Crony Capitalism for Dummies: Housing and Economic Recovery Act of 2008. How the Bailout will not Help you and Cost you Money. A Deep Look at the 694 Pages of the Bill.
As it stands, the Housing and Economic Recovery Act of 2008 otherwise known as the housing bailout bill is moving quickly through both the House of Representatives and the Senate. This weekend, the Senate overwhelmingly passed the bill with a 72-13 vote and now heads to the White House for President Bush’s signature even though he earlier voiced that he would not sign such a bill. As it stands, the majority of our politicians are backing this bill which as time goes on, will prove to be the biggest and most costly bailout in American history. Time will prove this out.
In this article, I have taken some time at digging through the 694 pages of the bill and will highlight some of the most important mechanics of how this will play out in the country. The initial centerpiece of the bill was a $300 billion FHA-insured mortgage nucleus that would allow cash-strapped buyers and lenders to refinance toxic mortgages. As you will see in this article when we deconstruct this part of the legislation, very few people stand to benefit from this smoke and mirrors. The more troubling aspect of the legislation is a stealth bailing out of Fannie Mae and Freddie Mac with an almost bottomless pit of financial access. The bill practically guarantees a taxpayer bailout for these two.
The problem with our current politicians is this. Democrats with control of the House should have fought harder to simply come out and nationalize the two mortgage giants. If their mission of providing liquidity to the secondary mortgage market and helping provide affordable housing to the American public is so vital, these two should be nationalized, allow shareholders who knew these were quasi-private enterprises take their hit and move on. Unfortunately, the party had no backbone of standing up for fear of being labeled a “socialist” or for fear of their political life come this November. Incredibly the market is the only thing living up to the original mission of the GSEs; ironically lower prices via this correction are making homes more affordable. That is why we have seen some increased action in sales for the Inland Empire where prices have fallen drastically.
Yet the majority of Republicans are playing even a more clandestine game of politics. What the current administration is playing is verbally acknowledging free market capitalism but in reality, what they are doing is nothing more than crony capitalism. Some have called what is currently going on as socialism but socialism by definition is a redistribution of wealth from those at the highest income brackets to the vast majority of those at the bottom. Simply by looking at how the lower to middle class of our country is being on the verge of financial destruction, there is nothing socialist about this. Bailing out Bear Stearns was a targeted effort at propping up a few big key players. The market still ended up going into bear market territory and now here we stand at passing a bill that the current Republican administration strongly said it would not sign.
After looking at the bill, the $300 billion FHA-insured refinance program doesn’t seem like the biggest problem. In fact, I think much of it was to provide bread and circuses for the masses. The unlimited lifeline to Fannie Mae and Freddie Mac will prove to be the undoing. It would in fact be cheaper to nationalize these two entities and be done with it. Why keep up the pretense of free market capitalism? That generation mantra is crumbling and the majority of Americans realize that there is nothing capitalistic about privatizing gains for a few of the most wealthiest and socializing the largest losses on the vast majority of the public.
Here is a brief summary of some the big items in the bill:
-FHA to insure up to $300 billion in new mortgages.
-Federal debt limit increase from $9.815 trillion to $10.6 trillion (this is where I believe most of the Fannie Mae and Freddie Mac boondoggle will be shoveled).
-Raise loan limit of mortgages purchased by Fannie Mae and Freddie Mac to 115% of the local area median price, with a nationwide cap of $625,000.
-Gives the Federal Reserve a monitoring role over Fannie Mae and Freddie Mac over soundness and regulation (put the fox in charge, not a good move).
-First time homebuyer tax credit of $7,500 for those that purchase a home up until June of 2009.
-$4 billion in grant money to state and local governments to buy and rehabilitate foreclosed homes in low to moderate income areas. (Amazingly this is the part the Bush Administration had a major hang up over and not the Federal debt limit increase of $800 billion or the $300 billion FHA part!).
-Federal backstop for Fannie Mae and Freddie Mac. Gives both GSEs a credit line increase and also allows for the U.S. Treasury to have an “equity” stake in the agencies. (This as time goes on will prove to be the most costliest mistake of the entire bill).
-Elimination of down payment assistance programs
-Elimination of OFHEO
It is hard to delve too deeply into the Fannie Mae and Freddie Mac component since the details are so vague and open. Paulson tries to make it seem that this is only a rainy day insurance fund but fails to acknowledge that we are in a major financial hurricane. These two will use this provision and use it to its fullest. The fact the debt ceiling is so high in this new bill is because realistically this is going to be incredibly expensive. Essentially, what is happening is nationalization yet they are still trying to keep the pretense of free market capitalism. That is why I find it hard to believe Democrats did not take this angle. The vast majority of Republicans keep allowing crony capitalism to play out while Rome burns. If anything, that is why candidates like Ron Paul were able to garner support and was able to raise $34.5 million. He tapped into the fiscally conservative wing of the party which Senator Bunning tried to defend. They of course have been marginalized.
So let us now dig into that $300 billion FHA component of the bill which seems to be the biggest lighthouse of hope in stopping the sliding housing market.
Requirements for FHA Insured Mortgages
It is useful to go through the requirements for those who will not qualify for loans since it practically rules out nearly 100% of all those in California. Take a look at this:
“The mortgagor shall provide certification to the Secretary that the mortgagor has not intentionally defaulted on the mortgage or any other debt, and has not knowingly, or willfully and with actual knowledge, furnished material information known to be false for the purpose of obtaining any eligible mortgage.”
Well all those that have defaulted would not qualify. Of course this should be obvious. But why should someone today at risk of default benefit more than someone who defaulted last year? Either way, this narrows the scope of who will be helped. Now in the first part of the requirements there is a clear penalty for lying on applications:
“FALSE STATEMENT.-Any certification filed pursuant to clause shall contain an acknowledgment that any willful false statement made in such certification is punishable under section 1001, of title 18, United States Code, by fine or imprisonment of not more than 5 years, or both.”
This comes out quickly in the requirements on page 397 of the bill. This is something that should have always been enforced but unfortunately, it takes a bill in 2008 to state the obvious. Better late than never I suppose. Here is the part that in expensive states like California will do very little:
“CURRENT BORROWER DEBT-TO-INCOME RATIO.-As of March 1, 2008, the mortgagor shall have had a ratio of mortgage debt to income, taking into consideration all existing mortgages of that mortgagor at such time, greater than 31 percent (or such higher amount as the Board determines appropriate).”
31 percent debt to income ratio seems realistic and actually prudent. Yet the vast majority (approximately 80%) of Pay Option ARM borrowers, $500 billion in the United States and $300 billion in California, make only the minimum payment each month. Some of the other provisions which we will look at such as income verification will demonstrate that many of these people never should have qualified and don’t qualify today even with this bill.
Here is a list that is required in terms of borrowing:
– “…be determined by the reasonable ability of the mortgagor to make his or her mortgage payments.”
– “not exceed 90 percent of the appraised value of the property to which such mortgage relates.”
– “All penalties for prepayment or refinancing of the eligible mortgage, and all fees and penalties related to default or delinquency on the eligible mortgage, shall be waived or forgiven.”
This of course is the meat of the proposal. Many of the high YSP mortgage broker products were the most risky to the borrower. The vast majority of mortgage brokers naturally went with the highest commissioned products and could care less about the borrowers ability to pay or remain sustainable. This was proven by what we are dealing with right now. This wasn’t a small fringe group but became the industry standard.
There is some confusion about the principal reduction. The 90 percent principal reduction applies to the current appraised value of the home. Of course, this puts a lot of pressure on lenders to find appraisers that are more willing to make more generous appraisals. In fact, a recent report by the California Association of Realtors showed that the median price of a California home is now down by a stunning 37.7% on a year over year basis. So if a lender was to participate here in California with a median priced home, they would be chopping the price of a home to nearly a 50% loss given that homes are now down 37.7%. 50% in the eyes of many is a crash and not simply a correction.
The waiving of penalties of course is not going to bode well for bringing back any of these toxic mortgages and is only going to put another nail in the coffin of the exotic mortgage product market. This in fact is good. Anyone thinking we will have mortgage chop shops on the scale that we once did is not reading this bill carefully.
One of the major issues may be with second liens on homes. However that is where shared appreciation comes in:
“All holders of outstanding mortgage liens on the property to which the eligible mortgage relates shall agree to accept the proceeds of the insured loan as payment in full of all indebtedness under the eligible mortgage, and all encumbrances related to such eligible mortgage shall be removed.”
The perk of course is the shared appreciation. After all, why would any second lien holder of say 20 percent relinquish their piece of equity? Given the extent of a correction in California, most second liens in the last few years have become worth nothing. In fact, this bill offers the promise of future gains, which of course are not going to happen because incomes are not going to catch up. This program would also require the new mortgage to be a 30 year fixed mortgage:
‘‘(A) bear interest at a single rate that is fixed for the entire term of the mortgage; and ‘‘(B) have a maturity of not less than 30 years from the date of the beginning of amortization of such refinanced eligible mortgage.”
So much for adjustable rate mortgages that only a few years ago seemed to be Alan Greenspan’s favorite kind of mortgage.
Another lovely piece in this legislation is that it is going to destroy the home equity line of credit (HELOC) market and any second liens on homes that do go into this program. Take a look at this piece:
‘‘(7) PROHIBITION ON SECOND LIENS.-A mortgagor may not grant a new second lien on the mortgaged property during the first 5 years of the term of the mortgage insured under this section, except as the Board determines to be necessary to ensure the maintenance of property standards; and provided that such new outstanding liens (A) do not reduce the value of the Government’s equity in the borrower’s home; and (B) when combined with the mortgagor’s existing mortgage indebtedness, do not exceed 95 percent of the home’s appraised value at the time of the new second lien.”
So much for jumping the consumer economy again through the mortgage equity withdrawal market. This effectively puts a hold for 5 years on any 2nd liens. Since home equity withdrawals played such a huge role in keeping our consumer economy up, any loans that do get refinanced into this program will not have the opportunity for 2nd liens. In addition as you will see, there are provisions that will cap any equity gains for the homeowner.
The appraisal component will probably be the most important in assessing current value. This is the place were I envision most of the fraud would occur:
‘‘(8) APPRAISALS.-Any appraisal conducted in connection with a mortgage insured under this section shall- (A) be based on the current value of the property;”
Well as many of you know, the current value of homes are declining as we speak. This will be important when it comes to appraising property for this program. There are other parts in the legislation for appraisal standards and this will be important in maintaining integrity with this program.
The legislation will also put an end (at least for mortgages that are refinanced) to no documentation and stated income loans, another good thing:
‘‘(9) DOCUMENTATION AND VERIFICATION OF INCOME.-In complying with the FHA underwriting requirements under the HOPE for Homeowners
Program under this section, the mortgagee shall document and verify the income of the mortgagor or non-filing status by procuring (A) an income tax return transcript of the income tax returns of the mortgagor, or
(B) a copy of the income tax returns from the Internal Revenue Service, for the two most recent years for which the filing deadline for such years has passed and by any other method, in accordance with procedures and standards that the Board shall establish.”
Well there you go. You will now have to show at least 2 years of tax returns to verify your income. No longer can you call a mortgage broker and just make up your salary or have them go on Salary.com and pull a hypothetical pay scale of what someone in your field would make. Amazingly what this admits is that there has been hardly any verification of incomes in the past decade. These minimal things should have existed.
This bill will also not help any second home and vacation homeowners. Refinances will only work on primary residences. Over the past decade, many people bought second homes to flip so there will be no help for those either. Another good thing:
‘‘(11) PRIMARY RESIDENCE.-The mortgagor shall provide documentation satisfactory in the determination of the Secretary to prove that the residence covered by the mortgage to be insured under this section is occupied by the mortgagor as the primary residence of the mortgagor, and that such residence is the only residence in which the mortgagor has any present ownership interest.”
What has been a criticism of the bill is lenders will choose to unload their most toxic products into the program. This is labeled as adverse selection. There is a part in the bill addressing the concerns of adverse selection yet I’m positive that it will be difficult to enforce. How are you going to be able to tell a legitimate case of someone wanting to keep their home and someone simply seeking to pass the buck to the taxpayer?
There has also been some confusion about the 10% principal reduction and also a 15% reduction. I think the confusion is because the 10% reduction is part of the principal reduction by the lender, a 3% one time premium paid to the FHA, and an additional 1.5% premium paid by the borrower on an annual basis. Either way, the bottom line is lenders can off load the loan if it meets all the above and get 85% of the current appraised market value of the home:
‘‘(i) PREMIUMS.-For each refinanced eligible mortgage insured under this section, the Secretary shall establish and collect-‘‘(1) at the time of insurance, a single premium payment in an amount equal to 3 percent of the amount of the original insured principal obligation of
the refinanced eligible mortgage, which shall be paid from the proceeds of the mortgage being insured under this section, through the reduction of the amount of indebtedness that existed on the eligible mortgage prior to refinancing; and
‘‘(2) in addition to the premium required under paragraph (1), an annual premium in an amount equal to 1.5 percent of the amount of the remaining insured principal balance of the mortgage.”
In addition, I see very little incentive for any California borrower because future appreciation is locked away. If you look at page 410 in the bill you’ll notice a sliding scale of future appreciation. As a borrower, this is almost like a semi-quasi rent/own situation. My doubt is that because of the income requirements, loan verification, and also the shared appreciation that many borrowers will elect not to go with this:
‘‘(1) FIVE-YEAR PHASE-IN FOR EQUITY AS A RESULT OF SALE OR REFINANCING.-For each eligible mortgage insured under this section, the Secretary and the mortgagor of such mortgage shall, upon any sale or disposition of the property to which such mortgage relates, or upon the subsequent refinancing of such mortgage, be entitled to the following with respect to any equity created as a direct result of such sale or refinancing:”
The bill goes on to break down the shared appreciation as such:
< 1 year 100% of equity goes to government/lenders
< 2 years 90% of equity ” ”
< 3 years 80% of equity ” ”
<4 years 70% of equity ” ”
<5 years 60% of equity ” ”
>5 years 50% equity share
Now really, how many borrowers are going to elect to do this? I see this benefiting moderately priced states were a loan might be a horrible Pay Option ARM with a balance of $120,000 but no way do I see this helping the larger than $500,000 market in California. Let us run a 6 year scenario for the sake of argument here.
Home Purchase in California at peak for : $550,000
80/20 financing for full amount (zero down)
Current appraised value: $350,000 (drop of 36.3% consistent with median state price drop)
Assume borrower qualifies with all the above restrictions and lender is opting to go with this program.
New loan amount: $350,000 x .85 = $297,500 30 year fixed mortgage
The second mortgage is wiped out and given the legislation, the only hope of recovery is future appreciation. The first mortgage holder had to take a hit of:
$440,000 – $297,500 = $142,500 loss
Only hope there is for the government and lien holder is future appreciation. The current owner now has a mortgage of $297,500 on a 30 year fixed note. Let us assume in 5 years the home is now valued at $400,000 and the owner sells. How is this broken down?
$400,000 – $297,500 (this will be less because of principal pay down but let us assume this for this example) = $102,500 (50/50 split here) – $51,250
So in the end, the borrower would be the biggest winner but again the likelihood of prices jumping up that high is extremely remote. Many of the lenders will eat the cut upfront and this is enough to sink many institutions. They are banking deferred interest from Pay Option ARMs as income and this would force a mark to market reality. In fact, I would suspect many lenders here in California would rather take the home back and take their chance with a foreclosure or hope the market turns around later.
These are crude number breakdowns but as you can see, this isn’t the part of the bill to fear the most. In fact after reading the details should it be enforced as stated, I see very little help coming from this. Some of the legislation I stand behind strongly and it is about time that we have this stated. Yet this is mixed bag of good, bad, and ugly stuff.
What the CBO estimates is that the FHA will insure approximately $68 billion in loans for about 325,000 borrowers because that is how many would qualify given the above guidelines. The real disaster is with the Fannie Mae and Freddie Mac backstop since it is nearly unlimited. It isn’t clear if they are going to provide support for the share price or how that will work. If the housing market continues to deteriorate, Fannie Mae and Freddie Mac will be put at even a higher risk and assuredly this will cost the taxpayer an amazing amount of money. These two GSEs cover about half the mortgags in the United States with a combined debt of about $5.1 trillion.
I’m surprised that the $300 billion part of the bill isn’t so bad. In fact, I agree with many of the measures. What shocks me most is in the last 2 weeks this knee jerked response to bailout 2 GSEs and the blind acceptance from the bulk of our politicians. Why didn’t the nationalization case get debated? Why wasn’t this bill looked at more closely (there is 649 pages! I was only able read about 50 pages and skim the rest)? Do you really think some in Congress read this entire bill?
This is a major win for Wall Street and as time will show, another major loss for the average American citizen. If you think income inequality isn’t a problem you need only look at the Gini Coefficient over the past 50 years. The Gini Coefficient is used in economics to measure the income inequality in nations:
As you can see from the chart, the USA being highlighted by the yellow line, income disparity has steadily been increasing since the late 1970s and early 1980s. Where 0 is perfect equality and 100 is perfect inequality the US has been steadily becoming more unequal. And with crony capitalism like this, is it any wonder?
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