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Subprime Crisis Affects Us All

Jim Prevor’s Perishable Pundit, December 14, 2007

Hat tip to the Pundit Poppa for passing along this humorous U.K. take on the subprime mortgage crisis and the role of the markets and investment bankers in general.

It is interesting to see how things play in different cultures. The video, in making reference to the subprime customers, adds a superfluous reference to the prototypical subprime mortgagers’ race — a reference that is both not true and irrelevant. To American ears, it rings slightly racist.

Yet I run it because it so perfectly captures the absurdity of the situation.

One of the problems with relying too much on trade associations and trade publications for business intelligence is that their narrow focus can lead you to miss big, societal issues that can have a major effect on the business.

The subprime crisis is like that. If it is not resolved soon, you will see many bankruptcies result of perfectly good companies. Why? Business depends on rolling over debt and the ability to get short term waivers of covenants.

Very few companies could stay in business if their creditors demanded immediate repayment, and nobody else would take on the banker role. This is true even though these companies may never have been late on even one payment and not in violation of any covenants.

If you think back to Sun World’s first Chapter 11, the key issue was that the company couldn’t refinance the land acquired in its acquisition of Superior. Its original bank was exiting the business, and new banks appraised the land at lower value — thus an industry icon came tumbling down.

Covenants are another issue — most business loans are filled with covenants, and it is fairly common for businesses to require waivers at certain times of year or to complete certain transactions.

The sub-prime mortgage crisis has created a dynamic whereby it is becoming more difficult to get loans rolled over and more difficult to get waivers of covenants.

The reason is not that the sub-prime crisis is so large — best estimates are that even catastrophic losses in this area will not exceed, say, the value of 3% of the world’s public stock markets. The problem is that nobody knows the extent of the losses or who, exactly, holds what securities. Subprime mortgages are not generally held as individual mortgages. After they are issued, they are revamped into securities but the securities do not hold full mortgages.

To make the matter simple, if you have $10 billion in subprime mortgages, you might sell them in ten tranches of a billion each. The top tranche, which has first dibs on any money collected, will probably be rated AAA. Even now, those investors will probably be paid in full with interest. But the 10th tranche, which has last call on any money, will probably pay nothing now — those investors are wiped out.

Until it is clear who owns what, and what it is worth, banks are hesitant to lend, especially to other banks or financial institutions that might have exposure to this area.

But banking depends on borrowing as much as lending, so a hesitancy to lend to a bank quickly translates into hesitancy by the bank to lend.

A combination of higher interest rates and a liquidity squeeze leads banks and financial institutions to refuse to waive covenants and to decide at a loan expiration date that they want to reduce exposure.

Although the PACA trust generally secures most produce vendors, it is not a 100% guarantee, and if you sell things not covered by the PACA trust, it is not a guarantee at all.

The government is desperately trying to do something, but the situation is constraining. The dollar is weak, commodity prices are high… if the Fed tries to lower interest rates enough to save all these institutions, we can expect inflation to zoom.

Many of the government proposals are going to make the problem worse. The government has tried to encourage a pool to buy some of the subprime mortgages from major financial institutions. Of course, they could all be sold tomorrow at market price without any pool. The point seems to be to avoid having them sold at market price. This proposal will make the situation worse by contributing to the obscuring of market prices when what we need is clarity.

The President pushed holders of sub-prime mortgages to agree to a complicated program by which certain people who received mortgages that had low initial “teaser” rates will be spared from having those rates reset for a few years. It is a very complicated plan, excludes more people than it includes and probably won’t, in and of itself, do much harm or much good. But the principle, that the government will pressure people to change the terms of contracts between private parties, will hurt capital markets in the future.

Many other plans are outright catastrophes. For example, John Conyers, the Democratic Chairman of the House Judiciary Committee, is pushing a bill that would rewrite bankruptcy law to allow bankruptcy court judges to reduce the principle amount due on a mortgage and let the debtor keep the house.

Of course, this means mortgages will become much more risky to grant, which means they will become much more expensive.

It is important to keep in mind that many bad outcomes have a silver lining. You may have read projections of over a million homes to be foreclosed on and the immediate image is of a million families being evicted.

Each family’s situation is, of course, a source of sadness. But the story doesn’t end there. The houses don’t get knocked down; they wind up being resold to new families and, probably, at lower prices that these families can actually afford.

So the actual capital stock of America doesn’t grow or shrink from this crisis and the imagery has a good side as well as a bad.

Long term, there are a few steps we could take that reduce the likelihood of such a crisis happening again:

  1. Appraisers must be independent
    In a sense the whole crisis is odd. Even if everyone defaulted on their subprime mortgages, accurate appraisals should mean the losses are minimal. But, today, when the issuers of mortgages rarely hold them for long, the incentive structure is bad. When the Pundit refinanced his mortgage, the first question the appraiser asked was — “How much are you looking to get?” — a question one would think completely irrelevant to his work.
    The key problem is that the mortgage originators are the ones who call for the appraisers and the originators want to do the deal. If the appraiser comes in with low numbers, the mortgage originators never call that appraiser again.
    What we need is some kind of pool of certified appraisers who give out the jobs. In other words, the originators would just ask for the “Appraisers Society” to send an appraiser and they would do so in random order. The originator could challenge an appraiser for incompetence or demand an appeal appraisal, but the originator can never control who gets hired to do appraisals.

  2. Mortgage brokers’ incentives need to be fixed.
    Part of the issue is compensation: Mortgage brokers sometimes get paid based not just on the value of the loan, but based on how high a charge they can get. This makes them like a car salesman who gets a commission not on the value of the vehicle but on how high a profit he can talk you into giving the dealer. We should never allow mortgage brokers to have any financial incentive to steer clients into more expensive products.
    The other issue is responsibility. It doesn’t work perfectly but at least a stock broker has the responsibility to make sure what you buy is appropriate for your investment goals. That is why they always make you fill out those forms defining your goals.
    Mortgage brokers should have similar responsibilities. It is a free country and if a guy wants to stretch to buy a house, he should be able to, as long as someone wants to lend him the money. But let’’s make him fill out the form and declare that he wants to do that — rather than run the risk that a mortgage broker may steer him into taking on more debt than he can presently afford.
  3. We need more flexible financial instruments.
    For all the innovations in financing, they don’t go far enough. We need markets that would serve to reduce the cost of living in a home. Why couldn’t someone buy a house and simultaneously sell the appreciation rights to that house? We need to find ways to facilitate these things so people can get nice houses for their families without stretching so far.
  4. We need to reduce the cost of housing.
    The growth of interest-only mortgages and subprime options has enabled prices on homes to keep going up, but the dangers have been obvious for a long time. It is one thing for home prices to go up due to inflation or to go up due to incomes increasing. But our home prices have been going up due to a combination of people devoting an increasing portion of their income to housing and easier financial standards, such as no longer requiring payment on principle. That meant it had to stop at some point.

There are probably four things we can do to address this problem:

  1. Governments have to move faster. Permit and zoning approvals can take months and sometimes more. Time is money and we need to have default systems that grant approval if action isn’t taken within, say, 30 days.
  2. Building codes are often antiquated, restricting use of prefab construction, plastic pipes, and other economical methods. We need the equivalent of a WTO, a national board where anyone could bring a complaint that a restriction is not based on science. This would break us free of the local political fiefdoms that have kept these inefficiencies in the building codes.
  3. Density is typically key to reducing costs. It also fits very well with the new sustainability ethos as urban dwellers tend to use cars less and leave less of a carbon footprint on the planet. All over the country, density is treated as the enemy, yet if we want affordable housing, it is essential.
  4. Houses have gotten very large and we may need to rethink if this is sensible. This has been encouraged by tax policies that encourage excessive home purchases. Instead of, for example, giving a tax deduction on a mortgage payment — thus encouraging people to borrow and buy bigger houses — why not give a tax credit to encourage home ownership at a fixed amount. Is there any public interest in encouraging people to take mortgages or buy bigger houses?
?

Whatever the future holds, for now the prudent thing to do is to be cautious. There will be fortunes made in this crisis. The obligation to “mark to market” means that all these subprime mortgages will be valued at what they can be sold for now. Because few will want these assets, the price they will sell for is probably significantly less than the value that will be realized as people make mortgage payments, mortgages are renegotiated and as foreclosed properties are sold.

The fact that fortunes will be made doesn’t mean that your best customer won’t be going broke. This is definitely a market environment in which “Cash is King” and caution is the watchword.

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