Solution to the Home Mortgage Problem

[Pure]

http://www.slate.com/id/2212649/

The Better, Cheaper Mortgage Fix:
How to renegotiate all those bad loans at no cost to the taxpayer.

By Eric Posner and Luigi ZingalesPosted Monday, March 2, 2009, at 5:55 PM ET

A home in foreclosure Earlier this month, President Obama announced a homeowner-relief plan that would offer $75 billion in subsidies to homeowners who have trouble making mortgage payments. The problem with the president's plan is that it does little to address the principal source of the housing crisis—the fact that the bursting of the housing bubble has plunged millions of homeowners into negative equity. Their houses are worth less than their mortgages, or "underwater." What's still needed is an approach to mortgage forgiveness that will give homeowners the right to force mortgage holders to accept terms that both sides can live with. Executed correctly, this could resolve the crisis without costing the taxpayer any money. Really.

The key to understanding our plan is that houses are worth more if kept or sold by their owners than if they are foreclosed on. Bankers tell us that when they foreclose on a house, it typically loses a great deal of value, as much as 30 percent to 50 percent. And this is on top of the loss that the house has already suffered because of the general economic downturn. This means that if you bought a house for $300,000 and today you can sell it for $240,000 but instead lose it to foreclosure, the house will eventually go for only $120,000 to $168,000. The reasons are well-known: Foreclosure can be a time-consuming process, and empty houses are difficult to maintain. [...]


If foreclosure is so costly, why don't lenders avoid this cost through renegotiation? Renegotiations aren't happening because so many mortgages are securitized. In the old days, if you wanted to renegotiate your loan, you just called your bank. Now you have to deal with the loan servicer, who acts on behalf of the thousands of mortgage-security holders who have a right to a share of your payment. The loan servicer gains little and loses a lot if it attempts to renegotiate a loan. [...]

The solution to this problem is for the government to force renegotiations to occur. A simple plan could do this. The plan would give all homeowners who live in a ZIP code where house prices have dropped more than 20 percent the option to have their mortgage reduced to the current market value of the house. In exchange, these homeowners would yield to their lenders 50 percent of the future appreciation of the house.

To avoid any gaming and future moral hazard, both the current and the future value of the house will be determined by multiplying the purchase price and the variation in the housing price index. So if you bought your house for $300,000, and the average house in your ZIP code has lost 20 percent of its value, then your new house is assumed to have a value of $240,000. If your mortgage was $280,000, now it is $240,000 (the new value of the house). You are no longer underwater. [...]


For the lender, there is also money to be made. If he were to foreclose, he would get only $100,000 to $140,000, the market value of the house after it has declined 30 percent to 50 percent because of foreclosure. If the mandated renegotiation occurs, he gets $236,000 ($200,000 from the mortgage and $36,000 from the option). This is an excellent deal, even if some homeowners default on the renegotiated mortgage. [end excerpt, less than half the article.]

 

[neonlyte]

Foreclosure crystallizes a loss. Mortgagors need to take the hit and dispose of the downside of their balance sheet. Renegotiation maintains a 'bad debt' until the mortgage is completed.

If governments want to pump money into the system, it should be done to guarantee renegotiated mortgages, underwriting the lenders downside, thus removing a potential liability. The government, lender and borrower can enter into agreement to share the upside on an eventual disposal underwriting each of the parties exposures. E.g. 210k property is revalued at 140k, a level at which the borrower can afford the mortgage repayments, the government underwrites any loss on disposal below 140k to the lender. If the property is eventually sold, in a recovering market, a three way split shares the profit above 140k. The borrower could be allowed to 'purchase back' the shared equity by making 'profit repayments' to the lender and government either from windfall gain (inheritance, bonus payments, etc) or by re-mortgaging in a rising market.

 

[Handprints]

In my view, this is a dangerous idea, and one more likely to cause widespread destruction in the financial system than anything else I've heard suggested lately.

Let's say the US tried this exactly as Posner and Zingales recommend. And let's say I'm any one of a pension fund, endowment, municipality, sovereign wealth fund, bond fund, broker, banker or insurer (or customer/user thereof) in any of the world's 50 most developed countries. I just got screwed and I'm not just going to sue, I'm going to win, bankrupting pretty much everyone in front of me in the domino chain that brought a home mortgage into my investment portfolio. Here's why.

I didn't buy (and don't want) a badly-defined call option on some future appreciation in house prices. I bought the rights to a stream of payments from a set of existing mortgages. Almost any attempt to renegotiate the terms of those payment streams - whether by law, by bank, or by service company - triggers a default in the security. (By the way, the article is absolutely right to suggest that mortgaged homeowners should be furious that their debts were securitized: doing so eliminated any and all possibility of mortgage alterations other than through straight whole-loan refinancing.)

If the default is triggered by anyone other than the homeowner (her/him defaulting is the one risk I signed on for), the language of the securitization contract gives me some gold-plated rights to sue everyone in the security's distribution chain: the originating bank, the servicing company, the securitization packager, the distributor and the seller (and probably Barry Bonds as well.) Put another way, if you sold me a steak and now want to deliver an option on some smelly fish that may someday recover its freshness, talk to my lawyer (in any and all of about 100 global courts).

Worse, this default triggers my CDS insurance. That's what I bought to protect me not only against the homeowner defaulting but also against anyone else screwing with my payment stream (ie, the above list). Were the government to put such legislation into practice, it would wipe out - in one day, straight into bankruptcy court - Berkshire Hathaway, General Re, Swiss Re, Prudential, the Hartford and pretty much every other insurer you've ever heard of. The reason AIG is getting so much cash, so often, is that it's a CDS guarantor: if it goes down, it takes a truly ungodly swathe of the insurance industry with it. Anyone want to find out if a run on an insurer really is worse than a run on a bank? Remember, no FDIC for insurance policies and it's first claimed, first served.

I have to admit, I'm a little surprised that an idea of this quality came from a couple of well-respected guys at Chicago. I can only suggest that, while it does a neat intellectual job of better aligning banks' interests with borrowers', the authors didn't bother to chat much with the rest of the securitization food chain; in this case, the part of the chain that has all of the rights. I don't know the political map of the Obama sphere of influence but I'm willing to guess this is somebody's half-baked theory and not a trial balloon for a real policy idea. At least, I hope so...

The only mechanism available to the US government in relieving borrowers' problems - and this is exactly because of securitization - is to bail out the borrowers directly, either through mortgage interest tax relief or the establishment of a FHMA-like facility specifically designed to refi upside-down mortgages at full loan value, with the government taking the equity option on the houses. Everything else is a death sentence for anyone who touched a securitization package, including the buyers.

Hope that's of interest,
H

 

[JAMESBJOHNSON]

What The World Needs Now, Is Love, Sweet Love

HANDJOB

But they CARE...and YOU dont.

 

[Pure]

note to hand

i confess i'm no economist and i don't understand all the complexities.

that said, my impression of your points and the recommendation you draw is unclear. you seem to be saying that the gov would have to buy out the little guy's debt at full value, else the guys up the food chain sue for full value.

this seems unrealistic. for if nothing is done, some of the guys up the chain are going to do quite badly, e.g. the european banks that bought the bundles of mortagages from the american institutions. similarly for the insurers. so i think the basic principle must be that each accepts a percentage of 'write down,' not that they spend time in court against other near bankrupt institutions.


it seems to me that the principle of P and A has, instead, to be applied successively to the pairs up the chain. if i understand the situation Bank A has loaned money to a homeowner, H. Bank A thus holds a mortgage, with the home as security. But the home descreeases in value and the homeowner cant' pay. So it seems P and Z's scheme can be applied; i see no objection from you.

NOW, if Bank A bundled that mortgage and a hundred others of dubious nature into a security S, and sold it to bank B, then IF there's foreclosure at the bottom, bank B is out a bundle. let us say, perhaps half the value of the sucurity. What bank B, then, must do is accept a write down, of say 30%, if that's the average reduction being dictated on the mortgages themselves. bank B does not really want to take bank A to court, after all, A may go bankrupt.

if i read you right, you're saying bank B took out insurance on their investment in the security S from bank A. this from insurance company I. well insurance co. I doesn't want to be on the hook for the full amount of S, so there is also a write down of what they will cover.

now, i understand that the gov of the US has already given banks billions. so perhaps it's necessary for the gov to pay bank B a portion of the money lost; and likewise the insurance co. and i think this can be more attractive than the alternatives.


iow, i'm lacking the techinical jargon, but *becauses the whole damn thing is collapsing, everyone in the chain has to accept 'write downs', diminutions of holdings. the government can try to inusre that there's no collapse by partially convering the write down.

i might also add that Congress can vary existing laws; in effect, then, lawsuits could be stifled. the company with the loss would apply to the gov, i'm suggesting, for partial compensation.

thanks for your comments.

 

[Boxlicker101]

I can see a couple of problems with this. Many homes have both a first and second mortgage,and nothing has been said about that fact. Besides that, on a new home purchase, the buyer always makes some improvements in the first week or so, and more over the next few months. Those don't seem to be mentioned. These improvements are usually rather minor, when compared to the cost of the ome itself, but should be considered in extablishing the value of a home.

Most people aren't really having that much of a problem, even if they are under water. They don't want to move or sell the homes or do anything else and, as long as their payments are up to date, they are doing alright. My wife and I, for example, bought a new home four years ago. Right now, the mortgage is more than the market value but we don't intend to do anything different. We are making payments with no real hardship, and will continue doing so. If the mortgage holder offered us a chance to reduce our indebtedness and payments, we would accept it, but we don't really need it.

 

[Stella_Omega]

The securitization food chain.

I just threw up in my mouth.

 

[Handprints]

iow, i'm lacking the techinical jargon, but *becauses the whole damn thing is collapsing, everyone in the chain has to accept 'write downs', diminutions of holdings. the government can try to inusre that there's no collapse by partially convering the write down.

i might also add that Congress can vary existing laws; in effect, then, lawsuits could be stifled. the company with the loss would apply to the gov, i'm suggesting, for partial compensation.

thanks for your comments.

Pure,

I appreciate the response and I want to try to explain just why this seems like such a bad idea to me in terms that are more readily accessible. Let's take this in three parts: why trying to align the interests of buyers of CDS with homeowners is a fundamentally dangerous thing to do; why the "share the future gains" benefit isn't either workable or a fair substitute for foregone repossession money; what the government actually can do to decrease repossessions and increase house price stability.

The animating spirit behind the P&A proposal, as far as I can see, is that financial pain should be shared more equally behind mortgage holders and everyone who has a financial interest in the repayment of their mortgages. If we were talking about any kind of instrument whose value was in some way related to economic growth - shares, used car prices, actual home values - I'd agree with you that the beneficiaries' interest should be aligned with the owners. But we're not: we're talking about mortgages, whose value is in no way directly related to economic growth. (It is related, but only indirectly: clearly mass unemployment can affect ability to repay a basket of mortgages and clearly a severe downturn in housing prices adds risk by devaluing the key underlying asset on which the mortgage is based - the house. What's interesting about those two indirect risks is that a CDS (or mortgage issuer) has two extremely good defenses against them, something I'll get into in a later paragraph) Who wants a security whose value is in no way related to economic growth? Insurance companies, pension funds, annuity providers, income funds and municipalities: groups who have future stream-of-payment obligations (often to people for whom they provide the only source of income). They don't want any risks except the ones they can control; essentially, bond and bond-like products, such as CDS, are the only instruments that exempt them from these risks. A huge mass of legislation in every country, including the US, prevents these bond and CDS buyers from taking meaningful risks on economic growth. These laws were passed to ensure that these groups only concerned themselves with liability matching: my obligations match, more or less, your mortgage payments and therefore I won't be forcing any retirees onto the Purina plan. P&A don't just want to rewrite the mortgage laws, they want to change the basic investment model for every group I just named. That forces a very large population of investment professionals who have never had any interest in or experience of economic growth risks to own things that embed a gigantic economic growth risk - one that nobody really knows how to price. The whole point of 70 years worth of regulations has been to ensure that this doesn't happen, and there is a library of pre-40's trust, insurance and municipality bankruptcies to suggest why the existing legislation isn't a bad thing. Let's be clear: bankers don't own much of this stuff, securities firms don't own much of it either: the groups who do own it - USD2.5tr+ of it - are the people you absolutely do not want to inflict economic risk on; the people who make retirement, illness, disaster and sewage treatment survivable experiences.

So let's move from a relatively abstract concept - why some investors should avoid economic growth risk (and why governments shouldn't force them to eat some) - to why the P&A plan isn't nearly as fair as the authors claim. First, the plan assumes that there is some long-term appreciation to be had in house prices. Maybe, maybe not. If you look at the period from 1875 to 1940 on an inflation-adjusted basis, total housing stock price appreciation was less than 20%. Nobody knows what the future holds, but we've got a relatively recent example of a 65-year period where you can't get from current prices to original housing value levels. But let's say we don't want a worst-case scenario, we just want to put a value on the things right now. We need to do it right now for a reason: everybody in the groups above needs to sell those participation rights in house appreciation immediately: they've just taken a giant haircut on their income stream, there's no way to match the rights they've been given to future liabilities, and they need to dump the rights in order to fund purchases of other debt.

I don't know how to value those rights very easily. For one thing, the only more-or-less reliable way we have of calculating their value (NPV method, for those keeping score) requires you to know when the house will be sold. It looks to me like that's up to the homeowner, not the CDS owner. I don't think that losing 50% of a house's appreciation (if any) is going to make the buyer more willing to sell. In fact, I'd assume that any homeowner in that position will hang on to their current home a lot longer than he would if he was about to get 100% of the appreciation. Also, I have trouble imagining the government forcing a sale if a dying homeowner wants to leave his house - unsold - to his wife or disabled child. Not a lot of votes in supporting that kind of cruelty. I can't know when I'll ever see that gain. (P&A engage in some reprehensible statistical sleight of hand in their Slate article: why is an 11-year tenure a reasonable assumption and, more pointedly, why is 8% volatility - a truly unheard of figure except for the past 10 years - a reasonable number to plug in? And I thought CDS sellers used sketchy assumptions...) That makes it all but impossible to price the present value of my future participation in the sale of the home. It gets worse. Even if we hack together some sort of best-guess value for the participation rights, every one of the CDS buyers needs to sell right now. They're going to flood the market with stuff nobody can price well and that's a recipe or rock-bottom prices. They won't make enough back from the sale of the participation rights to buy enough new debt to match their liabilities and income streams. No chance. And when insurers, pensions, annuity companies and municipalities can't match, they're out of business - forced liquidation is mandated in every country in which they do business. You can see where I'm going: this plan, if adopted, would immediately force the government to do what it is currently trying desperately not to do: bail out the majority of the insurers, pensions etc...

Here's the kicker: repossessions put more money in the hands of all of the above groups than the P&A plan looks likely to, while improving the quality of their investments. The present value of stream of income payments from a mortgage alone is estimable (not perfectly, because of unexpected refis, but that's another topic.) Certainly, for an individual mortgage that the homeowner can't refinance, we can get a very good guess at present value. It's usually surprisingly low - in real (ie inflation-adjusted) terms, about 15-20% more than the face value of the mortgage. Yes, a CDS buyer is going to see an immediate drop in income stream if mass repos hit. But remember, that's not only a risk he signed on for, it's one he has (if he has a brain) insured against. If repo rates rise past a preset level, he hands the CDS over to insurer and collects the full value of the sum insured. Even if repo levels don't hit the trigger mark, the repo value he's getting can be put straight back to work, financing the mortgage of someone who (presumably) passed a much more stringent set of qualifying tests and is buying at (or near) a market trough. The CDS buyer not only escapes having to value then sell an impossible-to-value and unsaleable right to some future payment, he actually gets to improve - immediately - the quality of his CDS book. This, to me, is a much better and fairer option for the people who rely on a fixed income to survive.

So what can the government do? First, consider who actually should be bearing risk. I'm a fairly hard-nosed guy but I can't see why any government should consider that a USD600,000 upside-down mortgage holder has a better claim on its assistance than a retiree who's getting by on a pension plus some disability insurance payments. Second, make sure every major provider of CDS insurance survives (given AIG's intensive care, I think this one has already been taken to heart). Those guys are the linchpin in a system that is keeping any number of insurers, pensions, municipalities etc out of bankruptcy, thereby keeping the government bailout bill lower than it already is and the Treasury's focus less shredded than it already is. Finally, fund the hell out of FHMA, stick every mortgage tax break you can think of into every budget you pass and do everything you can to push your banking legislation and practices towards the Canadian model, where none of this crap was possible.

I'm sorry if this isn't as concise as you or I would like. I'm writing at speed while doing other things. The three things that come right from the heart are: first, don't force fixed-income specialists to become home equity participants - they aren't going to be any good at it and their history with economic risk is horrifying. Second, don't believe for a minute that the models of what CDS owners might get out of the deal make any sense: they're far, far less realistic than the models behind CDS in the first place. Third, there is nothing that can be done that will work as effectively as direct relief for homeowners. Nothing aimed at any other part of the CDS transaction chain (any better, Stella?) can possibly work as well, as quickly or as cleanly.

Last thing: before CDS, banks were connected to the welfare of their local areas. Renegotiating a mortgage, taking some losses, sharing the pain - all of that stuff made sense for them if they had the brains to take a long-term view of their community's welfare. CDS changed all that. That the people who bought them have no reason to care abut community welfare is, arguably, not a step forward. P&A seem to think that forcing them to care will correct the problem. The reason I disagree isn't philosophical: the people who bought these CDS tend to be groups that shouldn't ever be connected to growth risks. They're the groups who do more than any other capitalist institutions to protect the vulnerable in their old age, illness or disability by guaranteeing a stream of income, come hell or high water. Forcing the CDS buyers to share the pain means forcing those old, ill and disabled customers to share it. That's a step too far for me. Better by far to endure a decade of repos, prevent banks becoming disconnected in future, and, if necessary, spread the pain to all taxpayers by helping the mortgage holders directly.

Hope that's an improvement on the original post or at least a complement to it.

Best,
H

 

[JAMESBJOHNSON]

The bottomline is it's a shit sandwich no one wants to eat, and someone has to eat it.

If it doesnt get eaten, deflation is unleashed and eats everybody. Government gets less tax revenue from deflated home prices, deflated home prices kill new home sales and retard the sale of existing homes, wages for construction labor and prices for materials drop, and eventually it comes full-circle where everyone loses money or income.

IF THE GOVERNMENT CAN VIOLATE MORTGAGE CONTRACTS, IT CAN VIOLATE ANY CONTRACT YOU MAKE.

Obama may get the notion that your retirement check is too big, and cut it. Or maybe the money you get for a story is too much, and cut it.

FUCKING WITH CONTRACTS IS A PANDORA'S BOC YOU DONT WANNA OPEN.

So someone has to eat the shit sandwich.

I nominate STELLA.

 

[Pure]

thanks handprints,

that was enlightening.

 

[trysail]

If you don't understand residential mortgage finance, READ THIS post:

...I want to try to explain...

H.-

My hat's off to you— nicely done! I just do not have the time or the patience to explain business, economics and investing to folk with no background ( there's a reason I'm not a teacher— it takes a certain personality type— and I'm not it! )

Aside from opening the Pandora's Box of interfering in the fundamental, longstanding and deep legal precedent of the "sanctity of contracts," the mind-boggling opportunities for operation of the law of unforseen consequences of a "one size fits all" solution offered up by a pundrity that knows not whereof it speaks leaves me aghast.

I simply cannot fathom how the trillions of dollars spent on American education somehow manages to produce enormous numbers of graduates with no understanding of economics and a staggering proportion of innumerates. It saddens me and makes any thoughtful person wonder about the efficacy of the education system in the U.S.

 

[JAMESBJOHNSON]

TRYSAIL

Nassim Taleb says that economics education is filled with nonsense, proselytized by rubes. That is, the economist gods dont recognize fortune and unintended consequences.

 

[trysail]

TRYSAIL

Nassim Taleb says that economics education is filled with nonsense, proselytized by rubes. That is, the economist gods dont recognize fortune and unintended consequences.

Economics education is very different from investment education; while sharing some aspects, while complimentary they are ultimately separate and distinct fields. Just as every adult should be able to add, subtract, multiply and divide, a functional adult needs to understand the concept of supply and demand and the role that a dynamic pricing system plays in creating supply and demand equilibrium. The basic concept is not terribly complicated.

Taleb is worthwhile reading— and, god knows, the misuse and abuse of statistical models by buffoons recently minted by the academic assembly lines lies at the heart of the current mess. The Long Term Capital Management ( as has been accurately observed by many, that firm would have been more appropriately called "Short Term Capital Mismanagement" ) debacle was a case study in the idiocy of blind reliance on computer-generated statistical models. That its 1998 crackup was essentially ignored by regulators and far-too-many financial managers does not give one confidence in the ability of humanity to learn and benefit from the mistakes of others. As Buffett has observed, "it should have served as a wake-up call." I, for one, don't understand why it didn't. Roger Lowenstein's When Genius Failed: The Rise and Fall of Long Term Capital Management is a reasonably accurate recounting of that comic and idiotic saga.

Having said that, Taleb is one more in a long series of people who have made far more money by selling books than by putting what he preaches into practice. His actual investment performance and record ( at least that which is publicly available and verified by audit ) is in fact not all that impressive. He is— and has always been— a trader, which is of course the antithesis of an investor.

The First Amendment exception that protects financial journalists explains the prominence of an enormous number of charlatans promoted to ( and thus incorrectly perceived ) by the public as financial "gurus." CNBC, PBS' "Nightly Business Report" and virtually all financial media are largely platforms for promoters; I make a point of avoiding them like the plague. The idiocies that emerge and are broadcast by these outlets are largely noise that does nothing except annoy me.

Only long experience gained by observing and understanding the weaknesses and dangers of over-reliance on statistical methods can prevent their misuse. The academics ( including several Nobel Prize winners ) whose theories underlie many of the statistical methodologies of financial models lacked practical experience. Many of the fundamental assumptions that underlie their theories including, most importantly among others, the existence of normally distributed events, are not accurate. Part of the failings of the academic theorists is their complete failure to provide a mathematically reliable and rigorously accurate definition of RISK. Nobody has yet succeeded at defining that term. All efforts so far have been in the direction of defining it as variation around a mean. That effort is easily derailed by a simple question: please tell me what upside risk is. If you can invent a workable, universally applicable mathematical definition of RISK, you will ( deservedly ) win a Nobel Prize.

Here's a little exercise in mental gymnastics: is the S&P 500 ( currently at ~683 ) now riskier than it was a year and a half ago at, say, 1150? For that matter, is residential real estate now riskier than it was, say, three years ago?

Peter L. Bernstein's 1996 Against The Gods: The Remarkable Story of Risk is a wonderful, readable introduction to the history and development of the concepts that underlie the field of statistics.

 

[trysail]

Myron Scholes has the unusual and dubious distinction ( shared only, to my knowledge, with Jerry Tsai ) of having TWICE utterly destroyed the capital entrusted to him— first with Long Term Capital Management, then by the hedge fund cited below ( Platinum Grove Asset Management ).


http://www.bloomberg.com/apps/news?pid=20601010&sid=aNRppMJqgURA&refer=news
(Fair Use Excerpt)
Scholes Advises ‘Blow Up’ Over-the-Counter Contracts
By Christine Harper

March 6 (Bloomberg) -- Myron Scholes, the Nobel prize- winning economist who helped invent a model for pricing options, said regulators need to “blow up or burn” over-the-counter derivative trading markets to help solve the financial crisis.

The markets have stopped functioning and are failing to provide pricing signals, Scholes, 67, said today at a panel discussion at New York University’s Stern School of Business. Participants need a way to exit transactions and get a “fresh start,” he said.

The “solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over,” he said, referring to credit-default swaps and other complex securities that are traded off exchanges. “One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices.”

Scholes also recommended moving the trading of credit- default swaps, asset-backed securities and mortgage-backed securities to exchanges to allow for “a correct repricing” of the assets. The securities are currently traded between banks and investors, without any price disclosure on exchanges.

Scholes served almost eight years on the board of CME Group Inc., the world’s largest futures market, until his term expired in May, said Allan Schoenberg, a CME spokesman. CME operates the Chicago Mercantile Exchange, Chicago Board of Trade and New York Mercantile Exchange. He was a partner in Long-Term Capital Management LP, the hedge fund whose $4 billion loss in 1998 set off a near-panic in financial markets and prompted the Federal Reserve to orchestrate a bailout by 14 lenders.[ The episode should have served as a wake-up call for The Federal Reserve, all governments and financial market participants and regulators worldwide. It was recognized as such by Warren Buffett. Instead— to the subsequent rue, rack and ruin of the world— the lessons from the crackup of LTCM were largely ignored and forgotten. ]

*****​

... Scholes won the Nobel Prize for economics in 1997 along with Fischer Black and Robert Merton for their Black-Scholes model of pricing options, contracts that give the buyer the right, but not the obligation, to purchase a security or commodity at a later date for a specified price.

He is now chairman of Platinum Grove Asset Management LP in Rye Brook, New York. The hedge fund was forced in November to freeze investor withdrawals after a surge in redemptions.

Among other recommendations, Scholes urged changes to the accounting rules to give better disclosure on risks, said that banks should focus on their return on assets instead of return on equity, and said central bankers shouldn’t try to quell market volatility, which provides a natural brake on risk- taking.

 

[amicus]

With two such erudite and experienced posters, HandPrints and TriSail, explaining, albeit in Greek to most lay peeps, there really is no place in this dicussion for someone at my level or most of us here, of knowledge or experience in the complicated and complex world of macro finance.

Who can really judge what either put forward without some underlying, easily understood tenets or premises?

Let us begin with a base stipulation: everyone needs some place to live.

Thus, 'property', has an intrinsic value.

So too, does the structure, the actual housing, the 'fixtures' on such real property, also has an intrinsic value.

Purchasing said property and fixtures, for most, requires taking out a 'loan', borrowing money and paying interest on that borrowed money, usually over a long period of time, 30 years seems commonplace, in other words a sizeable committment to an investment that by its very nature, depreciates over time from use, wear and just the aging process.

Enter what I consider the 'villain', government, at this point, really a bit early for the introduction but I need a 'tease' to keep you reading.

Without delving into the complexities of the 'money market' per se, as HandPrints and TriSail have, let us just 'know' that the Fed controls the amount of money in the system and tinkers with it by 'Prime Rate', which affect banks and lending institutions as well as investors and speculators.

Still, the interest rate of borrowing money to purchase a home is somewhat governed already by events taking place on both a national and a global level, of which most have no knowledge or concern.

Most everyone has some knowledge of the principles involved in 'supply and demand', that is to say, that when the demand is high and the supply is low, prices increase for any commodity, including homes and property.

Strangely enough, the market place senses the variation in supply and demand and just naturally works to balance one against the other, that is, except when 'manipulated', usually by government, but also by fraud and corruption in any of the competing and contributing factors that go into the construction, financing and purchase of 'real property.'

There has been a 'folk myth' in existence forever it seems, that the Automobile industry has had a 100 mpg carburator hidden from production by collusion between auto makers and energy companies to bilk the public into paying more for transportation.

While certainly the federal agencies, Fannie and Freddie, with the social goal of enticing more people into home ownership, those who barely qualified for loans and even those who did not qualify, were offered and given loans that financial dealers knew would end up in foreclosure, that is only part of the problem as this layman sees it.

Social and environmental legislation has artificially driven the cost of homes higher by diminishing the supply of land, property, on which to build a home.

Local building codes, driven by safety concerns, insurance goals and a host of social manipulators, has added thousands of dollars to the construction of homes across the nation.

This is especially true in areas such as California, Florida and the Gulf Coast as architects, builders and community do-gooders attempt to achieve the impossible, creating homes that will withstand hurricanes or 7.5 magnitude earthquakes. All in the name of public safety, of course, and well intentioned no doubt, but the consequence is the addition of thousands of dollars per unit of housing on the market.

The higher priced homes are good for local governments because 'property tax', used to support the public education system, are levied on each and every home built and included in the 'borrowed money', mortgage charged the buyer.

Not to belabor this, as you can determine already where I am headed, government knows that each and every person must have a place to live and they tax it to the maximum that the home owner can tolerate in order to satisfy the insatiable demand of government at all levels.

I am certain that requiring R-(to the nth) insulation in every home, reduces energy consumption by a measureable amount, but it also adds to the cost of the finished home, which, of course, the buyer/home owner is faced with as the average price of a home increased over a period of decades.

There is also the size of the average family to consider, although you couldn't detect it, as the number of three and four bedroom homes being built do not reflect the 1.3 children in the average American household.

Compared to the learned verbosity of those discussing high finance, this offering is poor indeed...but, I suggest, that what I have said and much more, all factors into why people cannot afford the over $200,000 price-tag for newly constructed homes.

Although, from the latest I read, still, 92 percent of all home owners are current on the mortgage payments and it makes one wonder how that eight percent of toxic mortgages acts as the tail wagging the dog.

Another example of high priced homes...excellent modular homes, in any shape, size or form, built to the buyers specifications, could be built in factories by minimum wage, unskilled workers doing a repetitive task over and over, resulting in a basic building cost of less than half of what it takes Union carpenters, electricians, plumbers and concrete workers to construct the building on the property.

I know, that is heresy in this age of social and political correctness.

Economic viability in any society rises and falls as a natural cycle as supply meets demand and then over supplies before it is recognized and dealt with. There is an unspoken wish or dream, call it what you may, that if only we could tinker, adjust, manipulate or prime, Keynesnian style, the economic health of a nation, that there would never be boom and bust cycles.

It ain't so.

I remain certain that Trisail and Handprints speak only truth, I think it is not the entire story of the current mortgage dilemma and that until the market is free of the manipulations I referred to, the cost of a home will exceed that which a reasonable buyer can meet.

Like the housing market that everyone expect to keep appreciating in value, also was the earning power of working people expected to rise accordingly. It just does not and never has worked that way.

For what it's worth....

Amicus...

 

[JAMESBJOHNSON]

AMICUS

As you know, we dont live in a world where supply & demand is allowed to operate, so our economy is chaotic. Demand for gasoline is falling, yet prices are rising. The economy is driven by politics and bribery and force.

I'm reading a book about the Usual Suspect God, Josef Stalin. Stalin operated the Russian economy pretty much like we operate the American economy. For example, he liked green paint on everything but farm tractors, so the Russian paint factories made green paint but no red paint. Stalin insisted that farm tractors be painted red, but no red paint was available because the paint factories were producing green paint. And Russia's agriculture industry couldnt harvest its crops because the tractors were parked at the factories awaiting red paint.

This is fascinating: Stalin was planning to attack Hitler, and Adolf beat him to the draw. Everyone thought Hitler mad for opening a 2nd front, but Stalin forced Hitler to attack.

 

[Le Jacquelope]

Another example of high priced homes...excellent modular homes, in any shape, size or form, built to the buyers specifications, could be built in factories by minimum wage, unskilled workers doing a repetitive task over and over, resulting in a basic building cost of less than half of what it takes Union carpenters, electricians, plumbers and concrete workers to construct the building on the property.

You haven't actually lived in one of those homes built by unskilled labor, have you?

I have walked through brand spanking new homes like that and have found all manner of problems with their construction. Stuff left inside the walls, such as food; sucky drywall work; uneven floors. Far more than is seen in union-made homes where workers and work environments alike are better monitored. This will cost a homeowner money for repair work and the homebuilder its reputation, and will eventually erase the initial advantage of a cheaper house.

Ultimately, unskilled labor is more likely to produce unsafe homes.

There is, thus, one basic rule you left out here when you wrote that: you get what you pay for.

 

[ishtat]

If any one thinks Handprints has been talking Greek try reading some of the papers produced by a mob called Julius Finance. They specialise in producing mathematical analytics to value CDO asset/liabilities. It's hard going even for me who is a very rusty former mathematician. Handprints did a pretty good job.

Just one question keeps bobbing up in my mind.

Is there any chance that an entity which took on any of these complex mortgage packages might be contemplating denying the ensuing liabilities on the basis that the products originally sold to them were misrepresented by the sellers/brokers? It seems unlikely in the extreme, but if it was possible...

 

[JAMESBJOHNSON]

Most things in life are pretty simple, but professionals like to hide their arts & sciences within obscure jargon, to puzzle and dazzle non-professionals. The jargon conceals your handcuff keys and makes the rubes think youre Houdini.

 

[trysail]

If any one thinks Handprints has been talking Greek try reading some of the papers produced by a mob called Julius Finance. They specialise in producing mathematical analytics to value CDO asset/liabilities. It's hard going even for me who is a very rusty former mathematician. Handprints did a pretty good job.

Just one question keeps bobbing up in my mind.

Is there any chance that an entity which took on any of these complex mortgage packages might be contemplating denying the ensuing liabilities on the basis that the products originally sold to them were misrepresented by the sellers/brokers? It seems unlikely in the extreme, but if it was possible...

March 5, 2002
By: "Trysail" ( in his former professional capacity )

With the advent of large quantities of securitizations, there are assets going on the balance sheets of banks and other intermediaries that nobody (and I mean, NOBODY) can value. This, in combination with “mark to market” accounting, is going to produce lots of volatility and some unexpected surprises. It is completely and absolutely inevitable.

ishtat-
As always in commerce, the rule of caveat emptor is generally going to apply. In the absence of very hard evidence of intentional fraud or misrepresentation, plaintiffs are not likely to prevail. As any trial attorney will tell you, proving intent in a commercial dispute is a tough row to hoe.

The cyclical nature of business and economics repeatedly show eras where emptor forget or ignore caveat. This is simply another episode of same. The raptors are always testing the fences.

 

[ishtat]

ishtat-
As always in commerce, the rule of caveat emptor is generally going to apply. In the absence of very hard evidence of intentional fraud or misrepresentation, plaintiffs are not likely to prevail. As any trial attorney will tell you, proving intent in a commercial dispute is a tough row to hoe.

The cyclical nature of business and economics repeatedly show eras where emptor forget or ignore caveat. This is simply another episode of same. The raptors are always testing the fences.

I don't entirely agree. So far as contracts of insurance, guarantee, and warranty and the like are concerned the Common Law would generally require the higher standard of Umberrima Fides (Utmost good faith) rather than Caveat Emptor. However, I acknowledge that under the usual wordings of these contracts the entity buying the CDO would normally give the originating entity an unconditional indemnity thus negating their own Common law rights.

However, notwithstanding that I suspect the entity holding the CDO may be able to make significant recoveries.

Firstly they will sue their auditors for negligence in failing to advise them of the risks in these contracts and secondly they will sue the companies which broked the contracts to them. Those brokers enjoy no protection under the original contract because they were not parties to it, only facilitators . I expect that at least some of them will be sued for non-disclosure of material facts and misrepresentation, comparatively easy to prove compared with fraudulent non disclosure.

The litigation lawyers will find an angle somehow to take a slice of the action.The Savings and loans scandal provided similar opportunities for lawyers to effect recoveries.

 

[Handprints]

Is there any chance that an entity which took on any of these complex mortgage packages might be contemplating denying the ensuing liabilities on the basis that the products originally sold to them were misrepresented by the sellers/brokers? It seems unlikely in the extreme, but if it was possible...

Everyone in the chain (except the originating banks) now has their briefs in order, ready to sue everybody else (including and especially the originating banks). One of the reasons foreclosures and repos have been so low, so far, is that banks are holding people on non-performing lists as long as humanly possible to avoid setting off CDS insurance claims, which will trigger waves of litigation. The suits will start the moment someone decides that they're not going to get paid, ever, government intervention or not.

Best,
H

 

[Handprints]

HANDJOB

But they CARE...and YOU dont.

I care so much I moved to one of the few countries not in any way directly affected by the mortgage mess and changed my fixed-income fund managers to guys who would rather be sodomized with broken beer bottles than cut a CDS salesman a check. Oh wait, that's the wrong kind of caring, I suppose...

Best,
H

 

[JAMESBJOHNSON]

HANDPRINTS

When I worked for the state I always tried to be a stand-up guy and let the chips fall where they may, but such an attitude creates enormous problems for the holder. What works best is fucking everyone, collect your commissions, and get out of town before it all explodes.

 

[trysail]

I don't entirely agree. So far as contracts of insurance, guarantee, and warranty and the like are concerned the Common Law would generally require the higher standard of Umberrima Fides (Utmost good faith) rather than Caveat Emptor. However, I acknowledge that under the usual wordings of these contracts the entity buying the CDO would normally give the originating entity an unconditional indemnity thus negating their own Common law rights.

However, notwithstanding that I suspect the entity holding the CDO may be able to make significant recoveries.

Firstly they will sue their auditors for negligence in failing to advise them of the risks in these contracts and secondly they will sue the companies which broked the contracts to them. Those brokers enjoy no protection under the original contract because they were not parties to it, only facilitators . I expect that at least some of them will be sued for non-disclosure of material facts and misrepresentation, comparatively easy to prove compared with fraudulent non disclosure.

The litigation lawyers will find an angle somehow to take a slice of the action.The Savings and loans scandal provided similar opportunities for lawyers to effect recoveries.

Time out.

Are you talking about:
(A) MBSs
(B) CDOs
or (C) CDSs ?

The possible causes of action, complaints, contracts, representations, warranties and likelihood of success would (obviously) vastly differ.

I will continue to believe and assert that the potential for legal redress by purchasers of MBSs, SIVs and CDOs ( in the absence of very hard evidence of outright fraud or misrepresentation— which is not likely ) is very limited. Purchasers of those securities may attempt to argue that assumptions respecting defaults proved to be inaccurate but that is a risk that is specifically and contractually assumed by the owner-assignee. In the absence of difficult-to-prove fraud, legal precedent holds that buyers/assignees/holders-in-due-course of fixed income instruments bear and assume default risk.

The buyers, presumably "professionals" resident in financial institutions, didn't do their homework properly ( i.e., "due diligence" ). It is a story I've witnessed more times than I care to recount: for an extra 25 basis points, people bought garbage they didn't understand. Many relied on the rating agencies to do their homework, a bad habit born of laziness and incompetence ( Moody's and S&P have never been reliable— seasoned and competent investors have always understood that— just as seasoned and competent investors/fiduciaries have never relied on brokers/jobbers for investment advice, knowing that they are [ and have always been ] bent ).

I don't see why auditors would be involved as either plaintiffs or defendants; their involvement would appear to be limited only to counting the bodies after the smoke has settled. Auditors ( in the U.S. ) have no role in advising purchasers ( unless specifically engaged through a consulting/advisory contract ).

I don't believe any of the above involve "contracts of insurance, guarantee and warranty" other than those specifically defined by written agreement. Claims based on "verbal contract, representations or warranties" are usually specifically excluded by broker/dealer agreements and/or boilerplate contract provisions.

CDSs are a separate and distinct area— if that's what you are talking about— if so, that's something else entirely and insurance contract law ( with its separate and distinct laws and precedents ) would likely apply.