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Analyzing the Popular Proposals for Mortgage Principal Writedowns, Part II

Submitted by Stone Street Advisors on 10/27/2011 14:48 -0400

Yesterday, we posted the first part of a series of articles written by The Managing Partners of Peterson Bliss Advisors, analyzing the popular proposals for mortgage principal writedowns and their the effects thereof. In that first article, we examined:

• The numbers quoted in the proposal as stated in the media

• The issues surrounding the stated numbers

Today, we're going to delve further into the debate and look at:

• The costs to the Borrowers

• The costs to the Taxpayers

• The costs to the Banks (and eventually the Taxpayers) and Timing.

There will be (at least) one more post in this series so keep that in mind. Enjoy reading and please leave your thoughts in the comments section, as we know this is a rather contentious issue. –JT

The costs to the Borrowers

Anyway, let us continue down this rabbit hole a little further. Let us make a few more assumptions using this basic math. $350 billion in principal reductions, assuming an average interest rate of 7% (these were not the strongest borrowers in the market at the time so this is a decent assumption) would result in a loss of $24.64 billion in annual interest payments. Divide this by the 11 million underwater mortgages we are discussing and you find that the average savings per borrower is $2,240 per year, or $187 per month. That doesn’t work out to be very much of a savings, now does it?

However, any savings on these payments will be a significant help, right? Sure it would be. However we can only figure out how much help it will be if we can compare it to something, like, say, the average monthly rent you would pay if you were not paying that mortgage. The average rent in the US is somewhere between $650 and $750 per month (Census numbers are not very clear on this point) so let’s just assume the larger $750 per month. The average $200,000 mortgage at 7% yields a principal and interest payment of $1,330 per month. The spread of own to rent is $580 per month (or, roughly, a new iPhone 4S). If you saved $187 per month of your mortgage the own to rent spread reduces to $393 per month. If your budget is really under intense pressure, would you not still have more of an incentive to default and move in to an apartment to save that additional $393 per month? I think most people, after doing the math and seeing the savings of $187, would still elect to default, live rent free in their home for a period of time, buy that new iPad and iPhone and then move in to a foreclosed home an investor is renting out or in to an apartment.

Remember, I said these numbers could be off by a multiplier of 2, so let’s double these assumptions just for giggles. Average rent is now $1,500, average mortgage is now $2,660, the monthly savings of your principal reduction is now $374 per month, which results in an own to rent spread of $1,160, or a modified own to rent spread of $786 per month. This makes it even more obvious that people would choose to buy Apple products and let the bank take the home back some 350 days (average foreclosure length) to 500 or 700 days (averages in Florida, New York and a number of judicial foreclosure states). You can do some quick and dirty calculations using the same math based on what you see in your local market to see what the situation would be near you.

Based solely on these assumptions and quick calculations, I do not know why any sane person would give a bank personal recourse on their mortgage debts instead of buying some new toys while living rent free and then moving in to a rental. I think this pretty clearly shows that should this be implemented, people would not rush to take advantage of it once they learned what the “benefit” they are receiving truly is.

The costs to the Taxpayers

We have been able to debunk some of the math being thrown about, let us begin to look at some of the ripple effects the principal reduction scheme would have.

The obvious point to start with in this portion of our rebuttal is more of the fuzzy math and how it affects taxpayers and the banks. Do taxpayers really want to “bailout” the roughly 11 million homeowners that have LTVs of greater than 110%? Remember, these 11 million borrowers represent 14% of the housing stock and 7% of households.

Do they really want a bill that could balloon from $350 billion to $700 billion (or be in the low billions if no one uses the program)? It doesn’t make sense that, after the outcry due to the moral hazard created when bailing out banks, that the answer to housing valuation declines is more moral hazard.

The costs to the Banks (and eventually the Taxpayers) and Timing

We would like to take a minute to compare this $350 billion or greater principal reduction/“bailout” to the bailout that started them all, the Troubled Asset Relief Program, better known as TARP. The US government voted to give US banks (707 total banks including the ten TBTF) approximately $205 billion in cash to shore up their balance sheets during the financial crisis. These loans were to be repaid and according to the most recent SigTARP Quarterly Report to Congress in July 2011 (pdf) (pages 29-50, especially the tables beginning on page 43) over $180 billion (88%) of that money has been returned to the taxpayers. The TBTF and other US banks currently owe the US approximately $24 billion. $24 billion is roughly 7% of what the principal reduction scheme would cost. Or, said another way, the principal reduction scheme would cost 14.6 times as much as TARP has cost the taxpayers through July 2011.

There is a good reason for this. TARP was designed as an investment program. The funds used were to be repaid. In fact, if you take the time to break out the bank only portion of TARP (a lot of TARP was targeted to automakers) you can see that the losses have been sustained from only handful of financial companies (such as AIG whom is not a bank). In fact, the ten largest recipients of funds under CPP (the TBTF) had repaid all of their principal or repurchased shares (bottom of page 8 of Executive Summary). This information combines to be one of the most important points we can make. TARP is considered to be a “bailout” to the TBTF; money that the taxpayers gave away to the To Big To Fail banks. However, the reality is that most of this money has been repaid, more is being repaid, the TBTF have repaid their share and the losses are from other industries. The principal reduction scheme is a tool that will cost taxpayers and banks billions of dollars, with no chance to recoup those losses the way TARP intended.

The pundits and politicians would have you believe that the taxpayer will only have to pick up half of this “bailout“ tab. The banks and investors would have to pick up the other half. So banks, mainly the TBTF because most small banks don’t hold much of a balance of residential mortgages on their books, would need to write down $175 billion plus of mortgage losses. It doesn’t take a math whiz to realize that $175 billion plus is dangerously close to TARP bailout territory. If banks do not have enough capital reserved to handle the original $245 billion shortfall they had due to write downs, then why would they have it this time around?

The scenario that needs to be given extreme weight is not only the headline costs and capital that will need to be raised, but the ripple effect of these losses. The idea is that banks simply write down, take losses, raise some capital and everything will move along. Incorrect. Major banks (and small banks) generally do not hold mortgages on book. They have packaged these mortgages into securities and sold them in to the secondary market. The buyers are institutional investors, sovereign wealth funds around the world and other major banks. “So what?” you may say.

Well, the other investors are taxpayers pension funds, Fannie and Freddie, and even the federal government through Quantitative Easing (QE) purchases via the Fed. All of these are governed by contracts that state what the values of the securities are and what yields are expected to be. Banks may not unilaterally change the underlying assets and not face additional pressures or costs. Without all the investors agreeing to these changes then the investors, even our own government, can sue to “put back” these transactions causing even steeper losses for the banks to absorb and raise capital to overcome. We think this scenario is actually pretty funny; We help out a small subset of homeowners that made bad choices, agree to split the costs 50/50, when the banks can’t absorb the losses the taxpayers have to step up to cover the balance, and then, after all of this (!), the government sues on behalf of taxpayers to get rid of these altered mortgage backed securities causing additional losses to banks that taxpayers have to step up to absorb. The folks saying this is a good idea obviously do not understand how intertwined the system is and how the QE system has them on the hook for the losses.

The TBTF banks have already raised more than $200 billion in capital reserves since the financial crisis (via Dick Bove in a New York Time Op-Ed piece and a Bloomberg article). Basel III is currently trying to force international banks to increase their capital reserves to just over to 8.5%, or 9% for the TBTF. This increase in capital reserves required will result in US banks having to raise an additional amount of capital between $525 billion (via The Clearing House via The Financial Services Roundtable) and $870 billion (via The Economist). And the folks backing this principal reduction scheme think the best idea at this point is to wipe out all that hard gained capital the banks have reserved by forcing them to realize another $175 billion plus in additional losses directly before they have to raise 3 to 5 times as much? Are the taxpayers on board for “TARP 2: Principal Reduction For Irresponsible Homeowner Borrowers Edition” and then to watch banks fail as they struggle to adhere to Basel III?

Maybe one of the most interesting tidbits in The Financial Services Roundtable notes is that this increase in capital required could result in an increase in borrowing costs of 468 basis points, a 2.5% or greater reduction in US GDP output and a potential loss of 2.9 million jobs. These kinds of negative affects, at approximately the time when you would expect the US economy to be gaining momentum would be devastating. Continually requiring banks to book more losses, raise additional capital to reserve against these politician induced losses and then immediately following it up with a huge round of capital raising would likely lead to financial ruin, not only for the nations largest banks, but nearly all banks. These unintended consequences, when acting in concert, would quick plunge the US into another recession and create a scenario where we are in, or near, recession for greater than ten years and in to the next decade. These are the worst-case scenarios that have to be mitigated and explored, yet the conversation is all about some irresponsible borrowers that could lose their homes.

Tomorrow (or perhaps this weekend), we will discuss the remaining pieces of the puzzle, namely:

• The “fairness” of the proposal

• The most recent proposal from banks to a “finite number of current borrowers”

• The ultimate solution to the decline in home values

Stay tuned!

Peterson Bliss Advisors

Stone Street Advisors LLC