Thursday, November 20, 2008

Homeowner Help?

Lately, there has been a lot of talk about helping homeowners who have mortgages that they cannot afford, and risk going into foreclosure. A lot of anger has, rightly, been directed at politicians who authorized $700 billion for a financial bailout, while much less, if anything tangible, has been done for homeowners.

During the course of this year and the last, many different proposals have been thrown around as ways of altering mortgages so that homeowners would be able to pay them. These proposals have usually included measures such as the following:

- negotiating with lenders to reduce interest rates

- negotiating with lenders to switch to fixed interest rates

- negotiating with lenders to reduce the principal of the loan

- negotiating with lenders to allow homeowners to stay in their homes until a payment plan can be devised

None of these efforts have been successful, for one simple reason:

They are unconstitutional

The reason for that is, if banks were to try to alter the lending contracts (mortgages), they would be in violation of the contracts that they have with the people who also own all these mortgages, and by extension, a part of all the homes. This was clearly and eloquently expressed in a Senate hearing yesterday by Senator Charles Schumer. For 20 years, mortgages have been broken up and sold in pieces to thousands of investors, so that lenders don’t own the mortgages anymore. The ones who really own them are hedge funds, pension funds, mutual funds and other Wall Street firms. Trying to force lenders to alter mortgages is useless, because they can’t do it even if they wanted to. If this were 20 years ago, negotiating with banks might have worked.

Imagine if 5 neighbors on a block got together and bought an expensive lawn mower by means of a loan. They don’t really need to mow that often, and by pooling their resources they can get a nicer machine than they otherwise would have been able to get. They agree to make equal payments monthly until the lawn mower is paid for. One day, one of the neighbors tells the others that he does not think the lawn mower is worth what they paid for it, and says that, as a result, he will decrease his monthly payment by 30%. Obviously, the other neighbors are angered by this, because, regardless of the actual value of the lawn mower, the bills still have to be paid based on what the original price of it was.

That is a similar situation to what would happen if banks were to modify any mortgages to make them cheaper for home owners. Because the banks don’t own the whole amount, they cannot unilaterally change the terms of the payments. If they did, it would be a unilateral breach of contract, hence unconstitutional, and the banks would be sued by the hedge funds and other owners of the mortgages.

There is only one solution to the problem of making expensive loans cheaper: to alter the bankruptcy laws, so that when a homeowner files for bankruptcy, the bankruptcy judge can alter the mortgage and make it cheaper. That would not be unconstitutional. This has been suggested by Senator Durban, and supported by Senator Schumer as well as Barack Obama. The present prediction is that, by early next year, this proposal will go through. A bankruptcy judge can do this same thing with other forms of loans today, such as loans for farms, so it’s a procedure that is well established. This could potentially help tens of thousands of homeowners and maybe stabilize the housing market somewhat. At the very least, it would save some houses from being abandoned and eventually torn down.

So what are the problems with this proposal? Well, because the ownership of the mortgages is so spread around the country and around the world, a lot of people would have to take a loss if the values of the mortgages were to be written down. If one day, a certain investment were worth $100, it could be worth $50 the next, after a bankruptcy judge has altered mortgages. Obviously, this will make the stock market go down further, and a lot of hedge funds and other investment firms would go under.

I say, let that happen. These firms are already on the brink of collapse, and Wall Street is so thoroughly corrupt that the solidity of the assets that people in the financial industry sell, can barely even be likened to a house of cards. The United States must move forward without any sort of reliance on Wall Street. That means: no more 401(k)s with stocks in them, no more college savings accounts with stocks in them, higher fees and taxes on buying stocks, no more advertising of financial products and so on and so on.

To illustrate the point of the weak content of financial products these days, consider the following story of a home that was bought in Bakersfield, California in 2005: a Mexican strawberry picker who did not speak any English and made $14,000 per year got a loan to buy a house for $720,000…

Loans such as this one are what make up many “assets” in people’s retirement portfolios these days. Happy retirement!


JimF said...

I believe the values of the derivatives are already written down (sometimes to zero), so lowering the values of the underlying mortgages wouldn't be as severe as you imply.

As for the legality, I'm not remotely a lawyer (thankfully) but contracts are often re-negotiated. If the government could ever figure out what it wanted, it could force write downs.

Jacob said...

Jim, thank you for your comment. It would be legal to write down the value of the mortgages if all the owners agree. That might even be the best thing in terms of value for the individual owners, but not for the stock market as a whole. But getting that agreement would be pretty hard to achieve, since there are hundreds of thousands of owners for each.

The reason this would be so severe is not the write-down value of individual securities, it is that for each individual security, there are thousands of others that are derived from them, "mirroring" them, following the value of them, multiplying the losses of them and so on. This has already happened to some extent, but it's like a cold becomes pneumonia, and the pneumonia becomes lung cancer.

I continue to believe that large institutions are hiding enormous amounts of junk on their balance sheets, and something like this might expose all that. That's the main reason why I think this could be very severe, but necessary.

an average patriot said...

I think the banks could adjust the rated of those that took out Predatory loans but there is no incentive too as it was left up to them to do so. I agree with you that the courts should get involved and force them.

Colette Amelia said...

glad I stopped by.very interesting and thought provoking.

Anonymous said...

I don't think many people who are facing foreclosure will even bother filing for bankruptcy. It's too complicated and it costs too much money.

They will continue to do what they have been doing and that is...just walking away from their houses and telling the banks to take them.

Nobody seems to be talking about what I think is the banks biggest problem: People have become so frustrated, that they no longer give a damn about having bad credit.

Why even bother filing for bankruptcy when you can just walk away?

Lisa M said...

Jacob, did you see the article in Bloomberg today regarding the Fed's proposal for pledging another 7.5 trillion in taxpayer money for bailouts? I'd love to hear your thoughts on this.

Jacob said...


thank you very much for your informative comment. The article can be found here:

The article says that the total amount of money that is potentially at risk in this whole bailout process is close to 8 Trillion. I think this is the number we should be using from now on. I have mainly 2 thoughts on this:

1. The government has no idea what it's actually guaranteeing (as I mentioned in the posting above). As a result, you have to say that 8 Trillion is actually on the line as we speak, and that is just baffling.

2. I would argue that the Federal Reserve has been involved in a usurpation of powers for 20-30 years, a usurpation that has greatly accelerated lately. In the 1800s, the Supreme Court went from being obscure (as it's equivalent is in many countries today), to being one of the most powerful political forces in the country. The same seems to be happening with the Federal Reserve. However, these powers are more easily reversed.

I believe that the Federal Reserve already had too much power, and, as I wrote earlier this year in my posting "Grandma for President", I believe that the Federal Reserve should only have a mandate to deal with inflation. There should also be legislation similar to that of the Economic Stability Pact, which exists in the EU.