Photo: Niall Kennedy / Flickr
This article is from The Managing Partners of Peterson Bliss AdvisorsThis is the first in a series of articles intended to review the matter of principal reductions for “underwater” residential mortgages and has been created for, and in collaboration with, Stone Street Advisors. In a few installments, we will discuss:
• The numbers quoted in the proposal as stated in the media
• The issues surrounding the stated numbers
• The costs to the Borrowers
• The costs to the Taxpayers
• The costs to the Banks (and eventually the Taxpayers) and Timing
• 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
Recently there has been a lot of talk from the likes of #OccupyWallSreet, Elizabeth Warren in an ABC News segment and Martin Feldstein in a New York Times Op-Ed piece about the residential housing sector and the “need for principal reductions”.
They (the pundits and politicians) toss this “solution” out as a panacea for the national residential market that will cure the continued decline in home values.
The thinking then turns to the magical notion that increasing home prices and increasing sales volume will result in a decline in the unemployment rate and the national economy will be reinvigorated.
Well, we don’t buy what they are trying to sell. This will get a bit long winded, but let us examine some of the “facts” they introduce and try to see what this really means in dollar terms for borrowers and banks.
The numbers quoted in the proposal as stated in the media
As the New York Times Op-Ed piece states, we could easily write these mortgages down to save borrowers a ton of money ($350 billion!) and the banks will only need to eat half that as the government (read: tax payers) will take on the rest.
Maybe the largest issue with this principal reduction scheme is when people try to throw out numbers and rely on the sheer size of the numbers to impress people in to believing that this will make a magical impact on their monthly expenses. Let’s dive in to the nitty-gritty of these calculations before we get in to all the other reasons this is a horrible idea.
First, we need to get some statistics to base our assumptions on. We pulled ours from the US Census Bureau and a particular Saxo Bank Capital Markets study from August 2009 that we think does a god job of tackling a large issue and giving some solid data to the reader.
The US housing market is made up of approximately 160 million households living in somewhere between 115 and 130 million housing units. Roughly 90 million of these housing units are of the single-family residence (SFR) type and approximately 80 million are occupied full time (primary residences).
Of these 80 million housing units approximately 27 million are owned free and clear of debt while the other 53 million are encumbered by a mortgage of some sort. The total value of residential real estate in the US is approximately $19.3 trillion. This total housing stock value breaks down as $8.7 trillion in equity and $10.6 trillion in outstanding mortgage debt. If 53 million housing units have $10.6 trillion in debt that equates to an average of $200,000 in debt per housing unit.
The issues surrounding the stated numbers
Given these statistics we can start to make some very general assumptions. It is important to note that these assumptions will be imperfect as you would need much more accurate micro level statistics to create a true representation of the markets we are discussing, however, for the purposes of this article these numbers will suffice to have the conversation. Additionally, using the same simplistic maths as the people backing this principal reduction scheme is kind of fun as it shows how wrong they can be when using their own facts.
These articles and politicians cite that 15 million homeowners are underwater on their mortgages, having a loan to value (LTV) of greater than 100%. 15 million sounds like a lot, but it is 9% of the total households and 19% of the primary residences, a minority whichever way you slice and dice it. Of these 15 million underwater borrowers, 11 million have LTVs greater than 110% and nearly 7.5 million have LTVs greater than 130%.
This means that $3 trillion in outstanding mortgages have LTVs greater than 100%, $2.2 trillion greater than 110% and $1.5 trillion greater than 130%. So roughly 10% of homeowners made some really poor choices by jumping in to the market at the top of the valuation bubble and didn’t have adequate (or any) equity to invest as their down payment.
The grand principal reduction idea suggests that we take the most underwater borrowers (those that made the worst purchases with the least to put down) and we should have their principal reduced to an LTV of 110% in exchange for granting personal recourse of the loans (meaning they can be sued for the amount of the mortgage they don’t repay, in contrast to the current system wherein the bank forecloses and sells your home).
The real sales pitch here is that “If everyone eligible participated, the one-time cost would be under $350 billion.” A quick calculation shows that an average reduction of 16% (all the loans with LTVs greater than 110% reduced to 110%) to the 11 million underwater mortgages will indeed total $352 billion. The caveat being what we stated in a previous paragraph, where these are incredibly generic assumptions as most of these underwater mortgages do not have a $200,000 balance.
A significantly larger balance, probably on the order of an approximate $300,000 average, with a huge proportion being even larger than that when figuring that the largest valuation declines were in higher valuation states such as California, New York, Arizona, Nevada and Florida, is to be expected. Should the average underwater loan amount be $400,000 this would immediately double the costs to $700 billion.
Are you starting to see why the principal reduction scheme won’t function nearly as the back of napkin maths would have you believe? It’s dependent on overly simplified averages, not the accurate micro level numbers.
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 maths. $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 maths 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 maths 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 maths 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 maths 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 10 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 10 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 maths whiz to realise 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 realise 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 10 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
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