Friday, February 22, 2008

Home Scott Free - The Proposed Federal Housing Market Bailout

According to articles in the New York Times and Washington Post the federal Office of Thrift Supervision (OTS) is preparing a plan designed to help ease the financial pain experienced by lenders who recklessly provided highly leveraged financing to prospective home"owners" during the peak housing bubble years and who are now facing enormous potential losses as the US housing market collapses and such loans turn sour. This plan proposes to do this by refinancing those borrowers whose mortgages are now greater than the market value of their home at the current market value and issuing a call option to the owners of the mortgage for the difference between the current market value of the home and the value of the original loan that gives some eventual opportunity to the lender to be made whole on the original loan.

The problem here is that many of these home"owners" now realize that they never really purchased a home at all, they purchased a call option whose strike price was the purchase price of the home. The option was especially attractive for those home"owners" who paid little or no money down since such "owners" had everything to gain if their home appreciated in value and little or nothing to lose if the home's value declined. Now that home prices have begun plunging, home"owners" whose mortgages are greater than the market value of their homes have realized that they can, with relatively little pain, exercise their option at a value of zero by jingle-mailing the keys back to the bank and walking away from their financial obligations. The result is that the owners of these mortgages now understand they have effectively written naked put options whose negative value is the difference between the mortgage value and the discounted price they receive in a short-sale after foreclosure.

Of course, this mother-of-all-bailouts is being spun by the OTS as a plan to rescue those poor borrowers and the NYT article feeds uncritically into this nonsense by focusing the article on poor, unsuspecting upper-middle class people blubbering about their terrible financial choices and their wish to somehow be made whole, with a tale of two of the downtrodden to provide presentation balance. But make no bones about it, this proposal is a bank bailout since it focuses on those loans for which the lenders face the greatest risk, namely those 0% equity, peak-of-the-market loans made in markets with the greatest froth. And, should this proposal actually see the light of day, the effect will be to slow the pace of home value decline in the short run but greatly lengthen the time until an eventual recovery in the market since it will supress demand for years in those households receiving such a "lifeline". If the US wants a 1990's Japan-style deflationary spiral to take hold in the US economy, by all means let this monstrosity of a proposal see the light of day. If not, let the lenders dine on their put options, provide a reasonable safety net for those people who will truly suffer from the housing downturn and, in time, enable households to slowly repair their tattered balance sheets.

No comments: