Financial Win-Win or Financial Debacle-in-the-Making: What Is Wall Street Up to Now?

A recent article in the New York Times describes how investment funds are buying “billions of dollars worth of home loans, discounted from the loans’ original value.” The investment funds are helping home owners refinance the loans working with lenders that work with the Federal Housing Administration (FHA) and other Federal agencies. The advantage for homeowners is that because the loans were purchased at a discount, the funds can afford to refinance by reducing the loan amount below the amount of the homeowner's original loan.

The funds make money by selling the refinanced and now taxpayer-insured loans to another Federal agency, the Government National Mortgage Association (GNMA) or Ginnie Mae which in turn bundles them into mortgage-backed securities (MBS) that are sold to other investors.  As long as the refinanced amounts in aggregate exceed the value originally paid by the investment fund for the discounted block of loans, the funds make money.

Homeowners benefit because as of last June roughly 30% of outstanding mortgages were under water. By reducing the value of the loan, homeowners enjoy lower monthly payments, a loan amount that is closer to the home’s true market value, and increased incentives to continue to make payments on the loan. All of this contrives to elevate the probability that they will continue to make mortgage payments (barring job loss) and taxpayers won’t be called upon to pay off the loans when homeowners default.

Is this the beginning of another sub-prime mortgage mess with US taxpayers underwriting investment fund profits or is this an example of the beauty and power of financial markets to “fix” some of the problems created by many of the same players in those markets using  similar securitized instruments?

I don’t know. I know that homeowners are more likely to keep making payments on a mortgage that reflects the true value of the house it secures and they’re more likely to keep making payments when the payments are a smaller share of their income. I know that investors holding MBS that have fallen in value can either hold or sell at a loss. I think some of them deserve to take a loss and if that loss can be turned into a win for homeowners, it’s not a bad thing.

Because I'm an economist, I'm probably not as exercised as some might be by the same wonderful players who nearly bankrupted us now making a profit by refinancing loans. I'm enough of a realist to know that fairness is elusive and markets often don’t even approximate it.

But I also wonder about the loan insurance that taxpayers are being asked to underwrite along with all the other risk and potential liabilities we’ve assumed over the last year or so. If the economic recovery doesn’t include a rebound in consumption and increasing employment, the refinanced loans may be underwater again or in default with US taxpayers obligated to pay investors holding Ginnie Mae MBS.

This is either the best example of the market producing a financial win-win that I have ever witnessed or it is the beginning of a national disaster. I can’t tell which. The best solution would be transparency in these markets. It would greatly reduce the likelihood that Gyges is lurking, obscured behind complex financial instruments, syphoning off capital while US taxpayers are left holding the risk and the obligation to compensate investors holding Ginnie Maes.

Let the sunshine in.

Comments

[Joni Carter]

My gut says this will end in mortgage meltdown part II. There's just too much secrecy for it to be an honest win-win solution. I'm not an economist so maybe you can explain to me why banks that currently hold these mortgages don't follow a similar program. Why is it less painless for them to sell $100 million of shaky mortgages for $40 million to a vulture group than to negotiate with the homeowners directly?

[Maxine Udall (girl economist)]

Not sure, Joni, but Maxine would guess it is a combination of higher transaction costs: high start up costs (i.e., banks lack experience and expertise in restructuring sub-prime and alt-A loans) and inexperienced borrowers increase transaction costs considerably. Here's a link to a recent article in the LA Times that describes some of the problems banks are encountering in restructuring loans: http://www.latimes.com/business/la-fi-mortgage26-2009nov26,0,4853098.story (Maxine feels compelled to point out that the much touted efficiency of the private sector is not evident in this example, which seems odd because it appears banks would gain financially from the restructuring.