Oct012008

Bubble Market Psychology – Part 3

Bailouts and False Hopes

Home Page ImageOne of the more interesting phenomena observed during the bubble was the perpetuation of denial with rumors of homeowner bailouts. Many homeowners held out hope that if they could just keep current on their mortgage long enough, the government would come to their rescue in the form of a mandated bailout program. Part of this fantasy was not just that people could keep their homes, but that they could keep living their lifestyle as they did during the bubble. What few seemed to realize was any government bailout program would be designed to benefit the lenders by keeping borrowers in a perpetual state of indentured servitude. With all their money going toward debt service payments, little was going to be left over for living a life.

All of these plans had benefits and drawbacks. One of the first problems was to clearly define who should be “bailed out.” The thought of bailing out speculators was not palatable to anyone except perhaps the speculators themselves, but with regular families behaving like speculators, separating the wheat from the chaff was not an easy task. If a family exaggerated their income to obtain more house than they could afford in hopes of capturing appreciation, did they deserve a bailout? The credit crisis that popped the Great Housing Bubble was one of solvency, and there was no way to effectively restructure payments when a borrower could not afford to pay the interest on the debt, and this was a very common circumstance. None of the bailout programs did much for those with stated-income (liar) loans, negative amortization loans, and others who are unable to make the payments, and since this was a significant portion of the housing inventory, none of these plans had any real hope of stopping the fall of prices in the housing market.

The main problem with all of the plans is the moral hazard they created because those who did not participate in the bubble and instead behaved in a prudent manner would be penalized at the expense of those who were cavalier about risk. In one form or another either through free market impacts or direct subsidies from the government paid by tax dollars, these bailout plans all asked the cautious to support the reckless. [xv]

Many of the early bailout plans called for changing the terms of the mortgage note. This might have been easy in the days when banks held mortgages in their own portfolios, but it was much more difficult once these mortgages were bundled together in collateralized debt obligations and sold to parties all over the world. Even if it would have been possible to easily change the terms, the resulting turmoil in the secondary mortgage market would have caused higher mortgage interest rates. When an investor faces the risk of the government changing the terms of their contract, and these changes would not be in their favor, the investor would demand higher returns. Higher investor returns means higher mortgage interest rates which would raise the cost of borrowing. This was the opposite of what the government bailout plans were trying to accomplish.

Hope Now?

The first of the numerous bailout programs was “Hope Now” introduced in October of 2007. As the name suggests, Hope Now was sold to the general public as a reason for them to hang on and continue making crushing payments for as long as possible. It was a false hope, but even false hope gave homeowners a little emotional relief, and it provided a few more payments to the lenders. According to their website, “HOPE NOW is a cooperative effort between counselors, investors, and lenders to maximize outreach efforts to homeowners in distress.” [xvi] The plan was to streamline the process of negotiating workouts between lenders and borrowers to keep borrowers making payments and ostensibly to stop them from losing their homes. The emphasis was on making payments and maximizing investor value in collateralized debt obligations. Very few people benefited from the program, despite government claims to the contrary, and no rights or benefits were conferred to borrowers that they did not already contractually have. There was much fanfare when it was first announced, but the program did far too little to have any impact on the housing market.

The next bailout was aimed directly at the lenders with the Super SIV program introduced in October of 2007 (Paulson, 2007). An SIV is a special investment vehicle. It is an off-balance-sheet investment designed to hold investments a company (usually a lender) does not want to show on its own balance sheets. It is a smoke-and-mirrors device used primarily to get around regulations intended to stop lenders from taking excessive risk. The Super SIV program was intended to purchase assets from the troubled SIVs and provide liquidity for lenders who desperately needed it. The problem with the Super SIV was simple: nobody wanted these assets. Moving bad mortgage paper around was akin to rearranging the deck chairs on the Titanic. Few in the general public knew what this program was for, and even fewer cared. Most wanted to know their government was doing something to solve the problem, and the Super SIV announcement provided them with much wanted denial.

In December of 2007, the government offered a more direct homeowner bailout plan. The proposal was to freeze the interest rates on certain loans for certain borrowers for five years. This was greeted as a panacea by all parties, and the beast of homeowner denial was fed once again. As with the Hope Now program, few people qualified, and it did nothing to hold back the tide of increasing defaults and foreclosures. The denial was short lived, and this unnamed bailout plan quickly fell from the headlines.

In February of 2008 Congress and the President signed the Economic Stimulus Act of 2008 temporarily increasing the conforming loan limit for Fannie Mae and Freddie Mac, the government sponsored entities (GSEs) that maintain the secondary mortgage market. The GSEs provide insurance to mortgage backed securities, and by raising the conforming limit, the GSEs were able to insure large, so called “jumbo” loans. This enabled the holders of jumbo loans who were unable to sell these mortgages access to capital in the secondary market. All of this was seen as another reason for homeowners in severely inflated bubble markets to hope the government was going to rescue the housing market.

Forgiveness of Debt

Perhaps the most outrageous suggestion put forth was the suggestion by the FED Chairman Ben Bernanke when he proposed lenders forgive mortgage debt in early 2008 (Bernanke B. S., Reducing Preventable Mortgage Foreclosures, 2008). The moral hazards were obvious. Would people stop making their payments to make sure they qualified? Would more people buy homes they could not afford then appeal for debt relief? Rational people became frightened when they heard the head banker in the United States propose massive debt forgiveness as they realized this meant the entire banking system was in peril. The implications of this proposal were lost on the typical homeowner who only saw how they might benefit from it. Debt forgiveness was the ultimate fantasy of every homeowner. They could be relieved of their financial burdens and get to keep their houses and their lifestyles. It did not matter to the financially troubled that the proposal made no sense and had no possibility of happening, the thought of it would motivate them to hang on a little longer to see if maybe they could hit the jackpot.

Housing and Economic Recovery Act of 2008

In late July 2008, Congress passed and the President signed the Housing and Economic Recovery Act of 2008 that included the following provisions: Federal Housing Finance Regulatory Reform Act of 2008, HOPE for Homeowners Act of 2008, and the Foreclosure Prevention Act of 2008. At the time of this writing, these programs have not been fully implemented, and it is too soon to determine if they are successful. Of course, success can mean different things to different parties. For homeowners, success means keeping their house, getting a lower payment, and profiting from its eventual sale. For lenders and holders of mortgages, success means keeping a steady flow of money coming in from previously insolvent debtors. For the government, success means doing something to make angry homeowners less likely to vote them out of office and keep our financial system from complete collapse. As with many pieces of legislation, it is an ugly series of compromises, and ultimately, none of the concerned parties may deem it successful.

In the Savings and Loan disaster of the late 1980s, the government was liable to investors for their losses through the Federal Savings and Loan Insurance Corporation (FSLIC). The government had no choice but to compel taxpayers to cover the costs of the industry bailout. The Great Housing Bubble had no such direct government liability until this burden was assumed by the government retroactively. The Federal Housing Finance Regulatory Reform Act of 2008 established a regulator to watch over the GSEs. This was too late to do anything about the serious problems facing the GSEs, and it acted as an interim step toward a direct GSE bailout of lenders and investors at the expense of the taxpayers. If one of the GSEs would have failed prior to this legislation, many in Congress would have resisted a taxpayer bailout because the activities of the GSEs were not strictly regulated. Once the regulatory framework was in place, Congress had greater political cover to justify a taxpayer bailout.

In early September 2008, not long after the legislation was passed, the Department of Treasury took over “conservatorship” of the GSEs. It is unclear what will happen once under government control–other than the taxpayers of the United States will be directly responsible for all losses. In time, the government’s interests in the GSEs will likely be sold, and the GSEs will become private companies again, but this time with greater governmental oversight. With any regulatory framework, enforcement is pivotal to its success. If another bubble starts inflating, enforcement may not take priority over profits, particularly when the GSE lobbyists start donating heavily to key Congressional leaders.

The HOPE for Homeowners Act of 2008 and the Foreclosure Prevention Act of 2008 are of primary interest to homeowners. [xvii] It falls well short of what most homeowners wanted: direct debt relief from the government. However, it does provide incentives for lenders and investors to forgive the debts of homeowners, but it makes homeowners agree to take out an FHA loan with a higher interest rate and give half the profits on the eventual sale to the FHA. Neither of those provisions will be palatable to borrowers. Both the lender and the homeowner must voluntarily participate. If the lender is determined to foreclose or if the borrower is determined to give up paying back the loan, neither party is compelled to work with the other. For lenders facing taking a property back in foreclosure, writing off a significant portion of the original loan may be preferable to taking a larger loss in a foreclosure. Desperate owners facing foreclosure may like the idea of debt forgiveness, but their payments will not go down much, and giving up half their appreciation will not go over well when they go to sell the property.

Emergency Economic Stabilization Act of 2008

In early October 2008, the Congress passed and the President signed the Emergency Economic Stabilization Act of 2008. The purpose of the bill was “to restore liquidity and stability to the U.S. financial system and to ensure the economic well-being of Americans.” The law authorized the Secretary of the Treasury to establish a Troubled Asset Relief Program (TARP) to purchase the toxic waste poisoning the balance sheets of lenders and other financial institutions. This measure was passed in response to an unprecedented seizure of the short-term credit markets. Banks quit lending money to other banks once it became apparent that few of them were solvent. This fear spread to all short-term commercial paper and threatened to bring down the entire financial system. It is unclear whether or not this new program will save the institutions holding the toxic waste.

When this legislation was first introduced, there was widespread public disapproval of what amounted to be a transfer of wealth from taxpayers to rich bankers on Wall Street. There was no mention of bailing out troubled homeowners who were the cause of all the financial distress in the lending industry. Since desperate homeowners were not being given any new false hope, they saw no reason to support the bailout. A series of dramatic drops in the equities markets while the legislation was being debated helped turn the tide of public opinion.

The impact of this legislation is unknown at the time of this writing; however, it appears to be designed as part of a controlled implosion of the banking system. With $700,000,000,000 at his disposal and complete discretion on how to spend it, the Treasury Secretary, with cooperation from the Chairman of the Federal Reserve, will be able to sort out the healthy banks from the unhealthy ones, broker mergers and acquisitions and recapitalize the survivors. By October of 2008, the need for bailouts and false hopes had gone beyond foolish borrowers; the banks were the ones who needed some denial.

Zero Coupon Notes

Of all the intervention programs put forward, only one had any chance of providing any real relief to homeowners if it had been implemented, but the terms would not have been to the liking of homeowners, and the long-term implications would not have been pleasant: convert part of the mortgage to a zero coupon bond. A zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. The borrower pays neither the interest nor the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

There were many borrowers who were capable of making the payments on a conventional 30-year mortgage when their loans reset, but they were unable to refinance because they owed more on their mortgage than was allowed to qualify for refinancing. For this group of borrowers, the government could have instituted a “loan guarantee” program similar to what they did for Chrysler in the 80s. It would have been in both the lender’s interest and the borrower’s interest to make the loan and have the borrower continue to make payments, and some banks would have done this on their own (or would have been forced to in a “cram down“); however, many other banks would not, so a government program would have been necessary to prevent further disruption in the market.

Here is how it would have worked for our typical homeowner: Assume a borrower utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Further assume the borrower’s real income (not what was reported on the liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homeowner could have made their payment and kept their house; however, when they later sold their house, they would have owed the bank a great deal of money. If they sold the house in 20 years, they would owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home would have gone to the bank.

This would have solved a multitude of problems: First, it would have provided a mechanism whereby people who were victims of predatory lending could have kept their homes. This would have made the homeowner happy, and it would have kept government regulators out of the lender’s business. Second, it would have made the lenders more money in the long run because they still would have been making their interest profit even if they did not see it until after the home was sold. (Many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures were the primary mechanism facilitating the crash, it would have kept home prices from crashing by reducing the number of foreclosures.

Sounds like a panacea, but there would have been some problems. The first problem would become apparent when people start selling their houses. People are greedy. They would not have wanted to give the bank all their equity when they sold. They would have conveniently forgotten the debt relief and avoiding foreclosure and all the problems they had earlier. All they would have seen is that they sold the house for much more than they paid for it, and they did not make any money. And what happens when the appreciation does not match the term of the note? Would they have completed a short-sale 20 years down the line? This would have caused a huge uproar and more calls for congressional intervention. In other words, for everyone involved the day of reckoning would be delayed, not avoided.

This solution would have done nothing for the affordability problem. If prices did not crash, a great many people really would have been priced out forever. To solve that problem, banks would have had to make zero coupon bonds available to everyone, and eventually everyone would have had them. Think about where we would have been then: we would have become a society of homeowners who had collectively agreed to give all our equity to the bank for the pride of ownership: starts to sound a bit like Pottersville from It’s a Wonderful Life. [xviii] Is that the way we all would have wanted to live?

The zero coupon bond solution would have effectively eliminated the move-up market because people would not have had any equity to take with them from house to house. Unless a prospective move-up buyer has saved a substantial sum or obtained a large pay increase to afford a larger payment, they could not get a more expensive home. This would have resulted in a dramatic flattening of prices. In other words, the low end would have been supported at inflated levels while the high end would have stagnated or declined.

Also, based on the problems above, it would have been difficult to find a new equilibrium in prices. How would people have calculated how much anything was worth? How would all price ranges have been supported equally? Small changes in the interest rate on the zero coupon bond would have made the difference between hundreds of thousands of dollars at the time of sale, particularly on a long-term hold. Does anyone think this would have turned out in favor of the borrower? We would have undoubtedly seen many short-sales as the banks graciously agreed to take all the gains and forgive the rest of the debt. This would take us back to our first problem with angry, greedy sellers.

Finally, this would have been only a short to medium term solution to the foreclosure problem. For as much as we are addicted to credit in this country, there is a point where people would have said “enough is enough.” When a house fails to have any investment value, people would not have been so excited about home ownership. People can blather on about pride of ownership all they want, but people want to make money when selling their houses. Inflated valuations are only supported by greed. If home ownership becomes less desirable, prices would have ended up falling back to their rental equivalent values because the demand would not have been there. In the long run, we would have ended up with prices where they should have been anyway, it would have been a much more prolonged and painful journey very similar to the Japanese experience of the 1990s.

Zero coupon bond structures and other exotic financing terms are quite common in complex real estate deals. Exotic loan terms are the exclusive purview of sophisticated investors who understand what they are doing. They are not intended for consumption by the general public. Given the profusion of interest-only, and negative amortization loans in the market, is not a surprise the financial innovations of the Great Housing Bubble turned out badly.

Let Markets Work

It is difficult not to become cynical about all the various bailout programs, and the proposals outlined were not the only ones discussed in the public forum. There was a steady drumbeat of public plans and announcements that were never substantial, and their only purpose seemed to be to foster denial among those who needed it.

There is no possible bailout program without the commensurate moral hazards and unfair benefits they would contain. The best course of action would be to ease the transition of people from overextended homeowner to renter and not to attempt to manipulate the financial markets for the benefit of a few. There is nothing that can be done to prevent of the collapse of financial bubbles. The solution lies in easing the pain of their deflation and in preventing them from inflating in the future.

Summary

The motivations for purchasing real estate or any asset differ considerably between investors and speculators. Since speculators rely on capturing the change in asset price, they are much more emotionally involved with the gyrations of market resale value, and since their emotions work against them, they most often sell at a loss. Trading houses became epidemic in the Great Housing Bubble. Houses became commodities to buy and sell and lost their intrinsic value as a shelter or a place to call “home.” People utilized 100% financing and treated mortgage obligations as little more than options contracts.

The emotional cycle of an asset price bubble emanates from the emotional cycle of individual speculators. Efficient markets theory would say these emotions are irrelevant as each investor acts rationally based on fundamental market data. Behavioral finance theory argues our herd instincts coupled with irrational beliefs and expectations are primary forces at work in financial markets. Efficient markets theory fails to explain asset price bubbles, whereas behavioral finance theory does. When the bubble bursts, each speculator must go through the stages of grief as she comes to accept her loss. These stages have analogous counterparts in the price cycle of an asset bubble, and it is through the actions of these grieving speculators that the timing of the cycle takes place.

Asset price bubbles can distort the values and behaviors of entire segments of society. Pathological beliefs can take root and grow into an unsustainable system doomed to crash down around all those who subscribe to the cultural pathology. The activity of governments can serve to reinforce pathological behaviors, and when called upon by a desperate public, the government can pander to the emotional needs of the citizenry through generating false hopes and supporting denial.

Many people like it when houses go up in price. During a rally the bulls become intoxicated with greed and obsessed with owning real estate as an investment. However, once houses become an investment, the prices of houses begin to behave like an investment, and volatility is introduced into the system. When houses trade with the volatility of a commodities market, it causes more harm than good. Price volatility is a very disruptive feature in a housing market: the upswings are euphoric, and the downswings are devastating–and there are downswings. Declining house prices are emotionally and financially draining both to individuals and to the economy as a whole. The upswings create massive amounts of unsustainable borrowing and spending, and the downswings create economic contraction, foreclosures and personal bankruptcy. Is the ecstasy of a rally worth the despair of a crash?

Houses should not be viewed as a commodity to trade. Most people lack the financial sophistication to successfully trade in commodity markets. Buying and hoping prices go up is not a successful strategy. Volatility in housing prices is harmful to the community as the financial and emotional costs of the inevitable price crash are just too great. Everyone pays a price. Renters who chose not to participate are forced to wait to obtain the security of home ownership at an affordable price, and buyers who endure the crash… well, their pain is obvious.


[xv] Todd Sinai in his paper, The Inequity of Subprime Mortgage Relief Programs (Sinai, 2008), documented the moral hazards involved with the various programs in the public forum of the time. He accurately characterized the problem as follows, “These programs may help some borrowers, but they do not bestow these benefits equitably. Some reward those who made riskier decisions over those who made prudent decisions, exclude those who live in states that experienced an early economic downturn, benefit those with high incomes at the expense of others, and spread the costs of the program among all taxpayers or future borrowers – regardless of whether they benefit from the proposals.”

[xvi] The Hope Now Alliance website address is http://www.hopenow.com/.

[xvii] The Hope for Homeowners Act of 2008 was built on 5 principals: 1. Long-term affordability. The program is built on the idea, expressed by Federal Reserve Chairman Bernanke, that creating new equity for troubled homeowners is likely to be a more effective way to avoid foreclosures. New loans will be based on a family’s ability to repay the loan, ensuring affordability and sustainable homeownership. 2. No investor or lender bailout. Investors and/or lenders will have to take significant losses in order to benefit from the proceeds of the loans refinanced with government insurance. However, these losses would be less than the losses associated with foreclosure. 3. No windfall for borrowers. Borrowers will share their new equity and future appreciation equally with FHA. Borrowers will pay for the FHA insurance. 4. Voluntary participation. This will be a voluntary program. No lenders, servicers, or investors will be compelled to participate. 5. Restore confidence, liquidity, and transparency. Credit markets are fearful and frozen in part because banks and other financial institutions do not know what their subprime mortgages and related securities are worth. The uncertainty is forcing lenders to hoard capital and stop the lending necessary for economic growth. This program will help restore confidence and get markets flowing again.

[xviii] (Capra, 1946)