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

Documentary Review: House of Cards

I just finished watching the CNBC documentary House of Cards (hat tip to Gregg for pointing it out to me). For those who don't want to wait to find out if they should watch it till the end of this review....you should watch it.

I cannot say that this documentary presented the complete picture or even an accurate one, but it does present many of the basic precepts that helped cause our current crisis. It clearly places the blame on Wall Street (what I now refer to as Hubris Street) and very little on government or the people, but from my extensive readings I'm not so sure they are wrong. There is plenty of blame to go around, but Hubris Street deserves the overwhelming majority.

I think I bring an interesting prospective to this current crisis as I and most of my clients lived through it. I moved to Orange County in 1995 and housing prices were fairly low, in fact I was working for Bank of America doing first and second home loans. What I found was that a lot of people were underwater or had very little equity.

I bought a townhome in the OC in 2000 and watched the price double in just a few years. I saw the whole of Orange County come out of its housing slump and boom. What I saw scared me. In 2004 I sold my condo as I thought housing was becoming overpriced. I was quoted in a bloomberg article saying "I think there's a bubble. It's similar to the Nasdaq (stock market) several years ago. I tell any clients who come to me who want to buy a house that there's more downside than upside now to the home market."

I had people coming into my office at least once a week wanting to flip homes and going to community college workshops (Marshall Redick anyone) to learn how to buy and sell property. To my amazement these people were getting loans for several homes at one time. I would tell people that I love real estate and that I think its a great way to build a net worth, however it has to make sense. Nothing that people brought to me made any sense.

Prices continued to go up as I rented a home in Orange County. I decided to move out Orange County as I knew I couldn't afford a $1.5 million home (notice I didn't say I couldn't get a loan for that amount). I ended up moving to Murrieta where I could buy the exact same home for a third of the price and I could afford the payments. I figured that I was willing to take a short term loss of even up to 20% in order to have some safety and stability in my life, I still thought prices would fall.

It wasn't until about 2005 that I started to see and hear more and more about people getting loans that should not be getting loans. I was seeing people buy homes who didn't have jobs and they were financing 100% of the purchase price (technically more as they would bid a higher price in order to get a rebate to pay for closing). But prices continued to go up. My house was at one point appraised at almost 20% higher than I had paid just a year or so earlier. The appraisal felt bogus, I knew there was nobody out there who would buy my house at that price - they'd be crazy. Heck, I figured I had overpaid.

If only I had followed my instincts a little further and attempted to understand better what was going on maybe, just maybe I could have seen what was coming.

Little did I know Hubris Street had been funding huge amounts of purchases and refinances with no money down and low teaser rates for people who couldn't afford a home that was even half the price of the one they were buying. I naively thought that the banking industry was regulated enough to prevent such stupidity. Of course, I was wrong.

The documentary basically ends at this point - after the fall, it doesn't tell us much more about what they think will happen next.

Watching this documentary I can't help but kick myself for not being more of a sleuth. Here I was one of the very few advisors to go on the record with Bloomberg and equate the housing market to the tech bubble and yet the possible consequences of such a meltdown escaped me. I faced ridicule amongst some of my colleagues. In one meeting an older financial planner openly mocked me for my position on real estate values and basically called me a fool for selling my townhome....sometimes I'd rather be that fool than be the person who was right. Of course being right and predicting the outcome of being right are two different things, I never in my wildest imagination expected what has happened in the past six months.

I've now read hundreds of articles and about a half dozen books on the current crisis and have filled in a lot of the back story as to how things got to where they were. I'm now convinced that what we are experiencing is unprecedented and the future is still unknowable.

What I do know is that this mess has to be cleaned up and that it can't be cleaned up by allowing the same set of policies that led us into this mess lead us out. It is going to be tough and heartbreaking, but good people are going to have to be foreclosed on. The market needs to purge itself and prices need to find an equilibrium, this means that homeowners who can't afford their home even under a massive principle reduction program must be foreclosed on. I've outlined a basic framework in previous posts as to how this can be done. Its actually a terrible framework as it relies on government money and is full of moral hazard.....but its most basic element is to begin the purge, find a bottom and then move on. It will take years to work out, quite possibly a decade.

The good news is that if the right plan is implemented I believe that the stock market won't wait until housing recovers to go up, it will rally based on the fact that it sees direction, clarity and a way out. Until the market sees such direction, I believe it won't be able to have a sustained rally. This doesn't mean you should sell.

America's brand has been tarnished, but it hasn't been destroyed. The American people are unlike any other this earth has ever seen and the march of progress will continue, even if slower than we originally thought.

As for talk about a Depression or a Great Depression......I can't discount these feelings, what I can say is that the poorest among us (in America) live better than many of the rich people during the Great Depression. Did you know that penicillin was not widely available during the Great Depression? We have a standard of living that could fall dramatically and still never compare to what the average person went through during the Depression. The Great Depression wasn't America's first Depression, it was something like its 13th......it was just much worse than the others. At this point in time during the Great Depression unemployement was in the 20% range, we are at 7.6%.

The bottomline after all this rambling is that House of Cards was a pretty interesting story to watch and I think you'll find it entertaining, angering and educational.

I also want to say one thing about Alan Greenspan - for the next several decades, perhaps centuries we will debate whether he caused this mess with his prolonged period of low interest rates - however just because you have low interest rates it doesn't mean that you have carte blanche to eliminate all lending standards....that was done by the Investment Banks, not Greenspan.

Scott Dauenhauer CFP, MSFP, AFI

Will The New Mortgage Plan Work? Not A Chance...Strike Three

Several months ago I said it would probably take four times before the government actually came out with a program that would help mitigate the current foreclosure and credit crisis. Today marked the third attempt and it will fail. Ordinarily this would be Strike Three and you're out, however since Obama just became President we'll give him another shot at hitting a home run.

The plan announced today is based on a fairy tale - the same fairy tale that the Bush administration and congress hoped would have a "happily ever after" ending. That ending would be a world where foreclosures stop and home prices climb back up allowing the banks not to have to write down trillions in bad mortgage loans. This is what everybody in Washington is hoping for, but it just won't happen - it isn't possible.

This latest plan fails on five fronts:

1. It aims to help those who can least afford to stay in the home
2. It helps people who have reasonable interest rates already and have only lost a little on their home
3. It doesn't help out anyone for whom helping would make financial sense
4. There is not enough money being used
5. There is no provision for real write down of principal

This plan aims to keep people in their homes who simply can't afford to keep such an expensive loan. It does this by subsidizing interest rates, not by principal reductions. This distorts the marketplace and will eventually lead to a prolonging of the crisis and perhaps even more foreclosures.

I presented a framework for a mortgage plan in a previous post. A simple test could be designed to see if the homeowner could afford the house if the principal was reduced to about 120% of the current value (this is for hard hit regions) for example, if not the home could be rented to the homeowner and eventually sold or the the foreclosure process would start. As hard and as bad as it might sound we need to purge the market of those who will never be able to afford the house they are currently living in - subsidizing them doesn't help anyone and only prolongs the inevitable.

The second part of the plan is really the weirdest provision, it's going to be cool for those people who have an LTV higher than 70% as they'll be able to refinance and lower their rate, but these aren't the people in trouble of foreclosure, so it doesn't actually save anybody from going into foreclosure, it simply makes money for a mortgage broker (hey, they gotta eat too) and gives the owner some more dough in their pocket......kind of like a tax cut - but at other taxpayers expense.

This plan will basically bypass most of California, Arizona, Nevada and Florida......where the problem is. It doesn't help, if someone can demonstrate how it will, I'm all ears. Those who are most likely to foreclose and leave the banks with billions and trillions in losses aren't addressed at all.

The actual cost of a real mortgage plan is not $275 billion. This plan is similar to Bush's Hope For Homeowners program which helped only 25 people when it was supposed to help 400,000. The real goal with that plan was to provide bailout money to Fannie and Freddie - we could dub this Hope For Homeowners II - it does more to help Fannie and Freddie than anyone else. Two mortgage plans have been proposed - $75 billion will be spent in some manner (this isn't actually clear to me) on helping homeowners - $400 billion for Fannie and Freddie.....see where I'm going with this. Both plans are, were and will be smokescreens for getting money into these two failed entities.

Without a plan that focuses on principal reductions and lower interest rates, along with the sharing of equity and actually foreclosing on those who should be foreclosed on......there will be no recovery. This plan doesn't focus on principal reductions and will thus fail, potentially costing the taxpayers another $500 million as the housing market continues to crumble.

Wall Street obviously wasn't impressed with the plan, there was no rally.

Here is the problem - this housing crisis will cost possibly $2 Trillion or more to fix. The "T" word is scaring the heck out of the politicians and so they are putting their finger in the dike, the problem is that there are holes everywhere and not nearly enough fingers. The longer we wait the higher the price tag.

I've said it will take four stabs to get it right, the good news is that this it the third one.....perhaps we are closer to the point where the politicians finally capitulate and do what is actually needed.

Until then, no recovery. You'll know that they got it right when they announce a plan and the market jumps a thousand points. The bad news is that the only way to pay for the cost of this fix is to print money, leading potentially to higher commodity prices, inflation and the devaluation of the dollar.

The funny thing is that the housing crisis isn't our real problem (though it is huge and needs to be fixed), we could fix it for a mere couple trillion dollars (I'm not saying that with a straight face). Social Security, Medicare and Medicaid on the other hand..........that is about $65 Trillion and that is the real crisis that everyone is ignoring.

Scott Dauenhauer CFP, MSFP, AIF

SEC charges Stanford in alleged $8 billion scheme

"The Securities and Exchange Commission said Tuesday it charged billionaire Robert Allen Stanford and three of his companies with defrauding investors in an alleged $8 billion scheme involving certificates of deposit."

People believed the impossible, that you could safely earn twice the normal interest rate of FDIC insured CD's. When something sounds too good to be true, it is - if you live by this rule you will never be swindled out of your money. Note that I didn't say you would never see your holding fluctuate in value.

This guy is a slimeball and why it took the SEC this long to figure out what was going on is beyond me.

Scott Dauenhauer CFP, MSFP, AIF

The Barron's Plan

Barron's plan for housing is similar to mine, but still needs a little work.

Scott Dauenhauer CFP, MSFP, AIF
949-916-6238