Foreclosure

[kenberg]

I am sometimes stunned by my own ignorance. I will present a scenario where I truly don't know what is happening currently.

 

1. Pete and Suzy live in a home that currently could be sold on the market for $300,000.

2. They owe $400,000 on their mortgage.

3. They can't/don't keep up the payments.

4. The bank forecloses.

5. Eventually the bank gets the house and puts it on the market. After cutting the price to get it off the books and paying various costs, the bank clears $250,000.

 

So the bank had an asset worth $400,00 on paper and cleared $250,000 on it. Who actually loses the $150,000? The bank? An insurance company? Some holder of one of these credit default swaps? The taxpayer through some FHA guarantee of the mortgage?

 

I have a vague grasp of what happened a year or so back. The banks had passed off the loans to investors and we bailed these investors out so that they wouldn't totally crash the economy. But the morning Washington Post reports that experts are expecting a new wave of foreclosures. I have no idea what is currently happening to the lost value when a foreclosure occurs. I mean, who actually suffers the $150,000 loss?

 

 

I suppose it varies, but is there an answer of the form "Usually X suffers the loss"?

 

I am sort of hoping that it won't be me.

[hrothgar]

The case that you describe is comparatively simple: The bank owns the mortgage, therefore the bank takes the hit.

 

Here's a slightly more complicated version:

 

Let's assume that the the bank sold the mortgage. The buyer repacked 100 slices of the mortgage into 100 separate Collateralized Debt Obligations (CDOs). In this case, the streams to some of the CDOs is going to change (in general, the more senior tranches will not be impacted as much as the junior tranches). Moreover, the default will have an statistically negligible impact on the price of CDOs.

 

The upper tranche of the CDOs are typically owned by companies that want to purchase in investment grade securities. The lower tranches are typically owned by Hedge Funds.

 

Now, lets consider the folks who bought the CDOs. Those same institutions that purchased the investment grade securities typically purchased Credit Default Swaps to protect themselves against little oopsies... The Credit Default Swaps were issued by companies like AIG.

 

At the micro level, this describes what happened: It all sounds nice and simple...

 

Its also completely misleading...

Micro level considerations like an individual foreclosure are complete insignificant.

 

The real story has to do with the covariance between the default risk on various mortgages. Here's a repost of some stuff I posted on this last month

 

____________________

 

Here' an analogy that will help describe what happened to much of the wealth that was transfered:

 

Assume for the moment that you hold a pair of IOUs. Each IOU promises that the lender will pay you $100 in a years time. Each IOU has a 20% chance of default. To make life simple, I'm going to assume that you are risk neutral (you are indifferent between holding the IOU and holding $80). Furthermore, I'm going to also assume that the time value of money is zero (this is a simple example and I don't want to deal with discount rates). Last, but not least, I am going to assume that the pay off for the two IOUs is independent. The chance that one lender defaults is unrelated to the chance that the second lender defaults. (This is the big assumption. We're going to come back to this one in a bit)

 

You decide that you you're going to repackage those two IOUs and create a pair of securities that are backed by the IOU. The first security is the senior tranche from the two IOUs. The first security will pay

 

$100 if neither IOU defaults. (A 64% probability)

$100 if one IOU defaults but not the other. (A 32% chance)

$0 if both IOUs default (A 4% chance)

 

The second IOU will pay

 

$100 if neither IOU defaults (a 64% probability)

$0 if one IOU defaults but not the other. (A 32% chance)

$0 if both IOUs default (A 4% chance)

 

You go off and sell senior tranche for $96 and the junior tranche for $64...

 

The senior tranche is is a very secure asset. It gets purchased by banks and pension funds and other institutional investors that are required to purchase high grade securities.

 

The junior tranche is a very risky asset. It gets purchased by hedge funds and the like (folks who prefer to invest in risky assets)

 

Now, lets consider what happen if the payoff from the two assets isn't independent of one another: For simplicity, lets assume that the two assets become perfectly correlated. In this case,

 

The probability that neither IOU defaults increases to 80%

The probably that one IOU defaults but not the other drops to zero

The probability that both IOUs default increases to 20%

 

Lets consider what happens to the expect value of the two securities

 

The expected value of the senior tranche has just dropped from $96 to $80.

The expected value of the junior tranche has just risen from $64 to $80.

 

People who purchased the senior tranches got destroyed. People who purchased the junior tranches made out like bandits.

 

Now think of the IOUs as mortgages and ask yourself whether the assumption that the chance that multiple mortgages defaults are independent events.

 

This should give you a basic idea about what happened....

[helene_t]

In most European countries, Pete and Suzy still owe the 150.000 to the creditors. The creditors may agree to reduce that amount, the idea being that Pete and Suzy will have a stronger motivation to repay if they have a realistic chance of becoming dept-free. In Denmark there is a legal basis for forcing minor creditors to accept such a dept reduction if the major creditors want it. Dunno about other countries.

 

In Denmark, people tend to have multiple loans on the same house with different priority. Usually the taxman and the building society will get their money but banks and private creditors lose.

 

In the Netherlands, the building society is typically the only creditor (other than local govt) and people tend to borrow lots of money because the interests can be tax deducted, so building societies are likely to lose money.

[Winstonm]

It can get even stickier. Let's say the mortgage backed security similar to what Richard described was bought for $0.94 per dollar, and the owner then used that as collateral for 30X more in loans, with which he bought other MBS, all at $0.94.

 

Now the described house and thousands more just like it foreclose, and not only has there been a loss of $150,000 per house, but there is also a loss in the value of the collateral backing the loans ($400K houses are now only worth $300K), so the lenders on the 30X leverage call for more collateral to back the loans - so the borrower goes into the market to sell some of his MBS but finds that instead of $0.94 he only gets bids for $0.50.

 

So now he has a major problem - he can't sell for any of his holdings for $0.50 as accounting rules force him to mark-to-market the value of all his holdings, so if he sells 5 of these at 1/2 price he has to show all of the rest he still holds as being worth 1/2 price.

 

To keep this monstrosity from occurring, the Fed buys his MBS at higher prices than the market will pay, suspends mark-to-market accounting, and the end result is that whatever loss occurs will be guaranteed by the taxpayer.

 

This somewhat simplistic, but it shows the basic problem with securitizations that go bad.

[y66]

I have heard anecdotally that in Denmark some mortgages are marked down when the property value declines. This sounds like a good idea to me.

[vuroth]

I have heard anecdotally that in Denmark some mortgages are marked down when the property value declines. This sounds like a good idea to me.

Doesn't that disincline lenders from offering mortgages on properties they fear might decline in value? Loaning out 100k to get 85k back in repayments is not good for stockholders....

[helene_t]

I have heard anecdotally that in Denmark some mortgages are marked down when the property value declines. This sounds like a good idea to me.

I don't think that is correct.

 

For so-called "Indekslån" the dept follows the general inflation. I thought that it would make some sense to let it follow the overall property market index instead. As far as I know that has not been done.

 

The construction is not very popular, though. This is partly because the increase in dept, which substitutes part of the interest, is not tax deductible. Partly because people avoid the unfamiliar and prefer old-fashioned mortgages.

 

They have been quite popular for financing subsidizes rental houses, though. Not sure if they still are.

[Winstonm]

Btw, most of the real estate loans in the U.S. are non-recourse, meaning the lender has no other recourse to fend off loss than the property. This has spurred much of the "just walk away" idea for owners to leave properties that are seriously under water.

[hotShot]

The banks "insured" their loss and distributed it by selling CDO's.

The buyers of the CDO's invented insurances for their risk and sold them.

This process was sometimes repeated.

In the end most of those papers where hold by big insurances and investment banks, and by people who had no idea what they are investing in.

These people had a direct loss, but since the insurances invested the money that people where saving there in form of life insurances and pension plans, these pensions will be a little smaller because of the loss.

[kenberg]

Right, Richard, I remembered that previous post of yours and it was very useful I thinkwhat I am asking now is along the lines of "Are we still in the same sinking boat?".

 

If someone owes $400,000 on a house that is now worth $300,000 I am guessing that no one can alter this fundamental problem, at least not short term. Someone has to take the hit. Since I gather that there may be something like a million homes in this situation, it's a problem. I really don't think there is any appetite for a repeat of the bailouts. Even a year ago it's a bit disingenuous to say that we the tax payers bailed them out. Actually we wrote a check to be redeemed by future generations. I am not moaning that it wasn't necessary, I am willing to at least consider it likely that it was. But I don't think we will be doing it again. Yes I know we are getting some of it back but still...

 

Someone is going to lose a lot of money here. Who? And what will be the fallout?

 

Added: A quick comment on the reduce the mortgage: Banks naturally don't wish to do this. Otoh, the facts are ugly. Reducing the mortgage to, say, $325,000 might seem attractive comparde with the alternative of foreclosing and getting back $250,000. That, of course, would be if they were confident that the new mortgage would be paid off. Such confidence is not at hand, and as I understand it this pessimism is at least somewhat reality based.

[phil_20686]

Right, Richard, I remembered that previous post of yours and it was very useful I thinkwhat I am asking now is along the lines of "Are we still in the same sinking boat?".

 

If someone owes $400,000 on a house that is now worth $300,000 I am guessing that no one can alter this fundamental problem, at least not short term. Someone has to take the hit. Since I gather that there may be something like a million homes in this situation, it's a problem. I really don't think there is any appetite for a repeat of the bailouts. Even a year ago it's a bit disingenuous to say that we the tax payers bailed them out. Actually we wrote a check to be redeemed by future generations. I am not moaning that it wasn't necessary, I am willing to at least consider it likely that it was. But I don't think we will be doing it again. Yes I know we are getting some of it back but still...

 

Someone is going to lose a lot of money here. Who? And what will be the fallout?

The number of homes in this situation isnt really the issue, the issue is how many of the people will default on their loans, and that is a big unknown. I really didnt realise that in america if you default the bank takes the hit. In britian if you default and they reposses your house and dont get enough you still owe the bank the balance (normally plus some fees). This means there is a big incentive not to walk away from a house when you are negative equity. I would imagine that even in america there is a fairly strong invcentive not to walk away because your credit rating will go down and you will get charged higer interest on your next morgage.

 

Part of the problem in valuing the risk was that foreclosures are not independent events: in recession they go up a lot, in boom times they go down a lot. If the recession ends and unemployment goes down then there will be fewer foreclosures and less loss.

 

On a related note, the idea of whether the banks will lose more money depends on whther the expected risk (===expected number of foreclosures) actually corresponds to how many there actually are. When they price the asset on their balance sheets they include an adjusmtment for their risk of the loan going bad. If their value turns out to be too low then they "lose money" as the actual money they make is less than they expected. If its too high they can gain money as they make more than expected. The actual rules for how you adjust for the risk are labyrinthine (at least in britian), and i dont really understand how they do it.

 

 

On a somewhat unrelated note i found this pretty good Q&A on the banking crisis - i learned a lot from it.

 

http://online.wsj.com/public/resources/doc...risisqa0210.pdf

 

Also if you are interested in economics i am going to plug my two favourite blogs:

 

http://gregmankiw.blogspot.com/

http://uchicagolaw.typepad.com/beckerposner/

 

the second is not exclusively economics but still has some v interesting pieces. FYI gregory mankiw and becker are among americas top 5 most cited economists, and posner was cheif judge of the 7th circuit court of appeals, and part time law professor.

[kenberg]

I think, but I am not certain, that in theory a person who loses his house to foreclosure is still legally responsible for the remaining debt. But from what I have seen this country deals very strangely with debt. You read in newspaper accounts of people who spend years rebuilding their credit by paying off all of their debt but from what I have seen at closer range if you just ignore the debt then after five years or so everyone just sort of forgets about it. I don't really know how this works. At any rate, with my hypothetical couple if the bank forecloses and nets $250,000, I think that they, or whoever actually holds the mortgage, can effectively kiss the rest goodbye.

 

I have a pretty ominous feeling about all of this. As you say, the issue is not whether the mortgages exceed the value of the property but whether there will also be a default. If there is a default and the property can be sold for roughly the value of the mortgage then however bad it may be for the individual losing his house the pain should be localized. But a large number of foreclosures on property that is worth substantially less than the debt will cause severe trouble, it seems to me. I acknowledge, even insist, that I really do not understand all of this. But lots of foreclosures and limited recovery of the money seems like a big problem to me.

[Winstonm]

You might want to look up recourse versus non-recourse loans on Google as those terms apply to home loans. The nature of the type loan affects who takes the loss.

[y66]

I have heard anecdotally that in Denmark some mortgages are marked down when the property value declines. This sounds like a good idea to me.

Doesn't that disincline lenders from offering mortgages on properties they fear might decline in value? Loaning out 100k to get 85k back in repayments is not good for stockholders....

Yes, which is what I think you want (more accurate pricing of risk), esp. if your goal is more financial stability. It seems to me this would provide a built-in braking mechanism on defaults and also lead to stronger secondary markets in securities that protect mortgage holders against loss of principal (vs weak markets that "protect" against defaults, like the one AIG operated out of a renegade bucket shop in London).

 

I thought I heard Denmark did this. I'm probably misremembering. Have no idea if it makes sense.

[barmar]

If the borrower had to make up the difference, I think you'd see lots of under-water mortgagees declaring bankruptcy to get out of it.

[Mbodell]

A number of things to consider: recourse versus non-recourse loans. In California primary mortgages are non-recourse so the mortgage owners can't come after the defaulters. But refinances are often recourse.

 

So the bank loses, but consider something called PMI. In theory, people who put less than 20% down were required to pay extra for private mortgage insurance that is supposed to cover them for this situation. So there may be a kick back there.

 

Also consider, the person who walks away from their property and gives it back to the bank, if the loan was for $400K and the property's fair market value was $200K when they defaulted then the gov't will consider that they have a win fall of $200K. Which they did if you think about it. If someone gives me a $400K loan and I pay them back later with a $200K object and they forgive the debt that is like them giving me a gift of $200K.

 

Also losing out, are the local gov't that collect property taxes on the property.

 

Also losing out are other home owners in the area.

 

Also gaining are realtors who will likely make commissions of the short sale and/or foreclosure resale.

[mike777]

Excellent thread

 

 

Now guys expand it to all loans to all corporations.

 

 

Now guys expand it to all loans including Greece!

 

 

IN any event this thread is way beyond most. and this is great.

 

----------------------

 

 

this thread basically says.....in bridge terms......after 1nt:

 

we have stayman

we have tfrans.

[kenberg]

Do I detect sarcasm behind this praise? Anyway, I want to carry on. If we really will be hit with another large wave of foreclosures we had better be prepared for what sort of measures we will support politically.

 

I hadn't thought at all of the tax consequences for the individual. Foreclosures have been with us for a long time and I hope that the former home-owner is not left with a large debt to the IRS. But writing down the mortgage to a lesser amount is a recent innovation, as far as I know. Without legislation to the contrary it certainly seems that a write-down of x dollars is a gift from the bank to the homeowner of that x dollars and thus subject to taxation. Since in many cases it has appeared to me that the homeowner borrowed more than was wise and the bank lent more than was wise I have not really been happy with the (perhaps necessary) act of subsidizing the write-down. But not taxing the owner as making a profit seems sensible even though the bank will be able to reduce its own taxes by writing it down as a loss.

 

Psychology counts for a lot in getting support for a policy. If I, as an individual, assist someone in a jam than a large part of my expectation, far more important than any gratitude, is that they not be back the next year with another need. Of course this is all more complicated, a lot more complicated, but I don't think the population will look favorably on suggestions that the government come up with some more cash.

 

 

As to Greece, taking your request for comment at face value, I know even less about that crisis. But I get the idea that some of the psychology is the same. Apparently the normal retirement age in Greece is a few years earlier than in Germany, and a sizable portion of a rescue would involve money transferred from Germany to Greece. Some Germans, and other Europeans, are wondering why they should do that. Again the full analysis is immensely more complicated but the psychology is there.

[Winstonm]

Before anyone tries to jump in with the oft-repeated misrepresentation that CRA caused the crisis, read this about the CRA from Wikipedia: http://en.wikipedia.org/wiki/Community_Reinvestment_Act

 

The law, however, emphasizes that an institution's CRA activities should be undertaken in a safe and sound manner, and does not require institutions to make high-risk loans that may bring losses to the institution.

 

The Federal Reserve, having examined the evidence, holds that empirical research has not validated any relationship between the CRA and the 2008 financial crisis[98]. At the FDIC, Chair Sheila Bair delivered remarks noting that the majority of subprime loans originated from lenders not regulated by the CRA, calling it a "scapegoat" and declaring it "NOT guilty."

 

This may be somewhat off-topic, but this discredited CRA argument presented as a cause of the credit crisis can only still be brought by those whose religious-ferver-like beliefs in their typically ultra-conservative dogma obviates any need to produce meaningful data.

[kenberg]

Winston,

 

I recommend that you don't take as Gospel everything that the government tells you. You are very willing to be skeptical of government claims that you wish not to believe but this desirable trait seems to vanish when the claims go in the other direction.

 

My knowledge of the CRA stuff is small. I assume that the purpose of the law was to get banks to make loans and investments in areas that they would, left to their own judgment, not get involved. Saying that of course the banks should only make safe and sound loans reminds me of W when he was advocating having some social security diverted into stocks. He emphasized that this would only go to safe and sound stocks. I have always thought the to be the right strategy: Make totally safe investments that give a high rate of return. As with buy low, sell high, it's really sound advice. If someone makes an investment that fails, well clearly the law says that he were not supposed to do that. Certainly no one should blame the law, or even worse, blame their elected officials.

 

All that being said, at least some of what went on was nuts.

 

 

Anyway, I want to look forward: If there is to be another large wave of foreclosures, what really should we do? I'm not all that interested in helping someone who has a bigger house than I have meet his mortgage payments. I am not interested in helping people who made bad investments recoup their losses. I hope that both the borrowers and the lenders can work this out themselves, because I doubt that much additional outside help will be forthcoming.

[Aberlour10]

As to Greece, taking your request for comment at face value, I know even less about that crisis. But I get the idea that some of the psychology is the same. Apparently the normal retirement age in Greece is a few years earlier than in Germany, and a sizable portion of a rescue would involve money transferred from Germany to Greece. Some Germans, and other Europeans, are wondering why they should do that. Again the full analysis is immensely more complicated but the psychology is there.

Psychology plays in this special crisis enormous role. Greece needs at the moment from EU-partner like Germany more psychological support on the finacial markets than fresh cash. Several EU states gave such "signals" and the result was: the new greek state bonds over several billions € have been sold out within 60 minutes last week. The financial market tursted in these psychological signals of the European support.

[Winstonm]

I'm not all that interested in helping someone who has a bigger house than I have meet his mortgage payments. I am not interested in helping people who made bad investments recoup their losses. I hope that both the borrowers and the lenders can work this out themselves, because I doubt that much additional outside help will be forthcoming.

 

Ken,

 

We argued for totally unencumbered free markets, and then when those decisions produced massive losses we refused to allow laissez-faire to operate, and bailed out the failed institutions and their bondholders with public funds.

 

It is imperative to know the reasons behind the attempts to keep foreclosures to a minimum - the actual reason is to keep more home inventory from coming onto the market and further depressing home prices, (further diluting MBS values and causing another wave of bank write-downs) although prices are still 15-20% above historical norms.

 

Sometimes you are required to look back in order to know whose solution to trust.

[kenberg]

As to Greece, taking your request for comment at face value, I know even less about that crisis. But I get the idea that some of the psychology is the same. Apparently the normal retirement age in Greece is a few years earlier than in Germany, and a sizable portion of a rescue would involve money transferred from Germany to Greece. Some Germans, and other Europeans,  are wondering why they should do that. Again the full analysis is immensely more complicated but the psychology is there.

Psychology plays in this special crisis enormous role. Greece needs at the moment from EU-partner like Germany more psychological support on the finacial markets than fresh cash. Several EU states gave such "signals" and the result was: the new greek state bonds over several billions € have been sold out within 60 minutes last week. The financial market tursted in these psychological signals of the European support.

Sounds like good news. I'm glad to hear it.

[Gerben42]

Psychology plays in this special crisis enormous role. Greece needs at the moment from EU-partner like Germany more psychological support on the finacial markets than fresh cash. Several EU states gave such "signals" and the result was: the new greek state bonds over several billions € have been sold out within 60 minutes last week. The financial market tursted in these psychological signals of the European support.

 

This is really crazy because the public is okay with giving "psychological support" but do not want one cent of tax payer's money to flow to Greece. What bothers me most is why the governments promised measures to make the banking system more crash-safe and so far nothing happens.

[kenberg]

I'm not all that interested in helping someone who has a bigger house than I have meet his mortgage payments. I am not interested in helping people who made bad investments recoup their losses. I hope that both the borrowers and the lenders can work this out themselves, because I doubt that much additional outside help will be forthcoming.

 

Ken,

 

We argued for totally unencumbered free markets, and then when those decisions produced massive losses we refused to allow laissez-faire to operate, and bailed out the failed institutions and their bondholders with public funds.

 

It is imperative to know the reasons behind the attempts to keep foreclosures to a minimum - the actual reason is to keep more home inventory from coming onto the market and further depressing home prices, (further diluting MBS values and causing another wave of bank write-downs) although prices are still 15-20% above historical norms.

 

Sometimes you are required to look back in order to know whose solution to trust.

Different people will have different reasons. The only justification that I bought into was that there really was a serious possibility of crashing th e whole system. A vague phrase surely, but ominous.

 

I am not a banker. Or a financial analyst. Or etc. Most people whose support is needed for any program are not bankers or financial analysts or etceteras. Do I trust Paulson, Geitner, Bernanke, those guys? Well, yes in the sense that I don't think that they are crooks. And I fully accept that they are proabably just generally smarter than I am and most certainly they are more experienced, better informed, better educated and so on in these matters. Still, basically they collectively said we need 800B or so to fix this, we gave it to them. Coming back and saying oops we need some more will not play well. This won't be because I think I know more than they do, but it still won't play well. If a plumber can fix a leak for $200 and I give him #200, I expect the pipes not to leak. If someone says they can fix the financial crisis for 800B, it's best if when they get the cash they fix the problem.

 

So I have no idea what happens next, but I suggest that the principals in all this figure out what to do without coming back for more cash.