Felix Salmon

According to the latest Pew survey, only a minority of Americans think that their home has fallen in value since the recession began in December 2007. And the poorer and less educated you are, the less likely you are to think your home has fallen in value:

I don’t have hard statistics on this — I don’t know whether they exist or how they would be put together — but I think it’s fair to say that the overwhelming majority of US homes have fallen in value since the start of the recession. Which means, essentially, that most Americans are wrong.

What does this mean? During the boom, Americans were hyper-conscious of how much their homes were worth. During the bust, they’re in denial. This is probably good for national happiness, but it’s also bad for the future of the housing market — and partially helps to explain why houses sit on the market for so long at a price no one is willing to pay.

This syndrome also contributes, I think, to the relatively low rate of jingle-mail, or underwater homeowners simply walking away from their homes and leaving the bank with the house. It’s the economically rational thing to do — but only if you know that you’re underwater. And given that it’s non-trivial to work out how much your house is worth, I can easily imagine that a large percentage of underwater homeowners don’t know that they’re underwater.

While ignorance of depreciated property values seems to be prevalent everywhere, it’s particularly common among those who didn’t go to college and those who earn less than $30,000 per year. (I don’t believe Pew’s statement that “the recession-era decline in home values has hit those with higher annual household incomes harder than those with lower annual incomes” — not without further evidence, anyway.) It’s probably no coincidence that these are exactly the people who were most likely to be sold unsuitable subprime mortgages: if you’re looking to rip someone off, it’s a good idea to look for a mark who doesn’t have the education or sophistication to understand what you’re doing.

Now here’s the kicker: if you asked me the question in the poll (“Thinking about the recession, which began in December 2007, is your home worth more or less NOW than it was BEFORE the recession began, or is it worth about the same?”) about my own place in New York, I’d probably say it was worth more. I don’t honestly know: I wasn’t particularly following the East Village property market in December 2007, and I’m not doing so now, either. But hey, that tide of money sloshing out from the New York Fed has surely had some effect, no? And it feels nice to think that I — just like everybody in Lake Wobegon — am bucking the national trend. Evidently a lot of other Americans feel much the same way.

Cheyenne Hopkins of American Banker, who first published the terms of the proposed mortgage servicer settlement in March, has now got her hands on a ridiculous paper from Charlie Calomiris, Eric Higgins, and Joseph Mason, which says that the settlement is a bad one which could cost the economy $10 billion a year.

You only need to look at the bottom of the first page of the paper to see where this thing is going.

First of all, there’s nothing in the proposed settlement saying that principal write-downs should be conducted “regardless of borrower distress.” To the contrary, the talk of principal reductions explicitly applies only to delinquent mortgages. Which actually the authors know full well, since on page 10 they say that “the settlement’s approach to loan modifications would encourage strategic default.” They can’t really have it both ways.

As for the fact that the paper was bought and paid for by the very banks opposing the settlement, Mason tells Hopkins that “we never allow any funder to dictate our conclusions.” But of course he doesn’t need to, since the authors know full well what they’re expected to produce. It’s basically a variation on that notorious Greenspan op-ed: attempts to regulate the financial services industry have failed in the past, therefore there’s no point in even trying any more.

Some of what the authors write about loan servicers defies belief:

NPV calculations are already used by servicers, exercising their fiduciary duty to maximize the value of payouts to investors, in determining whether a borrower qualifies for a loan modification…

That servicers have not modified more loans indicates that, under their NPV analyses, additional modifications would not result in higher payouts for investors, despite the benefits of avoiding a protracted and expensive foreclosure process…

Servicers already use NPV analyses as a matter of course. If a servicer finds a modification to be NPV-positive, then it will likely modify the loan without any regulatory oversight.

Even bankers aren’t making these arguments with a straight face any more. But, as HL Mencken famously said, there is no idea so stupid that you can’t find a professor who will believe it — and the banking industry, here, seems to have found just those professors.

In fact, this isn’t stupidity: Calomiris et al aren’t stupid. But it’s intellectual dishonesty: they know full well about the various lawsuits and other attempts that mortgage-bond investors are making to get servicers to change their ways, and they also know full well that banks’ servicing departments are badly-run and fundamentally broken. But somehow, after taking a long bath in bankers’ dollars, they’ve managed to persuade themselves that those banks always exercise their fiduciary duty to investors and never foreclose when doing so makes little financial sense. (And, for that matter, they’ve also persuaded themselves that taking large amounts of money to write papers for the financial services industry has no effect on what they end up writing.)

As for the authors’ attempts to quantify the costs of the settlement, they use numbers in the CFPB report uncovered by Shahien Nasiripour which says that “effective special servicing of delinquent loans would have cost 75 bps/yr more than the actual costs incurred” — except the way they put it is very different:

The CFPB recently estimated that five servicers avoided $24 billion in costs between 2007 and 2010, yielding a 75 basis-point reduction in interest rates.

Er no, the CFPB nowhere says or even hints that there was any kind of reduction in interest rates as a result of the banks’ broken servicing operations. (And it wasn’t five servicers, it was nine.)

I’m also particularly fond of the way that the authors calculate the increase in foreclosure inventory brought on by an increase in strategic defaults. “For simplicity,” they say in footnote 48, “we assume all strategic defaults result in foreclosure.”

What?

The entire reason why strategic defaults would go up, according to the paper, is that borrowers will know that if they default, they’ll get a loan modification. And yet somehow by the time we reach footnote 48, all those borrowers are mistaken, and in fact they won’t get a loan mod: they’ll be foreclosed upon instead.

It’s unclear whether this paper was ever intended for public consumption, or whether it’s just something for banks to quietly pass on to their lobbyists, who in turn will show it to lawmakers. But it’s certainly harder to take Calomiris seriously in his attempts to revisit Dodd-Frank when he’s happy churning out hack-work like this which shows him to be completely captured by Wall Street.

How many homeowners are current on their second mortgage while being delinquent on their first? When I wrote about this issue last week, I cited David Lowman, the CEO of JP Morgan Chase Home Lending saying that some 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. That came from his formal Congressional testimony, via Mike Konczal.

But Brad Miller has now sent me a bunch of other datapoints which paint a very different picture.

First up is this paper from the Philly Fed. The numbers here are roughly half Lowman’s 64%: depending on the type of second lien you have (straight second mortgage, home equity line of credit, home equity loan) it seems that somewhere between 24% and 38% of second liens are current when the first liens are in default.

Next comes a research note from Amherst Mortgage Insight. It shows that where the first lien is delinquent, just 12% of second liens are have always been current and outstanding. Fully 73% of seconds have been delinquent at some point, and 15% fall into an “other” category which usually means they’ve been paid off.

Amherst also breaks down the percentages according to lien type: if the first lien is delinquent, then 59% of Helocs have been delinquent, compared to 78% of closed-end second mortgages. This isn’t a pure like-for-like comparison, since there’s a difference between a loan which is performing now and a loan which has never been delinquent. But still, it looks very much as though most second mortgages suffer delinquency if the first is delinquent.

Finally there’s this letter, sent to Miller by the head of the OCC. According to the OCC’s analysis, just 6% of second mortgages were “current and performing but behind delinquent or modified first liens.” (Update: As my commenters point out, this number has a different denominator. In this case it’s 6% of all second mortgages, while in the other cases we’re talking about just the second mortgages which are behind delinquent first liens.)

I’m not going to hazard a guess as to what all these conflicting pieces of information mean, but when the statistics for performing second mortgages behind delinquent first mortgages range from 6% of one thing to 64% of something else, you know that this particular phenomenon is hard to pin down and subject to all manner of statistical manipulation.

It does happen, and it’s pretty clear why it happens: as the Amherst note says, “a failure to pay the 2nd mortgage has a far larger impact on credit availability than a failure to pay the 1st mortgage.” On top of that, first-mortgage payments tend to be large: if you default on them, that clears up a lot of cashflow to pay off your other obligations.

But how often does it happen? That’s much less clear.

Update: Stephen Tenison, the Senior Compliance Officer at Amherst Securities, objected to me posting their research note, so I’ve taken the link down.

Alex Ulam has a must-read article in American Banker which shows the biggest pitfall likely to face the mortgage servicers’ settlement with state attorneys general: enforcement.

AGs in general are much better at prosecutions and at negotiating settlements than they are at keeping close tabs on banks to make sure they’re doing what they agreed to do. On top of that, banks find it much easier and cheaper to simply deny allegations that they’re violating the terms of a settlement, and to fight those allegations in court, than they do to actually fix what’s broken.

The problem seems to be that banks are not entering into these settlements in good faith — as is evidenced by the banks’ behavior following a smaller settlement in 2008.

According to the settlement, a loan mod offer made by B of A in its role as servicer could be turned down if the investor or group of investors that actually owned the mortgage failed to approve the modification. But B of A was in charge of securing investor approval for the loan modifications.

Investor disapproval turned out to be one of the major reasons B of A gave when denying modifications to homeowners eligible for the National Homeownership Retention Program, according to the Arizona and Nevada suits. (Investor disapproval also has been a common reason that servicers have given for denying loan mods under Hamp.) But, according to the Nevada and Arizona AGs, while B of A refused to approve loan mod requests on the grounds that investors would not approve them, the bank, in fact, had in some instances received the delegated authority to make such decisions…

One investor in mortgage securities covered by the Countrywide settlement said that B of A never went through the procedures for obtaining approval or disapproval on loan modifications on the mortgages in the securities he owned.

“I know of absolutely no attempt by Bank of America to reach out to investors either through formal or informal channels,” said William Frey, the CEO of Greenwich Financial Services, a money management company.

This goes back to my conversation with Michael Barr back in November. He was fully cognizant of the issue, saying that “institutions are resistant to change and have difficulty implementing”; I was skeptical that the government had the ability to force these huge organizations to change. (In fact, I’m increasingly of the view that huge organizations simply can’t change that radically and that quickly, no matter how many incentives there might be to get them to do so.)

In any case, if and when any settlement is announced, the first order of business will be to look very closely at the enforcement mechanisms built in to it. If there’s anything less than a dedicated watchdog devoted to holding banks’ feet to the fire in such matters — and which is able to take complaints directly from the public — then I fear that nothing much will happen in reality, and Barr’s dreams of having real change by the end of this year will end up being dashed.

In the wake of my back and forth with Linda Stern, I took the advice of commenter Kid Dynamite and moved the discussion to email. Here’s how it went:

Felix: Why do you think it makes sense to borrow against your house to invest in the stock market? And if it makes sense for people buying houses, why doesn’t it make sense for people owning houses? If I own my home outright, should I take out a mortgage and invest the proceeds in a mutual fund? If not, why not?

Linda: My advice, intended for first time homebuyers who are trying to save up for a down payment, was based on the belief that both mortgage interest rates and home prices will rise faster than they can accumulate big down payments. Using leverage like this allows them to lock in a historically low mortgage rate and a home price, and start building equity in a home. If you already own a home, you wouldn’t need to lock in the home, so, no, I don’t think it’s necessarily wise to remortgage it for investment cash. That being said, if you have an outstanding mortgage with a fixed interest rate of 4.8 percent or less, I think it would probably be the better bet to take any extra money you have and invest it in a diversified fund instead of using it to pay off your mortgage early. If you could do that through a tax-advantaged retirement vehicle, that would be even better.

Felix: OK, let me try again. It seems to me, just like it seems to my commenter Kid Dynamite, that you’re making two different claims in your posts. The first is that first-time homebuyers without much of a downpayment should buy now anyway. The second is that even if you do have a large downpayment, you shouldn’t put it all into your house, and instead you should invest that money in a diversified mutual fund. I’m trying to concentrate on the second claim here. So, let’s build four different scenarios here; let’s assume they’re all at an interest rate of 4.8%, and that in every case the homeowner can comfortably make her mortgage payments.

1. Alison is buying a house for $250,000. She has $50,000 — 20% of the price — in savings which she can use as a downpayment. You suggest that she should not put all that money down, and instead should invest some of it in the stock market. “The less you put down,” you write, “the better off you are”. So if Alison can buy the house with just 3.5% down, or $8,750, should she be investing roughly $40,000 of her savings in the market rather than using that money as a downpayment?
2. Brenda already owns her house, which is worth $250,000, and it carries a $200,000 mortgage which she wants to refinance. If the lender is willing to refinance for more than $200,000, should she accept the offer of a cash-out refinance and invest that new cash in the market?
3. Christie is in the same boat as Brenda, except that her outstanding mortgage, which she wants to refinance, is much smaller — just $50,000. How much should she refinance for, in the knowledge that she will take any extra cash and invest it in a mutual fund?
4. Debbie owns her house, worth $250,000, outright. Should she take out a mortgage of any size at all, and invest the proceeds in the market?

In each case, homeownership is a given: Alison, Brenda, Christie and Debbie are all going to own that house either way. I’m just trying to zero in here on the idea that you should borrow against your house and invest the proceeds in stocks. When is that a good idea, and when is that not a good idea? And if it’s a good idea for Alison to have less than $10,000 of equity in her home, why is that not also a good idea for Brenda, Christie, and Debbie?

Linda: Sorry, Felix, you’re not going to get me to give individual advice about who should and who shouldn’t use home equity to invest in the stock market. That depends on many variables that you don’t go into here: How much do you already have saved for retirement or invested elsewhere? How intelligently do you invest? What’s your ability to withstand risk? When will you need the money? How comfortable is your income stream? Etc. etc. etc. My main point is that a homeowner who can comfortable make their mortgage payments on a fixed 4.8 percent home loan could probably find better places to put extra cash, rather than buying down the loan. For someone, that might be an emergency fund. For someone else, that could be a Roth IRA invested in a balanced mutual fund. I’m not going to tell any of your readers or mine to remortgage their paid-off homes and put all the cash in stocks. But I’m sure there are some folks out there — well-heeled and well-capitalized folks — who would do that, and would end up happy for it.

Now let me answer your question another way: I, personally, have taken cash out of my paid-off home to pay for home repairs while at the same time contributed money to my IRA. Isn’t that the same thing?

Felix: Linda, of course I wasn’t asking for individual advice any more than you were giving individual advice when you wrote your initial posts. But back then you seemed quite happy to generalize and say that the less you put down, the better off you are.

My point is that your advice seems to be, shall we say, path-dependent. If you start off with no house, then you’re advising putting as little money down as possible. If you start off with lots of house, on the other hand, you’re shying away from making the same advice to lever up, even if it brings the homeowner to the exact same place.

Economics is full of cases where people will make different choices depending on how the choices are presented. Here’s a good example. But as personal-finance columnists, it’s incumbent upon us to point out those areas of irrationality and to to say that if you have the choice between A and B, then you should plump for the outcome which makes the most sense, regardless of how you get there. The choice facing Alison is the same as the choice facing Brenda. Your original column was quite clear about what Alison should do, but now you’re backtracking on what Brenda should do. And that’s why it seems to me that what you’re advising is irrational.

For me, the choice in all cases is clear: it’s pretty much always a bad idea to borrow money and invest it in the stock market — and it’s an even worse idea to borrow money against your house and invest it in the stock market. Because that way you not only risk losing money in the market, you also risk losing your house. I’m sure you can come up with an extreme example of “well-heeled and well-capitalized folks” for whom your idea might make sense, but even there I’m having difficulty working out why people who are so well-heeled (and who therefore have diminishing marginal utility of future returns) would feel the need to leverage their investments in such a manner.

I’m quite happy saying that my advice applies to at least 95% of the homeowners in the country. Yes, individual risk appetites vary, as do total savings and the like. Individuals are unique. But this is one area I feel very comfortable generalizing. Leveraging your stock-market investments with unsecured debt is dangerous; leveraging stock-market investments with secured debt is downright foolish.

Does that mean you’re foolish to borrow money against your home while still contributing to your 401(k)? Maybe not — 401(k)s are special, in terms of tax treatment, and if your employer is matching your 401(k) contributions then of course it makes sense to maximize them first. On the other hand, I do find it revealing that you borrowed specifically “for home repairs”, which are a very prudent expense, rather than for stock-market speculation.

Let’s say that you, Linda, didn’t have any home repairs this year, and that you had maxed out your 401(k). In that case, would you still have borrowed against your house, and put the proceeds in the market? I suspect not. On the other hand, let’s say you were buying your house. In that case, would you follow your own advice and put as little money down as possible, leaving the rest for investment in the market? If so, then I’m detecting an irrational inconsistency here. No?

Linda: As I’ve already said, I think the two examples — (1) someone buying a house for the first time and (2) someone refinancing a home to take money out isn’t the same thing. Alison and Brenda are two very different people! I think the person buying a home is using the leverage afforded by the low down payment to get the house in the first place. (Locking in loan, home price, beginning to build equity, saying goodbye to rent.) The person refinancing a home they already own is putting more at risk — the home — and spending money on closing costs etc. to get that investment money.

Now let me ask you a question. What about Alison, the homebuyer who has that $50,000? She could put it all down on the house, building 20 percent of equity immediately. Or she could put $8750 down, and have $41,250 left. Wouldn’t that money, invested cautiously or saved in a liquid account, better protect her from bad financial times (job loss, housing price decline, etc. etc.), than having it all tied up in the house? Again: from the homeowner’s point of view and not the bank’s.

I do think there is value, and not irrationality, in making “path-dependent” decisions, and in gradations of behavior. Taking some affordable amount of money out of home equity and investing it might make sense in some situations — such as putting it in that retirement account and that balanced mutual fund, even in the absence of home repairs. Cashing in the place where your kids sleep at night to make a big bet on Apple doubling one more time? Not so much. I didn’t recommend that kind of speculation in either of my posts.

Felix: OK, thanks Linda, I think we’ve probably wrung this one dry — although I’d point out that $41,250, if “saved in a liquid account,” is very unlikely to yield more than 4.8%.

I did promise you the last word — so, anything else you want to add before I publish this?

Linda: This has been fun and I look forward to doing it some day with wine. I think I’m done.

Bank of America is setting up a bad bank, which will be run by Terry Laughlin. Roughly half of its 14 million mortgages are going to be carved off and put into the bad bank, in an attempt, according to FBR analyst Paul Miller, “to get investors focus on the good” and as “a way to talk about good things and ignore the bad.” The presentation which Laughlin handed out talks about how his new group will work on loan modifications for delinquent customers: “as borrowers default,” he said, “we’ll evaluate them for a loan modification.”

Essentially BofA is doing two things here. One is to try to sweep its bad loans under the carpet by creating the new Legacy Asset Servicing unit; the other is to step up its pushback against the proposed mortgage-servicing settlement, which quite explicitly does include loan modifications for borrowers who aren’t in default. Check out part II.K.8:

Servicer’s employees shall not instruct, advise or recommend that borrowers go into default in order to qualify for loss mitigation relief.

This is something BofA hates — because it opens the door to underwater borrowers who are making timely payments being able to get a loan modification and thereby reduce the value of the loan. And BofA CEO Brian Moynihan is on the warpath against it, saying that such a system would be unfair to borrowers who don’t get their loans modified.

As Adam Levitin points out, Moynihan’s line of argument is pretty disingenuous. There’s nothing in the proposed settlement which forces BofA or anybody else to do anything unfair: indeed, BofA is encouraged to draw up its own set of standards and then apply them to all of its borrowers in a consistent manner. The real reason that BofA is fighting back is simple: if it behaved according to the settlement’s guidelines, it would lose some of that $35 billion to $40 billion a year that Moynihan reckons it should be able to make going forwards.

I’m pretty sure that no bank in the history of the world has ever made $40 billion in one year, and that no bank ever should, with the unique exception of the Federal Reserve. Bank of America is far too big to fail, and as such it benefits greatly from an implicit government guarantee. The least it can do in return is treat its borrowers fairly.

Linda Stern has replied to my post about her dreadful advice to leverage up as much as you can to buy a house right now. And she’s not backing down:

My job is to write about what’s good for the consumer, not the bankers and brokers. And, for a young person who wants to own a house, the numbers say it’s better to squeeze together your 3.5 percent down payment and lock in a 30-year fixed rate loan now, at 4.87 percent (with deductible interest).

Got extra money? I’m guessing a nice balanced mutual fund will do better than 4.87 percent over 30 years…

And if you banked your cash instead of tying it up in your house, doesn’t that give you more leeway to pay your bills while you sort out your finances?

The line about “what’s good for the consumer, not the bankers and brokers” is truly astonishing. The argument here, if you don’t want to follow it back to the beginning, comes down to a simple choice: do you buy a house now with very little money down, or do you save up for a larger down payment? Linda recommends the former course of action, I think the latter is much more prudent. But what’s undeniable is that bankers and brokers will end up making much more money if you follow Linda’s advice than if you follow mine.

After all, the more that banks lend, the more money they make. If you maximize your borrowings, as Linda recommends, that’s extra profit for the banks. On top of that, Linda reckons it’s a good idea to use any excess cash not for your down payment (which would lower the amount you have to borrow and therefore lower the amount of money the bankers make) but rather for long-term investment in “a nice balanced mutual fund.” Which of course means profits for the fund managers and stockbrokers involved in selling you that fund. And we’re not done: the house you buy will probably be sold by a broker, who will profit 6% or so of the sale price. More money going to intermediaries.

And has Linda forgotten this bit, from her original post?

To get one of those 3.5 percent down payment loans, though, borrowers have to pay one percent up front and annual mortgage insurance premiums. Beginning on April 18, those premiums will rise 0.25 percentage points, to 1.1 percent for borrowers who put at least five percent down, and to 1.15 percent for borrowers who only put 3.5 percent down.

That’s 1.15% of the value of your mortgage every year for 30 years — all going directly to insurance premiums, which are a crucial part of the financial-services profit machine.

So if you want to do what’s best for the financial-services industry, and for bankers and brokers, you should definitely follow Linda’s advice.

Meanwhile, Linda does seem to be a bit fuzzy on what exactly you should do with the money you don’t put towards a down payment. On the one hand, she says it should be tied up in that mutual fund for the next 30 years, in the hope that it will return more than 4.87%. But on the other hand, she says that it should be “banked” so that you can “pay your bills.” Well, you can’t have it both ways. If you want the cash to be liquid and available for bill-paying, you shouldn’t invest it on a 30-year time horizon. (After all, as we saw during the crisis, people have a tendency to need cash at exactly the time their investments plunge in value.)

As for Linda’s “numbers,” I’m completely unconvinced that there’s any clear math showing that buying now makes lots of sense. Linda’s argument is based on speculation about the future — that interest rates and house prices are both going to go up over the next five years. That’s possible, of course. But it’s hardly an obvious mathematical truth. In recent years lots of people have lost lots of money by making exactly that bet. Which would seem to indicate that a bit of prudence, and saving up money for a decent down payment, makes a lot more sense than a speculative plunge into a highly-leveraged and extremely illiquid asset.

I know that memories are short on Wall Street. But are they short on Main Street too? Reading Linda Stern’s latest paean to leverage and housing risk, it certainly seems that way. Saving for a down payment is hard, she says. It can take time!

And that doesn’t seem to pay. If you think about the cost of paying rent for five or more years, you may be better off jumping into a home with a low down payment now. That’s true even if you have to spend more money on fees and mortgage insurance to get one of those low down payment loans.

Well, yes, let’s think about the cost of paying rent for five or more years. In fact, let’s plug all our numbers into a rent-vs-buy calculator and see where we’re at after five years. The problem with Linda’s formulation here is that it helps to reinforce the common fallacy that 100% of rent payments are “wasted,” in a way that mortgage payments are not. But that’s simply not true. In both cases you’re paying money every month for your shelter; in the rental case that money goes to the landlord, while in the ownership case it goes to the bank.

Some small part of your monthly payment may or may not end up helping you build equity in your home, if house prices move up rather than down and depending on how much of your payment goes towards principal. But remember that the alternative here is saving up for a down payment — which is essentially the same thing as building up equity in a future home. If you save up $250 per month for five years and then put down $15,000 as a down payment, then you immediately start off with $15,000 of equity in your home. By contrast, if you buy today with no money down and start making mortgage payments, there’s a good chance your equity will be much less than $15,000 in five years’ time.

But Linda’s on a roll here, and manages to come out with one of the most astonishing pieces of personal-finance advice I’ve seen since the crisis hit:

Even if you have the money for a bigger down payment, there can be good reasons to save your cash. Mortgage rates continue to skirt all-time lows: Why not put your money to work for yourself and borrow as much as you can reasonably afford, on a monthly basis, at today’s rates? You can put the money you’re not paying into a down payment to work elsewhere. If home values rise, you will have done your best to leverage a small down payment into bigger equity. If they fall, you’ll have less skin in the game, and that could put more pressure on your banker to improve your loan terms lest you walk away.

This, in a nutshell, is everything that was wrong with the housing market before the crash — everything that we want to avoid going forward. Can’t Linda look around at the current devastated state of many people who bought with little or no money down, and see the dangers here? Evidently not. Instead, she seems to think it’s a bright idea to borrow more money than you need, to the point at which you’re pushing the envelope of what you can reasonably afford. And then take the cash you’re not using for a down payment, and “put your money to work for yourself.”

I barely know where to start on this. Here’s one way of thinking about it: banks are not charities, and that they expect to make money from their loans. They have a cost of funds which is lower than the mortgage rate that you’re paying; the difference between the two rates is their profit. You, however, if you follow Linda’s advice, have a cost of funds which is your mortgage rate: if you wind up getting a lower return on your savings than you’re paying on your mortgage, you would have been better off just using the money for a down payment. Needless to say, if there was an easy way of getting a higher return on capital than the mortgage rate, the banks would have done it already, rather than lending you the money. And it’s pretty delusional, frankly, to think that you can invest better than say JP Morgan. Yes, there are tax benefits to having lots of mortgage-interest payments. But they’re not sufficient to make the difference here.

Here’s another way: let’s say you own your home outright. Would you take out a mortgage against 95% of your home’s present market value, and then invest that money in the market somehow, trying to “put it to work for yourself “? Of course not: you don’t have remotely that kind of risk appetite. Borrowing money against your house to invest in the market is, always, stupid. But that’s exactly what Linda’s proposing you do.

And here’s one more: shit happens. Sometimes, you end up needing money, in an emergency. If you’re already borrowing as much as you can reasonably afford, that’s a big problem. If you have a bit of fiscal breathing room, you’re much better off. If you end up in a situation where you’re in a position to put pressure on your banker to improve your loan terms lest you walk away, that’s not a good situation to be in. It means you’re broke. It’s something you want to avoid, whereas in Linda World it seems to be something to actively court.

Linda’s also convinced that house prices are going to rise: if you buy now rather than later, she writes, that means you’re buying “while housing prices are low.” That’s debatable — they still seem quite expensive, on some measures: the price-to-rent ratio, for instance, is still well above its historical average. And more generally, buying low doesn’t help you in the slightest if prices just continue to grind lower.

Linda’s conclusion is that “the less you put down, the better off you are.” Which is true so long as you keep on making all your mortgage payments without any problem, and nothing goes very wrong either with your personal economic situation or with the US economy as a whole. That’s the way that leverage works: it makes everything sunny, so long as things go right. And then it plunges you into misery when things go wrong.

The scariest part of Linda’s post, for me, is when she talks about how it’s a good idea to “do your best to leverage a small down payment into bigger equity.” It’s not the dollar amount of the equity she’s talking about here, it’s the leverage used to get there, and the higher the leverage the better off you are. Following that advice got us into our current mess. And taking it now is a recipe for disaster.

No wonder the proposed settlement with mortgage servicers is proving too hard to write about: it’s really hard to read. There might be a lot of Elizabeth Warren in its substance, but there’s none of her in its style.

For those who can wade through it, however, it really is a code of best practices for servicers and it’s sorely needed. There’s much to love here, but it all basically comes down to the golden rule: treat your borrowers with honesty and humanity and common sense and you’ll be fine. Do servicers really need to be told that if they make more money from a loan mod than from a foreclosure, they should do the loan mod? Or that “sworn statements shall not contain information that is false”? Evidently, yes, they do.

I do have my doubts about whether all of this is feasible in the real world. Consider II.C.4:

Servicer shall create a Single Electronic Record for each account, the contents of which shall be accessible throughout the servicer, including to the Single Point of Contact, all mitigation staff, all foreclosure staff, and all bankruptcy staff.

Or II.F.1:

There’s even a bit later on (see page 19), where the servicer is asked to “consider”, whatever that means, partnering with Kinko’s or Wal-Mart to allow borrowers to scan and email documents for free.

All of this is reasonable, on one level — but at the same time it’s also setting the servicers up to fail, since few if any of them have the ability to implement all of these changes. Some of the settlement is easy: if you’re currently doing force-placed insurance, stop doing it. But the parts of it which involve massive IT overhauls will certainly break and go over budget and not play well with various legacy systems and generally be incredibly difficult to get working.

As a result, the big question here isn’t whether the settlement is reasonable — yes, it’s entirely reasonable. Instead, we should ask what the penalties for non-compliance are, since just about every servicer will be non-compliant for the foreseeable future.

Those penalties come at the end of the document and they’re extremely vague: there’s talk of “monetary penalties and additional remedial actions”, but there’s also talk of “failure to meet timelines”, which implies that much of this stuff could be pushed off far into the future and of “a special master or referee to resolve violations”, with no indication of how such a person might be chosen.

I’m reminded of the tale of the scorpion and the frog. In this case, the servicers are the scorpion and the frog is a legal settlement which can get them some kind of protection in law. The two will get, uncomfortably, halfway across the river and then the servicers, unable to go against their nature, will doom them both.

Ultimately I still feel the same way I did in November, when I said that only a radical restructuring of the entire securitization architecture—and especially the broken relationships between investors and trustees and between trustees and servicers—has any chance of actually working. The settlement’s heart is in the right place. But I have no faith in the ability of the servicers to implement it successfully.

Cheyenne Hopkins, of American Banker, has a great coup today: she’s found the famous 27-page term sheet laying out exactly how the state attorneys general are trying to force mortgage servicers to “change a dysfunctional system”, in the words of Iowa AG Tom Miller. There’s a lot of material in here, and unfortunately I’m a bit pushed for time right now and can’t give it a full go-through until later tonight.

So have at it, and let me know what you find — do you think this will actually result in a lot more principal reductions, as outlined on pages 18-19? I do hope so, but that bit about being “reserved for further discussion” does give me pause. It’s certainly the part which would cause the greatest immediate harm to banks’ balance sheets — much more than any fine the AGs might come up with.

27 Page Settlement

How incompetent are mortgage servicers? So incompetent that faced with one of the most prominent journalists at one of the most prominent newspapers in the country, they contrived to subject him to, in his words, “a months-long odyssey: rates misquoted, interest charged on a phantom account, legal documents issued in wrong names, a mortgage officer who disappeared for days at a time (first it was his birthday, then his laptop was in the shop), a bounced check from Citibank’s own title company, and the freezing of our bank accounts”.

These stories are less shocking than they should be, these days, just because we’ve heard them so many times. Which is why the banks are going to find it very difficult to say no to the 27-page proposed settlement being offered by the states’ attorneys general. Does anybody have a copy of this thing? I’d love to see the details of the principal writedowns and the like, but although everybody is writing about it (see for instance American Banker, Bloomberg, WaPo, NYT, WSJ) and the NYT in particular says that they have a copy, no one seems to have posted it.

The one thing which does seem clear is that the OCC is still completely captured by the banking industry. It’s the one arm of the government not signing on to the proposed settlement, saying that $20 billion is too much money and could harm banks’ finances. Which is ludicrous, given that banks are chomping at the bit to eat into their capital by paying out dividends. $20 billion is tiny, by the standards of the size of the U.S. banking industry and mortgage market. Anything less would be a slap on the wrist and tantamount to a nod and a wink giving banks the green light to go on treating people like Dana Milbank just as they’re being treated right now.

Back in November, Michael Barr told me that by the end of the first quarter this year, the government should be in serious discussions with banks about how they’re going to fix their broken mortgage operations. Those discussions seem to have started up, on an informal basis, as the government has cobbled together a not-quite-ready-for-prime-time settlement proposal which it will at some point formally present to the banks.

The most interesting part of the proposal, as it’s described in the WSJ, is that it looks as though the banks are going to be encouraged to do principal reductions on mortgages in lieu of paying fines:

If a unified settlement can be reached, some state attorneys general and federal agencies are pushing for banks to pay more than $20 billion in civil fines or to fund a comparable amount of loan modifications for distressed borrowers.

I’m cautiously optimistic about this. There are risks of the banks ultimately getting off very lightly: a fine is a punishment for doing something wrong, while principal reduction, by contrast, can actually benefit banks if they do it right. But in this case it seems that most of the benefit might go to homeowners and bondholders rather than banks.

The one thing I’m sure about is that the final settlement, if and when it arrives, is going to be extremely complicated, and will be presented with great fanfare and a huge headline dollar amount. But the settlement will in reality mark the beginning, not the end, of the process, and the proof of the pudding will be in the execution.

“You should hold us to whether things get better or worse,” said Barr in November. “If a year from now nothing has changed, that would be a reasonable criticism.” There’s still a lot of time to go, on that front. But amid all the noise surrounding the settlement, let’s keep our eyes on the ultimate prize, which is meaningful help for homeowners. Both government and the banks have made lots of promises on that front in the past, none of which have turned out to be worth very much. The settlement will constitute yet another high-profile promise. And we won’t know until much later this year whether it’s done any good at all.

After I appeared on All Things Considered this weekend, I got an incredibly gratifying email from a listener in McLean, Virginia, who’s moving to Jupiter, Florida:

You were talking about the fact that taking your money out of one house and putting it into another means you’re still stuck in one place – just a different one – and trapped into an economic nightmare in which you work and work just to sustain a lifestyle you’ve faked yourself into because you now own a house. You’re so right, and something else that struck me was that I’ll never have cash to do the kinds of things I enjoy – travel, mostly… I  have always felt stifled by a mortgage, condo fees, taxes, and basically, that “stuck” feeling…

I am going to continue renting my little place by the beach down here for a while, and continue to keep my very nice Mclean condo rented out, so that mortgage is paid, and give a little more thought as to why owning a house is really anything more than a self-imposed prison of bricks and sticks!

It’s easy to glorify the wonders of homeownership because of all the psychological reasons for wanting it — the place to call one’s own, the nesting instinct, the desire for stability, the feeling that it’s silly to put lots of work and love into a place if it ultimately just ends up benefiting the landlord. But at the same time, the downside of homeownership can be truly enormous and devastating, and renting carries with it a very American sense of freedom, I think, and a world of opportunities.

Richard Florida likes to talk about how it will take decades to reshape the American psyche into something where renting an apartment in the city is considered even more desirable than owning a house in the suburbs. I’m hopeful that one consequence of the housing bust will be an increase in the number of nice suburban houses being rented out, like my correspondent’s in McLean. Which means that it might not be necessary to re-architect the national lifestyle to one which is much denser and more urban before we can start seeing renting becoming increasingly prevalent in white, middle-class neighborhoods. After the renters move in to the place in McLean and their neighbors start getting friendly with them, perhaps the stigma associated with renting might start to erode.

I’m impressed with Treasury’s long-awaited report on reforming the US housing market. It’s a good length — it comes in under 11,000 words, which makes it shorter than, say, Michael Lewis’s Vanity Fair article on Ireland. It’s written in a very clear manner, laying out in a simple and honest way exactly what went wrong, and what Treasury is proposing. And although it might look as though providing three different options for reform is a bit of a cop-out, in fact they’re not as far apart from each other as you might think, and all of them would constitute a radical change from the status quo.

The message is clear: what we have right now is unacceptable, and we need to do something big; the main choice facing Congress is between a modest government housing guarantee, a tiny one, or none at all.

It’s worth reading the rest of the report, too, not just the section laying out options at the end. One very welcome theme running through the report, from the beginning of the introduction, is that an important part of “affordable housing” is giving people “rental options near good schools and good jobs” which don’t take up an inordinate proportion of total income. This kind of language appears all too rarely in papers on mortgage-market reform:

Today, renters often face significant affordability challenges. Half of all renters spend more than a third of their income on housing, and a quarter spend more than half. And for low-income renters, adequate and affordable homes are increasingly scarce. For every 100 extremely low-income American families, for example, only 32 adequate rental homes are affordable.

The report is also clear-eyed about two aspects of the US mortgage market which seem to be sacrosanct: the pre-payable, 30-year fixed-rate mortgage, on the one hand, and the mortgage-interest tax deduction, on the other. It notes that both are pretty much unique to the US, and cause significant distortions and risks: “tax incentives like the mortgage interest deduction can encourage investment towards housing over other sectors in the economy”, the report says, adding that investment in those other areas “may lead to greater long-term growth or job creation.”

There’s even a nod to the concept of covered bonds — look closely, it’s buried in a subordinate clause at the bottom of page 14, but it’s there. Such things are hard to understand, but they’re very attractive from a policy perspective. The problem is that banks don’t like them, and so it’s going to be hard to implement them given the lobbying power of the banking industry.

But banks are going to have to start putting a lot more of their balance sheets at risk in the housing market whatever happens, if any of the options in this report are adopted. The idea is to replace the current system, where the government guarantees nearly all the mortgages in the country, with a private system where government is involved only at the low-income end of the market or in the event of a major crisis.

If any of the choices are adopted, then mortgage rates will continue to rise — they’re already above 5%, and that’s a good thing, since the cost of a mortgage should reflect the risks inherent in it. It will be harder to get a pre-payable 30-year fixed-rate mortgage. But if you do get one, your monthly cost might not be much higher than it is right now, since as Dean Baker calculates, the headline price of your house is likely to be lower. The obvious cost of such a system, then, is that it would increase the number of homeowners with negative equity, and thereby increase, at the margin, the number of defaults and foreclosures that we’ll be seeing going forwards.

More generally, it’s far from clear that there’s enough private money at all which is willing to fund such a system. The main problem I have with Treasury’s report is that it simply assumes that if government support for the housing market is slowly removed, then private money will come in to take its place — at a higher price, to be sure, but at some price.

The big risk is that private money won’t come in, at any price, if there isn’t a guarantee — that the amount of private funding for the US mortgage market will be substantially lower than the demand for mortgage loans. The result would be a broken, non-clearing market, with people stuck in their homes because they can’t sell them, and the idea of a “market price” being somewhere between a purely theoretical entity and an outright joke.

That’s why my preference would be for Treasury’s third option, where the government guarantee remains extant, just with a lot more safeguards than it has right now, in a system where it’s priced rationally rather than well below market. Fannie and Freddie would go away, and be replaced by private mortgage insurers; the government would reinsure the mortgage insurers, rather than insuring the mortgages directly. And the government would only lose money after the private insurers had lost all of their money.

Are there private-sector players who would step up and insure mortgages in such a system, willingly providing a buffer between banks and the government? Treasury simply says that “a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards” — but it’s not immediately obvious to me who those companies might be. If such companies can be found, and if they’re well-capitalized enough to credibly backstop an enormous proportion of the entire US mortgage market, then this solution is I think a good one. But those are two very big ifs.

There are a lot of financial-sector players who have every incentive to claim that such private-sector companies will never appear, and that a broader government guarantee, like the current one at Frannie, is sadly necessary. As this debate moves to Congress, it’s going to be crucial to be able to examine such claims impartially, and to decide whether Treasury’s optimism regarding the future risk appetite of private capital is justified. Any bright ideas as to how to do that? Because I can’t think of anything offhand.

In the standard narrative of the mortgage crisis, there were prescient bears who got it right, and then a head-in-the-sand majority which missed what was going on until it was too late. But in a fascinating article about a lawsuit against former Lehman subsidiary Aurora Loan Services, Kate Berry of American Banker shows that it’s a bit more subtle than that.

A large part of the bear case, when it came to mortgages, was that there was a huge number of adjustable-rate mortgages whose “teaser rates” were going to expire, landing homeowners with massive monthly payments they could never afford. In reality, however, the notorious “exploding ARMs” didn’t explode at all. And now a chap named Andrew WeissMalik is  suing Aurora because his ARM didn’t explode, and he wants all the benefits that should have come his way as a result of his interest payments going down.

It turns out that in July 2008, Aurora wrote to WeissMalik — he says he never got the letter — telling him that they were going to modify his loan, and that it would lock in his teaser rate of 5.875% rather than let it explode. He didn’t need to do anything to accept the offer, he just needed to keep on making his monthly payments. Which he did, and his rate stayed at 5.875%, rather than falling as low as 2.625%, as it would have done had the loan not been modified.

Aurora certainly didn’t make it easy to opt out of this modification, which WeissMalik claims has cost him some $20,000:

The form letter, which WeissMalik eventually obtained, says that “we will assume that you have accepted this offer if you make two on-time payments following your adjustment date at your current, unadjusted monthly payment amount.”

The letter describes only one way to decline the offer: it told borrowers that if they did not make the two required mortgage payments, the servicer “would assume that you declined our offer and we will adjust the interest rate and monthly payment as provided in your mortgae note.”

“To reject Aurora’s ‘offer’ for modification,” Davidson said, “WeissMalik would have to be required to default on his mortgage loan … thereby damaging his credit score and putting himself at risk of other adverse risks of nonpayment.”

There’s a malign view of what Aurora did — which is that it could see the writing on the wall, reckoned that the Fed would be forced to slash interest rates in order to save the economy, and therefore locked in the teaser rates before they fell sharply. I don’t buy that entirely.

More likely, I think, is that Aurora knew that its borrowers couldn’t afford to see their interest rates explode, and had no ability to refinance. So it decided to just keep them on their teaser rates instead, on the grounds that it would have many fewer defaults that way. And because it was an incompetent Lehman Brothers subsidiary, Aurora failed to modify the loans in a legally or ethically defensible way — even if its heart was in the right place.

Still, I don’t think Aurora has a remotely colorable defense in this case. I wonder how many other people accepted the modification and don’t even know how much money they’ve lost as a result.