The Breakdown of the U.S. Mortgage Market

This is a placeholder for some ideas I want to develop further.   Obsidian Wings makes a catch I’ve noticed in this debate too: “In any event, I noticed commenters at every blog giving a ritual statement that ‘of course I don’t have any pity for people who are defaulting on their mortgages’ before they get down to the business of apportioning blame.”   If there’s anything our elite can agree on, it is beating on the so-called ‘losers’ who are getting kicked out of their homes.

I think this is a backwards way of looking at what is going on with the foreclosure crisis. The way we deal with mortgages in this country is a brand-new phenomenon, one that only dates back 15 years or so, and it is a failed system. It’s like a car in an accident that wasn’t tested, but instead of an airbag not deploying the car has exploded.  That a record numbers of homeowners are delinquent and defaulting is the sign of a sick system, and efforts to ‘purge’ delinquencies out doesn’t get at what has gone wrong.

The real debate for me is: why are we having so many foreclosures?  Think of the iconic example of a local housing bubble, Texas in the 1980s. Here’s how bad the foreclosure rate got:

That was after a pretty vicious oil and housing bubble popped around 1986, and we don’t see anywhere near as many foreclosures as we do now (the number has gone up throughout 2009 and 2010).

Because the first rule of mortgage lending is you don’t foreclose.  And the second rule of mortgage lending is you don’t foreclose.  For all the talk about how principal modifications will harm other economic parties, it’s the other way around. Imagine a house is worth $200,000, but the mortgage is worth $300,000 and the person can’t make the payments at $300K but could at $250K. If the person’s principal isn’t written down, the bank seizes the house and sells it at….$200K.  And that assumes they don’t lose 30+% as is common for a foreclosure sale.  This loss that will raise the cost of capital for everyone else. Why is this breaking down this way?

One is that there isn’t anyone standing in the center acting as the fiduciary.  We only have to look at the structure of the servicers to see this. Designed to do automated, scalable and streamlined work, they are being asked to do work that is time and energy intensive. Then comes the incentive structure where it’s less profitable for loans to be current and functioning, and built into the business model is that loans that are delinquent will balance out the lack of profit from fewer mortgages being started (what they called a counter-cyclical diversification strategy).   This is what people like Amar Bhide are pointing out about local knowledge; issuing loans can harness economies of scale.  Servicing loans can harness economies of scale.  Managing loans that are delinquent and in need of modification is time and knowledge intensive.

The second is the structure of multiple liens. That this would make it incredibly difficult to modify and deal with a mortgage crisis wasn’t an accident. If you go back and read the arguments put out by a conservative think tank like the American Enterprise Institute, arguments like Charles W. Calomiris and Joseph R. Mason’s High Loan-to-Value Mortgage Lending: Problem or Cure? (which we discussed here), the idea that leveraging up and using your home as a credit card with multiple different entities having multiple different claims, junior claims that senior claims might not even know about, would lock you into having to be a more responsible party and also save you some pennies on that housing credit card. Calomiris:

Misplaced concerns about the riskiness of HLTV lending and the destabilizing effects of reloading and churning have led some in Congress to advocate altering personal bankruptcy law to allow cram-down—or bifur-cation—of mortgage debt exceeding 100 percent of home value. Under such a scenario a borrower filing under Chapter 13 would avoid foreclosure. Mortgage lenders would retain senior claims on the borrower up to the amount of the fair market value of the underlying property at the time of bankruptcy. The HLTV loan would thus be second in line as a claim on borrower wealth up to a maximum of the value of the mortgaged property. The amount of the HLTV loan greater than the value of the underlying property at the time of bank ruptcy would be treated as unsecured debt and placed on an equal footing in the bankruptcy process with other unsecured debt….Cram-down would essentially eliminate that special bargaining power of the HLTV lender.

So AEI thought it should be incredibly difficult to modify a failing mortgage so that homeowners could save a tenth of a percent on their house credit card.  It’s worth noting that the “special bargaining power” is designed to eliminate modifications, or the simple pareto-improving agreements between a senior debt-holding bank and a lender. As we noted before, it would be insane to allow this kind of structure to go on in the corporate bond market.

Another way to think of this more general idea is that if we seal someone inside a car and take out the airbags and seltbelts, they’ll be the best driver ever. I had an economics professor back in business school who was proud of the fact that he never wore a bicycling helmet, even after he broke his collarbone in an accident, because he found some half-assed research saying that cars drive closer to people with bike helmets on.

This bizarre idea, known as risk homeostasis in the economic ideology, is useful as a thought exercise, but a dangerous way to run a mortgage system. And this is the system that we are dealing with.  Because it ignores the fact that sometimes a gigantic truck of global imbalances and a systemically large housing bubble and financial crash will be racing the opposite way right into your direction.

Last bit of real talk: there’s not a point in making a partial payment on a mortgage from the standpoint of keeping the mortgage current. If your mortgage payment is $1,000, and you pay $900, you aren’t any more current for it. Is there an instrument we can use to see if people are trying to stay current and make some sort of payment? Here’s one, Mr. David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at House committee on “Second Liens and Other Barriers to Principal Reduction as an Effective Foreclosure Mitigation Program”:

It is important not to confuse payment priority with lien priority. In almost all scenarios, second lien holders have rights equal to a first lien holder with respect to a borrower’s cash flow. The same is true with respect to other secured or unsecured debt, such as credit cards or car loans. Generally, consumers can decide how they want to manage their monthly payments. In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.

So what you see is a lot of people, over half, who have stopped paying the first trying to make some sort of payment. (In a way that strikes me as a weird conflict of interest if it’s consistent across all servicers. Talk about bad financial literacy.)  If there’s ever been evidence that, rather than trying to leech out a vacation, there are a large number of people trying to get current on their loans, trying to pay something to stay in their homes, it’s this number about people paying the smaller junior lien first. Why can’t the system meet them halfway?

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4 Responses to The Breakdown of the U.S. Mortgage Market

  1. Milton Recht says:

    Possibly, it is a liquidity issue. Second liens can be revolving credit lines. Some of these second liens can be interest only. Consumers are possibly using these lines to pay for everyday living expenses. They are making minimal payments to keep the lines active and current, but are not reducing their second lien debt, or are reducing it for part of the cycle and then re-borrowing it. Homeowners are paying second liens before their first lien mortgages to keep liquidity and credit lines open. It could be that there really is no extra cash flow available in the households to put towards the first lien mortgage.

    Additionally and interestingly, the Mortgage Bankers Association chart shows an upward trend in mortgage foreclosures from 1979 to 2002. Defaults appear to be about 5 times greater in 2002 than in 1979.

    The foreclosure drop from 2002 to 2006 can be attributed to the housing bubble price appreciation, which allowed homeowners to avoid foreclosure by selling their homes at a price that paid off the mortgage and other second lien debt.

    If the home bubble had not occurred we might have seen a foreclosure rate of about 2 to 2.5 percent now, based on an eyeball estimate of the upward slope of the chart.

    The high rate of current foreclosures may only be slightly higher than the expected trend line and the bubble allowed avoidance of trend line foreclosures from 2002 to 2006.

    The current foreclosure rate may seem high because the housing bubble artificially allowed the foreclosure rate to deviate from the trend line and suppress it, but it may be close to trend now.

    The economic and social factors that raised the foreclosure rate from 1979 to 2002 probably are an important force in today’s foreclosures and the collapse of the housing bubble and the higher than norm unemployment maybe less of a cause than common consensus believes.

  2. Tony says:

    If your business model depends on a certain percentage of customers not handling your product, you’re in an immoral business.

    Jim Beam is a more moral company than Visa. Jim Beam makes money off of casual drinkers, but Visa can’t make money off of casual spenders.

  3. David says:

    I find it strange that practically every lawsuit involving Investors & lenders or insurance companies & lenders – the Senate Committee hearings – ALL have ONE thing in common… MORTGAGE FRAUD…

    Countrywide has admitted to creating a separate Underwriting Program that automatically picked borrowers apps rejected from their CLUES underwriting program and switched the loan to a NINA or SISA loan and APPROVED those loans. 142-Billion dollars worth of mortgage loans that were sold to borrowers KNOWING those folks could NOT repay the loan. Sold to borrowers using deception and NOT telling them their 7-800 mortgage payments could jump to 2500 bucks.

    These folks TRUSTED these loan agents. These loan agents were supposedly held to a hire standard of professionalism – yet, the borrowers are being pounded into poverty.

    What the mega-mortgage insurance fraud going on whenever these lenders foreclose? The PSA states they are PAID 100% of the unpaid principle and 100% of the unpaid Interest up to the time of foreclosure.

    The loans were guaranteed 100% – yet these borrowers getting burned.

    They separated the loan from the security – yet are still foreclosing and taking the collateral? That is illegal seizure of private property – no matter how its sliced…

    Keep the Powder Dry

  4. I agree with you. It is a new model of doing business. most likely we have to wait to see the results. Trying to predict it is futile.
    For news on Canadian mortgage market please visit

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