Bailout

Let?s not bail out more subprime lenders

By Felix Salmon

Gretchen Morgenson is absolutely right, in the words of her headline, that “Housing Doesn?t Need a Crash. It Needs Bold Ideas.” The problem is that the bold idea she’s pushing is not the kind of bold idea that housing needs. Meanwhile, she sidles up to a genuinely good, if not particularly bold, idea, but fails to connect her own dots:

Many lenders and some government agencies bar borrowers who sold their homes for less than the outstanding loan balance ? known as a ?short sale? ? from receiving a new mortgage within a certain period, sometimes a few years.

For example, delinquent borrowers who conducted a short sale are ineligible for a new mortgage insured by the Federal Housing Administration for three years; Fannie Mae blocks such borrowers for at least two years. Private lenders have similar guidelines…

68 percent of properties in Nevada are worth less than the outstanding mortgage, CoreLogic said, while half in Arizona and 46 percent in Florida are underwater.

So, the first, easy thing to do is to get rid of the blunt restrictions on lending to people with a short sale in their recent past: the housing market needs all the potential buyers it can get, right now. Once upon a time, it might have made sense to think that people with recent short sales would be such bad credits that no bank should think about selling them a mortgage. But not now, when the presence of a short sale on your credit report is likely to say much more about the broader housing market in your region than it does about you.

Of course, lenders can always refuse any individual for any reason, after doing their underwriting. But there’s no point in having a blanket restriction on lending to people who have done a short sale.

But that’s not Morgenson’s bold idea. Instead, she reckons that Fannie and Freddie should happily step in and refinance — at par — any and all performing subprime mortgages that they can find.

The problem with this is the same as the problem with HAMP: there’s no principal reduction. Without principal reduction, these borrowers will remain underwater on their mortgages, and therefore will remain at very high risk of defaulting.

Think about it this way: the subprime mortgage crisis came about because banks were blindly and happily lending 100% of a home’s value. Now Gretchen Morgenson wants the U.S. government — through Fannie and Freddie — to lend out much more than that: maybe 150%, maybe more. That’s idiotic.

Here’s how the Congressional Oversight Panel characterizes such schemes:

Lack of principal forgiveness means that homeowners will continue to be underwater. It also means that more of each payment will be going to interest, rather than paying down principal, and it may mean that some borrowers have to pay for a longer period of time. All of these factors increase the re-default risk on modified mortgages, and to the extent that a permanent modification is not sustainable, it merely delays a foreclosure and the stabilization of the housing market.

The main beneficiary of Morgenson’s scheme would be the investors and lenders who would jump at any opportunity to take mortgages worth much less than par and sell them at 100 cents on the dollar to Uncle Sam. It’s a bailout of bondholders, primarily, and as such it stinks. These investors, when they lent to subprime borrowers, knew they were taking credit risk. They should suffer some kind of loss now that the market has crashed, and any idea which takes them out at par is fundamentally ugly.

Full post as published by Macroprudential on September 12, 2010 (boomark / email).