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Why banks won't help homeowners                                                                                    

Posted at: May/12/2010 : Posted by: mel

Related Category: Economics,

The investment banking sector is in the toilet. There are millions of homeowners who are underwater on their home loans. The federal government has pushed a program out to banks for restructuring home loans. It would seem obvious that we should be seeing a wave of easy refinancing to resolve this mess, but it just isn’t happening. Sometimes the obvious is just not all that obvious.

Let’s take a look at how we got here so there is a foundation for a common perspective. First we need to define the term “CDO” which has appear in a lot of the media during recent months. CDO is an acronym for Collateralized Debt Obligation. CDO’s first appeared on the scene in the late 1980’s. CDO’s are an investment grade security backed by a pool or bundle of loans, bonds, or other investment assets. The CDO’s of greatest concern in recent years have included mortgage securities. Still confused, let me paint an example. Let’s say that 10 different banks across a 3 state area sell 10 million dollars in mortgages. Each of these mortgages is a contract with either a fixed or some kind of adjustable interest that the thousands of home buyers have agreed to. All these loans get bought by an investment bank, shoved in one envelope and called a CDO. Because these home loans were all issued as contracts, it is easy to calculate the fixed rate of return this CDO will have over a 5, 10, 20, and 30 year lifespan. Pension funds, corporations, and mutual funds are encouraged to invest in these CDO’s because of their guaranteed rate of return. Just to make the CDO more appealing to invest in a third party is ask to provide insurance that guarantees the short and long term interest return from this CDO. By the way, the most common insurer of these CDO’s was and is American International Group (AIG).

Do you see the problem yet? It is all about contracts and who should pay. Let’s say the City Employees Pension fund of “the city of Nowhere” California bought these CDO’s. They have a contract for what the rate of return will be. If the investment bank alters that return downward they will have to pay the difference. I know, something is better than nothing, but no one in this process wants to be the one who gives. The pension fund says we have a contract for a specific rate of return. The bank says we issued a contract and we don’t want to pay the difference, besides “we insured” the rated of return for the investor. Since no one wants to give in, it is easier to let the investment default and turn to the insurance company. Of course we know that this could mean draining the coffers of the insurance company to the tune of hundreds of billions of dollars.

What about that insurance? The cost of this kind of investment grade insurance can very widely depending on the rating or risk associated with a given CDO and its content parts. Unfortunately, until recently, CDO’s were not risk-rated in an open and transparent manner or market, kind of a “trust me…you’ll like it”.

Let’s revisit the adjustable rate mortgages since there are other issues to be considered here as well. Many of the people who are facing mortgage payments they can’t afford are not necessarily good risks for refinancing to a fixed rate loan. Many banking analyst are reporting that these same people would likely default in one to two years if refinanced, making it a poor effort for the bank to pursue. The reality is that these same folks in a more conservative financial climate would never have been offered mortgages of any flavor. Many of the adjustable rate mortgages are associated with homeowners’ who have unverified incomes or who have since lost their income.

So how did we get here? To this question I believe the simplest answer is “lack of ownership”. Through most of the history of the American mortgage industry loans were written by community banks that held the mortgage for the life of the loan. In this situation the bank had a vested interest in being sure the borrower was truly was able to handle the loan over the long haul. Failure to do this meant the bank would end out owning a house which is not the business they want to be in. Remember, banks are in the business of making money through interest compounding. When banks started to bundle and sell the loans they made, they lost their long term ownership in the process. The focus turned to making the commissions on writing as many loans as possible in a short time span. Sounds kind of like the traveling used car saleman of story fame. So a market situation was created that encouraged many people to become home owners who really would not have qualified under more conservative rules.

So what’s the bottom line? A contract is a contract. No one in the banking industry really wants to offer refinancing to these people. Someone would have to absorb the loss of writing the down the expected return on the current loan contract. Additionally, many of these same people would not qualify for a loan under the conventional scrutiny we have now returned to. A bad risk is a bad risk, loaning money to people who are not qualified to make long term payments hurts everyone.

Best of intent set aside, there will likely be a continuing wave of foreclosures for the next few years as this mess is slowly and painfully purged through the system. There are a lot of loans in limbo whose status is likely to move into the default category during the rest of 2010. Until all the unqualified loans are ultimately purged from the system, the home construction and banking industries will be on tenuous ground and everyone suffers from the related uncertainty.

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