Felix Salmon

Yesterday, I published the chart on the right, showing that in the nation as a whole, houses look like they’re a pretty good value, relative to rents, for the first time in many years. The chart elicited an email from one New Yorker, asking whether the same thing was true here in Manhattan.

It’s a good question, so I asked Jonathan Miller, of Miller Samuel, to provide some New York data which I could overlay on the US chart. And here’s the result:

The most striking thing, of course, is how expensive New York is relative to the country as a whole: that huge spike in the original chart now just looks like more of a foothill.

But it’s also clear that even with record-low interest rates, Manhattan prices are still a lot higher than Manhattan rents.

It wasn’t always that way. Rents were higher than prices from the fourth quarter of 1994 through the fourth quarter of 1999 — a full five years, during which prices rose from $227,500 to $320,000. Which in hindsight was a great time to buy, seeing as how prices now are at $775,000.

Obviously the Manhattan data series, with fewer transactions, are much noisier than the national series. But broadly speaking, it costs you the same amount to buy a house today, in terms of your monthly mortgage payment, as it did at the end of 2004, when the median sales price was just over $600,000. By the standards of recent history, then, Manhattan real estate is a lot more affordable than it was during the bubble. But look back a couple of decades, and it still looks expensive. And compare it to rents, and it still looks like you’d be better off renting than buying.

This is an important milestone, even if it’s too little, too late:

Bank of America Home Loans has begun reaching out to customers who may be eligible for forgiveness of a portion of the principal balance on their mortgage under terms of a recent settlement…

The bank estimates average monthly savings of 30 percent on mortgage payments of customers who qualify for this program…

Bank of America actually began making principal reduction offers under the program guidelines in March, initially concentrating on homeowners who were already in the modification review process. So far under this early initiative, about 5,000 trial modification offers have been mailed, providing a potential total of more than $700 million in forgiven principal. Homeowners are required to make at least three timely payments before the modification can become permanent.

On average, the principal reduction being offered is substantial: it’s on the order of $150,000. And this offer is being extended to some 200,000 homeowners, which means we’re talking a lot of mortgage principal here: some $30 billion.

In reality, however, the actual amount of principal forgiven by BofA is likely to be much smaller than that. As we’ve seen with HAMP, banks are incredibly good at putting people into three month trials, and then managing to determine that for whatever reason they don’t qualify for conversion to permanent modification. What’s more, ironically, many homeowners might not be able to afford to accept this principal reduction, since after the end of this year, forgiven principal will count as income, for income-tax purposes, and the income tax on $150,000 of windfall income is substantial.

Still, principal reduction is exactly what the country needs right now, and I’m glad that it’s finally beginning to happen. I wrote about the subject in The Occupy Handbook, and this seems as good a time as any to put my chapter up online. So here goes.

There’s a lot of blame to go around when it comes to the causes of the financial crisis, but at heart, it was about debt — or, as the the financial markets like to call it, leverage. Investment banks created highly leveraged mortgage-backed securities that blew up; commercial banks backed up their holdings of super-senior debt instruments with little or no capital; homeowners bought houses with no money down, paying for them by borrowing amounts they could never afford to repay.

In many ways, the debt-fueled housing bubble was the financialization of America carried to its logical conclusion. From the early 1980s onward, economic growth was increasingly a function of leverage: small improvements amplified by being turbocharged with debt. A little debt can do wonders for growth — but like a drug addict, the economy eventually needs that much debt just to stand still, and ends up having to take on more and more leverage to sustain the growth it’s used to.

With leverage, of course, comes danger — what finance types call “systemic risk.” If the debt stops getting rolled over, as happened in 2007, then the entire economy can come to a screeching halt, with the loss of trillions of dollars in wealth, not to mention millions of jobs across the country. When the party stops, as happened in 2008, a new word enters the lexicon: deleveraging. It’s a central paradox of finance: while the economy needs credit in order to grow and to create jobs, it also needs to reduce the total amount of debt outstanding, in order to reduce not only individual and corporate debt burdens but also the risk of another massive crunch.

Deleveraging is always a painful process. When done on a nationwide scale, it often takes the form of inflation, which tends to hurt the poorest members of society in a particularly invidious way. When done on a case-by-case basis, it involves the loss of a lot of wealth. After all, your liability is my asset. (The money in your checking account, for instance, is counted toward your bank’s total liabilities. If your bank repudiated your claim to that money, then it would be richer, but you would be poorer.) Nevertheless, deleveraging is necessary. And every so often, it’s possible to find a positive-sum way of making it happen: a plan that makes everybody better off.

How can writing down debts ever benefit a creditor, the person to whom those debts are owed? The answer lies in the fact that if a debt is not going to get paid off in full anyway, the creditor’s best interest lies in simply maximizing the value of what he does end up receiving. Let’s say you owe me $1,000 — but then you come and tell me that you can’t afford to pay me back. You’re faced with a choice. Either you empty out your checking account and I take everything in it, which is $250, or you can find some money elsewhere and give me $450 in settlement of the debt. If I’m sensible, I’ll take the $450 — and I’ll leave you with a working checking account.

Compared to the $1,000 I had in the first place, I’m worse off, but that’s a sunk cost at this point, and there’s no point crying over spilled milk. I have to face the situation as I find it today, and make the best of it.

You’d think that banks, in particular, would be alive to the sunk-cost fallacy — partly because denial is a pretty bad business strategy at the best of times and partly because they all worship at the altar of something called “mark to market.” That is, they check to see what their loans are worth every day (or at least every quarter) and then value the loans at what they’re worth in the real world rather than how much was borrowed in the first place. Yet banks — and this probably comes as little surprise, at this point — can and do behave in surprisingly irrational and childish ways. A lot of the time, especially when it comes to dealing with homeowners, they seem more interested in inflicting misery than in maximizing their own financial returns.

All of this comes into starkest focus with respect to mortgages. America has millions of underwater homeowners, many of whom are behind on their payments and all of whom are significantly less likely to pay off their mortgage in full than they would be if they actually had equity in their houses.

It’s simple logic, used by every company and commercial real estate operation in the land. If you owe more than your property is worth, and you can walk away from that property and discharge your debt in full, then you should absolutely do so: indeed, the Mortgage Bankers Association did exactly that in 2010. It had a $75 million mortgage on its Washington, D.C., headquarters but sold the building for $41 million, moved out, and is renting elsewhere, relieved of the burden of $75 million in debt.

Banks hate it when people walk away from their homes. (The act is often called “jingle mail,” because you’re essentially mailing in your keys to the bank.) At the same time, they’re often enormously reluctant to do the one thing that is completely effective at preventing people from doing that, which is to reduce the principal due on the mortgage so that the amount of the mortgage is lower than the value of the home. The US government, too, has been reluctant to push this as a solution: its attempts to encourage banks to refinance mortgages have all been centered on reducing monthly mortgage payments rather than the total amount owed. In fact, many government-backed mortgage modifications actually increase the total principal amount because of various fees tacked on during the modification process.

Even if your mortgage payments go down, it can still make all the financial sense in the world to stop paying them, especially if you run into trouble. If you can rent a nice place for less than your mortgage payments, and if you have no real prospect of owning any positive equity in your home for the foreseeable future, it makes sense to free up a lot of cash flow by just stopping payments on your house. This is especially true when banks can take well over a year even to start foreclosure proceedings.

The result is a huge “shadow inventory” of homes overhanging the market. These homes aren’t yet for sale but will at some point get sold in a foreclosure sale, depressing values across the neighborhood. As a result, in 2011, no one wanted to buy — and house prices continued to fall, despite record low mortgage rates of less than 4 percent.

So what should happen when people get into trouble making their mortgage payments on a house that is underwater? After 2008, banks tended to do one of two things. They waited for an interminable amount of time, then initiated foreclosure proceedings and kicked the family out of their home. Alternatively, they worked out a mortgage modification that didn’t reduce the amount owed by a single dollar, thereby maximizing the probability of a redefault and of the homeowner’s having to go through the same painful process all over again.

There are multiple ways of doing this better. The simplest is just for the banks to unilaterally reduce the principal amount owed on a mortgage. It’s much more effective, always, for a bank to reduce principal and keep the interest rate constant than it is to do what they tended to do after 2008, which was to keep the principal constant and reduce the interest rate. Why don’t they reduce principal? They don’t because doing so involves writing down the value of the mortgage on their books — something they’re bound to do sooner or later, but which they’d much rather do later than sooner.

As the depressed stock prices of every bank in America in 2011 attested, however, no one really believed the values that the banks put on their mortgages — they weren’t kidding anyone. Coming clean on the true value of their mortgage portfolio might hurt banks’ quarterly earnings, but it wouldn’t necessarily hurt their share price. Once the mortgages are marked down to a reasonable level, banks can be much more sensible about how they’re going to deal with homeowners in difficulty.

There are circumstances in which banks have shown themselves willing to take losses on the mortgages they own. One is when they sell a big portfolio of mortgages to some third-party investor: such portfolios are often sold at just 10 percent or 20 percent of the face value of the mortgages if a lot of those mortgages are in default. Another scenario, and it happens pretty frequently, is the short sale, in which a homeowner sells a house and hands over all the proceeds to the bank, and in turn the bank writes off the mortgage, even though it isn’t fully paid off. Then, of course, there’s the worst scenario of all: you fall behind on your mortgage, and the bank forecloses on your property, taking over the deed to the house. At that point, the bank will turn around and sell the property, almost certainly for less money than it was owed on the mortgage, and take a loss.

All of these mechanisms open up possibilities for keeping homeowners in their homes, even after they’ve fallen behind on their mortgage payments: you just need a little imagination. For instance, let’s say you’re a bank that has foreclosed on a home. Standard operating procedure in such a situation is normally to kick the occupants out, put the house up for auction, and take whatever you can get for it. But there’s no rule saying you have to do that; indeed, there’s no rule saying that you have to evict the home’s occupants at all. Instead, why not rent the house back to them at the market rate? The market rent will almost certainly be lower than what they used to have to pay in mortgage payments, and at the same time you get to avoid kicking the family out of their home. Everybody wins in this case. The family gets to stay where they are, the neighborhood isn’t blighted by a boarded-up home being sold at auction by an owner who doesn’t care about it, and the bank gets a healthy income stream rather than a modest sale price.

And if the bank prefers to get cash rather than be a landlord? No problem: it can simply sell the property to someone happy to rent it out to the current occupants. Many such organizations and individuals exist: in days of record low interest rates, people with money often jump at the opportunity to make a decent rental yield on their investment, especially if they’re helping out a family in straitened circumstances at the same time. Often, such a rental contract will include a clause allowing the former owners to buy the house back at a pre-set price: the new owner might ask for a 10 percent profit after one year, a 15 percent profit after two years, and so on. If the family members manage to qualify for a mortgage to buy their house back, then the new owner will sell it to them — for less than the occupants originally paid but more than the new owner/landlord paid. Again, everybody wins.

Similarly, if a bank sells a defaulted mortgage for a fraction of its face value, then there are lots of ways in which the new owner can keep the former homeowners in their house and still make money. The principal amount can be reduced, of course, as can interest payments — and you probably wouldn’t be surprised to learn how much simple and sympathetic human contact can help.

Most of the time, homeowners have no ability to get through to a sensible human being at their mortgage company who can understand what they’re saying and make empowered decisions with regard to any possible mortgage modification. Instead, they get the standard run-around: they’re constantly being asked to fax in documents that always seem to then go missing. By contrast, if you buy a mortgage and approach the homeowner with good will and a genuine desire to find a reasonable solution, it’s amazing how often something mutually beneficial can be worked out. Indeed, a company called American Homeowner Preservation (AHP) is doing just that: it’s set up a hedge fund devoted to buying pools of defaulted mortgages and keeping the homeowners in their homes, and it is making good money doing so. All it takes, really, is a little bit of compassion and an ability to be inventive — rather than following exactly the same script every time.

AHP started with a simpler, nonprofit model: it would act as a broker, putting together willing buyers with underwater homeowners. The homeowners would do a short sale to the buyers at the home’s market value, and the buyers would lease the house back with an option to repurchase. That model didn’t work, because the banks refused to cooperate. While they were okay with short sales in general, they were emphatically not okay with any short sale that involved sellers remaining in their home. Tired of fighting and losing endless battles with the banks, AHP decided it would be a lot easier to buy the mortgages themselves. That way, AHP didn’t have to deal with impenetrable and illogical bureaucracies all day.

The banks have a reason for making it hard for people to sell their homes and stay in them regardless: they’re worried that lots of other homeowners will attempt the same stunt. However, it only makes sense to sell your house if you’re significantly underwater on your mortgage. And if you’re significantly underwater on your mortgage, then it probably makes sense to sell your house whether you get to stay in it or not.

Indeed, one of the more evil tricks of America’s banks is that the very people who need the most help with their mortgages — people who are far underwater — are also the people least likely to be able to get it. If you bought your home at the top of the market and it’s now worth a lot less than you borrowed to buy it, you’ll probably be rejected for the kind of mortgage refinance that everybody else can get with no difficulty. As a result, if you’re current on your underwater mortgage, banks and investors reckon that mortgage is worth not less than par (because it’s underwater) but, rather, more than par — about 106 cents on the dollar, on average. On a $200,000 mortgage, investors will pay a $12,000 premium just to be able to collect your high-interest mortgage payments, which you can’t reduce because you’re not allowed to refinance.

It’s a little bit crazy: if these homeowners were rational, especially if they live in a nonrecourse state like California, they would just mail their keys in to their bank and be done. That’s certainly what the bank would do, in the same situation. (In 2009, for instance, Morgan Stanley mailed back the keys to five San Francisco office buildings worth $1.5 billion rather than pay the mortgage on those buildings out of its record profits that year.)

Instead of reacting with gratitude to the fact that these underwater homeowners are paying their mortgages in full, though, banks punish those homeowners by forcing them to continue paying the high interest rates they locked in at when they bought at the top of the market. Mortgage rates had never been lower than they were in 2011, which meant that mortgages that couldn’t be refinanced to a lower rate were particularly valuable to banks.

If you’re current on your mortgage, the banks won’t let you refinance, and if you’re behind on your mortgage, they won’t let you stay in your home, even if you have a willing buyer waiting with the cash to buy the house and let you do just that. There’s only one exception to this rule, and it’s a fascinating one. If a bank bought its mortgages below par rather than lending the money out itself, then it’s quite likely to be open to the idea of principal reductions. For instance, when Wells Fargo bought Wachovia and when JP Morgan Chase bought Washington Mutual, they bought those banks’ mortgage portfolios at a large discount to par. It turns out that those mortgages — the ones bought from Wachovia and WaMu — have been getting modified with principal reductions.

The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans by writing down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, which is what Wells and Chase can do if they manage to put some smart principal-reduction plans in place. (Some principal reductions, indeed, have even been done for homeowners current on their mortgages.)

Economically speaking, of course, what the banks are doing here makes no sense at all. Either writing down option-ARM (adjustable-rate mortgage) loans makes sense, from a profit-and-loss perspective, or it doesn’t. If it does — and, yes, of course it does — then the banks should do so on all their toxic loans, not just the ones they bought at a discount.

The solution, then, is clear. We need to encourage banks — and servicers — to mark their mortgages to market, and to do whatever makes sense if they’re being realistic about how much those mortgages are worth. And while it’s okay to assume that homeowners will develop an emotional attachment to their homes and pay more than necessary to stay in them, it’s not okay to take advantage of that fact to extract thousands of dollars a year in extra mortgage payments from those homeowners.

More generally, principal reduction in mortgage modifications has to become the rule rather than the exception. The reason the government’s efforts to fix the mortgage market have failed so miserably is that those efforts have centered on interest payments, not the total amount owed. A sluggish housing market will act as an economic drag for as long as millions of homeowners owe vastly more than their house is worth.

If done right, these policies can be implemented in a positive-sum way, making everybody — including the banks doing the write-downs — better off. For instance, the government could impose higher capital standards on banks that insist on marking underwater defaulted mortgages at par, and give the banks an incentive to write down principal that way, while making the whole banking system safer at the same time.

Not all deleveraging can be done this efficiently or painlessly, but that’s a great reason to grab this low-hanging fruit while we can. If we don’t want the United States to continue to suffocate under the weight of far too much debt, we have to start making serious efforts to bring our debt burden down. This one’s a no-brainer. Let’s do it.

Many thanks to Ben Walsh for putting this chart together for me. The source is this data at the Census bureau, inspired by page two of the first-quarter 2012 Census bureau report on rental vacancies and homeownership.

The first thing to look at here is the blue line, which shows that the median asking rent for vacant rent units tends to rise pretty steadily. It doesn’t spike during housing bubbles, and it doesn’t plunge when those bubbles burst. Which is one reason why if you can, it’s always a good idea, when you’re buying a home, to take a look at what rents are like in the area. That’ll help you work out whether prices are too high.

David Leonhardt performed this exercise two years ago, and came to the conclusion that in some parts of the country, including South Florida, Phoenix and Las Vegas, buy-to-rent ratios were making houses look attractive again. I wasn’t completely convinced, but over the past two years, prices have continued to fall, while rents have continued to rise — sometimes painfully so.

In the chart, the red line shows the mortgage payment you’d have to make if you took out a standard 30-year mortgage for the median asking sales price for vacant sale units. In reality, your mortgage payment would be lower, since this doesn’t take into account any downpayment. But in any case, thanks to ludicrously low mortgage rates below 9% 4%, that number is now lower than the median national rental price. This is the first time that’s happened since 1988, and probably for quite some time before that, too.

Remember that houses for sale tend to be bigger and more valuable than houses for rent, too — which only goes to underscore how good a deal buying is versus renting right now.

Of course, not all markets work this way: around New York, there are lots of places where it’s still a lot cheaper to rent than to buy. But if rental prices are a good gauge of the value of housing — and I think they are — then I think we might finally have reached the point at which most Americans are getting good value when they buy a house.

To put it another way, we can now take advantage of long-term fixed financing (thanks, Uncle Sam!) to own a home for a monthly payment less than the cost of renting. Which doesn’t mean that prices won’t fall further, of course. But at least there’s a good chance that if you do buy a house right now, with a fixed-rate mortgage, then if push comes to shove you’ll probably be able to rent it out and more than cover your mortgage payments.

After Ben Walsh covered Ed DeMarco’s speech in the Counterparties round-up yesterday, I got a very smart note from the undisputed kind of the housing blogosphere, Calculated Risk:

I think DeMarco made a key point about “strategic modifiers” as opposed to what people have been calling “strategic defaulters”.

In the 2nd case, these are people who can afford their mortgage, but walk away because they are so far underwater that continue to pay makes no sense.

DeMarco is talking about people who will want to keep their home, but default for the purpose of receiving a principal reduction.

I think this is more likely than the classic strategic defaulter (something I’ve played down for years).

The reason is Fannie and Freddie will have to make the program guidelines clear and public. People are very good at figuring out how to game the rules. So, unless the rules are very tight, there will be more “strategic modifiers”.

Certainly this is something that DeMarco is worried about: in his speech, he defines a “strategic modifier” as “a borrower that either claims a financial hardship or misses two consecutive mortgage payments in order to attempt to qualify for HAMP and a principal forgiveness modification.” If there are enough of these borrowers, he says, then the financial benefits of principal reduction could go away quite quickly.

DeMarco’s worries are not entirely unfounded, given, as he says, that three quarters of the Enterprises’ deeply underwater borrowers are current. But the distinction between a strategic defaulter and a strategic modifier is a very subtle one, given that their actions — defaulting on their mortgage while being capable of making payments in full — are indistinguishable.

The difference is not in what they do, but rather in their motivation: the strategic defaulter expects to lose the house at some point, while the strategic modifier expects to retain the house, and the mortgage, but get a principal reduction along the way.

Personally, I don’t believe that the problem of strategic modifiers (over and above the problem of strategic defaulters) is likely to be huge. One reason is that I’ve been writing about the upside of strategic default for a long time, and it really hasn’t caught on, outside a few second homes and the like. Strategic default is not something that Americans like to do, and one of the main reasons is that they really care about their credit rating. Even if a strategic modifier keeps her house, she’ll suffer the same hit to her credit rating as a strategic defaulter would. And people don’t like that at all.

On top of that, the strategic modifier will still be running the risk of getting far behind on her mortgage payments, being unable to make them up, and then for some reason not qualifying for a principal reduction or indeed any other kind of modification. DeMarco is right that the principal-reduction program would be broadly publicized. But it will be publicized to people who are having real difficulty making their mortgage payments. If you can’t make those payments, then applying for a principal reduction is a no-brainer: it’s all upside and no downside. But if you can make those payments, the calculus is a lot more complex.

Even if principal reduction were made available to people who hadn’t missed a single mortgage payment — and I doubt that it would be — it would still constitute a write-off of a large chunk of debt, and would likely be considered a default as far as FICO was concerned. And if you do have to be in default to apply for a principal reduction, then not only do you suffer the hit to your credit rating, but you also run the risk of falling into a major mortgage-related nightmare which might well end up with you losing your home.

CR is right that people like to game rules. But he misses a crucial point here, which is that any principal-reduction program would be run by mortgage servicers. And the one thing that everybody knows about mortgage servicers is that they’re incompetent. No one will trust the servicers to play the game perfectly by the rules.

I, for one, would be petrified of playing this game, because I would have no faith at all that my mortgage servicer would do the right thing and give me that principal reduction, rather than having its left hand lose lots of paperwork while its right hand started foreclosure proceedings.

So let’s try principal reductions in the real world, and see what happens. If they turn out to be incredibly expensive, then we can revisit the issue. But my guess for the most likely outcome is not a wave of strategic modifiers. Rather, it’s that the program turns out to be much like all other government attempts to deal with underwater borrowers: a damp squib where very little happens at all.

If you haven’t read it, I can highly recommend Paul Kiel’s magnum opus on the US foreclosure crisis, available online or as a Kindle Single. Kiel tells the national story using synecdoche: the story of Shelia Ramos is representative of millions of others. And Kiel makes it very clear just how typical her tale is, zooming back out to a big-picture view on a regular and welcome basis.

What Kiel doesn’t do is look forward, and give his informed opinion on whether the new rules being outlined by the Consumer Financial Protection Bureau are likely to work to prevent such events from happening again. The question isn’t whether the new rules are good ones; the much more important and salient question is whether they will be followed and enforced. I’ll believe it when I see it: as Kiel shows, servicers are really bad at this kind of thing, and there’s a strong case to be made that they’re simply not capable of following the rules that the CFPB is laying out.

Meanwhile, the weird cognitive disconnect in the housing market seems greater than ever. If you look at Fannie Mae’s latest monthly survey, it shows lots of new highs being set: the percentage of people thinking that house prices are going up, the percentage of people thinking it’s a good time to buy, and, especially, the amount that people think they’re going to have to pay for housing if they don’t buy.

And yet, the facts on the ground don’t support any of this. Check out the latest quarterly home price report from LPS, for instance. Not only are prices still falling, they’re actually falling at a faster rate than they were a couple of years ago:

The rate of relatively slow price declines, from January 2009 to May 2010, was the time when there were tax incentives for first-time homeowners. When those tax incentives went away, so did the artificial support for the housing market; in hindsight, most of those first-time buyers would probably have been better off just waiting, and buying a house now without the tax incentive instead.

What’s more, this index, unlike other indices, excludes short sales. If you include short sales, then the numbers are far worse. And as the mortgage industry moves from foreclosures to short sales (since short sales don’t require the lender having to prove title to the home), the discount on short sales is growing alarmingly, and approaching the discount on foreclosure sales.

In Kiel’s story, Ramos abandoned her house to the mercy of her lender, rather than suffering through a foreclosure: in that sense, when it was finally sold it was more of a short sale than a foreclosure sale. But the distinction is less and less important these days — and there’s still a shadow inventory of millions of homes being lived in by delinquent borrowers, which are going to come on the market sooner or later at discounts of more than 20% to their peers. So long as that’s the case, it’s hard to see how house prices are going to stop going down and start going up.

So what explains Americans’ optimism surrounding house prices, especially when they think mortgage rates are going to rise? My guess is that it’s the fact that the recovery is proving itself to be real, combined with a natural bullishness when it comes to housing, which somehow wasn’t eradicated by the 2008 crisis.

But color me contrarian: if house prices can’t rise even with mortgage rates at all-time lows and the government desperately underwriting nearly all the mortgages in the land, I can’t imagine how they’re going to go up in future when rates go up and the government manages to extricate itself from the market. And if house prices don’t go up, of course, then the number of underwater borrowers will stay high, and the foreclosure crisis is going to remain a big problem for the foreseeable future. That’s the real horror of Kiel’s story. Not that it happened in the past — but that it’s likely to be repeated into the future, as well, for many years to come.

Ed DeMarco, the regulator in charge of Fannie Mae and Freddie Mac, has many critics, myself included, who would love him to allow Frannie to do principal reductions where it makes sense. But now he’s managed to find a defender. In Gretchen Morgenson, of all people.

Morgenson’s column today is utterly bizarre. She starts off by painting DeMarco as a “career public servant”, “under fire” in a “thankless job”. This is a phrase she seems to reserve for DeMarco alone: she made sure to describe him as a “career public servant” in 2010, as well as in her book. And as far as I can tell, she’s described no one else that way. And there are many career public servants, up to and including Tim Geithner, who can’t stand DeMarco* and who think he is being deliberately obstructionist here.

Morgenson then defends DeMarco from critics like Barney Frank and Elijah Cummings:

What the proponents of principal reductions at Fannie and Freddie don’t talk about is what a transfer of wealth from taxpayers (again) to large banks such a program would represent.

Morgenson is actually serious about this: the headline on her column is “A Bailout by Another Name”. And when she says bailout, she doesn’t mean a bailout of deadbeat homeowners, who would see their net worth jump overnight as a bunch of their obligations were written off at a stroke. No, she means a bailout of banks.

On the face of it, this makes no sense. How can reducing homeowners’ principal end up as a bailout of banks? And not just any bailout, either: Morgenson goes on to tell us that such a program “would constitute a direct and sizable gift from taxpayers to the largest banks”, “another backdoor bailout for the banks that brought you the mortgage crisis”, and “another stealth bank bailout, courtesy of taxpayers”.

Don’t worry, Morgenson does actually spell out her thesis here. In her 1,170-word column, she spends a full 65 words explaining exactly how principal writedowns are in fact a “direct and sizable gift” to banks. So I may as well quote those words in full:

Many banks hold second liens on the same properties for which Fannie and Freddie either own the first mortgage or have guaranteed. If principal amounts on these first mortgages are reduced while leaving the second liens intact, those seconds become much more likely to be paid off over time. With no principal reduction, the banks would have to write off many of those second liens.

That’s it. I don’t know what your idea of a “direct gift” is, but I’m pretty sure it’s not this. Even if Morgenson’s argument here made sense, which it doesn’t, the gift would at best be indirect. And there’s nothing here at all indicating that it’s sizable.

More to the point, Morgenson’s whole argument, such as it is, is based on a classic straw man — that the holder of the first lien would be perfectly happy to write down a large chunk of what they were owed without any kind of write-down whatsoever on the part of second-lien holders. As far as I know, nobody advocating principal reductions is proposing this.*

It’s worth remembering here, that the whole point of principal reductions is that when people are underwater on their homes, they’re much more likely to default than when they have equity in their homes. If you reduce principal to the point at which the homeowner has positive equity again, then you’re more likely to get repaid, and you can end up with a more valuable loan than one with a higher face value.

But if there’s a second lien on the house in question, then even if the first lien is reduced to less than the value of the property, the homeowner would still be underwater, thanks to that second lien. Which would quite literally defeat the purpose of reducing the principal on the first lien.

Banks holding first mortgages negotiate with banks holding second mortgages all the time. If the homeowner is in default, then the owner of the first lien is in a strong negotiating position: they can foreclose on the home, sell it, and take all the proceeds, leaving nothing at all for the holder of the second lien. And because the second-lien holder is well aware that the first-lien holder has that nuclear option, they’re normally well disposed to negotiate: they’ll accept $5,000, say, to write off their debt.

Why does Morgenson think that wouldn’t happen here? She doesn’t say — after all, her entire argument is just 65 words. But she does go on at some length about the loan modifications which we are seeing from Frannie — more than 1.1 million, to date, with an impressively low redefault rate. She writes:

This suggests that the types of loan modifications provided by Fannie and Freddie — reducing borrowers’ monthly payments — are working fairly well. Addressing borrowers’ ability to repay loans has been the focus, Mr. DeMarco said. At the same time, these changes in loan terms do not encourage people to default in spite of being able to pay.

What Morgenson doesn’t seem to realize, here, is that exactly the same argument that she’s marshaling against principal reductions could be used against loan modifications as well. If you reduce borrowers’ monthly payments, and increase their ability to repay their loans, then quite obviously you’re also increasing their ability to repay second liens as well. And if you do a loan modification rather than foreclose on the delinquent borrower, then the second lien holder isn’t wiped out and the homeowner can continue to pay off their second lien over time.

So how is it that principal reductions are a giveaway to banks, but loan modifications aren’t? Morgenson even says that loan modifications don’t encourage people to default on their original loans, which would seem to be an argument for principal reduction: the moral-hazard argument, that such things only serve to give people an incentive to default, seems already to have been disproven with the loan-modification program.

Remember, too, that Morgenson said in her 65-word argument that “with no principal reduction, the banks would have to write off many of those second liens”. Something doesn’t add up here. After all, banks will never voluntarily write off a second lien if the homeowner gets a loan modification which increases their ability to repay their debts. So if Frannie is great at loan mods, then they must also be great at forcing second-lien holders to write off their loans at the same time. But if they can do that with a loan mod, they should be able to do it with a principal reduction, too. And if they don’t do that with loan mods, then the banks wouldn’t otherwise be forced to write off those second liens.

And we haven’t even touched, yet, on the most obvious and silliest part of Morgenson’s case — which is that most of Frannie’s delinquent mortgages don’t have second liens attached. DeMarco doesn’t like the idea of doing principal reductions on homes with second liens? Fine, don’t do it, then. But that’s no reason not to do principal reductions on loans without second liens.

More generally, DeMarco is just the regulator, here — he’s not actually running Fannie and Freddie. If he lifted his injunction on principal reductions, then we wouldn’t suddenly see a huge influx of the things overnight. These agencies move slowly and deliberately, and they’d almost certainly start small, and only on homes where there weren’t second liens. If that program worked, then they’d expand it, taking just as much care in doing so.

Morgenson’s argument implies that were it not for DeMarco holding back the floodgates, Fannie and Freddie would be doing principal reductions on a massive and reckless scale, without even trying to involve banks holding second liens. She has no reason to believe this, because it isn’t true. The agencies might be philosophically inclined — for good reason — to do principal reductions, but only when and because they make financial sense. DeMarco, on the other hand, seems to have some kind of quasi-religious belief that principal reductions never make financial sense. And his arguments to that effect are extremely weak.

But not as weak, it must be said, as Morgenson’s effort today. If principal reductions really would be “a direct and sizable gift from taxpayers to the largest banks”, then the largest banks would surely be pushing loudly for their implementation. But they’re not. Because the principle beneficiaries of principal reductions are not banks, but rather homeowners — the people whom Gretchen Morgenson wants to see continuing to suffer under the weight of mortgages worth far more than their homes. And all because of some inchoate and irrational animus she has towards Fannie and Freddie.

*Update: Anthony Coley at Treasury emails to say that Geithner “has tremendous respect for Mr. DeMarco”, even as he thinks “there’s a pretty strong economic case for principal reduction as part of a strategy to limit the future losses of the GSEs. What Treasury is trying to do is encourage Mr. DeMarco, who is fully independent, to take another look at the evidence because we think there’s a place to do more in a way that is consistent with the mandate that Congress gave him.”

And Shahien Nasiripour, who’s been getting the same line from DeMarco, points out that there is at least one person who thinks that principal reductions should be done absent write-downs on second liens: NY Fed president William Dudley.

It’s principal-writedown day today! Jesse Eisinger has uncovered a huge story: that internal analyses at both Fannie Mae and Freddie Mac show that reducing principal on troubled mortgages has a “positive net present value”. That of course directly contradicts the testimony of Frannie’s regulator, Ed DeMarco — but it’s now going to be much harder for DeMarco to maintain his position that principal reductions would never help Frannie’s finances.

Meanwhile, Bank of America has launched a pilot scheme which is a variation on the theme of principal reduction. Remember that by far the most common form of principal reduction is the short sale — and it’s also the most damaging form of principal reduction, since homeowners invariably have to leave their homes when they do one. Under BofA’s new scheme, however, that’s not the case: the bank would buy the property from the homeowner, but would then immediately turn around and rent it back at a market rate.

This idea is hardly a new one. It’s known under many names, including Right to Rent, and dates back at least as far as August 2007, when it was proposed by Dean Baker. I’ve been bashing away at it for years myself, but I’d pretty much resigned myself to the idea that it wasn’t going to gain traction.

So what changed? The markets did. The WSJ’s charts show how home prices have been falling even as rents have been rising:

The left hand chart, here, shows why banks don’t want to foreclose: prices are still very depressed, making homes extremely hard to sell. The right hand chart, on the other hand, shows why banks might find the rental market rather attractive. Banks have no particular interest in being landlords, but if they can do right-to-rent deals with a large number of homeowners, they can bundle those deals up into a big package, and sell it off to investors searching desperately for yield. And that could make the banks much more money than trying to sell the houses off one by one.

The WSJ explains how the BofA scheme works:

Borrowers would agree to a what is known as a “deed-in-lieu” of foreclosure, where they essentially sign over ownership of the property to the lender. This is less costly to the bank and also does less damage to a borrower’s credit than a foreclosure.

In exchange, former owners would be offered one-year leases with options to renew the leases in each of the following two years at rents that the bank determines are at or below the current market price. Borrowers would have to demonstrate an ability to pay the market rent.

For example, based on a sampling of home values and rental rates in Phoenix recently, a consumer with a $250,000 mortgage and monthly payments of $1,600 could swap the house for a lease, renting the home for $900, depending on the condition of the property and the neighborhood…

Borrowers selected for the program must be at least two months past due on their mortgage and face considerable risk of foreclosure. Bank of America is reaching out to borrowers who have exhausted other alternatives to foreclosure or who haven’t responded to earlier solicitations. Homeowners with second mortgages or other liens won’t be selected.

This is a far cry from a right to rent a home that has been foreclosed, of course. All of these self-imposed rules seem silly to me: I would much rather see a scheme where BofA simply declares that anybody facing foreclosure will have the right to rent back their home from the bank at a market rate once the home is owned by the bank. If they fail to make their rent payments, then they can be evicted just like any other delinquent renter.

I’d also love to see BofA extend this scheme to include renters in houses being foreclosed. Rental homes are homes too, and people shouldn’t get kicked out, especially not if they’ve been making all their rent payments on time, just because their landlord had mortgage problems.

The real reason for this pilot scheme, I suspect, is just that BofA is very worried about its legal ability to foreclose on houses. The difference between a foreclosure and a deed-in-lieu operation like this one is that a foreclosure is involuntary on the part of the homeowner, who retains lots of legal rights. A deed-in-lieu, by contrast, is something the homeowner must agree to, and therefore doesn’t present nearly as many legal obstacles.

In any case, let’s hope that the pilot works, and is copied by other banks around the country. It’s about time.

It’s becoming something of a tradition for presidential candidates to (a) ritually attack high gasoline prices as being all manner of evil; and (b) suggest that there’s something the President can do to bring them down. Four years ago, both John McCain and Hillary Clinton supported the idiotic gas tax holiday; now, it’s Rick Santorum’s turn.

Calling for the United States to aggressively tap domestic energy sources, Rick Santorum said Monday that the nation’s economic crisis four years ago was caused by high gas prices.

“We went into a recession in 2008 because of gasoline prices. The bubble burst in housing because people couldn’t pay their mortgages because we’re looking at $4 a gallon gasoline,” he said. “And look at what happened: economic decline.”

This conjures up visions of the Santorum Strategy for economic growth: first, start blowing bubbles. Second, prevent anything which might possibly burst those bubbles from ever happening. Result: permanently bubblicious growth! What could possibly go wrong.

Any self-respecting economist, upon seeing this kind of logic, should and would run very far in the opposite direction. Unless, of course, that economist’s name is Steve Sexton. Santorum’s remarks “may sound far-fetched”, he writes, “but it is precisely the theory that I and a pair of coauthors presented in a working paper released five days before Santorum’s remarks.”

Oh dear.

Both the paper and Sexton’s blog post are titled “How High Gas Prices Triggered the Housing Crisis”, and both are very silly. Sexton actually articulates the Santorum Strategy in his blog post:

While the prevalence of risky loans made the housing market susceptible to collapse, had home prices kept rising in 2007, instead of turning down, rising home equity could have been used to renegotiate risky loans, thereby concealing and even resolving the market weaknesses.

Translation: if home prices had kept on going up in 2007 rather than going down, then we wouldn’t have had a housing-market crash. Thank you, Professor Sexton. That’s a bit like saying that if the price of technology stocks had kept on going up in 2000 rather than going down, we wouldn’t have had a stock-market crash. Sexton’s only venture away from banal tautology here is when he suggests that rising house prices could have “resolved” the weakness in the market — despite the fact that America in general, and California in particular, was full of subprime borrowers with no way of ever paying back the amounts they had borrowed. Extending the housing bubble for a year or two longer would only have perpetuated the Ponzi and made things even worse.

So even if it’s true that rising gas prices pricked the housing bubble and caused it to burst, we should be thankful that gas prices went up when they did: they saved us from an even more painful market crash a few months or years down the road.

But of course it’s profoundly silly to even try to identify the proximate cause of a bursting bubble. That’s what bubbles do, is burst. They all do it, sooner or later, for any reason or no reason. “Even the eminent bubble expert, the economist Robert Shiller, concedes we don’t know why the housing bubble burst when it did,” writes Sexton, as though this is evidence that Shiller just isn’t clever enough to have Sexton’s piercing insight about gas prices. In fact, what Shiller is saying isn’t really a concession at all: it’s an integral part of his thesis. You might be able to identify bubbles — Shiller certainly has a good track record on that front — but you can’t identify when or why they’re going to burst. Or, as John Maynard Keynes famously put it, “the market can remain irrational far longer than you or I can remain solvent”.

On some level, then, it doesn’t even make sense to say that bubble-bursts have a cause. For one thing, there’s absolutely no way to demonstrate causation, as opposed to simple chronological sequencing. And more generally, if a cause could be anything from rising gas prices to worries over Chinese drywall to a butterfly flapping its wings in Tokyo, trying to pin down a single cause is the ultimate fool’s errand.

But Sexton is a determined chap, and so he pulls out all manner of extremely odd arguments to buttress his thesis. For instance:

There is no doubt that subprime lending and speculation fueled demand for housing assets. But these are uniquely American phenomena. The housing boom and bust is not. A similarly volatile cycle was observed in Britain, Spain, France, and Ireland, among other countries that while not exposed to the aggressive lending in the U.S. would have been affected by global energy market dynamics.

In other words, you can’t blame subprime for the housing bust, since subprime happened only in America, but the housing bust was global. Since energy prices are global, on the other hand, they can explain the housing bust everywhere.

One big problem here, of course, is that if energy prices are global, then there’s really not anything the government can do about them, and the whole Santorum line of argument more or less falls apart. The second problem is that Sexton isn’t really talking about energy prices, he’s talking about gasoline prices. Which are something else entirely. Let’s look at gasoline prices in the UK, shall we?

As you can see, they’ve had a big run-up of late, but they hit a low point around the beginning of 2009.

Now, let’s have a look at the annual change in residential property prices in the UK:

The first thing to note here is that the big picture is pretty much the same in London as it is in England and Wales more generally. But London is pretty much immune from Sexton’s theory of property prices, which is that they fall when gasoline price hikes increase commuting costs. Londoners commute, but they don’t generally commute by car.

The second thing to note is that prices were rising until mid-2008, at which point they started falling, with the fastest rate of decrease coming in early 2009. Which happens to coincide with the low point of gasoline prices. The fall in UK house prices coincided with the big fall in UK petrol prices, not a rise.

Meanwhile, if Sexton’s blog post seems to have a weak grasp on the global, his paper errs far too much in the opposite direction, obsessing about house prices in California to the exclusion of just about everything else. Yes, prices in California suburbs fell a lot during the housing crash — and I daresay that an increase in the cost of commuting was part of the reason why. But that doesn’t mean that movement gasoline prices caused the national housing bubble to burst: it hardly, for instance, helps explain the price action of condos in Miami Beach.

All of which leaves just one big question: why on earth would a Berkeley economics professor publicly aligning himself with the primary-campaign rhetoric of Rick Santorum? I haven’t a clue on that one.

The WSJ has an interesting if unsurprising article today, showing that expensive homes are less likely to be foreclosed on than cheaper homes.

This stands to reason, of course. For all the talk of strawberry pickers buying McMansions at the height of the subprime bubble, expensive homes are much more likely to be owned by rich people than cheap homes are. And if a rich person owes a bank somewhere north of a million dollars, the bank is likely to be quite aggressive in attempting to get all of the money it’s owed, rather than simply letting the borrower walk away from their house. For a $200,000 house, by contrast, the cost of aggressively pursuing the homeowner is much less likely to be worth the marginal benefit.

On top of that, there’s a reasonably liquid market for smaller homes — if you put them on the market in a fire sale, there’s a good chance that they will sell, quickly, for within $25,000 or so of their fair market price. In the million-dollar-plus range, however, homes stay on the market much longer, the discounts for fire sales are larger, there’s no real rental market, and the cost of maintaining the home while it’s unsold can be substantial.

That said, there is a problem here, and it’s not that people in expensive houses get to live rent-free for 792 days on average. Rather, it’s that people in normal-sized homes are treated unnecessarily badly by Fannie and Freddie.

Smaller mortgages are more likely to be bundled into securities and later resold to investors with backing from Fannie Mae and Freddie Mac. Fannie and Freddie, the government-controlled mortgage giants, have set strict foreclosure timelines and will fine mortgage servicers that are found to be needlessly delaying the foreclosure process.

There’s no reason why mortgage workouts should be long, drawn-out affairs. Indeed, if you’re going to do some kind of restructuring, it’s always better to do it sooner rather than later. But the fact is that the big banks in America are pretty incompetent when it comes to these things: they lose paperwork all the time, they don’t provide a single point of contact for homeowners, their left hand doesn’t know what their right hand is doing, etc etc. But here’s the problem: as all those obstacles and delays get thrown up, the banks get ever closer to the Frannie-imposed deadline, and are effectively forced to foreclose even if they have good workout options. Freddie Mac tells the WSJ that it requires mortgage servicers to “explore every possible avenue to help a struggling borrower avoid foreclosure” — but if at first that servicer messes things up, Freddie’s far from sympathetic about giving them time to try to rectify the error.

It gets worse. The WSJ piece includes the story of Virgilio Wani and his wife, who became delinquent on their mortgage when they both lost their jobs. As soon as Mr Wani got a part-time job, he tried to start making payments again, but the bank refused those payments and foreclosed instead, handing title to Freddie Mac. What did Freddie Mac do with the house once it had title? First, it evicted the Wanis. Then, it started talking to them about a loan modification. Not to put too fine a point on it, this is the wrong way round.

It’s entirely possible that Freddie Mac and the Wanis will find a solution which allows the Wanis to get back the title to their home. So long as that’s a possibility, the Wanis should absolutely remain in their home: evicting them does nobody any good at all.

It’s a perennial frustration to me that foreclosure always and everywhere seems to be followed immediately by eviction. That’s just stupid, for all concerned. Kicking people out of their home creates a lot of deadweight losses which can’t ever be recovered. In a case like this one, where there’s a good chance that the original homeowner will regain title, the best solution is clearly for that family to remain in the home until the situation is resolved one way or the other.

But even when there’s no chance of the former homeowner being able to buy their home back, it still makes sense to keep that family in their home. These days, many if not most of the people buying homes out of foreclosure are buying those homes to rent out, rather than to live in. And it makes perfect sense to rent the home to the family which has been living there for years, if you can. It’s always worth a try.

So for me the important thing isn’t the amount of time between delinquency and foreclosure, but rather the amount of time between delinquency and eviction. Let’s allow families to stay in their homes even after they’ve been foreclosed upon, unless and until the home is sold to someone who doesn’t want to keep that family on as renters. It would improve the quality of life for millions of people, and would create economic value at the same time. What’s not to love?

The long-awaited mortgage settlement is here! And it looks like a good one. The biggest worry was that the attorneys general would give away the shop in return for big headlines. While in fact they seem to have been quite successful at limiting the immunity that the five banks (Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial) are going to receive:

In the agreement’s expected final form, the releases are mostly limited to the foreclosure process, like the eviction of homeowners after only a cursory examination of documents, a practice known as robo-signing.

The prosecutors and regulators still have the right to investigate other elements that contributed to the housing bubble, like the assembly of risky mortgages into securities that were sold to investors and later soured, as well as insurance and tax fraud.

Officials will also be able to pursue any allegations of criminal wrongdoing. In addition, a lawsuit Mr. Schneiderman filed Friday against MERS, an electronic mortgage registry responsible for much of the robo-signing that has marred the foreclosure process nationwide, and three banks, Bank of America, JPMorgan Chase and Wells Fargo, will also go forward.

Along with how broad the releases would be, California’s attorney general, Kamala Harris, also pushed for her state to be able to use the state’s False Claims Act. That would enable state officials and huge pension funds like Calpers to collect sizable monetary damages from the banks if officials could prove mortgages were improperly packaged into securities that later dropped in value.

If you’re a bank shareholder breathing a sigh of relief, then, don’t. The only thing you’re protected against, now, is lawsuits over robosigning. Were those likely to cost $25 billion if they had gone to court? It seems unlikely to me that they could have raised that much. Other big-money lawsuits over securitization can and almost certainly will still be brought — which means that the big banks all still have significant litigation risk hanging over their heads.

So why did they do this deal? Well, for one thing, it’s not nearly as expensive as it might look at first glance. It’s not like they’re paying out $25 billion and getting nothing but a bit of immunity in return. A huge chunk of the money will go towards principal reductions on underwater mortgages — which means that it’s not really a cash outlay at all.

Let’s say I lent you $350,000 to buy a house, and that house is now worth only $250,000. I’m holding that mortgage on my books at par, but if I sold it there’s no way I could get $350,000 for it, or even $250,000. I give you a principal reduction of $40,000, so that you now owe $310,000. That’s good for you — which is why the settlement is a welcome development. And it means that I have to take a $40,000 write-down on my balance sheet. But the mortgage is still being held on my books at $310,000, which is still more than I could have sold it for before the write-down.

In other words, what’s happening here is that the mortgage settlement is at heart largely just encouraging banks to bring their balance sheets closer to reality — which is something they’d have to do sooner or later in any case. Indeed, insofar as principal reductions can increase the value of a mortgage, this deal is actually making banks money, over the long term.

So think of this as that rarest of settlements, one which really is a win for all sides. The attorneys general get a big deal, homeowners who got foreclosed upon get $2,000 apiece, and the banks get to do the kind of principal reductions they probably have wanted to do for a while, but while getting significant immunity from prosecution at the same time.

Now, I guess, we just wait and see what happens with all the other possible prosecutions and lawsuits, especially in New York and California. And, of course, from the FHFA.

Prashant Gopal has an intriguing story today on the way in which banks are not only doing more short sales than they used to, but are even throwing in cash sweeteners to speed things along. Why would they be doing such a thing? The banks aren’t saying, but theories abound:

Lenders can often afford to forgive debt, offer the incentive and still make a profit because they purchased the loan from another bank at a discount, said Trent Chapman, a Realtor who trains brokers and attorneys to negotiate with banks for short sales…

Cecala of Inside Mortgage Finance said he wonders whether lenders are making big payments on properties with underlying title problems. Evan Berlin, managing partner of Berlin Patten, a real estate law firm in Sarasota, Florida, said representatives of a large bank told him the incentives are primarily given to borrowers when it doesn’t have the proper paperwork needed to win its foreclosure case.

It certainly rings true that banks are more likely to take losses on a loan when they purchased that loan at a discount. We saw that with principal reductions, last year, and it’s no surprise that it might be moving into short sales too.

More generally, it makes sense that once a homeowner has been living in their home for a year or more without making any kind of rent or mortgage payments, they start getting quite comfortable with that lifestyle, and become rather difficult to dislodge. Cash incentives can work much better than lawsuits, especially when there are title problems.

Frankly, the banks brought this on themselves. It’s well known in mortgage-servicing circles that the faster you move, when a mortgage goes into default, the more money you can save. But too many banks have let far too many mortgages fester in default for far too long — which means that all too many of them are all but worthless at this point.

What the banks should have done, when these mortgages went into default, was work with the homeowners, giving them a menu of options. Would you like to do a short sale? Would you like a modification, with lower monthly payments? Would you like some kind of principal reduction? Would you even be interested in some kind of deal where you sell your house and then get to rent it back from the new owner?

Instead, the banks did nothing, rebuffed attempts from homeowners to contact them and work something out, and generally said no to innovative ideas. Leaving them much worse off, and forced to resort to actions like this:

JPMorgan gave one Phoenix homeowner $20,000 after she sold her property in June for $32,000, according to Royce Hauger, the real estate agent who represented the seller and shared a copy of the settlement sheet with Bloomberg News. The bank also agreed to forgive more than $70,000 in debt, she said.

As such deals continue, and the homes then get dumped onto the market at any price, they will only serve to further depress the US housing market more generally. What’s more, they’ll act as an incentive for homeowners to stop paying their mortgage and start holding out for a big check in return for leaving their homes quietly. The whole thing is an unholy and unnecessary mess. Although I’m shedding no tears at all for the banks, who are admittedly the biggest losers.

Jesse Eisinger is back with a follow-up to his original piece about Freddie Mac and the inverse floaters; he’s also left a long comment on this blog, responding to various criticisms of his story which appeared in the blogosphere.

There are two main pieces of new information in the update. The first is that the size of Freddie’s inverse-floater position is even greater than we previously thought — $5 billion, rather than $3.4 billion. And the second is that the FHFA forced Freddie to stop making these trades last month, before the original ProPublica piece appeared. Now the FHFA, under Ed DeMarco, is a highly obstructionist agency which will always protect Frannie’s short-term interests over the broader health of the housing market and American homeowners. If even the FHFA was expressing serious concerns about these deals, that’s very strong evidence that something fishy was going on.

To get a feel for the tenor of the debate, check out the official FHFA response to Eisinger’s story:

The inverse floater leaves Freddie Mac with a portion of the risk exposure it would have had if it simply held the entire set of mortgages on its balance sheet. The CMO structuring activity results in some portion of the mortgage cash flows being sold off and a smaller amount needing to be financed by Freddie Mac with debt securities. It also results in a more complex financing structure that requires specialized risk management processes.

And here’s Eisinger, in his comment on this blog:

[Freddie] could have sold MBS on its portfolio outright and rid itself of the prepayment risk. The market for simple MBS with a government guarantee attached is liquid and deep – and certainly was then, in late 2010 and early 2011 when Freddie’s inverse floater bets ramped up.

Instead Freddie had the securitization structured, then retained the inverse floater portions. In other words, Freddie undertook transactions in which it retained a piece of a newly created deal that has basically the same risk profile as the original holdings. And what Freddie retained carried new risks: liquidity and LIBOR risks. Freddie engaged in reverse alchemy: it turned a position of gold into lead.

Moreover, these trades didn’t happen in a vacuum. Freddie is under a mandate to sell down its portfolio. Implicit in that mandate is that Freddie reduce its risk. In these trades, Freddie sells something notionally, so that the assets on its balance sheet fall, but it keeps most of the risk — and adds new risk. That raises the question of whether it is subverting the spirit, if not the letter, of its agreement with the U.S. Treasury.

I’m with Eisinger on this one. Let’s say you own a big house with a cottage in the back, which you’re renting out to tenants. And let’s say that you’ve been ordered to sell as many assets as you can. You can sell your property easily to homeowners who will be happy to take the rental income on the cottage. They know that the tenants can move out any time, so they won’t pay a huge premium for the cottage, but they will pay you extra for it.

Instead, you go to a very expensive lawyer and you carve your property up into two pieces. You then sell off the house, but hold on to the cottage yourself. You get less money for the house than you would have done if you’d simply sold the whole property. And what’s more, you now own a cottage, on its own, which is much harder to sell than either the house was, on its own, or the big house-plus-cottage property was before you split it into two.

The FHFA’s argument is, basically, “look, the cottage is smaller than the original property and the total risk associated with the cottage is, by definition, lower than the total risk associated with the cottage-plus-house original property. So we’re selling off assets, just like you asked.”

But this doesn’t make sense. Why go to the trouble of breaking the property up into constituent parts, at non-negligible expense, only to hold on to the more illiquid of those parts? If the sum of the parts were worth more than the whole, I could see it: breaking the property up makes sense if you sell the house to one person, the cottage to another person, and end up with more money than you could fetch for the property as a whole.

But that’s not what happened, because of the simple arbitrage in the markets: there are lots of traders out there happy to break up mortgage securities if doing so is profitable. There’s no need or reason for Freddie to start doing that itself.

It seems to me that Eisinger is right and that Freddie is violating the spirit of the Treasury’s instructions. Treasury wants Freddie to sell down and derisk its balance sheet. Freddie, in response, started selling down its balance sheet, but kept as much risk as it possibly could, in the form of inverse floaters.

And does anybody really believe that Fannie and Freddie should be taking on more risk, in relation to the size of their balance sheets? I’m sure that doing so is good for the annual bonuses of someone getting paid $2.5 million a year to run Freddie’s mortgage portfolio. But it’s unlikely to be a good idea for anybody else.

As for the now-famous Silversteins, the couple who aren’t being allowed to refinance their property — well, that addresses the one case where it does make sense for Freddie to be taking on this prepayment risk. And that’s the case where Freddie itself controls the rules as to whether or not homeowners are allowed to refinance.

To go back to that property with that cottage, suppose that if you sold the property with cottage attached, the new owner would have no control over whether or not the tenants in the cottage moved out. But you, the seller of the property, do have control over the tenants — you can force them to continue paying rent in a manner that the new owner can’t. In that case, it makes sense for you to hold on to the cottage, because it’s worth more to you than it is to anybody else.

And that’s what Eisinger was alleging in his original piece. That the only reason it makes sense for Freddie to do these complex trades which leave it with significant holdings of inverse floaters, is that Freddie actually controls whether or not people like the Silversteins are able to refinance and thus prepay their mortgage. And because Freddie has that control, inverse floaters are worth more to Freddie than they are on the open market.

Basically, Freddie can’t have it both ways. Either it is preventing the likes of the Silversteins from refinancing so that it can maximize the value of its inverse floaters or it has no particular reason to carve up its mortgage securities and retain an illiquid inverse-floater tranche. Which is it to be?

Jesse Eisinger and Chris Arnold have a really good story about Freddie Mac today, a company which is preventing mortgage refis at the same time as it’s making enormous prop bets that homeowners are going to continue to find it hard to refinance.

Back in September I noted that mortgage bonds are trading well above par just because investors are well aware that refis are hard to come by for many homeowners, and said that those investors were “taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates”. What I never dreamed of was that the investors and the rule-setters were the same people — in this case, Freddie Mac.

But here’s what Freddie is doing. In the past two years, it’s bought $3.4 billion of hugely-risky “inverse-floater” notes — essentially bets that homeowners with above-market mortgage rates won’t be able to refinance to market rates. And then it turns around and implements rules which prevent homeowners like Jay and Bonnie Silverstein from refinancing. The Silversteins have made all their mortgage payments on their current home in full and on time, despite the fact that they’re paying an interest rate of 6.875%. They’d love to refinance to get that rate lowered, but Freddie Mac won’t let them — because of the way they sold their previous home.

The Freddie Mac rule certainly maximizes Freddie Mac’s income, but it’s dreadful and unfair public policy. At the same time, it’s also policy which is very much in line with the FHFA’s stance on principal reduction, or anything else which might help homeowners. Given the choice between extracting short-term cashflows from homeowners, on the one hand, and improving the all-over health of the housing market, on the other, the FHFA will always choose the former.

Check out the long-awaited letter from FHFA director Ed DeMarco, for instance, justifying the fact that he won’t allow Frannie or Freddie to do principal reductions. It’s basically a long list of tables with precious little annotation or explanation, but at heart it seems to be based on two ideas. The first is that if you reduce principal to 115% of the value of the home, that doesn’t help very much. Well, duh. The whole point of principal reduction is to give homeowners back some equity in their home, and if they’re still underwater, you’re not doing that. And the second reason is just that Frannie’s computer systems aren’t really set up for principal reductions:

Neither Enterprise can accommodate the new accounting and tracking of principal reduction without operationally challenging changes to the existing IT systems, which are outdated and inflexible. The team did not require the GSEs to provide FHFA with cost projections, but experience implementing the HAMP program suggests that each Enterprise would need substantial funds and would rely upon scarce personnel resources to make the necessary IT modifications.

This is pretty desperate stuff — “we don’t know what the IT costs might be, and we didn’t bother to try to find out, but trust us, they’d be substantial”. In the wake of ProPublica’s story today, I don’t trust the FHFA at all. It signed off on all of Freddie’s trades, and its actions are entirely consistent with a regulator perfectly happy with Frannie taking on massive bets at the expense of homeowners, just to try to make some extra money. Oh, and the chap at Freddie in charge of buying these inverse floaters is paid $2.5 million a year.

It’s all quite a disgusting spectacle, really. Matt Levine attempts some kind of defense of Freddie’s actions, based on the idea that the inverse floaters are just what’s left after Freddie sells off everything it can easily sell — but that’s not what actually happened. In fact, Freddie went out and bought these instruments, on the open market. It almost looks like inside trading: they’ll pay off handsomely, just so long as Freddie continues to make it hard for homeowners to refinance. Which means that refinancings in general, and principal reductions in particular, are still going to be rare to nonexistent going forwards. Which is bad for homeowners, bad for the housing market, and bad for the economy as a whole. Even if it’s good for Freddie’s prop book.

The shape of a possible settlement with the banks over mortgage fraud has never been clearer. But neither has the fact that it’s not going to happen any time soon. And without a deal in hand, Barack Obama ended up making a different announcement in his State of the Union address:

Tonight, I’m asking my Attorney General to create a special unit of federal prosecutors and leading state attorney general to expand our investigations into the abusive lending and packaging of risky mortgages that led to the housing crisis. This new unit will hold accountable those who broke the law, speed assistance to homeowners, and help turn the page on an era of recklessness that hurt so many Americans.

Sam Stein has the details — but suffice to say that this is a new investigation, with no fewer than five co-chairs, which will run in parallel to the existing DoJ investigation:

The unit will not supersede the efforts already underway by the Department of Justice. Instead, it will operate as part of the president’s Financial Fraud Enforcement Task Force. In addition to Schneiderman, the unit will be co-chaired by Lanny Breuer, assistant attorney general at the Criminal Division of the Department of Justice, Robert Khuzami, director of enforcement at the SEC; John Walsh, a U.S. attorney in Colorado, and Tony West, assistant attorney general in the Civil Division at DOJ.

To recap: we were meant to have a settlement by now. And instead of a settlement, we’ve got yet another investigation, where the aggressive New York attorney general looks as though he’s in the minority with respect to punishing the banks for their misdeeds.

The settlement as it looks right now has a reasonably large headline figure attached — $25 billion — but most of that is principal reductions which would make a lot of sense for the banks even if there were no settlement at all. In fact, there’s a case to be made that the settlement talks have delayed much-needed principal reductions. If you’re a bank in settlement talks and you want to do across-the-board principal reductions while removing yourself from legal jeopardy, of course you try to connect the former to the latter. After all, principal reductions plus immunity from prosecution looks much more attractive than principal reductions on their own. And the government can’t announce a big settlement figure if the banks have already reduced the principal on a lot of mortgages anyway.

But frankly any settlement now looks just as far away as ever. After all, there’s no point in setting up a new investigation to hold banks accountable, if we’re about to see a settlement which prevents any law-enforcement body from doing that.

So expect the status quo to continue, probably through 2012: banks with huge contingent legal liabilities hanging over their heads and their stock prices, and the government holding back on prosecutions as it attempts to cobble together a global settlement. It’s a recipe for uncertainty and gridlock and banks hoarding their money rather than lending it out. New investigations are all well and good, but I can’t help but think that it’s a bit late to be launching them in 2012. This should clearly have been done in 2008, or 2009 at the latest.

It makes sense, for lots of reasons, to make your mortgage payment on the day you get paid. Most salaried Americans, however, get paid every two weeks. Which means, to all intents and purposes, that you need to be able to make one mortgage payments out of every two paychecks. And that in turn raises an intriguing possibility: if you take half of your mortgage payment out of every paycheck, you’re going to end up making 13 mortgage payments a year. Which will pay down your mortgage faster, and could save you thousands of dollars.

Enter the ever-helpful Citibank, with a product which does just that. It’s called The BiWeekly Advantage Plan®, and it’s essentially an automated mortgage payment, of half your monthly mortgage payment, which comes out of your account every two weeks. Easy. There’s even a Savings Calculator to see how much less money you might be able to end up paying.

And then, of course, there’s this:

There is a one-time non-refundable enrollment fee of $375 and a transaction fee of $1.50 for each draft.

That’s an up-front fee of $375, plus another $39 a year, just for the privilege of making your mortgage payments every two weeks rather than every month.

I asked Citi about this, and got a statement back from spokesman Mark Rodgers:

The BiWeekly Advantage program is completely optional. Borrowers may make additional payments on their principal balance independently anytime they like. Some customers, however, prefer the convenience of a disciplined payment plan that is administered for them. The one-time enrollment fee is reasonable and competitive for a service that requires processing more than double the number of standard payments and can save the customer many thousands of dollars over the life of the loan. We find high customer satisfaction rates among those enrolled in the program, demonstrating that these borrowers appreciate the value proposition of the service.

And it turns out that simply setting up Citi’s own online banking to make the same payments would not do the same thing after all. The reason is that CitiMortgage has a rule that it will only accept a full payment once per month. If you want to pay every two weeks, well, you can’t.

Which helps to reveal another fact: it turns out that Citi is making significantly more than $375 plus $39 per year for this service. Here’s the FAQ:

Payments are remitted to your mortgage company monthly.

The payments are made in arrears, of course. You make your half-payment, and then wait two weeks, and you make your second half-payment, and then the two are bundled up and sent off to the mortgage company (which in nearly all cases is CitiMortgage itself) as a single monthly payment.

Which means that for roughly half the year, Citibank is sitting on an amount of money equal to half your mortgage payment. That money has left your account: it’s not yours any more, and Citi can do with it as it pleases. And Citi gets the float from all that money until it gets around to sending it off to pay off the mortgage.

Basically, Citi is getting a big advantage from you making half your mortgage payment two weeks early — and then it has the chutzpah to charge you hundreds of dollars for the privilege. They even charge you $1.50 per extra transaction, as though that costs them any money at all. (It doesn’t.)

I can still see why people might want to sign up for this service: Citi basically makes it impossible to replicate it on your own, without going through an enormous amount of hassle. But the price is eye-watering, especially given that the service would make Citi money even if it were free. Think for a minute about all the things you can buy with $375. Then ask yourself how Citibank can possibly justify charging that much for this very small, if handy, service. It defeats me.