Sheila Bair Displays Practical Good Sense

At least in the spin of her enemies (she had a few) Sheila Bair came across as the Lucy Van Pelt of the mortgage meltdown: as head of the Federal Deposit Insurance Corporation--the "other regulator," alongside Treasury, the Fed and the Office of the Controller of Currency--she was the one who didn't seem to get the memo.  Which memo?  Why, the one that said she was supposed to show up on demand and sign here, here and here, so the big kids could get on with their game.   This was never quite plausible (for one thing, if she was Lucy Van Pelt, who was Charlie Brown?).  But her troops never seemed to have the publicity firepower as her more austere overlords were able to deploy.

So naturally, one looked forward to a memoir from Mrs.Blair, to let her tell (or vent) her side of the policy differences that drove her into the dissenter's role as the A-team struggled so mightily to stay in front of thee onrushing waves.

Now we have it, and so far (I haven't finished it), I'd say she does herself proud.  It's ;perhaps not as entertaining--for which read "intemperate"--as Neal Barofsky's book about his time as inspector-general of TARP (link).  It may lack some of the sophistication that you might expect from a Wall Street Banker, fhe reader is left to her own judgment as to whether that is a defect of a virtue.  What it does display is that Bair had a coherent and clear-headed vision of what her regulatory responsibilities were and a Kansas girl's practicality in trying to meet them..   One gets the sense of her various qaualities at work in the passage below, where she tries to explain one of the great puzzles of the whole sorry episode--why weren't the banks more willing to do workouts on loans that they didn't stand a chance of getting paid off under any scenario.  Here she offers one of the most useful, practical, clear-headed analyses of the problem that I can imagine:

 Prior to the crisis, the job of a residential mortgage servicer consisted primarily of collecting mortgage payments and passing them on to investors. When a loan would occasionally default, the servicer would simply refer the loan to a foreclosure attorney. Servicers were not set up to deal with mortgage default because it happened so infrequently. Similarly, the agreements under which they operated compensated them based on a flat fee; they were not paid more for dealing with a delinquent loan, so their economic incentive was to do as little as possible with a troubled borrower. Indeed, during the go-go years leading up to the crisis,  competition among servicers for the fees generated by the burgeoning securitization market intensified, driving fees down further and making the business one purely of volume, not of effective servicing. Not surprisingly, under that flat fee structure and in the face of intense competition, servicers never invested sufficient resources to deal with significant delinquencies. There are minimal costs associated with collecting mortgage payments from performing borrowers and passing them on to investors. However, when a loan becomes delinquent, working with a troubled borrower to restructure a loan can be a time-consuming, labor-intensive process, particularly if each modification is individually negotiated. Servicers were not compensated for making the extra effort, so why bother?

 Actually, as we would soon discover, if anything, servicers had affirmative economic incentives to go to foreclosure quickly.  That was because when a loan they serviced became delinquent, they were required to continue to advance the mortgage payments to the investors out of their own pockets. If they modified the loan instead of foreclosing, they would be reimbursed by the borrower slowly, over a period of years, by taking out a small part of the borrower’s new monthly payment. On the other hand, if they went to foreclosure, they were paid immediately, off the top, from foreclosure sale proceeds. If you were they, which would you do?
 
 Why wouldn’t investors tell the servicers to modify loans? After all, if a foreclosure cost more money than a modification, it was the investors, not the servicers, who took the loss. But in point of fact, just the opposite happened, with some investors threatening to sue servicers over modifying loans. Why would investors want to sue servicers for trying to rehabilitate delinquent loans? After all, that would usually save them money over the cost of foreclosure. The answer to that question goes to the heart of what I believe was probably the single biggest impediment to getting the toxic loans restructured: the conflicting economic incentives of investors themselves.

 Remember the tranches we discussed? As you will recall, most mortgage securitizations were set up to provide the senior tranche— the triple-A portion of the securitization— with substantial overcollateralization. What that meant was that if a mortgage   defaulted, it had no impact whatsoever on the senior tranche— unless the defaulting mortgages exceeded 20 to 30 percent of the mortgage pool. However, here is the catch: because of the way in which many securitization documents were written, if, instead of a foreclosure sale, the loan was modified, the reduced mortgage payments flowed through to all investors in the securitization pool, meaning that everyone’s income was reduced, including that of the triple-A investors. 

So again,  would you do if you were a triple-A investor? If a loan becomes delinquent and the servicer modifies it with a 30 percent payment reduction, your portion of the payment flows from that mortgage will be reduced along with all the other bond holders. If, however, the servicer simply forecloses on the loan, even if the losses on foreclosure amount to 50 percent, you will still prefer the foreclosure because that entire loss will be absorbed by the lower tranches. From the standpoint of investors as a whole, it obviously makes more sense for the loan to be modified with a 30 percent loss instead of a 50 percent loss on foreclosure. However, from the standpoint of the triple-A bondholders, it makes more sense to foreclose. And the triple-A bondholders were more numerous and more powerful than investors and more powerful than investors holding the subordinate tranches.

 Bair, Sheila (2012-09-25). Bull by the Horns (Kindle Locations 1149-1181). Simon & Schuster, Inc.. Kindle Edition.

East Stroudsburg?

Link.  

Sumner's Take

Scott Sumner, who always does his own thinking, offers up a platter full of non-conventional wisdom on banking, housing and macro.  I won't comment on his macro point; it's an  which I could only reduce the sum of human knowledge and BTW is there any other field of human endeavor with such an unfavorable signal-to-noise ratio?  But let me offer a word about his comments on banks and  housing.

One: I expect he is more right than wrong in saying that the big bank bailouts aren't costing the taxpayers a ton of money--a lot is indeed being paid back.  But that isn't quite the point.   Rather, "payback" is hindsight. The  Feds took huge risk in ladling out all that cash in '08 and if it worked out well, why then it was, as my mother so often said "more good luck than good planning."  We did it, of course, to protect ourselves from catastrophe-- but a catastrophe being inflicted by a banking system that seems less and less to perform any useful public service.


He's also right that depositors (as distinct from owners) got a ton of money from the FDIC--much more, that is, than most people notice.   Still, the fact is that 100s and 100s of small banks went broke in the crisis, with more to come.  Dick Fuld would tell us that he knows a thing or two about going broke and I suppose he does.  Still I think the record support the view that stakeholders in big banks mostly got ring-fenced while stakeholders elsewhere were just left to fend for themselves.

Re housing: partly right again--housing probably is not quite the mess we perceive it to be.  There sure are some green shoot in the desert--even the notoriously parched Las Vegas desert, as credit starts to loose up, and as rent-veruss-own ratios get ever more skewed.   Scott says the "oversupply" of housing (if any) will be soaked up in a heartbeat, and that "houses often last for 100 years."  Do they in fact?  I guess the President still lives in the White House but we've done a bit of upgrading since the British torched the place in the War of 1812.    In California, people do love those old Craftsman treasures, but I suspect that very few have the original bathroom.   How many people, think you, really want to live in a 1946 Levittowner without, at least, a humongous refit? I may be skewed by my own experience: Mr. and Mrs. Buce live happily in a 55-year-old house which we bought 30 years ago--but we've paid almost twice as much for various remodelings as we paid for the deed.  If it is around in 2057, I suspect it will look rather different than it does today.

Ventry on the Mortgage Interest Deduction as a "Social Program"

A must-read of the day: Bruce Bartlett (via James Kwak) on what we get from "social programs" versus what we pay.  Among "social programs," they count the home mortgage interest deduction, although Kwak rightly acknowledges that "you could get into an argument about whether it’s really a social program.'"

At 12:21 pm, in a mood of idle mischief, I fired the link, inviting comment from my colleague Dennis Ventry, whom I knew to cherish firm views on the topic.  At  1:34 pm, my Blackberry began to smoke.  Blowing away the brimstone, I read:

Of course it's a social program. A poorly targeted, inefficient, and inequitable social program, but a social program nonetheless.

If the policy goal is to increase rates of homeownership (a dubious goal in its own right--rather, than, say, increasing the rates of shelter--but one we'll take as a given here), switching from a deduction to a credit would immediately increase the number of homeowners, as would-be marginal buyers (rather than those who'd own a home with or without the deduction/credit) make the tenure decision to own versus rent. Indeed, economists (i.e., except, perhaps, those working for the National Association of Realtors or the National Association of Home Builders) have found that it does not raise rates of homeownership (just ownership of bigger, more expensive homes).

The deduction's inefficiencies are legendary and numerous: distorts cost of housing relative to other investments; contributes to overinvestment in the asset class and misallocation of capital stock; artificially raises housing prices; raises unemployment (by decreasing labor mobility); destabilizes the national economy; encourages overconsumption of bigger, costlier homes; and encourages precariously high loan-to-value (LTV) ratios.

Finally, with respect to its inequities, the deduction disproportionately favors high-income TPs; distributes benefits unevenly across different regions of the country; and discriminates against minorities & low-income households. Moreover, it is the classic upside-down subsidy in that it provides 10x the tax savings for households with income exceeding $250K compared to households between $40K-$75K; provides no benefit to 65% of TPs claiming the standard deduction; provides no benefit to almost one-half all homeowners; no benefit to one-quarter of mortgaged homeowners; no benefit to renters; no benefit to low-income households; and only minimal benefits to middle-income and elderly households.

 Okay, any questions?  

Life Before Google: Community Activists in Chicago

Back when Barack Obama was still in middle school, community activists in Chicago were already at work trying to rev up the troops for housing reform. After a bit of modest local success, they decided to go national.

It wasn't long before West Side Coalition interns headed out to O'Hare International Airport, the one [place where they could find phone books for every big city in the country. They would look for listings that sounded like they could be for community organizations, and back at they office they called those groups, asking them to come to a big conference ...

Such was life before Google. That's Alyssa Katz in Our Lot, a history of thre modern mortgage revolution (a splendid book about which I intend to say more once I've finished it).

Update: Well, yes, I should have specified. The date appears to be 1975.

Better Book than I Expected...

I took a quick spin yesterday through Gregory Zuckerman's The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History yesterday. I figured it for a reporter's quickie and I assumed it didn't deserve much time (then why did you read it at all?--ed. Ah, there you have me!).

But--surprise! It is a reporter's quickie, but it has at least one special virtue that I hadn't anticipated. That is: for a yokel like me, it probably gave me a better insight into the hedge fund craziness than a lot of more ambitious projects. I mean--here we have one somewhat bewildered and more or less invisible guy (okay, so he was first in his class, so were a lot of people)--somebody on nobody's radar--who had the good luck or good fortune to trust his gut and in one day made $1.25 billion.

I suppose you might say it was a bit more than that. Fortune favors the prepared mind. He did have some good research support (specifically, a researcher also willing to trust his gut). But what kind of poise must it take to go back to your backers every day and say "trust me," and then double down, and double down? Nothing about this was inevitable. Yes, "people knew" that the bubble was going to burst someday. But a lot of people didn't get it at all. And even among those who did--hey the landscape is littered with the parched bones of shorts who went insolvent while the market was still stupid.

I won't go so far as to say that Paulson "deserved" the c.$4 billion that he carted home during that one momentous year--that's a proposition too ambitious for me--but I guess I mind him getting it less than I would mind a lot of other things. You might go so far as to say he came by it honestly. So, not a great book, but a pretty good one, well worth a few hours' time. If you want the executive summary, go here.

The Big Builder Problem

Mark Zandi in Financial Shock, his whodunit about the current mess, showcases one issue I hadn't given much thought to before: the role of the builders. Zandi points out that home building traditionally has been low-rent, marginal and undercapitalized: typically one guy with a bunch of addresses in his shirt pocket, overdrawn on his credit line at the bank. That's why God created bonding requirements, mechanics' lien statutes, and criminal penalties for failure to pay subs and suppliers.

Over the last generation, that has changed. There still are plenty of shirt-tail home builders, of coufrse. But Yahoo Finance reports that the four top companies have an aggregate market cap moving on $8 billion.

As Zandi points out, this was supposed to be a Good Thing--bringing in a strong capital base and sophisticated management was supposed to stabilize the industry.

Of course nothing of the sort happened. No doubt there are exceptions, but as a whole, home builders acted just as stupidly and suicidally as bankers. all continuing to rattle the tools without seeming to recognize that the thing they were sawing off was the branch that they sat on.

I suspect you can add this to the lenghtening list of episodes in which a plausible and even compelling "economic" story turned out to be a lot less science than PR hype. I'm not nearly well enough informed myself even to guess what might have happened, but it must have been some combination of (a) suicidal optimism (this time, it's different!) and (b) settled knavery (we'll get our money off the table before the anybody notices that the party is over). Anyway, one more time: welcome to the new world.