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March 12, 2008

Ben Bernanke’s Blunder: How NOT to Solve the Mortgage Crisis

Yesterday the US Federal Reserve took a big step towards prolonging the mortgage crisis. Its short-term reward was a big one-day run up in stock prices; Today prices were down again. I hope Fed Chairman Ben Bernanke isn’t making the mistake that was so hard for so many of us CEOs of public companies to avoid: navigating with one eye on the stock ticker.

From the New York Times:

“In an action that sent stock prices soaring, the central bank offered to let the biggest investment banks on Wall Street borrow up to $200 billion in Treasury securities in exchange for hard-to-sell mortgage-backed securities as collateral. And the Fed made clear that it was prepared to do more as needed.”

What the Fed did is get squarely in the way of unraveling the mortgage mess. Accepting these unsellable loans at face value as collateral is exactly the same as offering home equity loans to people whose mortgages are underwater based on the equity they used to have before prices fell.

If the Fed didn’t act in this way, if it and politicians of every stripe made clear that the “biggest investment banks on Wall Street” were going to have to take their losses just like their clients do, then we’d be well on the way to a workout of this crisis.

Pretty far down in the Times article:

“Indeed, some analysts warned that the central bank might make things worse in the long run by postponing the repricing of mortgage assets that financial institutions are holding, or by further weakening the value of the dollar and aggravating inflation.”

The reality is that people who bought houses with little or no money down are not really owners in the financial sense even though they appear on the deed; they are renters with an option to buy. When prices went up, almost everyone exercised that option, at least in part, although many preserved their renter status by diligently withdrawing every dollar of equity in a refinancing or a home equity loan.

Now that prices are down, people both don’t want to and can’t afford to exercise their options to buy. If you had an option to buy a stock at 80 and it was trading at seventy, you obviously wouldn’t want to exercise the option. Surprise Wall Street, Main Street doesn’t want to buy a $400,000 house for $600,000 when prices are falling and the market is glutted. Mr. and Ms. Main Street don’t want to do that even if they live in the house. Maybe – if they can – they’ll keep paying the rent; maybe they’ll go somewhere cheaper.

Walkawayplan.com offers people help in escaping an underwater mortgage with minimal damage to their credit and other assets (they say, I don’t know anything about them first hand). It’s good that buyers have some leverage in dealing with the banks whether this outfit is helpful or not.

The solution to this crisis isn’t rocket science; it’s a workout of the kind that banks do all the kind when a commercial loan turns bad. The reality is that many houses aren’t currently worth the amount of the mortgages they secure and so those mortgages and securities based on those mortgages aren’t worth their face value either. Investors in some of those securities and securities based on those securities already have realized or unrealized losses. That’s what happens sometimes when you invest (or at least when I invest).

The principal on many if not all mortgages need to be written down to less than the value of the asset. This is more helpful than lowering the interest rate even when the result is the same in terms of a reduced monthly payment. Why? Because it lets the homeowners sell and move to something they can afford if they don’t have to ante up extra money to get out AND it gives those who stay an equity interest. Note that both of these things are as good for the banks as they are for the homeowners. In the move-away case the banks get the reduced principal back and have no further risk; in the cases where the families stay, the asset are taken care of by (partial) owners rather than renters who may well not feel like stretching their budget further to do maintenance on a house they have negative equity in.

In this kind of workout, the borrower and the lender share the pain. But workouts happen because both are better off when their loan agreement reflects current reality. So why isn’t this happening in the current crisis as fast as it should?

  1. Both homeowners and banks would be better off still if taxpayers put some money into the equation to bail them out. Since this seems to be happening, at least as far as the banks are concerned, why take any further losses?
  2. The web of financial instruments between the simple mortgage a homeowner has in a safe-deposit box and the financial instruments the Fed is now willing to take as security is extremely complex: there certainly isn’t a simple one-to-one relationship between debtors and creditors.

If there were no prospects of a bailout, the financial geniuses who figured out how to package these instruments in the first place are certainly smart enough to figure out how to unwind them. Ignoring the losses they’ve already incurred, they’d probably make money from the depackaging just as they did from the packaging. But it’s not gonna happen as long a the Fed is “prepared to do more as needed.”

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