Topic: Government and Politics

Solve the Financial Crisis (and Make Some Serious Money)

Peter Van Doren and I have been puzzling over this very interesting NYT op-ed on home foreclosures by Yale economist John Geanakoplos and Boston University law professor Susan Koniak. If G&K’s story is right, then shouldn’t there be an opportunity for some clever financiers to help struggling homeowners keep their houses, help banks and other investors repair their balance sheets — and the financiers could help themselves to piles of cash in the process?

G&K argue that all three parties to a home mortgage — the homeowner, the lender, and the loan servicer who works as a go-between — currently face grim financial prospects:

  • Many homeowners are “underwater” — that is, they owe more on their mortgages than their homes are now worth. According to First American Core Logic, some 20% of mortgages were underwater as of December 2008. The percentage varies greatly from state to state, with 55% of mortgages underwater in Nevada, but only 7% in New York. The homeowners who are underwater include not just those who purchased with little down payment, but also many people who put down the traditional 20 percent when they bought in 2005 or 2006, at the peak of the real estate bubble. According to Case-Shiller index data, house prices nationwide have fallen 27% (as of December) from their May 2006 peak. Some local markets have experienced more dramatic declines, highlighted by Phoenix’s 46% slide. Rental prices are now far below many homeowners’ monthly mortgage payments, and lots of underwater homeowners will have to make payments for years before they have some equity stake in their homes. Many of those homeowners would rather default and risk foreclosure. G&K’s op-ed includes this figure showing that defaults increase dramatically as homeowners sink further and further underwater. Given their current options, default is rational.
  • The mortgage lender faces heavy losses if the home enters foreclosure. According to G&K, ”the subprime bond market now trades as if it expects only 25 percent back on a loan when there is a foreclosure.”
  • The servicer also is at risk. According to G&K, the servicer is obligated to continue paying the lender its monthly payment even if the borrower is in default. That obligation only lifts at foreclosure.

Because of the servicer’s obligation, the servicer has strong incentive to push for quick foreclosure. However, the homeowner and the mortgage lender would likely benefit from a loan modification — even a significant write-down of principal — because that would keep the homeowner in his house and it would deliver a better return to the lender than the 75% loss from foreclosure. G&K thus argue that government, instead of continuing to bail out the banking industry and struggling homeowners (and putting taxpayers on the hook for hundreds of billions of dollars), should simply require that the lenders write down the mortgage principal.

But is government action needed? Couldn’t some private actors accomplish the same thing — and make some serious scratch in the process?

A financial wizard with sufficient backing could approach a troubled lender and offer, say, 50% of the original loan amount in order to take some of the toxic mortgages off the lender’s hands. Now, the lender won’t be happy with selling at a 50% loss, but that certainly beats a 75% loss, so the lender would grudgingly agree. The financial wizard would then approach the homeowner and offer to write down the mortgage principal to, say, 60% on condition that the homeowner purchase mortgage insurance. The homeowner should jump at the offer because it would put him back above water, purchasing a home that’s worth more than its debt. Finally, the financial wizard would get the servicer to release its control over the loan, because the servicer would want to be freed from the risk of having to cover the payments to the lender. The financial wizard would then pocket a cool 10% of the original mortgage’s value.

That is not chump change. G&K estimate some 8 million homes could be foreclosed upon in the coming years. Assume the original mortgage on each of those houses is $199,025 (95% of the median sale price of new U.S. homes in January 2004, about halfway up the bubble); that 10% would represent almost $160 billion.

Of course, if the bank proves recalcitrant and demands more than 50%, or the homeowner demands a write-down of more than 40% or he’ll walk away, that would cut into the profits. And the financial wizard would have to cover his costs and possible risk premiums. Still, at least in theory, there would seem to be a significant pile of money on the table.

So why isn’t this happening? Are there no money-loving financial wizards out there?

To some extent, they are. Last week, the NYT reported that some former Countrywide executives have formed a firm called PennyMac that, with financial backing from hedge funds and other investors, purchases toxic mortgages from insolvent banks at low prices, modifies the loans to increase homeowners’ likelihood of making payments, and profits from the rekindled mortgage revenue stream. In the particular case reported in the NYT, PennyMac paid 38 cents on the dollar. But PennyMac seems like very small potatoes compared to the $160 billion that may be on the table. And the banks were forced to sell the loans because they had been taken over by the FDIC.

So why aren’t there more firms doing what PennyMac is doing, or following the strategy that Peter and I have laid out above? And why aren’t banks lining up to offload their toxic mortgages (or to do the write-downs themselves and pocket the 10%)? Peter and I can think of three possible reasons:

  1. As G&K note in their op-ed, banks and other investors who’re currently saddled with toxic assets may be waiting for some form of government rescue that would enable them to recoup far more than the 50% or so that would be offered by our financial wizards.
  2. Banks are keeping bad mortgages on their books at values much higher than the 25 to 40 cents on the dollar observed in the rare sales of troubled assets, and so the banks are unwilling to sell the assets for 50 cents on the dollar. (Remember that PennyMac is purchasing assets from banks that have been taken over by the FDIC — in other words, these are forced sales.) The banks (and their managers) may strongly prefer to keep the assets on their books rather than sell them at a 50% loss.
  3. The transaction costs involved in this scheme (e.g., analyzing the toxic assets to determine which ones to buy, negotiating with the delinquent and at-risk homeowners) are prohibitively large.

Government can address (1) by committing not to bail out the investors. Unfortunately, it’s unclear how reliable that commitment would be, especially given government actions so far in this financial crisis.

Fixing (2) is difficult. Accounting rules could be changed to force the banks to lower their book values for bad mortgages, but it would be difficult to get that accounting change passed quickly. Besides, some accounting experts argue that, in stressful times, accounting rules should have more wiggle room rather than less.

As for (3), the PennyMac guys claim that the work is difficult. But c’mon, there could be a $160 billion payday for the guys who can figure it out.

So, come on you money-loving financial wizards: your country needs you!

He Has a Point

Stung by accusations that he is a “socialist,” President Obama pointed out to two New York Times reporters that, “it wasn’t under me that we started buying a bunch of shares of banks. It wasn’t on my watch. And it wasn’t on my watch that we passed a massive new entitlement -– the prescription drug plan – without a source of funding.”

Not to defend Obama’s unprecedented increase on government spending or plans to involve the government in almost every area of our lives…but he does have a point. As I pointed out in Leviathan on the Right, the Bush administration’s brand of big-government conservatism was, at the very least, the greatest expansion of government from Lyndon Johnson to, well, Barack Obama.

Mr. President, If You’re Involved It’s Already Politicized

Yesterday, President Obama coupled his lifting of an executive order banning federal funding for embryonic stem cell research with the signing of a memorandum directing “the White House Office of Science and Technology Policy to develop a strategy for restoring scientific integrity to government decision making.” In other words, at the very moment he was directly injecting politics into science by forcing taxpayers to fund research that many find immoral – and that could be funded privately – Obama declared that he wouldn’t politicize science.

Don’t insult our intelligence. When government pays for scientific work that science is politicized. Yes, it could be argued that government not funding something is also political, but which is inherently more politicized, government forcing people to fund research, or leaving it to private individuals to voluntarily support scientific endeavors they believe of value?

You don’t have to be a scientist to grasp the obvious answer to that one.  And as I’ve laid out very clearly regarding education, this kind of compelled support ultimately leads not only to ugly politicization, but social conflict and division.

Culture wars, anyone?

The rhetoric supporting federal funding of embryonic stem cell research – and lots of other science – may sound noble, but the means-ends calculations are anything but. They are divisive incursions on liberty, and make political conflict inevitable.

Who’s Blogging about Cato

Here’s a weekend round-up of bloggers who are writing about Cato:

  • The editors at Fiscons.com quote Alan Reynolds in a post about President Obama’s spending plans.
  • Peking University Professor Michael Pettis quotes Daniel J. Ikenson on his blog, which covers trade policy in China. The quote was pulled from Ikenson’s latest op-ed in the South China Morning Post.
  • Fr33 Agents blogger Morgan Ashcom cites Gene Healy’s Examiner op-ed that criticizes conservative foreign policy.

Let us know if you’re blogging about Cato by emailing cmoody [at] cato.org (subject: blogging about Cato) or drop us a line on Twitter @catoinstitute.

Hillary’s Shock Doctrine

Hillary Rodham Clinton, the secretary of state who no doubt thinks of herself as “fourth in the line of succession,” tells a European audience how the Obama administration will pass an agenda that Americans have previously rejected: “Never waste a good crisis … Don’t waste it when it can have a very positive impact on climate change and energy security.”

As I’ve written several times, governments throughout the decades have taken advantage of wars and economic crises to expand their size, scope, and power. Bob Higgs wrote about “Crisis and Leviathan” long before Naomi Klein called it “The Shock Doctrine.”

But the striking thing about the Obama administration is that they openly acknowledge that’s what they’re doing – using a crisis to ram through their entire policy agenda while people are in a state of panic. Projects like national health insurance, raising the price of energy, and subsidizing more schooling – the three prongs of President Obama’s speech to Congress – have nothing to do with solving the current economic crisis. But the administration is trying to push them all through as “stimulus” measures. And they keep proclaiming their strategy.

First it was Rahm Emanuel: “You never want a serious crisis to go to waste. And this crisis provides the opportunity for us to do things that you could not do before.” Then Joe Biden: “Opportunity presents itself in the middle of a crisis.”  Not to mention Paul Krugman and Arianna Huffington. And now Hillary.

Not since George Bush the elder told the media that his campaign theme was “Message: I care” has a president been so open about his political strategy. But these people are displaying a contempt for the voters. They’re telling us that we’re so dumb, we’ll go along with a sweeping agenda of economic and social change because we’re in a state of shock. They may be right.

But voters and members of Congress should remember Bill Niskanen’s sobering analysis of previous laws passed in a panic.

Corruption Rewarded in Government

In Downsizing the Federal Government, I discussed some of the corruption surrounding former Senator Ted Stevens:

Another example of abuse engineered by Senator Stevens involves Alaska Native Corporations. Because of rule changes slipped in by Stevens, these shadowy businesses based in his state are allowed to circumvent normal federal procurement rules and win no-bid contracts. The result of such loopholes is that taxpayers do not get value for their money. For example, in 2002 a half billion dollar contract for scanning machines at U.S. border crossings was given to a native corporation with little experience in the technology, instead of established leaders in the field who were not allowed to bid.

The Washington Post did a good job of bringing the scandal of ANCs to light a few years ago. Did the spotlight on ANCs and connections to disgraced Senator Stevens convince Congress to move ahead with reforms? Hardly. From Government Executive today:

In fiscal 2008, companies owned by Alaskan regional and tribal corporations earned a record $5 billion in federal contracts, nearly 10 times the $506 million they earned in fiscal 2000 … ANCs earned two-thirds of the $24 billion they accumulated in prime contracts since fiscal 2000 through the Small Business Administration’s 8(a) Business Development program … Federal acquisition specialists said the data shows that the program, which was designed to help small and disadvantaged companies, has been undermined by a system that rewards companies that earn hundreds of millions in annual revenue.

In the story, Steven Schooner, of George Washington University, summed up the scam well: “The ANC program, as currently implemented, is a blunt instrument that distorts the procurement system, injects well-founded cynicism into the process, and reinforces the belief that government procurement is more about allocating political spoils than ensuring that the government receives value for taxpayer money.”

President Obama has promised procurement reform. He could start be eliminating ANCs and other forms of procurement favoritism.

FutureGen: Economic and Political Decisions

People who support expanded federal intervention into areas such as energy and health care naively assume that policymakers can make economically rational and efficient decisions to allocate resources. They cannot, as a Washington Post story today on FutureGen illustrates.

The story describes the political battle over the location of a $1.8 billion ”clean coal” plant. I don’t know where the most efficient place to site such a plant is, or  if such a plant makes any sense in the first place. But the story illustrates that as soon as such decisions are moved from the private sector to the political arena, millions of dollars are spent to lobby the decisionmakers, and members of Congress are hopelessly biased in favor of home-state spending regardless of what might be best for the national economy as a whole.

President Obama has promised to ramp up spending on such green projects. So get ready for some huge political fights over the big-dollar spoils, and get ready for some monsterous energy boondoggles.