How To Potentially Correct The Mortgage Crisis

No doubt there is plenty of lamenting to go around in this ongoing economic crisis. But how does one go about looking for solutions? Thankfully Zacks senior equities analyst Eric Rothmann was on hand recently to tell us how he would begin the process re-working the current state of mortgage loans, keep individuals in their homes, get the banks back on track to lend, and help alleviate the some of the backlog of homes available for sale.

The investing public has had some time to absorb the ghastly economic situation we currently find ourselves in. What pearls of wisdom can you offer us?

Banks have been great lenders, but lousy as owners of real estate. While a ‘bailout’ was inevitable, much like the ‘Brady Plan,’ it leaves much to be desired. Of the $250 billion to be invested in the financial institutions, approximately half goes to about nine big banks — more than half are not the traditional residential mortgage lending institutions — Bank of New York Mellon (BK), Goldman Sachs (GS), Morgan Stanley (MS), JP Morgan Chase (JPM), Bank of America Corp. (BAC), Citigroup (C), Wells Fargo (WFC), State Street Corp (STT) and the soon to be merged Merrill Lynch (MER). One would think Hank Paulson (given his experience on Wall Street) could have gotten at least competitive terms (similar to Warren Buffett’s) for the big fistful of money he was handing out.

So your verdict is that Buffett worked himself a better deal than did Secretary of the Treasury?

Paulson negotiations yielded preferred stock with a 5.0% dividend for five-years, rising to 9.0% in the sixth year and there after. While preferred dividends must be paid on this stock before common stock, appears to be no other dividend restriction. In addition, the government’s preferred stock has no voting rights, unless the institution misses six straight quarters of payments. Buffett negotiations yielded preferred stock with a 10% dividend.

For Paulson, preferred stock may be redeemed at par after three years, or earlier if the bank is able to raise private capital. For Buffett, there is a 10% pre-payment penalty. In Paulson’s deal, warrants equate to 15% of the par value of preferred stock, versus warrants equating to 100% of the par value of the preferred stock in the Buffett deal. Finally, for Paulson, all current executives can keep their jobs, but no golden parachutes. Beyond this, there are only minimal other restrictions on executive compensation.

Well, for the less-shrewd among us, how should things have gone differently?

Clearly, one of the caveats should have been to reduce the common dividend to $0.01 per share per quarter) for this infusion of capital. A reduction in the dividend would in all likelihood negatively impact the share price in the short-term. However, the beneficial long-term impact would be to enhance capital at the financial institutions on top of the ?bail-out.?

Unfortunately, we do not believe these two actions — Paulson’s and a dividend cut to $0.01 per share per quarter — would be enough to get our financial system back on course as quickly as we would all like, as financial institutions continue to provide for additional losses at a rate substantially higher than the current rate of charge-offs.

Financial institutions should be required to fix their own ills in a manner that is beneficial to all parties, versus the ?Deer in the headlight? moratorium on lending. We think it is the time in the cycle to focus more on return OF investment, instead of return ON investment.

I understand you have put together a proposal of sorts of your own, is that correct?

Yes, we have separated the categories of the residential housing crisis into three general tranches. Some may disagree with our simplified out-of-the-box proposals, this is a complex dilemma and we agree there may be other approaches. And while Paulson’s plan is sort of a start, the fact remains that his plan started with three pages which opened the channels of discussion. Our goal is to get discussions moving, get the financial institutions lending, get digestion in the house market, and get individuals back to borrow, albeit responsibly.

What’s the first thing you would deem it important to say?

That would be this: if the borrower is still in the home, rework the mortgage loan now. To paraphrase Wallace Malone’s (former CEO of SouthTrust of Birmingham, AL), ?If you think a loan could go bad, go in and rework it today.? We do not understand why financial institutions basically idly watch as their assets (loans) move to the cliff like lemmings.

Imagine the potential if a financial institution began to rework the problem loans starting at the beginning of the year. While write-downs would have occurred and yields on the loans might have been reduced, loans would have retained performing status.

Clearly, people remaining in their homes and paying their mortgages would be a better scenario than mailing the keys back. Financial institutions still have a window of opportunity to moderate losses today and push the potential for future foreclosures out at least three-to-five years, when the housing market could be much stronger and able to absorb a lower level of additional homes on the market.

How about if the keys have already been mailed in?

If the financial institution has the keys, create a ?Rent-to-Own REIT? (real estate investment trust). As fewer individuals are willing to buy, rents typically increase.

Using myself as a benchmark, I saw my monthly rent increase 20% in the past year. While not all areas are like this, financial institutions are currently employing individuals to go around to the foreclosed properties to check for damage and make sure the heat and water is working (imagine the additional heating cost alone that these institutions are incurring this year).

So let’s suppose the institution was receiving approximately $24,000 from a $300,000 loan, or $2,000 month. However, the rental market has cratered and rents for the home are renting for 30% less, or $1,400 per month. Let us assume that the useful life of a home for depreciation purposes 27.5 years and housing prices have declined 30%, and now is worth $200,000. What’s an institution to do?

First, create separate REIT subsidiary. Move all the ?Other Real Estate Owned? and ?Nonperforming Assets? that match the criteria into REIT subsidiary at the mark-to-market valuation. This REIT subsidiary is spun out into a publicly traded entity.

While the subsidiary will still be responsible for the taxes (deductable), the benefit from depreciation, combined with the current rent should approximate $2,000 per month, close to matching previous mortgage and rent level. The rental agreement is written so that every month the REIT sets aside money (a couple of hundred) over the next three years to create enough funds for the renter to apply for a FHA loan (3% down version), but only through the parent institution. If the renter decides not to partake in the program, the funds go back to the REIT institution and the property may or may not go on the market at that time.

Very interesting. But what to do with the remaining toxic items?

If all else fails — If you can’t rework it, or rent it — sell it on the cheap.

First, since time is money for the banks, the quicker these pieces of property are disposed of, the better. We would suggest the financial institutions establish auctioning operations on-line. If it works for eBay (EBAY), why not the financial institutions? The difference being individuals that wish to bid on the properties must have funds on deposit with the institution. Or the individual has a loan preapproved (”FHA is A-OK”) with the institution selling the property.

For the financial institution, more auctions can be completed in a shorter amount of time, the funds prequalified (whether in cash or through a mortgage), freeing up cash to lend and or bringing a loan back on the books (albeit at a substantially lower level in a very quick fashion) and clearing up some more of the “Other Real Estate Owned” levels.

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