October 26, 2010

Two Thoughts on the Mortgage Meltdown:A Plague o' Both Your Houses

I won't for a moment pretend to have read everything written on the topic but here are a couple of thoughts on mortgage meltdown that i haven't seen elsewhere.

One: the banks are going ballistic hanging tough over the question whether they should rewrite some of these deals so that buyers can stay in their homes. They've pretty well sandbagged HAMP and they talk about a possible Chapter 13 writedown amendment as if it were the End of Western Civilization as we Know it.

What this loses sight of is the question of what will happen if the banks don't get writedowns. For borrowers, this is a huge issue, of course. Either they get to stay in their homes or they do not. For banks, I suspect it is not a big deal. The point is: they are never going to see this money anyway.

Consider the debtor with a $400,000 loan on property worth $280,000. He's out of work and can't pay. He walks away, leaving a deficiency claim of $120,000. What then? In a nonrecourse state, the bank eats it as a matter of law: the bank is debarred from pursuing the debtor for the shortfall.

In a recourse state, the bank can sue the debtor for the shortfall, but I suspect in most cases it won't be worth the bother. The debtor either (a) goes bankrupt and discharges the shortfall claim; or (b) does not go bankrupt and just limps along judgdment-proof, i.e., with no assets to play the game.

The point is that in all three cases, the bank is no worse off than if it took a modification. Indeed I can think of only one way that modification changes things and that is it may allow the bank to get more. How can this be? The answer is that if it plays its cards right, the bank may be able to position the debtor where he is obliged (and willing) to pay a bit more than the bare minimum--in our case, say $290,000. If these are the right numbers, than the bank is better off taking a carefully-done rewrite than otherwise.

That's point one. Now onto point two. We hear a steady drumbeat of argument that the debtors ought to get relief because the subprime fandango was full of "massive fraud." Correct, the subprime fandango was full of massive fraud, but look as little closer. From what I hear, the main fraud claim is that the banks (or brokers for banks) structured deals based on grotesquely inflated estimates of the borrowers' ability to pay--faked data about income and employment,l for example. Sounds like fraud to me, but who is defrauded here? Maybe the buyers of this caca, who took it on the bank's recommendations. Maybe the shareholders, entering into the delusion that their agents the managers were spinning straw into gold and thus deserved massive bonuses.

But the borrower? Maybe he was lied to--e.g., when he was told that it was perfectly all right to declare his income at eight times its actual number. Yet for the life of me I can't understand why a grownup loose on the streets could be misled into believing that he could pay, say, a $3,600 monthly mortgage payment from his takehome down at the car wash. 

Sure, there are cases and cases. That's why we have courts and lawyers (and that is why, inter alia, it is so bogus for the banks to say that they ought to be able to foreclose without paperwork). I might add that I'd feel differently if we were dealing with people 26 years into a 30-year mortgage who got whipsawed by some unseen society-wide calamity. But people take chances; it is okay with me that they take chances, but if you take chances, there is a chance that you will loses.

So, a plague o' both your houses.   I don't think the banks are ever going to get their money back on this one and I don't think they deserve to.  On the other hand, I'm not losing much sleep over debtors who so eagerly bought into such a lunatic fandango.

Cross-posted at Underbelly.

February 27, 2010

Why Is This Man Frowning? (Recourse Finance)

 

Per Mark J. Perry, here's reason #1 why the Canadians avoided a bank meltdown: recourse lending:

Almost all Canadian mortgages are “full recourse” loans, meaning that the borrower remains fully responsible for the mortgage even in the case of foreclosure. If a bank in Canada forecloses on a home with negative equity, it can file a deficiency judgment against the borrower, which allows it to attach the borrower’s other assets and even take legal action to garnish the borrower’s future wages. In the United States, we have a mix of recourse and non-recourse laws that vary by state, but even in recourse states, the use of deficiency judgments to attach assets and garnish wages is infrequent. The full recourse feature of Canadian mortgages results in more responsible borrowing, fewer delinquencies, and significantly fewer foreclosures than in the United States.


This is weird in so many ways that it is hard to know where to begin, but grant him his general proposition: There is indeed something problematic about the asymmetric heads-I-win, tails-you-lose structure of non-recourse finance.


The trouble is, once you start looking for it, you find "non-recourse" under almost every rock in the capitalist garden. I'm sure Perry would be happy to show you how the same problem underlies the bankruptcy discharge, where the debtor gets to walk away from his just debts. I'll bet (although I do not know) that he feels the same way about bank insurance, like the free-handed taxpayer guarantees that allowed the mischief-makers to bring down the Savings & Loan industry in the 80s/90s.

But it doesn't stop there. When I buy a call option on LittleCo stock, I acquire the right to take the stock or throw it away--analytically no different from my right when I buy my home on a nonrecourse mortgage. I have not heard Perry howling for the abolition of the conditional claims market, and I am not holding my breath.

Or consider the corporate limited liability form itself, the greatest social invention, so Bertrand Russell is supposed to have said, of the 19th Century. Restated: the equity stake in a leveraged company is a call option on the assets--you can take or walk away, just as with stock options, just as with the nonrecourse mortgage.

Probably nobody ever understood this better than the bankers. Look at that picture above of Mr. Banker Himself, J.P. Morgan Jr. Why does he look like he is ready to explode? Because it's his own skin in the game. He was a general partner. If the deals went sour, he stood to lose every penny. No wonder he was a prudent lender. No lwonder he staked so much on personal character.

Sadly, his successors appear at last to have grasped the full implications of his insight. What caused the late meltdown? Of course you can't bring it down to one cause, but if you had to name just one, I'd say--incorporation of investment banks, the great tectonic shift from unlimited to limited liability.* That's when the bankers stopped having skin in the game: when they shifted to heads-I-win, tails-you-lose. They bankers didn't worry about taking lunatic risks because they knew the downside was yours, or rather ours (indeed, any first semester MBA student can show you, the greater your capacity to shift he losses, the greater the inducement to take a risk and the more lunatic the risks you take).

I grant, there is a great puzzle here: why do shareholders get bankers get away with it--or more generally, why does anybody ever buy stock in a bank? But the same specter haunts Perry's argument: if banks operate in a regime of nonrecourse finance, you'd think it would make them more cautious in their lending, more prudent in protecting against risks that they couldn't offload. I don't know the answer to that, but Perry doesn't even seem to notice that it is a problem.

Final Jibe: I think it's pretty rich to see an endorsement of Canadian banking from a crowd who have spent the last dozen years or more telling us about the evils of Canadian health care.

Afterthought: and how could I have forgotten the biggest nonrecourse of them all?

--
*I first grasped this point in reading Barry Ritholtz' Bailout Nation, though I am not sure he would press it quite as far as I do.

[Cross-posted (with minor tweaking) here.   The piece was also picked up at  Brad DeLong's blog, where it has generated an interesting comment thread.]

Update:  Returning visitors will note the vastly improved glower on the face of JPM, but what is it with the knife?