Monday, March 2, 2009

A Solution to the Mortgage Crises

A Solution to the Mortgage Crises

Please pardon the next several paragraphs as they are necessary to establish the basis of the analysis and solution to the mortgage crises. If these are of no use to you read the solution and go back to the assumptions afterward.

Assumptions used in the analysis.

U.S. Census data reports that there are 64 million home mortgages in the United States. However, the Mortgage Banking Association (MBAA.ORG) tracks only 45.4 million mortgages of those mortgages. Either number you go by you'll soon discover that the lower MBA number actually accentuates my case I'm making below.

According to the MBAA's National Delinquency Survey 3rd Quarter report released in December 2008, roughly 6.99% of all mortgages are 60 days late which is the predictor used by the mortgage banking industry to predict eventual foreclosure. In addition, 2.97% of mortgages are in foreclosure for a total of 9.96% of distressed mortgages. The 45.4 million mortgages used in their survey is a huge sample size and can easily be used to make inferences toward the total number of 64 million U.S. home mortgages.

With that said, we'll assume that the 9.96% percentages of distressed mortgages should be applied toward the total number of 64 million U.S. home mortgages. This provides us with approximately 6.37 million mortgages are in distress and either in foreclosure or heading that way.

The median monthly mortgage payment in the United States is $1,687. Although this number isn't an average (I couldn't find a current average figure), I'm assuming since the mortgage statistics are well distributed, I'll use this number as an average. The average number will probably be somewhat higher because the lowest quartile is a linear progression with a shallow slope from the mean, whereas the highest quartile is a hyperbolic progression with a steeper slope from the mean. ** if anyone can source the average home mortgage, please let me know ** After I receive this statistic for the average monthly home mortgage, I'll use this more accurate number for my future calculations instead.

So if you take the 6.37 million distressed mortgages and multiply them against the $1,687 median monthly mortgage payment, you arrive at a $10.75 billion monthly mortgage cash-flow loss upon the mortgage banking and mortgage insurance industry. That's a fraction of the magnitude the Bush/Obama Administration Treasury Department has portrayed. The reason is in how they look at the problem.

The problem in the great depression and now is how they looked at the problem. Like any problem, if you cannot see the problem correctly your solution set will either be absent, or seriously maligned or skewed toward ineffective or inefficient solutions.

I contend that the mortgage banking problem is a flow issue and not a capital issue. The Administration is focusing on and attempting to fix the capital issue. We are in a vicious de-leveraging cycle. As banks are having to fully capitalize their losses which have eroded past their loss reserves, and with mark-to-market accounting forcing banks to book assets below intrinsic values, they have to sell these and other distressed (presently illiquid) assets to satisfy their reserve requirements maintained against their deposit base.

The banks are in a de-leveraging squeeze as their non-performing home mortgage portfolios are pushed through vicious algorithms that reassess future value. To give you a rough idea, if a bank originates a 30 year 5.41% fixed interest loan of $307,000 for a $1,687 monthly payment with 360 payment coupons, that loan's future value is $607,320 (we're assuming the homeowner pays all his/her payments on time). When the payments are delinquent or not paid at all, the future value of the loan is greatly depreciated. What's 360 payments of $0.00 worth? Nothing, right? Well that's an over-simplification but hopefully you get my point. When assets become non-performing all of a sudden you are forced to arrive at the asset value through some sort of imprecise liquidation appraisal arithmetic. The depreciation of the future value of the loan contributes heavily to the bank's cash-flow losses and when extrapolated forward using future value algorithms that access loss capitalization, it greatly affects the banks deposit reserves and the solvency of the bank. As a bank becomes insolvent, the next step is nationalization of bank assets and the FDIC takes over like in the case of Washington Mutual, et al.

This outcome is very tragic and what's worse, it's totally unnecessary.

Using the basic arithmetic shown above, the total future value for all distressed U.S. home mortgages is $3.87 trillion. That's if the loans were to be reset and carried forward in a 30 year fixed starting today. I'm saying this only to illustrate that the problem is far less severe than it's being made out to be by the Bush/Obama Administrations. The current payoff values on these mortgages would be much lower, approximately $2 trillion. You heard that right, the federal government could payoff all delinquent home mortgages and home mortgages in foreclosure for less than $2 trillion. But that would be an extremely inefficient use of tax payer money. My solution would be far less expensive and involves the government providing 2nd tier public mortgage supplemental insurance.

Approach the Problem from a Cash-Flow Crises not a Capital Crises

If you factor a 2 to 5 year duration to this mortgage crises, you arrive at a $258 to $645 billion financial catastrophe, respectively. But that is much smaller than the federal government makes this crises out to be. When certain people can't afford to pay their mortgages but are remaining in their homes, that is a cash-flow crises. The Obama Administration Treasury Department needs to approach the problem where the problem exists - where the rubber meets the road. Americans and our banks are having a cash-flow crises, not a capital crises. It's the conversion and extrapolation from cash-flow to capitalization that is so exponentially damaging to the banks as the leverage dynamic is being applied against the banks reserves. The Bush and now Obama Administrations are approaching this as a capital crises as the banks are forced to fully capitalize these cash-flow losses on their balance sheets which affects the capital used for their bank deposit reserve requirements. The $700 billion TARP money is being used to shore up the banks' capital requirements when it should be used to cover their cash-flow losses and therefore temper this vicious cycle of loss capitalization and de-leveraging of the financial sector. The loss capitalization methodology is irrational and thus indeterminant, whereas the cash-flow deficiencies are far more precise and manageable. And that's exactly where the solution should reside.

A Forbearance Strategy

The solution to the mortgage crises is a forbearance strategy and would involve the government acting as a national public mortgage insurer. Let MBIA, AMBAC, AIG, MGIC, and others who offer Private Mortgage Insurance (PMI) remain as primary 1st-tier insurers with the federal government acting as the backstop or secondary supplemental mortgage insurer. However, the taxpayers must be protected – I'm not suggesting a free lunch for anyone. The federal government's public mortgage supplemental insurance should maintain an enforceable first lien position upon owner-occupied properties at a substantial premium commensurate with the risk of default and the banks should have the right to opt out of the program. Mortgages made to real estate speculators and vacation homeowners would not qualify except for mortgages made upon their primary residence.

Here are more details on the way the program should work. When a homeowner is late by 30 days, the participating lien holding banks with secured home loans would inform the homeowner of his/her rights to make payment on their delinquent balance within 30 days to opt out and remain unaffected. However, after 60 days late payment, the homeowner would again be notified of the government emergency public mortgage supplemental insurance program and the first position lien supplemental payment being made to the bank by the government on the homeowner's behalf. After 90 days of delinquency, the federal government emergency public mortgage supplemental insurance payment would automatically kick in and first reimburse the 90 days of back payment to the bank and continue in force to supplement homeowner delinquent mortgage payments at 6% above prime as published in the WSJ (currently 3.25%) for a total of 9.25% APR being attached to the lien. After the homeowner has satisfied payment to the bank for all delinquent back payments and fees, the bank keeps the processing fees and the prime rate of interest portion while the federal government would receive the remaining 6% APR.

It is important that the federal government should remain transparent to the homeowner. No relationship should be established between the homeowner and the federal government other than a first position lien is placed upon the property that would be satisfied at sale if not previously released prior to the sale and dispossession.

At anytime, the homeowner can reinstate all back payments to the bank with interest and government-regulated bank processing fees. The bank keeps the processing fee and the prime rate interest and pays the government the 6% APR interest associated with the supplemental mortgage insurance reimbursement. The first position federal government lien would promptly be removed with all liens appropriately reinstated to their respective positions. The homeowner is then made whole with his/her credit re-established in good standing with appropriate forbearance toward future institutional lending.

If the policy, as outlined above, was pursued by the U.S. Treasury Department the banks wouldn't be facing nationalization - as the great extent of their cash-flow losses stemming from this mortgage crises wouldn't need to be capitalized and additional assets acquired and collateralized to be held in reserve against their deposit base.

This policy isn't perfect and won't solve the mortgage crises entirely as there exist a substantial number of highly-leveraged real estate speculators who have sustained substantial depreciation in appraised values who are walking away from their least performing inventory of homes in foreclosure and the banks will have to capitalize those unavoidable losses. But this is a smaller percentage of the total number of homes in foreclosure.

RFC: I would appreciate your comments and any pertinent mortgage/housing data (please provide sources and date range covered by the research)

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