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What the Government Should Do About the US Housing Bust

Housing-Market / US Housing Feb 15, 2008 - 09:11 AM GMT

By: Money_and_Markets


Best Financial Markets Analysis ArticleMike Larson writes: I told you it was coming. And there it was yesterday — summarized perfectly in the second headline of the Wall Street Journal's website: “Worried Bankers Seek to Shift Risk to Uncle Sam.”

The gist of the story?

“The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.”

I don't know about you, but when I see stuff like this, my blood boils and I want to bury my wallet in the backyard.

Today, I'm going to tell you why Washington is getting it all wrong ... and what I believe they should be doing to help ease the problems in the housing and mortgage markets.

First, Why Many Bailout Cries Should Fall on Deaf Ears

I want you to step back in time with me. Heck, we don't even have to go that far... just a few years. The time is 2004:

Neophyte real estate “investors” are throwing caution to the wind, snapping up one, two, three, or more properties at the same time ...

Lenders are having a wild, anything-goes bacchanalia, flushing standards down the toilet and handing out high-risk mortgages like candy at Halloween ...

Wall Street is clamoring for high-risk bonds, including mortgage-backed securities, with little regard for whether the underlying credits are good.

Meanwhile, by 2005, a handful of serious analysts are warning of a coming catastrophe. Robert Shiller, the architect behind one of the most popular home price indices, goes on record saying “I think this is actually the biggest (real estate) bubble in U.S. history and possibly even world history.”

We raised a red flag, too. Here's the headline of the Safe Money Report published exactly three years ago this month:

“Real Estate Boom ... and BUST!”

* 3 alarming warnings of coming declines .

* 4 protective steps to take NOW .

* 8 burning questions from buyers and sellers .

And in June 2005, Martin and I titled our Safe Money Report issue:

“Final Stage of the Real Estate Bubble. "

“When it pops, stocks of big banks, construction companies, and mortgage lenders will be shattered.”

China, and other Asian countries,       have <br />      piles of money in reserve.

Do you know what the mortgage and banking industries did in response to warnings? They kept LOWERING their lending standards even as clear indications of deterioration in the housing market started popping up!

Heck, some Wall Street firms were still BUYING subprime lenders as late as 2006 to grab a bigger share of the market for high-risk mortgages. Morgan Stanley closed on its acquisition of Saxon Capital in December of that year, and Merrill Lynch agreed to spend $1.3 billion for the higher-risk home loan units of National City in September 2006.

Now these very same lenders and investors are peddling bailout proposals around Washington. In plain English, lenders want the government-sponsored enterprises (GSEs), like Freddie Mac and Fannie Mae, and the Federal Housing Administration (FHA) to take on much more risk and/or give mortgages to borrowers who have already demonstrated they can't handle their private-market loans.

And they're making headway!

The economic stimulus package that was just signed into law will increase the size of the loans FHA can insure and Fannie Mae and Freddie Mac can buy. They will now be able to back loans up to $730,000 in certain higher-cost markets — compared with a current jumbo loan limit of $417,000 at Fannie and Freddie and a cap of about $363,000 at FHA.

According to the Wall Street Journal , officials at Credit Suisse Group are also lobbying the Department of Housing and Urban Development to back a proposal to allow FHA to insure refinance loans for borrowers who are delinquent on their current mortgages.

I don't know about you, but I find all this pretty incredible. The very same people looking for handouts minted billions and billions of dollars making, bundling, and investing in home loans and mortgage securities ...

They stuck many mortgage borrowers with crummy loans that they couldn't really understand and could essentially never repay ...

They abandoned sensible risk-management controls and processes ...

And they failed to take protective steps to prepare themselves for a serious housing downturn.

In short, they failed their shareholders ... they failed their borrowers ... and they failed this country. And those claims we're starting to hear now — you know, the whole “no one saw this coming” argument? Well, as I just showed you, that's total B.S.! Warnings were issued — lenders just chose to ignore them.

Why Putting Huge Amounts of Risk On Fannie, Freddie, and FHA Is the Wrong Move

Let's be clear about one thing first: Neither the GSEs nor the FHA mortgage program are directly funded by taxpayers. Fannie and Freddie are ostensibly private corporations who get paid guarantee fees by lenders to back their mortgages. FHA insures lenders against default on FHA loans; that insurance is funding by a premium that borrowers pay on their mortgages. So what is being discussed at this stage is not ... yet ... TECHNICALLY a full-fledged government bailout.

But I believe that's a distinction without a difference. If you think the federal government would let Fannie, Freddie or the FHA go broke or fail to pay default claims because of an insurance fund shortage, you don't know how Washington works.

Freddie Mac and Fannie Mae should not be forced to take on unnecessary risks!
Freddie Mac and Fannie Mae should not be forced to take on unnecessary risks!

Should defaults ever get so bad that the viability of any of these firms were threatened, taxpayers would almost certainly be called upon to support a bailout.

And therein lies the problem!

Right now, the private lenders are the ones getting hammered. The private mortgage insurance companies that assumed the risk of losses on many home loans are losing billions. The private banks that funded many of these risky home loans and bought many of these high-risk securities tied to mortgages are writing off billions of dollars and being forced to pay steep interest rates to raise billions in capital.

Is this having negative fallout? Yes. Federal Reserve Chairman Ben Bernanke talked about this at length in his testimony before Congress yesterday.

But you know what? That's how markets are supposed to work! In a capitalist society, you take risks. Not all risks work out. And when they don't, you suffer the consequences.

Sure, the write-down/credit contraction process causes short-term economic pain and problems. But it allows the excesses to be purged and the stage to be set for a longer-term, healthy recovery.

Hey, I bought some shares of Global Crossing and Nortel Networks during the tech boom. By doing so, I was indirectly helping fund the Internet backbone construction boom/bubble. And you know what? I took a bath. I lost money. I misjudged the risks and got my comeuppance for it. And many of the companies that got wrapped up in the bubble went broke.

However, once the debt and equity that funded that bubble was crunched ... and once the losses were taken ... the underling industry began to bottom out. Some buyers stepped in and snapped up Internet infrastructure on the cheap. The demand for expanded communications bandwidth gradually rebounded. And the surviving companies in the business took share and thrived.

In short, the market worked itself out.

That's what should be happening this time around, too. But the private lending industry is increasingly asking Uncle Sam to get in the way of the very same cleansing/purging process.

At the same time, I'm not some callous, coldhearted jerk. I see and hear about the impact of this housing crisis every day — the empty houses, the big price declines, the lost jobs. I know friends, family members, and former colleagues who are losing money in this downturn. Heck, the house right across the street from me is in pre-foreclosure.

So what can be done?

Three Sensible Ways to Ease the Burden For Those Who Deserve a Reprieve

First, the FHA and the GSEs shouldn't make the same mistake the private market did.

They shouldn't be making extremely high-risk mortgages. Period. If you give 97% or 100% loan-to-value loans to risky borrowers with excessive debt-to-income ratios, you might get somebody in a house. But the chances are unacceptably high that many of those borrowers will ultimately lose their homes because they have little to no cushion against unexpected financial or market problems.

The reality is that homeownership is not a fundamental right. It's something we should be forced to save up for, something we have to demonstrate we can TRULY afford. We don't have to go back to the stone ages here, and make everyone put 50% down. But we do need to have reasonable standards that ensure we get borrowers into SUSTAINABLE homeownership.

So if Washington wants more participation from Freddie, Fannie, and the FHA, they better make darn sure they do things right.

Something like requiring a minimum down payment of 5% or even 10% — and a back end ratio cap of 40% or 45%, barring significant mitigating factors — seems reasonable to me. That means total monthly debt expenses (mortgage + other debts) shouldn't be allowed to chew up more than 45% of gross monthly income.

Also, none of that “Frankenstein financing” garbage we've had in the past couple years. No interest only mortgages. No option ARMs/pick-a-payment mortgages. No 2/28s or 3/27s. Only fully amortizing 15- and 30-year mortgages, and traditional ARMs, such as 1/1s and 5/1s that require payment of both principal and interest and don't allow negative amortization.

Second, government efforts should be focused on things like principal cram downs and substantial loan modifications — and they should only target borrowers who deserve help.

There are some borrowers out there who I believe deserve help. I'm talking about primary home owners, not real estate speculators and second home owners. I'm talking about those people who took out a first and maybe a second mortgage to purchase homes. I'm not talking about those who are stuck because they refinanced five times or took out home equity lines of credit and blew the money on vacations, jet skis, or BMWs.

We should identify this group of deserving borrowers who are now threatened because of interest rate resets, surging foreclosures in their area and/or falling home values.

Then, we should keep the pressure on lenders to modify their loans. I'm talking about permanently lowering their interest rates, not just reducing them temporarily.

And I'm talking about drastically increasing the use of loan “cram downs.” In other words, lenders should be encouraged to reduce the actual principal balance of outstanding mortgages to the current market values of borrowers' homes.

Reason: Many people are defaulting because they owe more than their homes are now worth. In industry jargon, they're “upside down.”

If lenders won't play ball, then give bankruptcy judges the authority to cram down loan balances. This would give responsible borrowers who have demonstrated a willingness and ability to service their debts a second chance to stay in their homes.

And those speculators? Those people who used their homes like ATMs? Tell 'em to go pound sand!

Third, we have to accept that a chunk of today's borrowers never should have bought homes in the first place.

While I'm all for sustainable homeownership, I also recognize that a chunk of people simply aren't cut out for it. They never really had the financial wherewithal to buy and hold onto their homes over the long term. But the lending industry, by slashing standards to the bone and handing out higher-risk loans like candy, got them into houses anyway.

Frankly, we have to let these people go into foreclosure.

Sure, refinancing severely stressed borrowers into new loans, and sticking FHA or the GSEs with the credit risk bill, might temporarily keep these borrowers out of foreclosure. But are these people really better off struggling to stay in homes that are underwater by tens of thousands of dollars, eating Ramen noodles and burning newspapers to keep the heat on because their payments eat up 50% or more of their monthly income?

Or is the most sensible financial option for them to give up, go back to renting, rebuild their savings and balance sheets, and then re-enter the housing market when they can truly afford it? You know where I stand.

Look, no potential solution that I — or anyone else — puts forward is going to make everyone happy. Some will argue we're all being too generous. Others will label us modern-era Scrooges.

But one thing is for certain: Our country should not continue privatizing profits and socializing risk. If lenders want to make billions during housing market booms, fine. They should feel absolutely free to do so. But they shouldn't come crying to hardworking American taxpayers (or to the GSEs and the FHA) for a bailout when they lose money.

As painful as the credit crunch and foreclosure wave is now, it WILL help us set the stage for a brighter future. And more importantly, it will allow us to get back to the day when average Americans can afford typical homes with standard wages using traditional financing. Washington just needs to let that happen.

Until next time,


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