Monday, August 25, 2008

How About Subprime Scuttling?

Here's more proof that people do really care about real life--people are still talking about the subprime mortgage mess. We finally have a real world topic other than the invasion of Iraq that lasts longer in the media than Tom Cruise jumping on Oprah's couch or Britney Spears shaving her head. There may be hope for us yet. But let's not get too optimistic. There is still talk of "bailing out" borrowers who are defaulting or about to default on their mortgages. And by "bailing out" I mean using the money of people still able to pay their mortgages and of people who don't even have mortgages to cover the principal that the defaulters cannot cover.

There are several plans that have been proposed by several people, but there is one basic idea common to all of them. To recap the mortgage crisis, people who could not afford the house they bought and lenders who did not care if the buyers could afford the house they bought, bought houses and lent money, respectively. But then the lenders, who would have cared a lot more if they maintained ownership over the loan, sold the loan. If I loan you $10 at 10% interest, then sell that loan to someone for $11, it doesn't matter to me whether or not you can come up with $11 because I'll have made my money already. That's what lenders did. Only to make things worse, they packages the loans and sold them in bulk to groups of investors. That then diluted the perception of risk. So if I sold your $10 loan to my friend Joe, he would definitely care if you could come up with $11 in the future to pay off the loan. If you didn't seem like the type to be able to pay, he surely would not buy the loan from me. But I could sell your loan to 10 people for $1.10 each, and given the dilution of risk, they may not care quite so much if you could pay up in the future. That's what happened to these subprime mortgages.

So of course, these borrowers began to default on their mortgages. And as more and more of them defaulted, the owners of the loans (now sold, or "securitized" and dispersed) began to fully appreciate the risk of owning part of these loans. Of course, they would like to ensure that their investment in safe, but they cannot, because that is the point of buying loans. So as defaults become more frequent, the investors' risk of losing money rises quickly. After all, a defaulted loan pays no principal nor interest. Without principal, the investor gets none of his initial investment back, and without interest he makes no profit. So an investor can either stomach the risk and quite possibly lose a lot of money, of he can sell his stake of the loan. And that's what investors did. And the banks that sold the loans had to "buy" back the loans from the investors, albeit at a lower price. That leads to massive writedowns by the banks and loss of a bank's capital.

Okay, so it's more complicated than all that. But the flow of money and passage of the buck is true. Now so far, nothing has occurred that should make anyone believe the government needs to bail out these fools who bought a house they could not afford. That is where the supposed aftermath comes. What happens if a house in your development goes into foreclosure because the owner defaulted? Statistics say that neighboring house values drop about 4%. It goes up more if more owners default and lose their houses. That means that Joe Schmo loses home equity and cannot take out a HELOC (Home Equity Line Of Credit) because his house has little or no equity now, and so he cannot put in that backyard pool, or buy that BMW X5. Joe then theoretically spends less overall and that hurts the economy, and maybe your business then feels the crunch. Also, property taxes will fall because now homes are worth less. That means your district/city/county will have less to spend on potholes and teacher salaries (or on kickback endorsed construction contracts and high school athletics). So you can see how the greed of several million people affect everyone financially.

What's the solution, then? Well, according to the "experts", the solution is to bail out the borrowers. Most could care less about the banks and investment institutions, who are blamed for lack of disclosure to borrowers regarding risks and lending to borrowers at high risk of defaulting. And how do we bail out the borrowers? We reduce all their mortgages to an amount closer to the new price of their houses. The government takes over the mortgage and steps in if they default on the new lower price mortgage. But don't you worry, general public, not one cent of taxpayers money will go towards this schema unless the borrowers default on the new loan and Uncle Sam has to step in the foreclose. The foreclosure process does cost money, after all. Thus, the default and foreclosure rates will level out and decline, neighboring house prices will stabilize and climb, Joe Schmo will take out a HELOC and spend spend spend, and your community can keep it's inflated budget going strong. Everything will be all right.

Excuse me? Why are we simply giving these people a lower price mortgage? And they still get to keep their house? So we are essentially treating the bad borrower as an innocent victim? The only way that will ever happen is if you divert the public's attention by saying the economy is going to implode if we don't...oh, that's already happened.

The inherent problem that is not being addressed in that the vast majority of borrowers who are now defaulting did not buy a house to have a home. They bought a house to have a cash cow. They bought a large house with a little money and a lot of unfounded optimism that the real estate market would continue to grow. An important point to make is that even people who have had mortgages for over a decade and are worried about their house value falling bought a house for a cash cow. A house is an investment. Investments are risky. If you cannot handle the risk, you shouldn't make the investment. The correct solution is to refinance the bad borrowers for a slightly longer period of time (40 years), but not too long in case they aren't around to pay, and for the SAME AMOUNT as the original mortgage. They would get to keep their house in this case. Alternatively, they can LOSE the house and have to pay the difference in original mortgage and selling price of the house (as though they simply sold at an inopportune time) and possibly with a longer term on the new mortgage. Both ways preserve the nature of investing as a risk and allow some leniency to ensure payback.

The poor handling of the mortgage crisis is a clear case of capitalist gains and socialist losses. Capitalism works both ways. If you want the chance to ride the real estate bubble, you have to accept the chance it'll burst on you. And you'll have to suck it up and take the loss like an American, because this is one ant that isn't going to help you come winter, grasshopper.