Posted by
Paul D. Speer on Saturday, December 08, 2007 12:06:20 PM
the best solution to the sub prime problem would be the simplest one which wouldnot distort the financial marketplace as it is implemented.
Foreclosures result when the asset holder in effect can not provide the lender that payment which results in the rate of return on the asset (the mortgage or securitized mortgage) not matching the payment determined by the market rate of interest (the target rate of return to the lender or the holder of the securitized mortgage.)
Foreclosure stops the payment stream to the lender, ties up his asset portfolio until a new stream provided by the new owner can be substituted. It lowers his rate of return.
During this time (perhaps as long as two years) every other borrower will have to make up the difference --that is, interest rates to them must rise. Offsetting that will be the Fed having to lower the Fed Funds rate. Normally, this interbank borrowing rate might be lowered for other Bernanke reasons as well.
The Fed must now account for the loss of profitability and thus liquidity in the banking system. On the lending side of the equation, rates will not be lowered by the full amount of the change in the Fed Funds rate. Therefore, in order to truly the borrowing rate the Fed will have to go further than the economy would otherwise indicate in lowering their borrowing rate.
This is an artificial political solution to a problem which is better solved entirely within the lending system. As well,ad loans require greater reserves be held against loan losses. The obvious step is to make these loans good -- and marketable.
Proper balance sheet valuation suggests that in the current crisis we take a different look at the balance sheet surrounding the home owner. Under normal circumstance the property has been valued as an asset with the mortgage debt being the liability and the remainder being homeowner's equity -- the latter undividable.
For most properties this logic holds. We are in unusual times. If national economic policy is to avoid foreclosure, the liability must be made good regardless of the interest rate structure. This can be done by lowering the principal amount of the borrowing to that point at which the loan is good paper and replacing the remaining principal with an equivalent senior equity piece to be held initially by the lender.
We can do this by analyzing the mortgagor's income stream, valuing the liability at the market rate of interest, and applying standard lending criteria to the result. If Principal, Interest, Taxes and Insurance (the infamous PITI) placed against borrowers income meet underwriting criteria for the entire remaining principal which meets standard underwriting criteria (25% of income, and other debt including home equity and installment debt no greater than 33%,) the loan is measurably solvent. The loan itself must also not be greater than 80% of estimated market (appraisal) value.
Two problems exist in today's problem loans. PITI and the PITI plus other debt do not meet standard lending criteria, above. The principal amount of the loan is more than 80% of true market value. The second can be solved through legal recourse against the assessment firm and the mortgage broker and settlements applied as below. It is to the first that we offer the following solution.
The loan obligation of the mortgagor on the balance sheet must be marked down to the present value of the future stream of mortgage payments which are supportable and result in the loan meeting the standardized PITI and PITI plus other debt, given the borrower actual income. In exchange, the equity piece in the balance sheet equation is divided into two pieces. The senior piece is the value of the markdown. Call it, if you will, a Preferred Equity position. It is held by the mortgagee. The mortgagor retains the residual value.
We anticipate the following results:
1. Should the mortgagee or his representative (the owner of the securitized mortgage) receive a settlement from the original assessor and/or the mortgage broker, the preferred position is reduced.
2. Periodically, mortgagors income stream will be revalued and the principal amount of the mortgage increased or decreased with an opposing change in the preferred position.
3. Should the property be afterwards foreclosed and sold or sold in an open sale, the holder of the preferred position will receive the first part of the payout and the mortgagor the residual.
Foreclosure can be seen as generally unnecessary but a last resort. This will eliminate most perturbations in the economy and especially the housing market caused by mass foreclosures.
Freezing existing rates with no regard to the price of money and no prospect of loss recovery disregards all the principles of finance.
It would seem to me to be an easy task for the investment bankers and the private hedge funds to unravel their wonderful webs to accommodate the solution above. Having structured, they should be able to remodel. They may be required to buy back their originations to do it, but that would be an appropriate result. Indeed, there may be substantial profit in buying back the preferred positions. In any event, these entities are the logical recipients for the pain they have caused the economy.