"Homeowner bailout" really (another) bank bailout

According to The New York Times, “As of the third quarter of last year, more than 10 million homeowners — or about one in eight — owed more than 120 percent of their homes’ worth, according to Moody’s Economy.com. Nearly 4.6 million owed 50 percent more than their homes’ value.” Also, “About seven million households are behind on their mortgage payments.”

Who will bear the losses from these 10+ million “underwater” homes? If the “owners” of these underwater homes all vacated tomorrow, banks would eat the entire loss. But if those “owners” stay in those homes and continue making payments until the values of those homes exceed their outstanding mortgages, then banks would lose nothing.

Home “owners” are legally entitled to walk away and leave the loss on banks since mortgages are “no-recourse” contracts. Those contracts state what happens if the buyer defaults: the bank gets the house, no more and no less. Giant banks with trading desks are whining that underwater “buyers” are morally responsible to pay their bank loans in full. They’re being disingenuous because those giant banks walk away from bad deals whenever doing so saves them a buck.

House price appreciation from current low levels would completely benefit underwater lenders, not underwater “owners.” Why? If Mary and Bill “own” a house now worth $160,000 but still owe $200,000 on their mortgage, they can walk away from their home and let the bank eat the $40,000 loss. If Mary and Bill instead stay in the house until its value increases $40,000, their bank is $40,000 richer, but they would still walk away from their house with nothing because the entire $200,000 (plus all the additional mortgage payments they’ve made) would go to their bank. (Mary and Bill would, though, have avoided paying rent. But they’ve also damaged their credit rating.)

So banks don’t want underwater “owners” to walk away from their negative equity homes. If Bill and Mary mail the keys back to the bank, the bank loses Bill & Mary’s mortgage payments, the maintenance value of “owners” who keep the property safe and in good condition, and the property’s potential to rise in value. If Bill and Mary mail back the keys, they’ve effectively sold the $160,000 house back to the bank for the $200,000 they owe the bank. If Bill and Mary instead stay in the house until they sell the house for $200,000, the bank rakes in a $40,000 profit.

Now that the government is finally trying to address this massive problem, people are angry their taxes may help pay off private mortgage debt:

angry comments flooded in after the federal government announced it was expanding its program to assist unemployed homeowners, as well as borrowers who owe more on their mortgages than their homes are now worth.

Why, some asked on The New York Times Web site, should we have to pay for the mistakes of homeowners who lived far beyond their means when credit was easy to get? Shouldn’t they pay for their own mistakes?

I understand this anger, but people should realize this government program is (yet another) massive subsidy for BANKS at least as much as it is for home “owners” because banks profit when underwater “owners” keep making payments.

Bankers want to dissuade underwater borrowers from walking away from their homes, but banks also want to suck as much out of each borrower as they can without pushing them so far they walk away from their home. So, for example, Bank of America has rolled out what it calls a “targeted principal reduction program”, which is a nice way to say, “Get as much from each borrower as we possibly can.” Bank of America offers no help to people who are still making their payments or to people whose homes aren’t worth much less than their remaining mortgage balances. BofA offers principal write-downs only to “delinquent consumers with specific, deeply troubled loans” and “delinquent borrowers who are ‘underwater.’”

Here’s proof Bank of America foregives debt only when it believes doing so maximizes its profits:

What we have discovered is many customers with high loan-to-value ratios, even if you make the payment affordable, that’s really not enough for them. They may choose to walk away from their home versus sign up for the modification if they don’t have some chance for equity in the near-term future. Thirty percent (of underwater, delinquent customers) ignored all offers until we had the magic words “principal reduction” built into it. The successful modification can often make it cheaper [for Bank of America] because a modification the customer accepts and then redefaults still ends up being very expensive. The modification that’s sustainable ends up being cheaper.

Wells Fargo does the same: “We offer a principal reduction if that makes sense for that individual borrower’s situation.”

Banks are pursuing what economists call “price discrimination.” They’re trying to give breaks only to those underwater home “owners” who will otherwise walk away from their homes:

Many banks don’t want word to get around that they reduce principal. They fear that homeowners who can afford their payments will demand better deals. John Lashley, a 44-year-old salesman in Huntersville, North Carolina, is making his payments. But he is thinking about walking away from his four- bedroom home unless his lender, Sun Trust Mortgage, agrees to cut the principal on his $345,000 loan.

The house next door recently sold for $260,000, and Lashley doesn’t see the point of pouring money into his house when he may never recoup the investment he made in 2007. “Why should I stay in my house?” he says. “It’s not a moral decision. It’s a financial decision.”

But if banks continue being so stingy, more people will walk away from their homes and home prices will keep falling:

to truly break the cycle of declining home values, most experts agree that mortgage servicers must reduce the principal of the mortgage…. As part of the expanded program, the Treasury is being paid higher incentives to erase principal. But some experts say they think banks will continue to drag their feet, which will prolong the foreclosure crisis.

Indeed, Casey Mulligan, an economics professor at the University of Chicago, argued that both the Bush and Obama administrations had focused too much on making house payments affordable, based on income levels, and not enough on reducing debt.

“What we are really doing is propping up the banks in another way,” he said. “They are very powerful politically and they are very good at getting the government to give them money. So I think that’s why we don’t deal with the real simple problem, which is negative equity. Banks believe, and they are probably right, that there are probably some homeowners they can squeeze the money out of and they don’t want to give up the opportunity to squeeze such people.”

In fact, banks have fancy models that predict the likelihood any particular borrower will default on her/his mortgage. They can and do use such models to maximize profit by giving likely-to-default borrowers just enough debt reduction to convince them to pay off their mortgage.

Because of this, programs promising to help underwater homeowners are really helping banks far more than homeowners. They’re just the newest hidden bank bailouts.

(Paying off underwater mortgages was the bank bailout we should have STARTED with, not finished with. Paying off mortgages that had been packaged into CDOs and then re-packaged many times over in various CDSes could have avoided hundreds of billions in CDS payments, like those the U.S. government paid to Goldman and other banks on behalf of AIG.)

Posted by James on Wednesday, April 28, 2010