My previous post on this topic was a personal, emotional rant. This isn’t an apology – it was meant to be a personal, emotional rant. The primary source of my actual personal anger isn’t based on whether it’s good or bad policy but is based solely upon the fact that I’ve paid a lot of money in taxes in my life, there was nothing there to help me when I needed it, and now they’re busy siphoning off my tax dollars to bail out other people again. This has been the story of my life, and sometimes I feel (not unfairly, in my opinion) that I’m being specifically singled out to carry society’s burdens on my shoulders.
But beyond that, the mortgage forbearance plan described is bad policy. It’s not at all obvious that it’s bad policy because most people don’t understand enough about how banks and mortgages work, but it won’t take a very long education at all to see why this is yet another quite large bailout to the people who made stupid loans in the first place. At the same time, it’s very mild (at best) in how it helps actual homeowners, and in the long run it might actually cost them more depending upon details of the plan.
Let’s start with how this is actually another bailout for the banks in disguise. With just a little bit of knowledge about how mortgage loans work this becomes pretty obvious.
We’re going to assume that you purchased a home for $100,000 with 100% financing at today’s low, low interest rate of 3.2% on a 30 year loan. This makes the math pretty straightforward so it’s easy to follow. It also shows that what I’m about to describe holds true even for the best of borrowers with perfect credit and a home that’s truly within their means.
In today’s world, the vast majority of mortgages are not held onto by the organization that originates it. In simpler language, the guy who gave you the money may not be the guy you pay it back to. Instead, that person sells your mortgage to somebody else who hopes to make a profit off of it. How does this work?
To a bank, your $100,000 loan is worth a lot more than $100,000. To be precise, this particular mortgage is worth $193,188.07 – the total amount that you’ll end up paying the bank over 30 years. Or, at least, it’s worth pretty close to that. In reality there are costs associated with the loan, too – collection administration (somebody has to accept your mortgage check and cash it, or chase you down if you don’t pay on time), escrow account management, etc. Also, there will always be some chance that the homeowner will default. Let’s say, for the sake of argument, the buyer of the loan has figured out that over 30 years this is going to come out to about $25,000 in costs on this $100,000 loan. So to that buyer, the loan is worth approximately $170,000 in income (I’ve rounded a bit, don’t sue me) over thirty years. The person who gave you the loan originally only spent $100k plus some administrative costs (we’ll ignore those for this simplistic example), so they’ve only paid $100,000.
At some price in between, it’s a good deal for the originator of the loan to sell it to somebody else to maintain it for thirty years, and also a good deal for that somebody else to buy it. The mortgage originator gets all of his costs back in one lump sum, plus some profit, so he can go out and give somebody else a loan. The buyer of the loan gets a 30 year revenue stream that is, over time, worth a whole lot more than what he’s likely to pay. So they strike a deal. Let’s say that they settle on $135,000 – exactly meeting in the middle. The buyer of the loan has now spent $135k on the house that only cost you $100k.
Now our out-of-work homeowner enters the picture. That person can’t afford the mortgage anymore, so he wants to do a short sale or let the bank foreclose. Let’s assume a foreclosure here, and also assume that the bank can actually still sell the house for $100k (both bad assumptions, but they represent probably the best case for the bank in this situation). The person who bought your mortgage and is now servicing it sells your house for $100k, but they spent $135k on the house. Suddenly they’re out $35k, and things aren’t looking too rosy for them.
Note that this scenario assumes that they foreclose on your house on day 1 and you haven’t paid them back anything yet. This house carries a $536.63 monthly payment on it, so if you’ve been making payments for a year they’ve recovered a bit less than $6.5k of that $35k, but it still means you have to live there for almost 6 years before they break even if they have to foreclose.
Just as importantly, they’ve also lost an income stream going forward, and now they have to find a way to make that back up – or just live with lower profits. Investors aren’t going to like that too much.
Enter the Freddie Mac forbearance plan. Instead of foreclosing, these banks are now giving the owners a year to find a new job. A pretty good portion of the homeowners are probably going to be able to do so. Now, instead of eating a $35k loss, these companies have only lost a year’s worth of revenue from this loan, or $6.5k. But more than that, they haven’t even lost it. The homeowner still has to pay it back, so all they’ve done is postpone that $6.5k in revenue.
It might be even worse than that, depending upon how interest is handled. I haven’t yet been able to figure out if interest accumulates on the loan over that year or not, but I’m willing to bet that it does continue to accumulate. This means that homeowner is going to have to pay back significantly more money than the $193,188.07. Exactly how much more it costs will very depending upon how far into the loan each home is, but it’ll be a couple of thousand dollars per home. So the banks have been given a deal: postpone $6.5k in revenue (you’ll still get it, just one year later) and you’ll get an extra couple of thousand over the life of the loan. This isn’t exactly a terrible deal for the banks even given no other alternatives, but when the alternative is a $35k haircut, this is a terrific deal.
For the homeowner, on the other hand, the deal ranges from “meh” to terrible, depending upon individual circumstances. In today’s environment where the house is very likely worth less than the mortgage, he still can’t move to find a better job in another location. He still can’t sell it and downsize to a home he can more realistically afford. He’s very likely to actually have to pay the bank more money over the long term. His credit report is likely to still take a beating (no word on how this will be recorded yet, but I doubt it will be good). So he’ll still be able to borrow money (probably), unlike if he’d had a foreclosure – but likely at terrible interest rates. Again, a win for the banks.
At best, all he’s really gained is a year to find a new job so he can keep his home. For some people, perhaps many, this will be better than nothing or even a positive thing. But make no mistake, the banks are getting the better end of the deal by far.
I want to make it clear that I’m not at all sure that a bailout for anybody is the correct answer, morally or practically. But if you decide that a bailout is needed, this is the wrong bailout both morally and practically. A far better solution would be to help the homeowner actually pay down the principal of the home. Help make up some of the difference so that the homeowner can actually afford to downsize to a lifestyle he can actually afford, or so that he can move to find another job that pays the same.
Morally, this helps the people who really need it – the regular Joes who did nothing wrong except buy their home at the wrong time (peak of a bubble) and then get laid off – instead of big banks. So what if a couple of big banks go bankrupt? New banks will rise from the ashes. So what if a handful of rich assholes take a bath and lose some money? They’ve got to live like the rest of us now? Cry me a river.
Practically, this helps the economy more. New, stronger banks will emerge from the ashes of bankruptcy and continue on. At the same time, you’ll free people up to be mobile again, making it much easier to pair employees with the jobs that are actually open. Not least, typical consumers will have money to spend again – no small thing in an economy that is so heavily consumer driven.
This plan is better than HAMP, but that’s faint praise. It’s nowhere near as good as the best two options: do nothing, or bail out the actual homeowners.
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