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Enough already: Fixing the Mortgage Mess
March 11 , 2008 by EditorUnemployment is up. The economy may have had negative growth for a quarter. Confidence is down. Credit is tightening. Banks need more capital. To some the sky is falling. Well -- enough.
The origins of this mess lie in two places -- though the media and many politicians insist on ignoring half the equation. The half everyone knows is that banks and others lent monies based on dubious valuations and the fiscal equivalent of "if you build it, they will come." Loans based on the likelihood of increased valuations down the line, on "teaser" interest rates, and on "lo-docs" or "no docs" were really not loans at all but disguised equity investments. Debt carries with it a set of contractually obligated and predictable payments. Equity carries with it the risk of uncertain returns. Make no mistake --most of the loans which are contributing to the current crisis are really equity.
Funny, you say, banks and mortgage companies are not supposed to be making equity investments of that sort. Correct. Thus the first half of the "cause" can be labeled as improper equity investing disguised as loans.
But, there is a second and equally pugnacious cause. In the light of Enron and other such scandals, Congress and the Accounting Regulators took the position that discretion was "evil" when it came to valuing investments. Instead of discretion (where a company reports what it believes its investments are worth), the "rule" is "market to market." This rule insists that all assets be valued as if they were to be sold today. Whatever the market says they are worth is what they are worth is the credo. The credo is based on a giant lie. And with that lie lies the second cause of our crisis.
Market to market works if there is a liquid market for the asset in question and if the asset presents similar qualities to the multiple buyers in the marketplace. A tomato is a tomato is a tomato. Such is the theory. But as nearly every student of economics learns in Econ 101, markets provide bad pricing signals in the absence of liquidity or if the asset in question presents different qualities to different buyers. The airlines know this all too well. There is no such thing as the "market price" for an airline seat. Aunt Molly who bought from Priceline three months ago may be paying more or less than the businessman who booked yesterday. If airlines were forced to mark to market their inventory of scheduled but not yet flown seats chaos would erupt.
Such chaos has erupted with financial institutions. Especially where mortgages are involved.
Mark to market presumes that everything is for sale and that there is always a ready and willing buyer. For some assets (those where the item has a short life span like a tomato or an airplane seat), the failure to sell the item would leave a value of zero. Thus, such assets can be presumed to have declining values in the absence of ready and willing buyers.
For other assets (such as houses or highways) this assumption is nonsense. The asset is long term. The absence of buyers is just that an absence of buyers. The asset does not have intrinsically less value just because today there are few buyers. There is always tomorrow. There is always the existing owner.
Real estate appraisals recognize this. While the use of "comparables" helps to determine a likely value, when the comparables are few and far between two alternative appraisal techniques are considered appropriate. One is the income approach, if you rented out the property what could you receive and if that income is converted to a fixed dollar amount -- that amount is a representative of value. The other is the replacement approach. How much would it cost to replicate the asset?
Real estate appraisers have the flexibility to use some combination of all three approaches. Financial institutions have no flexibility. Mark to market in a world of few buyers is market to zero.
The present crisis has two causes: disguised equity and inappropriate valuation rules. The solution to crisis lies in forcing the equity to be treated as equity not debt and in fixing the valuation rules. No bailout is required. No need for expensive Federal intervention. Just a need for a bit of truth and some common sense.
First, relabel equity as equity.
The target is anyone who has debt which is in excess of the current value of their home or at an interest rate which endangers their ability to keep their home. In effect the excess debt on such homes is equity and is in need of relabeling. Relabelling can occur if the Federal Government will supply some credit guarantees with respect to the securable portion of a home’s value. This will force the lenders who are owed the remaining balance to accept their loans for what they are: an equity interest in the home.
Politically such a relabeling program cannot be seen as bailing out the wealthy who have made
investment mistakes. Thus the limits on this program need to be something like: primary residences only which have a current value equal to or less than 150% of the median home price in their SMSA or their State if they live outside an SMSA boundary. Married couples who are NOT legally separated should be restricted to one residence only. The program should only be available where the primary mortgage was entered into prior to 2007.
The program:
A) If the applicant's home is within the valuation limit above, FHA will provide a federal guarantee for 90% of the home's current value on an interest only loan of seven years.
B) To qualify the applicant needs to get three appraisals (appraisal fees of up to $250 per appraisal will be included in the refinancing).
C) The primary lender and any secondary lenders will need to agree to accept a certificate equal to 50% of the future appreciation on the home in exchange for their remaining debt.
D) If the home is sold during the first three years the future appreciation percentage would be equal to 100% in year one, 87.5% in year two, and 75% in year three.
E) financing costs, title insurance, and taxes would be includable in the FHA guaranteed amount as added debt.
To ensure that the program works there should also be a portion of the program available on a per capita basis with State by State limits which will provide new financing to a prior owner bidding on a foreclosed home. This will ensure that if the lenders to a home do not go along and there is a foreclosure the existing owner and only the existing owner is in a preferred position to reclaim the home -- the limits for this probably should be in the range of 1000 per capita. Such a program would cost Uncle Sam only the FHA in-house processing costs plus a very small default percentage.
This program quickly restores liquidity to the mortgage market.
Second, fix the valuation mess.
Allow financial institutions to use the income approach and the replacement approach in determining "mark to market." To avoid ‘scandals" such as Enron require mark to market disclosure of valuations using all three methods, but use the highest value as the value on the books rather than the present practice of the lowest value.
Third, stop the problem from repeating.
One definition of insanity is to engage in repeated behavior and yet expect different outcomes. Our reliance on financial models has much to do with what got us into this mess. Financial institutions are only required to report on the valuations which result from running the models and not on the assumptions used to generate the values. It is time we required that assumptions be disclosed and that alternate scenarios be provided so that an outside observer can judge not only the reasonableness of assumptions made by management but also the sensitivity of valuations to those assumptions.
Much of the present crisis is due to words (debt rather than equity, default rather than future opportunity, mark to market rather than distress sales valuation). Fix the words and we can fix the problem.
But the changes must be transparent. And the time to start is now.
Guest article contributed by Michael Lissack
http://www.lissack.com/
