The Great Debate

It has been nearly six years since U.S. home prices peaked and then plunged, and still the nation’s mortgage markets remain mired in slump. Despite occasional signs of improvement in some localities, the S&P Case Shiller Index shows home prices down 9 percent from their previous post-bubble high – itself very low in relation to trend. Meanwhile a backlog of some 400,000 homes awaited liquidation at the end of 2011, and an additional 2.86 million mortgages were 12 or more months delinquent. That’s a “shadow inventory” of 3.25 million homes already foreclosed or now facing foreclosure – an inventory that weighs on home prices, families and neighborhoods alike.

It also weighs on our economy, at the city, state and national levels. As a recent Federal Reserve Board white paper and other sources abundantly demonstrate, foreclosure and slump in the housing markets feed back into the broader economy by diminishing wealth and consumer spending. That lowers growth and employment – bad enough in themselves, but also sweeping more mortgages into the wave of defaults. Hence the familiar downward-spiraling “feedback loop” of high foreclosure rates, causing low growth and employment, causing yet more foreclosure, and so on.

Easily the worst source of drag is the large class of “underwater” mortgages – loans on which more is owed than the underlying post-bubble housing collateral is now worth. It isn’t hard to see why. Wrought by the rise in housing prices until 2006, the so-called wealth effect supported consumer spending even when wages and salaries stagnated. But it runs in both directions: Homeowners with “negative equity” cut their spending the most. Even tax cuts, rather than flowing toward employment-supporting consumer expenditures, go toward trimming back overhung mortgage debt. That’s why the 2009 stimulus did so little.

In light of these truths it is now widely appreciated that principal writedowns will be required for a broad swath of underwater mortgages. Even many creditors – the prospective bearers of writedown-wrought losses – understand and embrace this. For they are better than defaults, which underwater mortgages do at high rates. Indeed for most underwater mortgage debt, principal writedowns maximize expected value.

So writedowns will have to be done. The question is how. Unfortunately, a host of what lawyers and economists know as “collective action problems” stand in the way of the win-win solution here. For one thing, the securitization agreements pursuant to which many modern mortgage loans are pooled and then sold often require unanimity or supermajority votes among mortgage-backed securities (MBS) holders before loans can be modified. And today’s fragmented owners of MBS cannot even find one another, much less reach agreement on what’s best for them. For another thing, these same agreements likewise typically prohibit loan servicers, who act on behalf of the loan holders, from modifying as well.

The recession officially ended in July 2009, and yet the speed and scope of the subsequent recovery have been disappointing. Recent economic data have been encouraging, but there are three ominous trends in the consumer banking space that signal the waters ahead may be choppy.

1. No new banks were chartered in 2011

The Financial Times reported recently that not one new, or de novo, bank was created in 2011. (The FDIC actually lists three new bank charters for 2011 — the lowest number in more than 75 years — but they all involved bank takeovers of other failed banks.) What are some of the possible implications?

First, investors are clearly still gun-shy about banking. The dearth of new small banks is also a negative sign for small businesses generally, as they are particularly dependent on small banks for loans. Since most employment growth in the U.S. comes from small businesses that use external finance to grow into large businesses, a decline in these businesses’ access to loans could limit future employment growth as well.

Elizabeth Warren, it's not you they hate. It's what you represent. You want to be an honest cop when so many before you in Washington have looked the other way and pretended that the banking industry could police itself.

I can't think of a better reason why this presidential adviser shouldn't be the new chief of an unfettered Consumer Financial Protection Bureau.

She knows where the bodies are buried -- in countless toxic forms and statements that only bank lawyers fully understand. She'll make every attempt to end the silent rip-offs and myriad shenanigans that cost consumers billions.

By Jim Saft

With tax credits for house buyers gone and tough new banking regulations on the way, expect lending in the United States to come under significant pressure.

Demand for mortgages, kept artificially high through the end of April by juicy credits for first-time and other buyers, has now crashed and, at least to judge by the fundamentals in the housing market, should stay low. Loans to consumers too will be getting, appropriately, more expensive, at least in part due to costs imposed by new financial regulations, which while if anything not tough enough from a prudential point of view will without doubt make banking less profitable.

Supply of loans to businesses will also be hit, and demand should remain slack.

– James Saft is a Reuters columnist. The opinions expressed are his own –

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

James Saft is a Reuters columnist. The opinions expressed are his own.

Even in the good times, many British consumers were borrowing against their houses just to fund routine consumption, indicating a big hit to come for retail sales and for the banks who hold the loans.

With house prices falling rapidly and mortgage debt tougher to get, it is no surprise that homeowners are less able and inclined to borrow against their houses in order to spend.

That will be hitting the High Street now - analysts are expecting a 0.6 percent fall on the month in retail sales for November when data are released later this week. But a rise in unemployment next year could expose a really serious weakness in household finances, as consumers who counted on being able to extract wealth from their houses to smooth consumption in bad times find that, when bad times come, the wealth isn't there and the banks don't want to lend anyway.

(James L. Melcher is the president of Balestra Capital, a New York-based hedge fund. He co-authored this article with Joan McCullough, macro-economic strategist at East Shore Partners. They are writing in a personal capacity and the opinions expressed are their own.)

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have been behind the curve in dealing with the breakdown in the banking system and financial markets. All of their initiatives have had only limited impact as they persist in treating the symptoms and not the cause. We are in the early stages of a severe global recession. It is critically important to take more aggressive steps.

The most vexing variable in this entire crisis has been the value of underlying collateral. Any remedy, therefore, is ineffective unless we acknowledge first that the fate of the collateral lies in the hands of the borrowers. Thus, it is imperative that triage measures be taken without delay to ensure the survival of the mortgagors.