Sunday, November 2, 2008

Credit Suisse Housing Crisis Solutions: Meet the New NEIGHBOR

This proposal is taken from an April 15, 2008 Credit Suisse report out of their “structured products” group.

The proposed solution would involve a new public-private partnership. This new entity would buy out delinquent loans and REO properties at close to market prices from securitization trusts and portfolio lenders. The new entity would then work with other entities (GSEs, servicers, etc.) to craft an optimal solution. This new entity would have much greater flexibility, incentives, scale and resources and would result in far lower losses at no expected cost to the government. [We are proposing] a new RTC-like entity. The RTC itself was modeled after a Great Depression vehicle called the Home Owners Loan Corporation, or HOLC. We are calling our vehicle the NEIGHBOR Fund. While many object to any solution that smacks of a government bailout, we point out the following:
  • First, our plan proposes buying out delinquent mortgages at close to market prices (a deep discount) and at a level that would actually return profits to the government. Likewise, the HOLC, a similar government entity created in the Great Depression era, returned a small profit when it was liquidated.
  • Second, and perhaps more important, in an extreme scenario (which is becoming more likely by the day), the federal government has already explicitly or implicitly agreed to bail out the housing market. Through FDIC insurance, home loan bank lending, and GSE guarantees, the government has sold a massive amount of put options on the housing market. Therefore, attempts to avoid completely anything that smacks of a government bailout run the risk of forcing a far larger government housing bailout, i.e., if the housing market continues to slip out of control, the government may find itself the proud owner of over 50% of the U.S. mortgage market. Or put another way, the government-guaranteed portion of the U.S. housing market cannot be ringfenced from the non-agency portion. The continued meltdown in the one would inevitably infect the other. While this is a low probability risk, the severity would be very high should it materialize.

We hereby provide some additional details of our proposal, including the following:
  • A new entity, similar to the RTC or HOLC (we’re calling it the NEIGHBOR Fund) buying out delinquent loans and foreclosed real estate (REO) from lenders and securitization trusts. The NEIGHBOR Fund could contract out some of the tasks to the GSEs (Fannie Mae and Freddie Mac) and several large servicers. Further, the fund could employ significant additional resources, such as underwriters, due diligence folks, appraisers, landscapers, etc.
  • The cost to the government could be manageable, as the fund would buy loans at a substantial discount. ABS investors would earn a higher recovery than in a liquidation scenario as the fund’s demand for mortgage loans would help to improve the market price for mortgage loans and stabilize house prices. . Furthermore, to the extent this program would limit a housing meltdown, all investors and homeowners would benefit. There are many innocent victims of the housing crisis and they stand to suffer more should we continue down the current path.
  • The fund could engage in more successful and aggressive servicing. Currently, servicers’ limited flexibility in securitization deals is inhibiting optimal solutions. With the fund controlling the servicers, there would be far greater flexibility than with any other owner.Aggressive forgiveness/write-downs of second liens. This contributes to solving two problems – lack of equity that inhibits borrower willingness to pay and additional second lien payment, which impairs their ability to pay. We commented on this type of piggyback second lien modification in our December 7 Market TABS. Earlier this week, Federal Reserve Chairman Bernanke also suggested principal forgiveness to avoid preventable foreclosures. However, so far, this type of principal forgiveness and more creative second lien workouts are still very rare and difficult logistically given various securitization restrictions and different servicing standards. If the NEIGHBOR Fund owned both loans, they have far more flexibility.
  • Creating more refinancing opportunities with new mortgage structures. By forgiving the second lien and creating borrower’s equity in the home, the new entity could create more refinancing opportunities. More borrowers would become eligible for FHA or other GSE mortgage loans. It could also create new mortgage structures; for example, shared appreciation mortgages, in which the lender and borrower would share in any future appreciation. This provides upside to the lender and also allows borrowers to enjoy the potential for real estate appreciation.
  • Acting as a benevolent landlord for homes where the government isn't successful in working out with the borrower. Maintaining the property and renting at subsidized or market rates would prevent the sizeable increase in forced liquidations that will likely result if we continue on the current REO liquidation trajectory. Given the discounts paid for the loan, even a subsidized rental may provide positive returns. Currently, securitizations require servicers to liquidate REO. In many instances, these properties are sold to investors who don’t have a vested interest in maintaining neighborhood quality.
  • Aggressively pursuing fraud. This new entity would have far more flexibility in going after those who committed fraud. It is currently logistically complex and expensive to go after a borrower’s assets and to evaluate whether fraud was committed. In egregious cases, this entity could have the scale to pursue deficiency judgments. This could also minimize potential moral hazard, whereby borrowers intentionally become delinquent in the hope of substantial principal forgiveness.

  • Existing servicers would have incentives to sell the loans to the government. Servicing delinquent loans is very costly, and the current environment offers servicers limited opportunities to cure delinquencies. Based on our recent roll rate analysis published on February 1 (also in the January 18 Market TABS), the cumulative default rate on a 30-day delinquent loan originated in 2006 or 2007 is already around or even above 90%. Selling these delinquent loans to the government, even at a deep discount, would still be better than an REO liquidation, which means a lower severity on the ABS bonds. Thus, opting to sell would be considered as effective loss mitigation and is consistent with existing ABS documents. If the fund’s bid price provided higher proceeds to ABS investors and they rallied around this execution, servicers would likely be pressured into selling at what would be a best bid.
  • The fund could outsource servicing to several largest/best servicers using unified servicing standards. Given that there are nearly 20 subprime servicers, who in turn have to operate under hundreds of different servicing agreements, this new entity would simplify the process by having one unified set of servicing standards. These unified servicing standards could be easily achieved by enhancing the GSE servicing criteria already in place. Additionally, this government entity can also measure ongoing servicing performance via a few key metrics, such as those we published in our Subprime HEAT report.
  • Servicing fees could be structured with incentives. We believe many servicers are reluctant to ramp up servicing staffing as we reach peak delinquencies. This fund would have no such constraints and would ultimately profit through greater recoveries. Currently, most servicers earn a fixed fee and aren't incented to spend lots of money on servicing. This new entity could reward servicers who meet pre-defined performance targets.
  • Positive externalities. In order to maximize value, the government could hire a team of underwriters, brokers, carpenters, painters, landscapers, etc. (there may be a few housing folks looking for jobs). This temporary government employment program would target precisely the part of the economy that is losing jobs fastest – housing related employment. Further positive externalities would include preservation of neighborhoods.
  • Housing soft landing. While there is little doubt that housing prices need to adjust significantly lower, a government-engineered RTC-type program could help to provide a soft landing and limit the damage to neighborhoods that would probably occur if the market were left to work out these delinquencies on its own.
  • Where would the money come from? While much of the money could be provided by the government, it’s likely that GSEs could participate, as well as private investors and even municipal pension funds. The latter would particularly benefit, as they would be investing for returns while at the same time helping to support their neighborhoods and limiting the neighborhood degradation that comes from large foreclosure-related liquidations. Additional sources could be the large pool of social responsible funds. According to a recent Wall Street Journal report, socially responsible funds have increased to $2.4 trillion in the past year. Finally, garden variety private investors might also participate.
  • Measures of success. This new entity could measure returns along two dimensions – income-based returns and social returns. This dual focus is often referred to as having a double bottom line in the social investing world.

Or...perhaps it's the ideal program.

3 comments:

REIDeX said...

Hi Cormick,

What you want to accomplish could be better and easily realized by the SwapRentSM contract and its embedded mortgage product called Home Equity Locking Mortgage (HELM). This new consumer concept of "economic renting" as embodied in the free enterprise based SwapRentSM program could be borrowed by the government temporarily to solve the current crisis. Since it is 100% based on free market spirits, it does not need the government's involvement to operate but given the crisis in the US, it may be helpful for the US Administration to participate and kick start investors' confidence and interests. Please visit http://www.SwapRent.com for further information. Send me an email if you would like to have some more historical information on dealing with the banks and Wall Street firms on these SwapRentSM proposals since mid 2006 before the crisis even started to see how the crisis could have been avoided if they had been implemented back then. Thanks.

Cormick Grimshaw said...

I'll definitely visit the SwapRentSM website. Maybe it could be part of a NEIGHBOR-type solution. I'm very keen on the idea of decomposing the housing product into its constituent parts, although the US government's pro-homeownership policies definitely throw a monkey wrench into those lines of thinking.

REIDeX said...

Well, promoting homeownership without a plan by the government to offer "true housing affordability" could lead to disaster, just like what had happened.

In the past few years the fictitious housing affordability in the US was created based on transient short term variable interest rates. When the rates were already trending higher the low income borrowers were still lured into owning by the "teaser rates".

True housing ability simply means "don't bite more than you can chew". If you do not have the economic ability to own in terms of monthly income then share the appreciation potential with somebody else so that you could afford a bigger house to live in. The key is not to let people abuse debt leverage. Over leveraging hoping to get rich quick is the root cause of our current economic ills, for that matter, most of the economic problems in our human financial history.

As long as leveraging is under control, there is really nothing wrong for government to promote homeownership for social reasons and for wealth creation for our nation. They wealth ceated this way will simply go to those who deserve it as a prudent investment.