Tuesday, December 25, 2007

Squeezing Blood Out Of The Foreclosure Turnip: Life At The Casino

One of my correspondents from the great nation of Australia wonders out loud what the likely effect of the mortgage credit crisis in the states will be on the people who own pieces of foreign banks that bought and swigged mortgage backed security Kool Aid.

Here's my answer to him.

I think that's quite obvious, my friend, and that is because the financial 'product' that these folks 'bought' could no more be traced to individual mortgages than a Big Mac can be traced to an individual cow-or kangaroo, come to think of it.
The entire shebang was, in fact, casino capitalism writ large.

What happened was that the 'mortgages' (and I use that term advisedly) were loans that objectively had no reasonable possibility of pencilling out, unless and until property values continued to inflate 15-20 per cent per year.
Flip This House Nation, as it appears, was unsustainable.

The loans were generated by mortgage brokers who then sold them the same day to financial institutions and thus on up the food chain to people who had a new wrinkle. Many of these 'mortgage brokers' generated loans that had no objective likelihood of ever becoming paying propositions but that didn't stop the banks from sucking them up like free beer. A lot of those loans were originated with very low initial interest rates and little or no money down....the kicker was that they immediately went upside down, and the interest rates were set to jump in a few years.

A lot of borrowers from Flip This House Nation figured the property would appreciate enough to cover all this. A lot of people also took second and third mortgages under the same sort of rubric, and used the money to buy Harleys and bass boats. People had, as it happens, become a nation of speculators.

The new wrinkle I referred to was that all these individual mortgages would be pooled and homogenized and blended, and bits of the whole would be sold off as 'securities'-which is really no different than what happens when people buy into mutual funds, only the fact that the 'securities' were built on a foundation of sand.

So these loans (with what we now know are dim prospects) went upstream, got merged and repackaged and sold to folks like Deutsche Bank (now leading the foreclosure parade here in Iowa if court filings are any guide), while the individual mortgages were serviced by companies that do just that. They service mortgages, and they're trained to respond in only one way when a borrower gets in trouble. They litigate, even if that's the worst possible thing they can do under the circumstances, because they've got marching orders that haven't been updated in a few years.

Part of what's driving the foreclosure machine is the relative inability to arrange for lender and borrower to sit down together and generate a workout plan. That's because of the inability to determine who is the real party in interest with respect to any individual mortgage.

We had a similar situation here in Iowa in the late seventies which was the so-called 'farm crisis' described herein by Jason Manning.

There was a property bubble, it collapsed, the foreclosure machine got spooled up and the legislature stepped in.

What we ended up with was mandatory farmer creditor mediation. A farm foreclosure can't proceed until the matter's been mediated to see if there's a workout. Part of that was a financial analysis to determine if the farm operation made economic sense and could make the payments on the debt without foreclosure. Part of the underlying consideration was that the lender often stood to lose more money in a foreclosure of a viable farm operation than they would gain over time under a workout agreement.
It compelled people to sit down and have a conversation about what's in their mutual interest, and that's what's lacking at the present time in the residential housing market.

It worked pretty well, in cases where the underlying farm operation was financially sound. But the negotiation was actually between the people who owned the loan, and the person who borrowed the money.

We don't have that connection in the present situation.Our legislature here in Iowa goes into session in January, and I would be very surprised if such a process was not enacted into law for residential mortgages here, because we've got a good model to use and mediators in place. And things are predicted to get worse.

Something needs to be done to staunch the bleeding, and the creditor community is, in my experience, fundamentally unable to act in their best interest when the bloodletting goes outside normal manageable parameters. Part of that may be the ideology of people on the creditor side of things, who have problems functioning when all that moral outrage they're hardwired with runs smack dab up against people who, for whatever reasons, just can't pay.

Mother always said you can't get blood out of a turnip, and a lot of the borrowers in trouble are, unfortunately, turnips right about now. Moral outrage loses its utility as a normative force when you're confronted with a debtor with no assets and no resources.

Ultimately people (banks, institutional and individual investors) who bought those 'mortgage backed bonds' or whatever they were called are going to lose a lot of money, and their depositors who have unprotected assets will see the value of their holdings decline and their liquidity deteriorate. That's inevitable in the collapse of any bubble.

The value of the housing pool will also decline as it becomes rationalized, a lot of loans that were not viable are going to purged, and as you say there will be red ink enough for everyone.

One of our local commentators has observed that there are a lot of people who've been hanging on this winter, trying to get a price that would permit them to avoid a large deficiency that would be the outcome of a distress sale. He says they're going to be in worse shape next year then they are now, because the market's just not going to recover any time soon and the interest rates are going to jump.

On the other hand, people who are creditworthy and can actually point to real assets and steady income should have no trouble obtaining credit as they always have, and they're likely to pick up a lot of bargains selling at distress prices in the process.


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