Free Money if You're Underwater

Sagging under the weight of that giant mortgage?

Thinking about walking away and sticking faceless "investors" with your problem?

Don't move too fast! The Fed wants your bank (or those faceless "investors") to give you some free money to make that debt just a little less burdensome.

Here's how it works. Say you can't pay afford your $800k mortgage, but maybe you could make payments on a $600k mortgage. Great! We'll chop $200k off the mortgage. Then you won't default, and everyone comes out ahead.

You see, freezing interest rates and postponing recasts on interest-only loans to keep those loans affordable isn't going to be enough to stem the foreclosure tide. We know because Ben Bernanke says so:

Although lenders and servicers have scaled up their efforts and adopted a wide variety of loss mitigation techniques, more can, and should, be done... This situation calls for a vigorous response.

Bernanke knows that the tide is only beginning to come in.

People aren't just foreclosing because their payments have jumped. They are making the judgment to walk away because they're "underwater" – they already owe more than their homes are worth, and the housing correction has only just begun. They see the tide coming in and expect to get stuck even deeper below the surface.

So don't just throw them a lifeline, Bernanke says, bail out some of the water:

When the mortgage is ‘underwater,’ a reduction in principal ... that restore[s] some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.

Ben's plan makes some sense. If homeowners have some skin in the game, and some hope that they'll eventually have lasting equity in the home, they might not walk.

(Funny, more homeowners might already have had some skin in the game if they had put up significant down payments, not 0-5%, or hadn't been allowed to leverage their home's paper value up to 125% with equity lines, etc. But that's the past, no sense revisiting it now.)

Bernanke can't impose a solution. He's pitching this as "relatively more effective" and ultimately a net benefit to lenders/"investors." He's encouraging them to see that the hit from a foreclosed loan would be worse than the loss from a voluntary write-down. And in some cases, that's undoubtedly true. (Probably more so in the next year or two.)

Of course, if you chop someone's loan once to get them out from underwater, they might expect the same the next time there's trouble. More free money! Bernanke acknowledges this:

[Lenders] say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.

This is a form of "moral hazard" – writedowns encourage more risky behavior by borrowers in the future, without really protecting the lenders. And it's not exactly fair to the folks who bought homes at other times with less risky LTV ratios. (Sorry, responsible homeowners, you're not in this game.)

That the Fed chairman is proposing something so difficult and noxious, with such blatant downside risks, should be startling. It's an indirect way of communicating that the Fed is very, very... very worried.

Ben seems to have taken by surprise the former Goldman Sachs CEO, Henry Paulson, who currently serves as Secretary of the Treasury:

While these equity considerations clearly impact homeowners’ financial situation, they are not the primary concern in the effort to prevent avoidable foreclosures.

They're not part of Paulson's strategy at the moment, but then, he's walking in step with the lenders. Paulson is all for a housing correction and seems more inclined than Bernanke to let the bad loans to bad borrowers go bad ASAP so we can start over.

But we may be entering a time soon when people will be looking for anything at all that floats.

Loan 'Reset' Calendar - Trouble in 2-3 Years

It seems generally agreed that today's troubles in the sub-prime lending area were triggered by two factors: declining home prices and lousy lending standards.

Flat or declining prices closed off the "escape route" of refinancing for many buyers whose payments were ready to "reset," meaning the expiration of a low "teaser" rate of 1% to 4% and/or the end of an interest-only or neg-am period.

When the payments jumped, many stopped making payments outright. About 30 seconds later, 40-plus sub-prime lenders went out of business.

(Today's vivid illustration: Two weeks before Opening Day, the Texas Rangers have dropped Ameriquest from the name of their baseball stadium. In a fitting irony, the lender signed a 30-year deal in 2004, but now could no longer make the payments.)

Trouble in the sub-prime area should continue for many months to come, if we look at the dollar volume of sub-prime loans facing reset. (This chart [click to enlarge] is sourced to Credit Suisse, and comes courtesy of a poster at Mortgage Lender Implode-o-Meter. MBC has made no independent effort to confirm it, or judge its scope.)


How does the sub-prime flameout affect Manhattan Beach? Instinctively most people will say there is zero or limited impact. There are no sub-prime buyers in town, you might hear – this is just a different market segment. And the counterargument is that prices everywhere will be negatively impacted, because rot at the "bottom" of the market invariably drags prices at the top, too, with fewer first-time buyers and move-up buyers able to enter the market. This debate sounds a bit indirect and esoteric, however, and it could take years to settle it.

MBC is wondering about another factor: Loan resets on those million-dollar mortgages held by Manhattan Beach homeowners.

All over town, people who bought (or refied) in the last 4-5 years are sitting on adjustable-rate loans with 3- and 5-year "rate lock" periods and interest-only periods. (In MB, these are more likely to be "Alt-A" type or "prime" ARMs, similar in form to many of the subprime loans now going bad.) These "affordability products" were absolutely vital to allowing regular old upper-mid families to buy in during the boom.

Here's the problem. Often, the rate lock and I/O period on these loans will end simultaneously. If you're still holding the loan, you're in a for a payment shock. The only question is how bad it will be.

People who worried about these payment shocks after taking the loans simply told themselves they could always refinance and reset the clock with a new 3- or 5-year I/O period. But if home prices continue flattening or declining, maybe no refi is possible. Your LTV ratio might have gotten worse since you bought.

The next step for the homeowner in this situation is one of three things: 1) Pay the higher payment, perhaps $1,500-$3,000 more per month; 2) Stop making payments and skid along to foreclosure; 3) Sell if you can. It is obvious that more "must-sell" inventory would drag prices down in MB even in the absence of any other factors.

If we're going to see this effect in MB, the chart above suggests that the problems really start about 26-30 months from now (March-June 2009). That's when "prime ARM" resets start to swell. Over the next year or so after, if we're making the right assumptions here, the impact of the resets on homeowners translates into more sellers in trouble and willing to deal.

No less an authority than Alan Greenspan said just last week that all of these sub-prime problems would "disappear" if home prices simply went up 10%. But wishes aren't fishes. If prices don't go up, a downward trend could accelerate in 2-3 years even in our lovely, luxury beach hamlet.

Note that this discussion ignores the issue of short sales. We don't have short sales in Manhattan Beach!