Obama’s Plan: Making Housing Affordable Will Make Investing Unaffordable

Last week President Obama unveiled his Make Housing Affordable Plan (MHA), which helps those homeowners who either owe more money than their house is worth, or who face imminent risk of default.   Those owing between 80% and 105% of their house may refinance at a low, fixed-rate for 15 or 30 years.  Those who are in default or face imminent default may be eligible to restructure their mortgages with interest rates as low as 2%, loan terms as long as 40 years, and principal reductions.

The government will also reduce principal by $1,000 per year if borrowers remain current on the lower, updated loan payment for up to five years. There are many who claim that this plan increases moral hazard, and will create an artificial bottom which will only temporarily delay the market from finding a true market bottom.  These arguments are absolutely valid; however there are larger risks that come with the MHA, the risks to the MBS market.

Creating a Nightmare in the Judicial System

Many years ago, banks held onto loans that they originated.  If they sold a loan to another bank, that bank held onto the loan.  As financiers became more creative, this practice quickly dissipated.  Many banks continue to hold onto loans they originated, but with the creation of Mortgage Backed Securities (MBS), bankers began pooling these loans together into securities and then selling these loans en masse to investors or to other business entities that then did the same thing.

The problem is that under the MHA, the government rewards borrowers by reducing interest rates, writing down principal, and rewarding on-time payments; and rewards servicers for agreeing to make these adjustments.  The MHA does not reward the investors who took on risk by purchasing these MBS.  Many of you will argue that these investors took on risk by purchasing these securities, and should have to deal with the consequences.  If you’re one of those people, and you believe in the MHA, then maybe you should reevaluate your stance.  Lenders and mortgage borrowers also took on risk, but they’re being bailed out.

MBS holders purchased these securities with the expectation of receiving specific principal and interest payments over the course of the security’s maturity.  MBS returns can fluctuate based on prepayment speeds, which adjust based on the length of time people stay in their homes, or refinance.  When rates increase, prepayment speeds decrease, because fewer borrowers refinance.  When rates decrease, prepayment speeds increase because more borrowers refinance at a lower rate.  Most MBS have implied prepayment speeds of between seven and eleven years.

MBS holders are willing to assume the risk that prepayment speeds may change over the course of the investment, based on changes in the market.  But now the government is messing with prepayment speeds by paying servicers to modify loan payments.  The government is pressuring banks to refinance nearly five million mortgages at lower interest rates, and to modify an additional four million loans by lowering the interest rate, extending the maturity, and writing down principal.  This could lead to significant losses for MBS investors.

MBS holders will not stand for such government meddling and recklessness, and in a matter of weeks we will begin to see a surge in lawsuits filed against both the government and mortgage servicers.  The MHA doesn’t protect servicers from lawsuits, so they’re fair game.  Lawsuits could prompt federal judges to force suspension of the program on grounds of unconstitutionality or whatever other reasons they can find.  If this were to occur, those borrowers at “imminent default” would end up defaulting anyway.  If judges forced suspension of mortgage actions entirely, including foreclosure actions, these borrowers would be able to stay in their homes, but banks would suffer immensely as they couldn’t foreclose on non-accruing loans.

On a positive note, if the justice system freezes the plan but allows foreclosures to continue, it may leave room for a market based recovery.  The government’s meddling will cease, and buyers and sellers will help the market to find a true bottom.

Impairing Future Lending

If MBS holders get left out of the MHA, it could spell disaster for the supply of cash in the mortgage business.  The market for MBS provides an amazing amount of liquidity in the mortgage market.  If the US government announces that it favors mortgage borrowers over MBS investors, investors may avoid MBS altogether.  The risk of the government stepping in and destroying the value of these securities would be more than investors could handle.  If this happened, it would strain liquidity and many borrowers would be unable to secure mortgage financing.

If banks and mortgage brokers have high loan demand, they can fulfill that demand when the MBS market is thriving.  Banks and brokers have limited cash for loans, and once that money is gone, they can’t originate anymore loans.  But if the bank can pool those loans, or sell the loan to someone who can, they can make money. This inturn could fund additional loans.  This can only work in a vibrant MBS market.  Without a market for these securities, banks must hold every loan on their books, and when that money runs out, borrowers have nowhere to go.

The subprime market would be hit especially hard.  Individuals with less than perfect credit may be qualified for a loan, but many banks wouldn’t want the risk associated with those loans, regardless of loan-to-value and debt-to-income ratios.  With a vibrant MBS market, the bank may be able to pool those subprime loans and sell MBS to investors who could tolerate a higher level of risk.  Of course this requires rating agencies who can provide accurate risk assessments of these securities.  That’s another issue, for another day.  If subprime borrowers are unable to borrow money for homes, home ownership rates will fall, which will cause further declines in home values.

The best course of action for the government is to leave the housing market alone.  Mortgage products are simply too complex to allow the government to choose one group of investor over the other.  Leaving the market alone may cause more to lose their homes to foreclosure, but it will ultimately strengthen the economy.  If nothing else, those who lose their homes will learn a valuable lesson about living within one’s means, and having an emergency fund in the case of a layoff.  Plus there are many Americans who wouldn’t blink at the chance to invest in a foreclosed property.  I’m one of them.

Disclosure: None.

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Comment by jlounsbury59

2009-03-13 14:32:57

Nick - - -

Your final statement should be a listed as a disclusure. You wrote: “…there are many Americans who wouldn’t blink at the chance to invest in a foreclosed property. I’m one of them.”

You are interested in a market depressed by foreclosures (as well as an increase in foreclosures) as an opportunity for personal profit.

What you don’t discuss in your article is any possible benefit to MBS investors from reduced foreclosure rates. For example, you could have discussed the differences between some high level of foreclosures (say 10 million) and a reduced number (say 5 million) due to the mortgage rewrites you described.

If the net cost to MBS holders of the rewrites is less than 1/2 of the cost of the remaining 5 million foreclosures, the investor outcome could be better than the full 10 million foreclosures, if foreclosure values are around 50% recovery of the original principal. After all legal, maintenance and sales expenses, 50% recovery may be on the high side.

My discussion is back-of-the-envelope, but it indicates the topic has more variables than you covered in your article.

Now. all that being said, I think you have raised some significant points and I do appreciate your article.

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Comment by Myrna Loy

2009-04-07 22:38:06

Well sir, I am one of those who has lost a job not once but 4 times due to lay offs over the last 7 years. It took me aproximately 6-9 months to find employment but not once was I late with a mortgage payment or credit card payment. This time however, with so many people unemployed and age factor, I am finding it almost impossible to find employment. I have lived in my home for 12 years and did what I was suppose to even though I was scammed into a subprime refinance with a broker. I think the banks can stand to lower my interest rate after all the interest I have already paid them, yes sir I certainly do!!!!! Why should people lose their homes because they have lost their jobs due to greedy and unscrupulous bankers with a get richer and greedier scheme? Get real buddy, there are people losing their homes and if this is what it takes to stop it, then I say AMEN.

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