The following is an excellent excerpt from the book “DEBTORS’ PRISON: The Politics of Austerity Versus Possibility” by Robert Kuttner from Chapter 8 titled “A Home of One’s Own” from page 223 and I quote: “A Doomsday Machine – As housing prices fell and subprime mortgages began to reset, millions of Americans found themselves at risk of default or foreclosure. Sixty-one percent of subprime loans made in 2006 were in default by early 2010. One home in four, including many with conventional mortgages, was worth less than the outstanding principal on the loan. The housing bubble had produced a glut of speculative new construction. Now the millions of foreclosed or vacant homes added to the oversupply and depressed housing values generally. The declining housing values, in turn, put assets in the portfolios of banks underwater. These two parts of the great housing deflation fed on each other.
It was a far more convoluted mess than the one that confronted Roosevelt. When the New Deal created the Home Owners’ Loan Corporation in 1934 to refinance mortgages, FDR faced a similar downward spiral of falling housing prices, defaulting homeowners, and wounded banks. But Roosevelt, unlike the Obama administration, was willing to restructure the banking system and its entire business model. The government also compelled banks to recognize their losses. In one of Roosevelt’s first acts, the bank holiday of March 1933, the FDIC [Federal Deposit insurance Corporation] assessed which banks were sound enough to open, and closed (or merged) the rest. Roosevelt was not fearful of breaking up the big banks; his Glass-Steagall Act did so deliberately. And when the government helped recapitalize some banks through the Reconstruction Finance Corporation, it got a say in running them.
By contrast, when Obama became president, he inherited from the Bush presidency the new Troubled Asset Relief Program [TARP], whose purpose was to shore up rather than break up large banks. This program, developed in close collaboration with the Fed, was substantially the handiwork of the former president of the Federal Reserve Bank of New York, Timothy Geithner. That same Geithner was now Obama’s Treasury secretary and was not about to repudiate his own strategy for containing the crisis.
Propping up the big banks required colluding with them in creative accounting to reassure the public that they were essentially sound. That goal made it unattractive to compel the banks to book large losses in their portfolio of mortgages. This premise in turn killed the appetite for any program of broad refinancing.
In Roosevelt’s day, there was no securitization to complicate the challenge. So government refinancing of a mortgage was simplicity itself. The HOLC paid off the mortgage and created a new one. Full stop. But by 2009, most mortgages were no longer held directly by banks or thrifts. They had mutated into securities, and many had been split into separate streams of interest and principal. Turning them back into mortgages was technically tricky and politically fraught.
When a borrower fell behind in the monthly payments, the interest of the servicer and the bondholder diverged. The servicer kept getting paid for collection efforts, while it might be in the interest of the investor to reach an accommodation. Prolonged delinquencies actually maximized servicer fees. Conversely, when some servicers did offer relief, they were sometimes threatened with lawsuits by investors who didn’t want to recognize the accounting loss.
In these circumstances, turning underwater securitized loans back into whole mortgages, then refinancing them so that the homeowner might keep the home, was an imperative goal of macroeconomic policy. But it seemed a legal and logistical impossibility. Thus the lucrative invention of securitization, compounded by ever more complex derivatives and then by subprime, did more than cause the financial collapse. It created a doomsday machine that made recovery from the collapse seemingly unattainable.
HAMP, HARP, AND HYPE – Once the Obama administration decided neither to require banks to book losses from underwater mortgages nor to tamper with Frankenstein system of securitization, it was left with a series of feeble second-bests. The core weakness was that any program had to be voluntary to the bankers—who had no incentive to refinance.
Obama’s program, called Making Home Affordable, was unveiled on February 18, 2009. Its centerpiece was a cumbersome scheme with a clunky name to match: the Home Affordable Modification Program [HAMP]. It was budgeted at $75 billion of TARP money; to date, just $3 billion has been spent. Under HAMP, the government offered lenders incentive payments totaling as much as $4,500 per loan if they would reduce monthly payments to no more than 31 percent of a borrower’s gross monthly income. But this was voluntary, and many banks wouldn’t play.
One provision of Obama’s relief bill actually had some teeth. Bankruptcy judges were authorized to alter the terms of mortgages. That provision was fiercely opposed by the financial industry, and Geithner quickly spread the word to Congress that it was not an administration priority. Twelve Senate Democrats who did not wish to offend their bankers joined Republicans in voting against the provision, and it died.
The Obama program was aimed at homeowners who were only moderately underwater. But in much of inner-city America, and in states such as Nevada, Florida, Arizona, and California, half of homes had mortgages of 30 to 50 percent more than the value of the home. In these states, declining prices created a downward vortex. As homeowners walked away, local governments lost property tax revenues; neighbors with conventional mortgages and unblemished credit records lost all of their home equity, too. HAMP did little or nothing for the most damaged areas. The problem was not “unqualified’ borrowers but a collapse of housing values generally.
HAMP created an added layer of gratuitous complexity. Rather than a simple refinancing, the relief was initially to be in the form of “trial modification,” a category invented by Treasury bureaucrats to minimize risks to the banks. To qualify a borrower for relief, the servicer would perform tests based on a complicated formula that included the market value of the house and the borrower’s capacity to pay. According to TARP’s inspector general, the Treasury modified the formula nine times in 2009 alone. Only if the borrower met the terms of the trial modification and stayed current on loan payments for six months could the modification be made permanent.
Obama’s Treasury set an initial goal of five hundred thousand loan modifications by December 2009, but only about seventy thousand had been achieved by year-end. Servicers had been caught unprepared by the February announcement. The entire system of securitization was designed to minimize costs and operate like an assembly line. Loan originators with little training took applications, checked them against a formula, got underwriter sign-off, and approved the mortgages. That worked fine during the boom. But after the bust, restructuring mortgages was a very labor-intensive enterprise that entailed carefully assessing the capacity of the borrower to pay and the likely market value of the house, as well as complying with detailed government requirements to get the bonus payment. In corporatespeak, it was a cost center. Lenders were unwilling to allocate enough staff to do the job properly. An August 2010 survey by ProPublica found that the sevicer bureaucracy was so inefficient that a homeowner applying for a loan modification under HAMP had to submit the same documents an average of six times.
In October 2010, the Treasury reported some 700,000 failed trial modifications, compared with about 460,000 successful ones. And an estimated half of borrowers who received successful modifications fell back into default because either the relief was too shallow or the deeper problems of the recession, namely unemployment, were impairing their capacity to pay.
An underwater borrower mainly needed reduction in the principal amount of the loan. This straightforward approach, however, was unacceptable to the administration because it would have required the bank to book the loss. The inspector general for TARP, source of the funding for HAMP, issued a scorching report in March 2010 criticizing the Treasury’s failure to include principal reduction. The very next day, Treasury officials responded to this and other pleas by announcing a new $14 billion principal reduction program, to be run by the Department of Housing and Urban Development, intended to help one and a half million homeowners avoid foreclosure. Known as the Home Affordable Refinance Program [HARP], it was a bureaucratic maze designed to keep banks from having to book losses. By the end of 2011, only 646 homeowners had gotten relief.
Because the existing mortgage could be worth no more than 115 percent of the home, the vast majority of underwater homeowners did not qualify. Few lenders were willing to participate. In 2012, the administration sought to jump-start HARP by asking Fannie Mae to purchase mortgages with reduced principal. Fannie Mae, however, was still a ward of government, and this initiative was blocked by Fannie’s regulator, Ed DeMarco, who feared that many people would just stop paying their mortgages in order to qualify for relief. His concern was overblown, since a refinancing process would determine whether an applicant was proceeding in good faith. But even assuming Fannie’s cooperation, the program was far from sufficient. DeMarco’s agency calculated that only between 74,000 and 248,000 homeowners would be eligible for principal reduction through Fannie Mae and that fewer would actually get it. Simple refinancing by a modern-day HOLC would be a far better strategy.
According to the Treasury’s most recent documents (from late 2012), about 1.3 million homeowners have received loan relief through HAMP and its variants such as HARP. Roughly half of these are expected to go back into default. This compared with the 10.8 million who owed more on their mortgages than their homes were worth, representing some 22.5 percent of all mortgages. In Nevada, the figure was 67 percent. In California, it was 32 percent. About five million families have already lost their homes to foreclosure, and at least another five million are in serious default and in some stage of the foreclosure process. Over a million of these homes belong to banks, and millions more are vacant, subject to vandalism and dragging down the property value and the security of their neighbors’ homes. With this immense downdraft in the housing market, and with falling wages and rising unemployment, it is hard to see how housing prices can recover in weaker markets.
A better approach was proposed by Sheila Bair, the head of the FDIC. In the case of small and medium failed banks taken over by the FDIC, the process is both rigorous and straightforward. The agency performs a thorough audit. It fully guarantees insured deposits, pays off depositors who want their money back, writes off losses, and temporarily takes over the insolvent bank. The bank is then reopened as a healthy smaller bank, merged into a bank that acquires its assets, or it is shut down.
One failed bank, California’s IndyMac, gave Bair a chance to try out an ingenious strategy for dealing with underwater mortgage loans. When the FDIC took over IndyMac in 2007, in an early harbinger of the mortgage bust, the agency analyzed the entire loan portfolio to see which loans were good candidates for modification or refinancing. IndyMac, as run by the FDIC, modified thousands of loans, sparing homeowners from foreclosure. Bair’s strategy was to ignore the temporarily depressed value of the collateral if the homeowner could make payments on a reduced principal. This was the process that Bair recommended to Geithner. But the model was rejected because the Treasury secretary was unwilling either to have the government temporarily take over insolvent large banks or to undertake direct refinancing, Roosevelt-style. And so the mortgage crisis dragged on and on, sandbagging the recovery and the dream of homeownership.
In the absence of more robust remedies, the government was left with only one policy: the Fed’s strategy of very low interest rates. This helped homeowners with good credit and positive equity, but it did not cut the debt overhang. Between 2001 and 2012, the spread between lenders’ cost of money and average mortgage rates widened by a full point, as fees became ever more of a profit center. When borrowers complained, lenders cited the cost of complying with new regulations—which were necessitated by their own propensity to excess! The remedy of cutting the Gordian knot by vastly simplifying the system or making direct government loans was off the table.”
(THIS BOOK TALKS ABOUT WHAT HAPPENS WHEN A COUNTRY BECOMES A DEBTOR NATION, MUCH WORSE THAN WHAT FRANKLIN ROOSEVELT HAD, MAINLY BECAUSE OF THE SUBPRIME HOME LOANS AND ALL THE RIDICULOUS WAYS THEY CONNED THE BANK CUSTOMERS INTO GOING WAY FARTHER IN DEBT THAN THEY SHOULD HAVE, WHICH EVENTUALLY CAUSED THEM TO GO BANKRUPT, WITH THE BANK HOLDING THE LOAN AND DOING WHATEVER THEY WANTED TO DO WITH VERY FEW REGULATIONS ON THEM. THIS IS WHY SENATOR ELIZABETH WARREN, WHICH I AGREE WITH, STATED ABOUT HIS BOOK on the BACK COVER AND I QUOTE:
“Robert Kuttner has a gift for clear and forceful explanations of the complex dealings that brought the economy to its knees. Debtors’ Prison takes an innovative approach to economic history, using the lens of credit and debt to explore past boom-and-bust cycles and to illuminate the central issues in current economic debates. Kuttner’s impressive history also catapults the reader into the future, providing critical insight on strengthening the financial system. A must-read for anyone interested in our economic future.”
–SENATOR ELIZABETH WARREN
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members