Sunday, February 22, 2009

Foreclosure Solution: More Foreclosures / Also - What About Bank Nationalization?

This might sound strange coming from someone living in the middle of the biggest foreclosure crisis in our nation's history, however I have come to believe that one of the answers to our current foreclosure crisis is.....more foreclosures.

In previous posts I've laid out frameworks for helping to solve this current crisis. One of the key components is to purge the system of people who cannot now and cannot even if a loan was modified with a principal reduction afford a home. There are many people who bought homes they couldn't afford and would never be able to sustain. Some of these people live in homes that have dropped significantly in value, some live in homes that have only dropped a little in value (amazingly I consider "a little" to be 10 - 20%"). Ironically, the one's who have experienced the largest price drops are the ones who have the best chance of coming out ahead, but only because the economics work. Let me give a few examples of who should lose their home and who should keep their home:

A person takes out a $600,000 loan for a home worth about the same, the home price drops to $500,000. This individual makes $60,000 per year. This person, even with a loan modification that included a 4% interest rate and a principal reduction of $100,000 would have a fully amortized loan payment of $2387. Add in taxes and insurance and you are close to $3,000 per month. That is a front end ratio (PITI divided by Gross Income) of 60%. It doesn't matter if they have other debt, under no circumstance can they afford this home. If they stop making payments the only economically smart decision is to foreclose. Propping this individual up will begin a process (yet another one) of grossly distorting market values.

Let's take the same person who bought a house for $500,000 and the value has dropped to $200,000. Utilizing my framework (see previous post) the loan is written down to $250,000 with a 4% interest rate. The Payment is $1,194 and about $1,600 with PITI for a front end ratio of 32%. 32% is a reasonable front-end ratio and this person should be able to make these payments assuming employment; they should be given a modification and kept in the house.....because it makes economic sense. To foreclose on this person would yield a much bigger loss for the institution than if they modified the loan.

In both instances we had the exact same person, but we had different outcomes. Is it unfair to the first person who lost their home? You bet, but if we start using "fairness" as the key to solving this crisis we will make the crisis bigger and distort the market place leading to bigger bailouts in the not to distance future.

To solve the foreclosure crisis we must allow and encourage failure. Without failure we cannot succeed in purging the system of loans that have no possibility of being made good on.

I know that this type of position will lead to attacks on me for wanting to throw out good people from their homes. I don't want to see good people kicked out of their homes, I've seen it up close and it isn't pretty. The pain and suffering truly makes your heart hurt, however propping up people and keeping them in a situation that will never improve will serve as a much worse condition that ripping the band-aid off now and forcing a solution.

The Obama administration has completely dropped the ball with their mortgage plan. Ironically they are following the same failed housing policy that the Bush administration set forth last year. Does Obama really have it in him to bring forth "Change We Can Believe In" when it comes to the credit/foreclosure/mortgage crisis? Only time will tell, but I think he does.

Bank Nationalization

There is much talk these days about the government taking over the banks, or Nationalization. Many of my clients have been asking me thoughts on the subject, so here goes.

The government has already effectively nationalized our banking system.

My question really is - what would be the difference? If we convert the governments current preferred stock ownership into actual ownership in the nation's major banks we find that the government is already the biggest shareholder of every major bank. The government is already dictating to banks executive compensation and that they must make loans, so what is the real difference?

I think nationalization is a stupid idea, but its already been done. Shareholders have almost been entirely wiped out. Bank of America was a solid bank until it did the government a favor and bought Countrywide and Merrill Lynch to prevent a "systemic failure" in the system and now it is effectively an insolvent, failed bank. Shareholders have been basically wiped out because they did the "right" and "patriotic" thing. B of A would have been better off avoiding these toxic companies.

What should have happened is these entities should have been allowed to fail. Failure would have forced a mechanism whereby assets would be sold at a market price, not an inflated price (which is what is preventing current write downs of many of these assets).

We can play the "should have" game all day, instead we'll play the what should we do now game. My answer to this situation is "I don't know".

Should we nationalize or not? I don't know. The banks need capital, but they need it because they need to do massive write downs of bad loans, they can't even think about writing new loans write now, beside the FHA (the new subprime) and Fannie/Freddie are taking care of that.

Nationalizing the banking system poses a huge threat to our economic freedom and for that reason I am against it. Having said that the banks are already effectively worthless and cannot possibly raise the capital needed to make them solvent, they are effectively wards of the state already.

I've stated many times that I believe the government will need to pump a couple trillion into the system and will need to do so by printing money. This will facilitate greater government control over every aspect of our lives and this scares me. But what is the alternative? Again, I don't know.

The only possible solution would include a government guarantee that they will, at a specific point in time give up outright ownership of the nationalized banks. Evidently this is called "The swedish model"......which sounds like something out of a Victoria Secrets photo shoot (so of course I would normally whole heartedly endorse!), however I'm not so sure.

I still think there is a way to keep the banks from being nationalized and it is for the banks to move their assets off their balance sheets into a separate entity. I called for this back in December. This would not be a "bad bank" and current banks would not "sell" their assets to this entity, they would exchange their assets for equity and liability guarantees. The government would also help capitalize this entity and provide certain guarantees. This plan helps make the banks solvent, allows them to attract private capital and eventually gets them lending again to well qualified borrowers. It could also be the start to a plan where these entities begin the repayment process on the government preferred stocks, liquidating the government ownership.

None of this should be done without a better regulatory scheme put in place. At this point I don't support nationalizing the banks anymore than we have already done. We have existing institutions that function, they just need to be restructured - lets not reinvent the wheel.

Bottom-line: Banks have already been partly nationalized, further nationalization via complete takeovers is a bad idea, getting bad assets off the books is the only way out of this crisis and a process to work out the mortgage crisis must be undertaken that purges the system and makes economically viable decisions.

Is there a way out of this crisis that doesn't lead to a Greater Depression? Yes, it is up to out current leadership to make tough decisions and to lead.

Scott Dauenhauer CFP, MSFP, AIF