Time to Foreclose the Mortgage Companies

One thing that puzzles many people is how on earth could a relatively small problem with subprime mortgage loans in America have generated a global financial and economic calamity that is already (arguably) rivaling the Great Depression of the 1930s. After all, the total residential mortgage backed securities universe was only $7.1 trillion at its peak, of which just $1.3 trillion were subprimes. Other asset-backed securities were $2.5 trillion, with home equity loans amounting to $600 billion of that. Yes these are big numbers, but US home values were worth $20 trillion. If real estate prices fell by 30%, values would still be worth twice as much as the securities based on homes. And even if defaults reached 50% on subprime loans, it would appear that losses on the securities that used them as collateral could not amount to much more than a hill of beans ($650 billion of defaults, of which 70% is recovered through sale of the home generates losses of less than half a trillion). Even if we add losses on Alt A’s and prime mortgages, plus home equity loans, how could banks have already lost many trillions of dollars, requiring a federal government commitment of $23 trillion to try to resolve the crisis?

Here are three answers offered in partial explanation:

1. In the right conditions, a relatively small perturbation can generate huge fluctuations—like the flapping of a butterfly’s wings in India that creates a tornado in Kansas. Many point to the 1929 stock market crash as the trigger that began the Great Depression because speculators had to meet margin calls, thus, began to sell assets and default on liabilities. Yet, as John Kenneth Galbraith argues in his “The Great Crash”, the total number of players in that stock market boom could not have been a million people. It was the fragile condition of the entire financial system (and of the economy itself, in part due to a grossly unequal distribution of income) that allowed the crash to trigger a depression. As Hyman Minsky argued, over the entire postwar period, the US and even the Global financial system were evolving toward fragility, making “it” (another great debt deflation) possible. The trigger happened to be subprimes, but there were any number of other possibilities waiting to happen. Add onto that a distribution of income that is as bad as it was in 1929 and you have a recipe for disaster.

2. That leads to the second point: the problem was not just with subprimes. All kinds of debts—including those associated with other kinds of mortgages, with commercial real estate, with credit cards, with auto finance, with small business loans, and so on—were structured in a similar manner. To put it bluntly, much of the finance was “Ponzi”—pyramid schemes that make Bernie Madoff look like a piker. As soon as asset prices stopped rising, the pyramid collapsed—so the losses are across all asset classes, and all over the globe.

3. The same financial institutions that created this mess are preventing resolution because it is far more profitable for them to ride out the collapse. They made money hand over fist on the way up, and plan to continue to do so as they drive the economy to hell. Much of the profits are illusory or are provided by government handouts. But there is real money to be made squeezing debtors, as reported in today’s NYT.

Let me give just one example, based on that NYT article and some research done by UBS (UBS Investment Research. 2007. “Investment Strategist” Digital newsletter, November 27). Keep in mind that when we destroyed the thrifts in the 1980s, we transitioned to a new “market-based” home finance model that involves independent mortgage brokers, property appraisers, risk raters, title companies, mortgage insurers, credit default swap sellers, mortgage servicers, securitizers, accounting firms, commercial banks, investment banks, and pension funds and other managed money that hold the securities. In this “originate to distribute” model, almost all concerned live on fee income rather than on the interest and principal payments of homeowners (which service the securities). Of course, this is part of the reason that no one ever bothered to check whether the homeowner would actually be able to make the mortgage payments.

It is also the reason that almost no one in the home finance food chain cares about resolving the home mortgage crisis—it is far more profitable to most concerned parties if the homeowner cannot and does not make any payment. When the homeowner stops making payments, the mortgage company that services the loan makes the payments that are then distributed to the securities holders. In return, the mortgage company collects its normal servicing fee, plus late fees of 6% of the monthly payment. As the NYT reports, these late fees alone can amount to 12% of the total revenue received by loan servicers. (Of course, it is no different in the video rental business or in the credit card business—better late than on time!) It is in the interest of the mortgage companies to maximize the number of delinquencies as well as the amount of time each household is delinquent.

When a house is finally foreclosed, the mortgage servicer has first dibs on the revenue from sale of the house. According to the UBS study, foreclosure can take up to two years (depending on the state and on complications) and total costs—including paying off the servicer—can eat up 90% of the revenue from the home sale. This is why the total losses on home mortgages (absorbed mostly by the securities holders) are so huge even if home values fall by “only” 30%.

As the NYT reports, these mortgage companies actively interfere to ensure that homeowners are not able to renegotiate terms of mortgages instead of going into foreclosure. They prefer a “purgatory—neither taking control of houses and selling them, nor modifying loans to give homeowners a break.” When the foreclosure proceeds, the mortgage companies not only accumulates late fees, but also pay for many other services– often to their own subsidiaries–such as title searches, insurance policies, appraisals, and legal findings. That is all recouped with the property sale. This explains why none of the government policies to date have been able to keep people in their homes by negotiating better mortgages. Indeed, even though the government is trying to bribe mortgage companies with $4000 to modify a loan, they make more money if they drive the owner out of the home. Ideally, they will accumulate claims on the house up to the total market value!