Felix Salmon

Tyler Cowen stops short of calling the mortgage-freeze plan a bailout, so he’s

exempt from the last plea.

But this

kind of thing is still very annoying:

There are two main arguments for breaking the loan contracts. The first is

that we could limit human suffering. The second is that we could forestall

macroeconomic catastrophe. Put together, these arguments have captured many

hearts and minds, but neither is very strong on its own.

There are three reasons this is annoying. The first is that there’s no strong

evidence that anybody is breaking loan contracts – indeed, Tyler himself

quotes Tanta

to the effect that the plan is carefully constructed not to break loan contracts.

The second reason is that Tyler misses out the single biggest reason to break

a loan contract, if a loan contract is being broken: that both the

lender and the borrower end up with more money that way – or at least

the lender ends up with more money while the borrower doesn’t lose his house.

And the third reason is that it’s unclear from Tyler’s post whether he thinks

he’s referring to Bush’s mortgage-freeze plan or not. I think he thinks that

he is, but he does confuse matters by his reference to a debt jubilee.

When Tyler talks about "having the federal government arbitrarily rewrite

legally binding loan contracts," then, he’s constructing a classic straw

man. The federal government is doing no such thing, and no one near the federal

government has proposed doing any such thing. It would be great if the commentary

surrounding this plan stayed in the realm of reality, rather than criticizing

some other hypothetical plan which isn’t going to happen.

Please can the punditosphere stop referring to the mortgage-freeze plan as

a "bailout"? As Edmund

Andrews says in his first sentence on the front page of the NYT today, it

isn’t. The FHA’s FHASecure

plan, which has existed for ages, might conceivably be considered a bailout.

This one involves no government money or government guarantees, and there’s

no transfer of funds from the taxpayer to anybody at all. So it’s not a bailout.

Thank you.

I just got off the phone with a former colleague of mine, who was wondering

who the losers are in the subprime

freeze. What will this do to the balance sheets of banks and buy-side institutions

who ultimately own the loans being modified? (Or, as Floyd Norris puts

it, "Why is it good for a lender to be forced to make concessions to

borrowers?")

The more I talked to him, the more I convinced myself (if not him) that this

really is a positive-sum game, and that everybody is going to win, and that

there will be precious few losers. I’ve already said that I think there

will be very few lawsuits from irate investors who are losing money as a

result of reduced cashflows. But thinking about it more, I actually think there

will be very few investors losing money in the first place.

The reason is that pretty much the entire financial system uses some semblance

of mark-to-market accounting these days: there aren’t many institutional investors

who buy mortgage-backed securities, put them on their books at par, and just

keep them there, at par, until those securities either default or are repaid

in full. But if those investors do exist, this plan changes nothing –

if they haven’t seen the need to revalue their securities until now, there’s

no reason that they should revalue them just because there was a high-profile

announcement in Washington.

Most investors, then, are marking their securities to something: call

it mark-to-market, mark-to-model, mark-to-fantasy, whatever you like.

As we all know, marking to this particular market is very hard, because the

tranche sizes are tiny and liquidity is nonexistent. That’s why banks mark to

model. They plug in the parameters of the debt issue in question, put them all

into a black box, and out the other end comes a valuation. If you change only

one variable, and reduce the interest rate paid on performing loans from say

10% to 7%, then the model will spit out a lower valuation. On the other hand,

if along with a lower interest rate you also put in a lower foreclosure rate,

then you’ll probably end up with a higher valuation, especially if your loss

given foreclosure was high enough to begin with. And if the general discount

rate you use comes down on the grounds that the mortgage freeze has reduced

downside risks to the housing market as a whole, then your model’s valuation

will go up even further.

That’s why the American Securitization Forum has found it so easy to embrace

this proposal: all its buy-side members are likely to look at it and decide

that net-net they’re going to make money, not lose money, from it. To be sure,

there will be a tranche or two here or there which, at the margin, is a loser.

But those tranches will be more than offset by other tranches which are gainers.

Why am I so sure? Because the one thing which is always true in the world of

mortgages is that performing mortgages are worth more than delinquent or foreclosed

mortgages. And the subprime freeze is extremely careful to slice up the universe

of mortgages so that only those which increase in value upon modification are

eligible for that modification.

If you have good credit and are current on your mortgage, you’re not eligible

for the freeze. If you have bad credit and you are behind on your mortgage,

you’re not eligible for the freeze. The only way that you can be eligible for

the freeze is if you have bad credit and you’re current on your mortgage, and

it will reset to a higher rate after January 1, and your mortgage servicer

determines that you won’t be able to make your mortgage payments after they

reset.

Looked at this way, it’s almost guaranteed that the lender will make money

on the modification. Without modification? Foreclosure, and massive losses.

With modification? A steady income stream in the healthy 7% to 8% range, which

the borrower has already proved capable of paying. What’s not to love?

Or, look at it another way. Try naming a single investor who claims this plan

will cause him losses, or who has threatened to sue servicers for implementing

this plan. I certainly haven’t see one. The people complaining about bondholder

losses and violation of the sanctity of contracts tend to be people with no

real skin in the game at all. Meanwhile, the bondholders themselves, through

the ASF, have signed up for this deal quite happily. Which speaks volumes, I

think.

The Milken Institute has chosen today to launch three big studies on subprime

mortgages, which certainly makes it timely. In the first one, we’re told that

subprime

mortgages do help increase homeownership. (Whether

that’s a good thing or

not is of course a different question.) In the second, the

catch-all term "subprime" is examined in the context of 29 different

mortgage products and found to be not particularly illuminating. The third paper

looks

at hybrid loans, concluding that they "will indeed worsen the foreclosure

problem, but they are not the cause of it."

Also worth reading: Nouriel

Roubini, Tanta,

Elizabeth

Warren, Barry

Ritholtz, and the news that S&P thinks the

mortgage freeze may cause downgrades.

Thanks to the wonders of webcasting, I spent a large chunk of this afternoon

listening to president George Bush, Treasury secretary Hank Paulson, HUD secretary

Alphonso Jackson, ASF executive director George Miller, FDIC chairman Sheila

Bair, as well as men in suits from the FRB, the OTS, the OCC, OFHEO, and elsewhere.

The range of emphases was broad. Bush concentrated on the politics, chastizing

the Senate for not passing mortgage-related bills. Paulson was very much the

technocrat; Jackson concentrated on the narrative of suffering families. But

amidst a lot of grand rhetoric there was some actual news. The bit which jumped

out at me is that the mortgage freeze has been explicitly designed as a last-ditch

solution which only becomes an option after refinancing opportunities

have been exhausted.

Specifically, there was a lot of talk by the president and others about the

way in which many subprime borrowers are already able to refinance their loans

through the FHA’s FHASecure

plan. The president would like that plan expanded; according to him, it’s stuck

in the Senate somewhere. But the key point about the subprime mortgage freeze

is that it’s only available to people who are not eligible for FHASecure

or something similar. In other words, the first best solution for any subprime

borrower is to refinance into a federally-insured loan – something which

smells a little bit like bailout to me. Only if that doesn’t work will the private

sector step in with its streamlined process for freezing teaser rates.

I also liked the way in which the president talked about reforming the tax

code so that short sales, say, or any refinancing which involves a reduction

in principal, would for some temporary amount of time no longer generate a large

windfall tax bill.

And I was encouraged too when I heard Sheila Bair say that "in many cases

it would make sense to extend the modification for a longer period" than

the five years outlined in the present plan. There’s no reason that shouldn’t

happen, she said, if it makes sense for all concerned.

This plan has its critics

in the blogosphere, as well as its defenders.

Of course it doesn’t solve the subprime problem at a stroke – no plan

could. But there’s more to it than a simple five-year freezing of teaser rates.

And it’s undeniably a step in the right direction.