Oh, oh it's magic

Henry Farell at Crooked Timber reads this FT article about the Bush administration mortgage plan:

Mortgage service companies, which are responsible for calling on Americans to keep up with their loan payments, have assumed a pivotal role in President George W. Bush's market-oriented strategy for dealing with the pending wave of foreclosures in the subprime mortgage sector.

An estimated 6m high-risk subprime loans, worth a total of more than $1,000bn, are outstanding, which will in many cases reset to higher interest rates in the next 18 months, putting more than 2.5m Americans at risk of foreclosure.

"It is sort of like being in New Orleans a month before Hurricane Katrina hit when you know there is a storm coming," said Guy Cecala, of Inside Mortgage Finance.

Economists fear that a wave of evictions of borrowers unable to afford the higher payments will blight neighbourhoods, hit home prices, deepen the worst housing downturn in 16 years, and harm the wider economy.

The response to this crisis outlined by the president places considerable faith in the ability of mortgage servicers to mitigate this blow by helping distressed borrowers to stay in their homes.

Edward Lazear, chairman of the Council of Economic Advisers, said: "I believe, and I think the president believes, that markets are very good at finding ways to solve problems."

But many experts claim that the mortgage service sector is not fit for this purpose.

They argue it does not have the capacity to perform this role, and lacks the personnel, financial resources, technical tools, experience, incentives and oversight to deal with an economic crisis of this scale.

"Theoretically, it makes sense, but not in the real world," said Scott Syphax,a director at the Federal Home Loan Bank of San Francisco.

"These institutions are not built to handle this scale and volume of problems."

"The notion that federal regulators can urge services to reach out and contact borrowers who may face distress is unrealistic," said Mr Cecala.

And concludes:

There’s very little that I find more annoying than the “magic of markets” arguments that various right wing hacks and ideologues spew at the drop of a talking-point. It makes me want to forcibly enrol the responsible parties in an economic sociology program until they see the errors of their ways. Markets can indeed do extraordinary and impressive things, but they rather obviously depend on previously existing institutions, expertise and social conditions if they are to work. Not to mention proper incentive structures. These can’t be whistled out of thin air. The claim that a business sector composed of small firms specializing in foreclosure and themselves terrified of bankruptcy will have the appropriate motivations and expertise to stave off this crisis is self-evidently bogus, if you look at it at all closely. But sprinkle some of that schmeconomics 101 pixy dust on it, and you can get away with it, thanks to the supine US journalism industry (I don’t know of any US publication which has even mentioned this as a problem; perhaps I’m wrong).

I read it a little differently. Mortgage service companies would rather the federal government paid for subprime defaults than them. They would therefore like a straight bailout, rather than a program in which the Treasury helps them do workouts with homeowners.

It seems obvious that the securitization of loans has made workouts considerably more complicated, which is why the Federal government is getting involved; but it's not clear to me that it's made them less financially feasible, which is what the experts, all of whom seem to work for mortgage servicers looking for a bailout, are claiming. I see the Bush administration as feeling its way cautiously, trying to put together a package that will avert financial disaster without:

1. Creating moral hazard
2. Costing the government a scary enormous amount of money
3. Outraging voters as the government taxes people in modest homes in order to allow people who bought more home than they can afford in those houses. Whether or not you think that this is common among those who have gotten themselves into subprime trouble, or even admire the redistributive justice of it all, this is a real sentiment out there, and politicians have to deal with it.

These are reasonable goals. Against this, one has to weigh the fact that major crises are better averted earlier than later. But I am not yet clear on whether the mortgage market requires massive intervention, or just continual finesse.

Comments

"it's not clear to me that it's made them less financially feasible"

Well, the workout process is controlled by the servicer, which often (frequently? mostly?) has little financial incentive to minimize losses to the bondholders--i.e., other people. Doing analysis of which loans are potential trouble and then undertaking (rather expensive, at least in the aggregate) workout discussions with individual borrowers is not something that the servicers are being paid for. And then they need to get the approval of the bondholders.

It's all a different analysis if the program goes to the special servicer, who has a lot more power to make unilateral decisions. But, a lot of residential MBS do not have special servicer arrangements in place, so that path is not available.

Posted by zaleriana | September 7, 2007 1:45 PM

I can't find much to criticize in what you wrote, Megan, but what's missing from your bulleted list is the moral hazard that created this mess in the first place.

Homeowners took these risky subprime loans not merely out of their own greed, but because greedy predators cooked up all sorts of complex schemes to loan people more money than they could afford to pay back, convincing homeowners that prices would continue to go up and they could refinance later. Meanwhile, "economists" in the media clapped along and helped inflate the bubble by promoting these schemes and downplaying the risks. All the trusted sources of information from the WSJ editorial page down to the realtors had a vested financial interest in promoting the unsound lending practices that led to this mess, because the real estate bubble was a goldmine that boosted the entire economy.

Then, when the bubble predictably bursts, the industry demands a bailout, and "economists" in the media insist that the greedy suckers who fell for the risky schemes should bear the costs of their mistakes. Hardly anywhere is it suggested that subprime lending is an inherently stupid idea, and the government ought to restrict the practice in order to reduce the likelihood of future collapses and bailouts. And I don't have much faith that "economists" in the media will learn any lessons about the downside of deregulation and apply them to the next risky, yet profitable investment trend that gets out of hand.

Posted by LaFollette Progressive | September 7, 2007 2:46 PM

My understanding is that the existence of subprime mortgages isn't the problem. The loans were made with a risk factor built into the terms. The problem is that they were bundled and resold after being re-rated as being less risky. The current owners are finding that they overpaid for these risky mortgages.

Obviously, there is some level of greedy folks just buying way too much house and/or lying brokers tricking people into over-borrowing, but I don't think that's the biggest problem.

I don't want to bail out people who bought more home than they could afford, but I'd like to avoid a shock that will adversely affect the economy. If that means we have to bail some people out (or help them), then I'm okay with that... It's too bad that politicians are involved in making the decisions.

EI

Posted by Earnest Iconoclast | September 7, 2007 3:19 PM

Megan, unless a mortgage servicing company is affiliated with a lender (some are, most aren't), it's not at risk for defaults the way you frame it. Rather, these companies get paid for collecting payments for others -- the greedy fools who acted like risk doesn't exist and doesn't have to be paid at some point. I'm sure they're freaked out by the impending wave of defaults, but for the more prosaic reason that they make more money on collecting the easy stuff than putting a lot of resources in trying to squeeze blood from a stone. I dunno what they think of GWB's minimalist approach, but I'd guess that they're in there plugging for "transition counseling" funds as part of a progrem to walk borrowers back from the brink; and I'm sure they wouldn't mind being the "free market" provider of such services.

Posted by RB | September 8, 2007 3:37 PM