Yves Smith is one of the Team Members at the popular economics website nakedcapitalism.com. She is a Management Consultant/Corporate Finance Advisor in New York City. She has been working in the financial services industry since 1980 and has had over 40 articles published in such venues as the New york times, Institutional Investor, The Daily Deal, U.S. Banker, The Conference Board Magazine and Boss Magazine.
MW–Will Barack Obama’s mortgage recovery plan help to slow the rise of foreclosures and stabilize the housing market or is it just another public relations fiasco like Henry Paulson’s Hope Now? Nouriel Roubini says this week that, “while reducing monthly payments is positive”, the face value of mortgages will have to be reduced by “20, 30, or 40 percent” to have a meaningful impact on housing. Is Roubini being too pessimistic?
Yves Smith–No, Roubini is right, at least as far as the $75 billion “Homeowner Stability Initiative” is concerned. The results of previous efforts, such as Bush’s Hope Now Alliance and other efforts by servicers to modify mortgages, shows that when mere reductions in payments are made, the failure rate is high. 50% to 60% mortgage modifications redefault in six months.
Why the lousy outcome? Because the reductions in payments are often too small to make a real difference or because they’re only temporary. So, unless the borrower thinks his financial circumstances will improve substantially in the interim, or that the local housing market will rebound strongly, he knows he’s just kicking the can down the road which really doesn’t help.
Another problem is with a deeply underwater mortgage, a borrower has no incentive (even it they could somehow rustle up the money) to reinvest in the house. If the roof starts to leak, or the boiler goes, a stressed owner is almost certain to default, payment reduction or not.
Deep reductions in principal make sense. Due to the high cost of foreclosure, lenders typically recover only 70% on a foreclosure; they lose 30%. Now that the housing market is in such awful shape, their losses are certain to be even greater–probably 40%. Thus for a lender to offer a principal reduction of 20% to 30%, even 40% in the most troubled markets, should be a win-win situation.
And there is proof of this, too. Distressed investor Wilbur Ross owns the largest third party mortgage servicer. He’s been offering deep modifications and has found the 6 month recidivism rate is only 20%, a huge improvement over the “payment reduction” approach.
Another failing of the Obama program is that borrowers are selected for relief based on home payments relative to income. The idea is to get payments down to 31% of income (through lender relief and Federal subsidies) so that fewer people lose their homes. The problem is that if the borrower has other big debts–such as student loans, car loans, or credit card debt– he could still be a goner.
MW–In a recent speech, Treasury Secretary Geithner said that regulators would conduct “stress tests” to make sure that the banks are sufficiently capitalized. But you have pointed out that these tests will not be sufficient because there are not enough examiners to carry out the job effectively. What is going on here? Is Geithner trying to dupe the public into believing that the banks are safe so he can avoid nationalization?
YS–It appears that Geithner does not think nationalization is either necessary or desirable. An increasing number of economists disagree. The US taxpayer has already provided a great deal of financial support to faltering banks; it’s a given more will be required. No private investor would make this large a capital infusion into an entity without getting considerable control and upside. But the Treasury Department under Paulson and Geithner saw nothing wrong with providing massive subsidies to organizations that have been revealed to have considerable managerial weaknesses. Contrast the soft touch treatment the banks are getting with the way the auto industry is being treated.
As for the motives of the stress test, it is possible that Geithner simply doesn’t get it, in terms of the level of effort that it takes to do at least a cursory check that management’s data represents the underlying assets? He’s never been in a bank regulator post, and as you mentioned, the ranks of the FDIC have been thinned considerably since the S&L crisis, with the deepest cuts in the staff that did bank resolutions.
Moreover, the stress tests will not probe the banks’ risk models, those very same risk models that performed so badly. None of the bank regulators have the expertise to make an independent risk assessment.
A comment over the weekend, via CNBC, was revealing:
“Said one high-level official, ‘I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.'”
That certainly sounds like the results are predetermined. I’ve never heard of anything being called a “test” when the results are known in advance.
MW–So far, the Obama administration has done nothing in the area of reform. There’s been no “shake up” at the Securities and Exchange Commission (SEC) and it’s still “business as usual” at ratings agencies. Why is the Obama team dragging its feet on reform when they know that most people’s confidence in Wall Street has already been badly shaken?
YS–It’s hard to know why the Obama administration hasn’t acted. There’s been no official investigation of what went wrong or what needs to be done. That’s in marked contrast with the 1987 crash, where President Reagan formed the so-called Brady Commission within two weeks of Black Monday to investigate causes and recommend reforms. In the Great Depression, the Pecora Commission investigated the causes of the 1929 crash.
The lack of any scrutiny is troubling. Both of these were stock markets crashes, where data is much easy to obtain than in the murky over the counter debt markets that were the epicenter of our current crisis. That would seem to make it even more important to gather information, since it is even more wanting than in prior market meltdowns.
I don’t think there’s any intention to devise meaningful reforms. The key decision-makers, Ben Bernanke, Larry Summers, Tim Geithner, all had major policy roles as the crisis was developing. They are unwilling, perhaps unable, to question the paradigm they helped create. The direction of policy seems to be to restore status quo ante, even though that system produced what is arguably the worst financial crisis in history.
MW–The American people are drowning in debt. In fact, private debt has risen to 290 percent of GDP while household debt skyrocketed to 100 per cent of GDP. Add to that, the fact that homeowners have seen $8 trillion drained from their home equity in the last two years and face $14 trillion in consumer debt. These are staggering numbers which suggest that US consumer will not lead the world out of recession as some people expect.
No one disputes that fixing the financial system is necessary, but why is there no effort to strengthen the middle class and get working people out of debt? If the US fails to spark demand by creating good paying jobs, won’t we continue to decline as a global power?
YS–Unfortunately, economic policy has taken a turn since the 1980s, and it doesn’t appear likely to change. Prior to 1980s, one of the objectives was not only to achieve full employment, but also to promote conditions that would lead to rising worker wages. We now appear to have accepted the rationale that US workers compete directly with those of emerging economies. Hence, trying to create high paying jobs in the US (except, perhaps, for “knowledge workers” at the top of the food chain) is futile.
Yet Germany, despite its often derided tough labor unions, is an export powerhouse.
As for the US’s relative decline, sadly that seems to be in the cards regardless. Even countries like Sweden, which has implemented good policies to respond to financial crises, have seen their living standards take a permanent hit. Many forecasters in the US and abroad see the world in the early stages of a shift to multilaterralism rather than US dominance.
MW– Securitization seems to be at the center of the financial crisis, but the root problem is difficult to pinpoint. The process of transforming pools of loans into securities that provide a revenue stream can work as long as the underlying loan is made to creditworthy borrowers. But a problem arises when the bank merely serves as the originator of the loan and passes the risk (of default) along to the investor. This creates an incentive for the bank to cut corners and produce as many loans as possible whether borrowers are creditworthy or not. Should banks be required to keep the loans (mortgages) on their books to maturity or can securitization be fixed with better regulation?
YS–Even though regulatory fixes can alleviate the problem of bad incentives, the result is that it would require originators to do a much higher standard of due diligence. Why is that a problem? The reason that securitization largely supplanted the old “originate and hold” model is that it is great deal cheaper. Admittedly, the big reason holding loans is more expensive is that the bank has to assign equity against any loan, and implicitly also allow for some deposit insurance costs to be assigned. But the due diligence process over the years also became streamlined to drive costs down further.
Thus improvements, which are badly needed, will result in somewhat higher costs. That in turn will make some mortgages that once appeared economically attractive to lenders unappealing. At this point, that would appear to be a very good thing, since not only were a lot of bad decisions made, but too much credit was extended in aggregate.
The consequence of this sort of move would be that banks would be somewhat less profitable and have to have larger balance sheets relative to the volume of loans they originated. That in turns mean they have to hold more equity. But banks now have too little, thanks to all the losses.
As a result, policymakers have been schizophrenic: they act as if they can prop up the old securitization model in place (in part via the liberal use of federal guarantees, like Freddie Mac and Fannie Mae) and by creating new facilities to bribe, ahem, support investors in securitized paper. They have dropped the ball on fixing the model, despite a lot of sensible suggestions as to how to do so, and one of the reasons may be that it would require capital starved banks to have even more equity.
MW–Is free market capitalism possible without accountability? If Obama is serious about restoring confidence in the system, why haven’t there been indictments? Is it really possible that no one will be charged in, what may turn out to be, the biggest incident of financial fraud in American history?
YS–What helped get us in trouble was this whole slippery “free market” concept. The media and public have been indoctrinated to see “free markets” as virtuous, without defining what they mean. When the notion started to be bandied about back in the Cold War days, it seemed obvious what people meant; private ownership and no central planning. Now the phrase has developed a life of its own and has is used to express opposition to government intervention of any kind, including regulations. Would you really want to live in a country where it was OK to sell adulterated meat?
Rules of various sorts are needed to make markets function well. It would be useful to try to get a better grip on what a healthy level of regulation and oversight would be, since it’s clearly possible to over-regulate as well as under-regulate.
One case strikes me as a clear example of fraud, and if you have one, there are no doubt others. When Lehman went under, most experts assumed that if it has raised $10 billion in capital, it could have limped along for at least another quarter or two. Yet when it collapsed, it left unsecured creditors with over $100 billion in losses (on a balance sheet of over $600 billion).
That clearly says the public financial statements were misrepresenting the state of Lehman’s health and painting a far rosier picture.
And since there has been no investigation of Lehman, much the less any charges, I doubt that anyone save the Ponzi scheme artists like Madoff will be brought to justice.
MIKE WHITNEY lives in the Pacific Northwest and can be reached at email@example.com