Edgewood, WA Real Estate Blog

I posted the following comment to a post at The Tacoma News Tribune Open House blog.

I see a number of problems with the presidents plan.

There were some 6 million (your numbers show 7.5 million- the variance could be the fuzzy distinction/inclusion of alt-a w/subprime loans) people with no money and poor credit who purchased homes since 2004 by borrowing 100% (or more) of the value of the home. Lenders could make these loans because their risk was mispriced (why this risk was mispriced is another story).

Most of these loans included a low introductory teaser rate followed by a reset to a much higher rate some period later (usually 2-3 years).

Of the 6 million subprime loans, some 55-60% will reset to the much higher rate over 2007-2008. Approximately 15-20% are now in, or expected to be in, foreclosure.

Round it up to 2 million homes expected to be foreclosed upon. The presidents plan will only help perhaps 10% of these, or 200,000. This is because of the FHA guidelines for loan-to-value, plus the borrower must still be able to make the payments on the new loan.

Raising the FHA limits, and/or lowering the credit standards will only push the problem out into the future. Plus you have the moral hazard issue(rewarding poor judgment and bad behavior of both borrowers and lenders at the expense of the more prudent and conservative).

I do agree with the proposed tax code changes that forgiven debt on a primary residence will no longer be considered taxable income. There’s going to be a lot of short sales and that tax just adds insult to injury.

A better solution to the subprime mess may be the Ballie Mae program described at TCS Daily – A Plan to Address Troubled Mortgages.

The Ballie Mae solution notwithstanding, the direct effect of subprime foreclosures is the least threatening economic issue. The Federal Reserve estimates total subprime related losses at less than $100bn, which compared to the total debt in the US non-financial sector of $29.3trn is manageable. It’s true the problem could spill over to the non-subprime market (if home prices decline 15-20%, how many prime borrowers who put 10% down, and are now upside down, are going to walk away from their mortgage?)

The more serious problems are the liquidity issue (nobody knows what financial institutions bought into collateralized debt obligations and collateralized debt swaps toxified by mispriced asset risk, so nobody wants to lend money to anyone until they know for sure they won’t get “caught” making a bad loan), and the repricing of risky assets and subsequent investor deleveraging.

Most people are unaware of the extent to which leverage has been used in financial markets. Just about every investor can put up a dollar and borrow three to make a investment with 3 to 1 leverage. When you have funds investing in funds, investing in funds… and using leverage to do so, you can see how quickly leverage can build.

Positive leverage works great for amping up returns, but leverage cuts both ways.

As risky assets are repriced, which will happen regardless of the subprime solution applied (to correct for original mispricing), debt leverage could unwind in a hurry (because of margin calls). If it happens in a disorderly fashion it could result in aggressive rationing of credit.

The resulting financial carnage would be orders of magnitude greater than direct subprime losses.

So while the presidents plan is OK as far as it goes (assuming loan limits are not raised nor credit criteria loosened), it really doesn’t address the more serious problems.