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February 27, 2008

The Homeowners Own the Banks

There’s an old saying “If you owe the bank a hundred dollars, they own you. If you owe the bank a million, you own the bank.” The numbers need to be updated but the principle applies. The banks lent too much; they over-valued the housing stock that was the collateral; they made the same bet that the homeowners did: prices would keep going up. But the banks can’t afford to own all the houses whose mortgages are under water; so the homeowners own the banks.

The banks (by which I mean those who own the mortgages) should make a deal with the homeowners; they need each other. Naturally both the banks and the homeowners would like taxpayers to share some of the pain. There’s no good reason why taxpayers should get in the middle; but this is an election year so there are lots of bad reasons which may be compelling.

Bankers are suggesting that the federal government buy these mortgages at a discount; the bankers would take losses (which some of them have already booked); the feds would presumably go easy on the borrowers; people would keep their homes; and the downward spiral of housing prices MIGHT be stopped.

A couple of problems with this approach are 1) how would the government decide which homeowners “deserve” forbearance and which don’t? 2) what happens to people who can’t make any reasonable payments at all? 3) who decides what price the government pays for these mortgages? Overpaying means bailing out the lenders.

The prospect of a bailout is delaying the real negotiation and pain-sharing that would be the beginning of the end of this “crisis”.

Bank by bank, the banks should voluntarily set policies which let them reduce the principal due on some mortgages to less than the value of the collateral. The loans have already lost value along with the houses; “sharing” the loss in value with the homeowners increases the chances that the homeowners will be willing and able to stay and pay money to the bank. The banks don’t want the houses; they need to help their debtors work out of debt. Banks can also decide to forgo raising interest as much as they are entitled to by the mortgage contracts, all in the interest of getting paid as much as possible.

A second benefit of adjusting the principal to fit reality is that this strategy allows owners who’d rather have less house and less debt to sell. This good news for the bank which gets their (reduced) principal back; it’s good for the people who can reduce their debt burden by downsizing; and it’s good for the new owners who can presumably afford the joint because sub-prime mortgages are hard to get these day. As long as the face amount of the mortgage is more than the value of the house, the mortgagee is trapped since they have to come up with cash in order to sell.

Banks will still foreclose in cases where the collateral has enough value and/or there is no chance of getting repaid anything substantial.  Banks will still collect as much as they can from the mortgagees. This isn’t a bailout; it’s a recognition of reality. This kind of workout happens all the time with corporate debt. It’s not a “moral hazard” as a government bailout would be because there’s no subsidy and plenty of pain for all. Still more people WILL get to keep their homes than if the banks keep trying to collect full freight. A huge advantage is the government doesn’t have to decide who’s worthy of being bailed out.

BTW, I know I’m oversimplifying. The mortgages are often NOT owned by the banks which service them. They seem, in fact, to be owned by investors all over the world. Those investors are already taking losses on the securities they bought. Nevertheless, the sooner a settlement is reached with as many mortgagees who can settle, the less the future losses.

There MAY actually be a role for government in making any regulatory changes necessary to allow these complex negotiations to happen. There may even be a role for us taxpayers if the FDIC insurance fund is not sufficient to cover insured deposits at banks which may turn out to be underwater once their mortgage investments are valued at what they’re worth.

Two years ago politicians were echoing the complaint that housing was so expensive it was unaffordable. Now prices are readjusting to reality. More people can actually afford houses (without assuming someone will buy them out before their mortgage interest rate resets); that’s not all bad. The people already in houses will have a better chance of staying in them if their mortgage principal is marked down to reality; and the banks’ll have a better chance of collecting money instead of empty houses in declining neighborhoods if they forget the amount they actually lent and only try to collect what the collateral is now worth.

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