The One Sentence Solution for the Housing Crisis

The Housing Crisis

Every day new foreclosure suits are being filed in Northwest Florida -- not to mention harder-hit areas like Tampa Bay and, for that matter, across the nation. Anyone who subscribes to a courthouse filings service or foreclosure-watch web site can attest to the trend.

The daily mortality toll already is approaching bloodbath proportions. According to investment banker Peter Siris, "In 1982, foreclosures represented 3.6% of all homes for sale. Now they represent a staggering 38%."

At the moment it looks like "'at least' 1.4 million homeowners will lose their properties to foreclosure in 2008, according to the U.S. Conference of Mayors. And that's the optimistic view.

The Phony Solution

But George Bush has a plan called "Hope Now", right? It might save as many as a hundred thousand or so (less than 10%) of those unfortunates, right? Not.

Via Digby, we were directed earlier this week to an article by San Mateo, Cal. attorney Sean Orlender in the San Francisco Chronicle:

It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of "teaser" subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.

But unfortunately, the "freeze" is just another fraud -- and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value -- right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

And, to be sure, fraud is everywhere. It's in the loan application documents, and it's in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies - all the way up to senior management - knew about it.

Economics professor Paul Krugman made much the same point a few days ago when he wrote that the Bush administration's plan --

is entirely focused on reducing investor losses. Any minor relief it might provide to troubled borrowers is clearly incidental. And it is does nothing for the victims of predatory lending.

Disaggregating Mortgages to Create New Markets

What led to this crisis in the first place was the effort by investment bankers to create a brand new trading market for what is called "mortgage-backed derivate securities." In a nutshell, investment banks began to buy up multiple mortgages from disparate lending banks and locales. Then, they cross-cut these mortgages, as you might cut a steak across the grain, to subdivide them into smaller bits of commercial paper consisting of, say, the sweetest meat, some tougher slices, a little gristle and a lot of unwanted fat.

But we're talking mortgages here, not meat. In reality, when you disaggregate a mortgage what you are doing is separating some of the rights in a mortgage contract from others -- say, for example, the right to collect all interest payments, or all principle payments, or some other "right" that derives from an original mortgage. When you take those separate bits and re-aggregate, you have new packages of "rights," each a different bundle consisting of "derivative" rights ready to be sold to others.

Ultimately, as we know now, the investment banks got carried away by their own greed. They diced and sliced mortgage-based derivatives into subordinate rights, "rated" the new bundle of rights for investment purposes, then re-diced and re-sliced those derivatives again into yet another kind of commercial paper... and sometimes again... and even again. Each time, the newly created "mortgage-based derivatives" were sold and re-sold and re-re-sold until even the bankers couldn't be sure who owned what, which of the investors (if any) had the right to negotiate with the borrowers, and even who had the right to foreclose if homeowners stopped making payments. Now, many of those bundled securities are nearly worthless.

Hair of the Dog

So, the Bush administration's "Hope Now" program is nothing more than a mirage for most homeowners. And, the investment banks have made such a cocked-up mess of things that no one can be sure just what, if anything, their little share of the once-whole steak is worth, if anything.

However, there is something Congress could do that would bring immediate relief to millions of distressed homeowners and at the same time renew hope that the most troubled mortgages retain value. We call it a "hair of the dog that bit you" solution.

Like the famous nostrum for curing a hangover, it mimics to a degree the original cause of distress. Just as the root of today's crisis lies in the efforts of investment bankers to create a whole new trading market into which they could sell bundled mortgage-based derivatives , so now the solution is to create another housing market.

Check that. Not "create," exactly, and not a "new" market. More accurately, we mean re-create. And it wouldn't be a "new" market, but an old and honorable one that worked exceedingly well until Congress, itself, killed it a few decades ago at the behest of the banking industry.

Creating a 'New' Contract Market
What we are thinking of is the private contract housing market. Time was, in many states, that home owners with an outstanding mortgage could freely sell to willing and able buyers via a private contract. In at least 14 states, local law prohibited the courts from enforcing any "due on sale" clause in a mortgage on the grounds that it interfered with freedom of contract rights and was in any event against public policy.

In those states that either barred "due on sale clauses" or refused to enforce them, instead of requiring every buyer of a mortgaged home to take out a new mortgage loan, the seller and buyer were free (if they wished) to negotiate their own deal. Sometimes, those deals involved the buyer making agreed-upon payments to the seller while the seller continued to make mortgage payments to the bank. Other times, the parties might agree that the buyer would formally "assume" the mortgage and make the monthly payments himself.

For most of our nation's history, private contracts for home sales with freely-assignable mortgages sustained a healthy and vigorous housing market in many states. But then something happened to kill that entire market insofar as homes with outstanding mortgages are concerned. As Robin Paul from California explains on his web site

One trend in the mortgage industry has been the virtual disappearance of assumable mortgages. This is unfortunate for homebuyers, since an assumable mortgage allows them to retain a below-market interest rate and avoid many closing costs, such as a credit check and appraisal. Except for certain FHA and VA loans, almost all mortgages now contain a “due-on-sale” clause which require that the mortgage be paid if there is a change in ownership.

Typical “due-on-sale” language states that, “the Lender may, at its option, declare immediately due and payable all sums secured by the Mortgage upon the sale or transfer, without the Lender’s prior written consent, of all or any part of the Real Property, or any interest in the Real Property.” A reading of the language shows that the term, “due-on-sale” is misleading. In fact, the mortgage may be called in if there is any transfer of any interest in the real estate, and not just a sale of the property.

Back to the Future: Reviving an Old Law as the Solution

The "disappearance" of the assumable mortgage was the direct result of a one-sided piece of legislation engineered in 1982 by the Reagan administration and a cowed (or bought and paid for Congress.) A banking industry-friendly federal law was enacted that effectively killed the "freedom of private contract" rights of mortgagor-homeowners nationwide.

12 U.S. C. 1701j-3 states in pertinent part:

Notwithstanding any provision of the constitution or laws (including the judicial decisions) of any State to the contrary, a lender may, subject to subsection (c) of this section, enter into or enforce a contract containing a due-on-sale clause with respect to a real property loan.

What Congress hath taken away it can grant again. It only remains for some courageous congressman, senator, or presidential candidate to propose a one-sentence solution.

Due on sale clauses are contracts of "adhesion," as the lawyers would say. They are forced on mortgage debtors, not genuinely bargained for. Whatever should it matter to a lending bank (or holders of the mortgage-based derivatives) who makes the mortgage payments as long as they are made? Besides, as Atrios has explained, "The people who actually own the loans aren't in the mortgage business anymore than stockholders in Apple are in the IPod business."

As a matter of economics, due-on-sale clauses also unreasonably restrict the housing market available to sellers. Now we know, too, that they only exacerbate a credit crunch like those we're seeing now.

In the new era of "mortgage-based derivate investments" when the lender you owe is not the lender you know, due-on-sale clauses have outlived their usefulness, if they ever had any. They should be declared unenforceable as a matter of national policy.

AMPLIFICATION DEPT.
12/14 PM

Email responses from some readers point out that making due on sale clauses unenforceable (once again) would not completely solve the credit crisis brought on by imprudent mortgage lending or borrowing practices. Nor does it directly address the problem some homeowners are facing if they've already paid the mortgage but want to sell in the present market.

True enough, as far as that goes. But eliminating due on sale clauses would significantly expand the market of potential home buyers. That's the point. More buyers means greater demand. To that extent, every homeowner benefits whether he has a mortgage or not.

Another reader points out that "due on sale" reform does nothing for foreign or domestic inventors -- like the Florida Local Government Surplus Fund or the city of Narvik, Norway -- who are already stuck with bad commercial paper sliced-and-diced into existence by careless investment banks.

That's only partly true. As and when demand for homes rises, the portfolios of investor institutions like Florida's LGS Fund and Narvik should improve. In any event, it should be plain enough by now that the Bush administration is not principally interested in benefiting homeowners. It's the investment banks they want to protect from the consequences of palming off bad paper on unsuspecting customers.

Finally, another reader grumbles that the real winners of due on sale reform would be wealthy speculators seeking to invest in home purchases on the cheap. They wouldn't necessarily have to go through a bank; the seller becomes their 'lender.'

Our answer to that is those speculators are out there now. Like the poor, we shall always have them with us. Indeed, a good many seem to be gathering at the Canadian border, strongly-appreciated loonies in hand, just waiting for the U.S. housing market to bottom out.

They'll be buying, sooner or later. Wouldn't it be some relief to distressed homeowners if it was sooner, rather than later?