Sheila Bair's Bailout

Sheila Bair runs the FDIC, and she was tasked with handling IndyMac's 60,000 foreclosures (out of approximately 700,000 total loans). In an effort to reduce losses, she's proposed some aggressive workouts for homeowners in foreclosure.

Things like: preserving teaser rates for another five years, or reducing loan balances to 90 percent of "market value". These terms are actually similar to Countrywide's California bailout (which was motivated by a lawsuit, not loss mitigation).

But now, the IndyMac plan is being held up as a model for the entire country (LA Land link here, with interesting comments too), and that's where it gets dangerous.

I've debated the pros and cons of this proposal with a few friends, and I have a few thoughts:

1. The model seems to be that most markets have experienced their losses, and now we'll have a V-shaped or shallow-U-shaped recovery. We made bad loans, and now we don't, and so we can pay those off and be done with it. But this is not true. Houses are overpriced in some areas by almost double, and their prices need to fall more.

2. What do future losses mean? If these losses are still to be taken, it is dangerous to prop them up by reducing foreclosures. Not because it "reduces losses" in the short term (that's nice if you can have it), but because new underwater loans will be written on the 2008, 2009, 2010 homes, and will remain underwater for 10-15 years. This will make lending hard for everyone else, and will mess up the credit markets for years to come.

3. If it's extremely easy for a 60-day late borrower to adjust to half the previous payment, we'll see a huge rise in pre-foreclosure activity, with borderline borrowers failing to make payments so they can "qualify" for the bailout. (Peter Schiff advised people to do this on CNBC!) Costs for Bair's plan will double, triple, quadruple...we'll have half the 2004-2007 loans qualifying for 2% loans. There will be two classes of homeowners: those paying rent to the government, and those who use real money to buy and sell.

4. It's also nice, if you can do it, to avoid massive foreclosures, because typically foreclosures will "undershoot" correct pricing and cause destruction of assets, due to lower selling prices and non-maintenance. However, "normal" 5% down homeowners cannot afford to take 50% losses on property, and buyers cannot afford to pay more. If we read our history from Japan and California 1990-1995, sellers mostly think in nominal prices, not real prices, and so they will take an inflation-sized "real" decline, or maybe sacrifice a small downpayment, but not much more, not bankruptcy. Asset prices do not fall when they're propped up, they decline a few points beyond inflation for years and years. There are plenty of buyers at the right prices, and properly-priced homes will simply not be abandoned.

If we want every housing investment made in the next 5 years to be immediately underwater, but minimize short-term losses, with a ridiculous split between what sellers can afford to sell for and what buyers can afford, Sheila's plan is good. But I think everyone should agree that this is more short-term thinking, not long-term investing in our financial health. Even more borrowing against the future...the last gasp.

Ten years ago, 64% of the population "owned houses". Last year that number was 74%. I do think that some of the 10% of the population that have become homeowners in the last 8 years will probably need to become renters (not propped-up homeowners), and that a 2% teaser rate that resets in 5 years is not doing anyone favors. Pushing off a new round of teaser rate resets to a time in the future seems wishful...the only way this plan works is if we have enough inflation to burn off the excess in 5 years or so...imagine 1980's-scale inflation (15%).

Wells Fargo is selling its foreclosures into the market immediately, not trying to "spread out" losses over some future time. Why? Because it's actually smart if you can sell at elevated prices today and avoid selling at reduced prices tomorrow.

I would rather see us take our lumps now (these numbers are known and manageable), and have a healthy system for the future, rather than pretend that current asset prices will come back, and save a small portion of our losses this year, at a cost of messing up the system for the next ten.

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