between the lesser of two evils.
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