Tuesday, April 29, 2008

Curing The Recession, Part I: The Sub Prime Mess

The Executive and Congress have used the Fed as the "Miracle Worker" and gone their own foolish ways concentrating not on sound fiscal policies but on re-election (a personal fiscal and power policy.)

The fed has no more solutions and will not until the household sector can be induced to further liquify financial institution balance sheets.

The Japanese Central Bank could get away with lowering the its rate to as close to zero as accountants would permit because of the high savings rate of the Japanese household. That we do not have.

What we do have is a consumption/gratification society, with the political system riding the backs of increased consumer installment and home equity debt. The sector is tapped out; and housing debt is so large, given market values, that many home owners have zero equity and increasing interest rates. Thus, foreclosures, jingle mail and the lot.

Financial institutions have been playing the turnover game not holding but sending mortgages for securitization by the whiz kids -- even dumping their servicing businesses to an out of town firm. They are out of touch with the real world of their retail customers.

There are two huge, parallel problems. The first is in the housing market, which is really a domino business with people selling their entry level houses to first time buyers and fleeting up to the next level, using equity from that sale to provide the downstroke for the next level, and so on up the line.

There are entry level buyers, but at a reduced price. At the same time, the home equity loans have to be paid on sale, putting these step-up buyers in a position where they are unable to make the step up, because if they sell, they have little cash to move up with.

This problem can be solved by not moving up, of course. It is complicated by the under qualifica
tion of home buyers, the teaser rates offered, etc. If the mortgage could be desecuritized a solution presents itself.

Provided that the objective is to keep home owners solvent, participating in the economy and not incidentally depositing money on a regular basis in demand and savings accounts, a jointly beneficial solution presents itself. It demands that we take a new look at the home owner's balance sheet.

Traditionally it has had one Asset -- the property; one Liability -- the mortgagee provided loan; one Equity entry -- Owner's position, the remainder after subtracting the principal amount of the Liability from the value of the Asset. Prudent lending in accordance with GNMA criteria held the Liability to be no more than 80% of the appraised market value at closing of the Asset purchase. Owner's verified Income Statement showed that the mortgage payment would be no more than 25% of his income and that the combined mortgage and installment debt would be no more than 33% of his income.

That is the hallmark, forever stained by a combination of sub prime loans based on no documentation and faulty appraisals. These were complicated by teaser rates folded into a higher rate after the initial one, two or three year period and the present fall in home values.

Without the expected increase in home values the conversion of teaser into permanent rate caused mortgagors at the margin to fall outside of the GNMA criteria. Home equity loans caused further deterioration of the mortgagor's credit position

Problems were compounded by the fact that the original lender had no permanent customer relationship; everything was on a transaction basis. Some fault lay there.

Ideally, we would hope to rescue the balance sheet in being by restoring GNMA standards for balance sheet and income statement, while keeping the mortgagor in good standing, occupying the property and making a positive contribution to the economy.

We can do this by adjusting the balance sheet and income statement relationships and requiring future annual adjustments based on the hopefully improving financial position of the mortgagor. All that is required is that we open a new Equity category, a Preferred position in the Asset, nominally held by the Mortgagee -- the Lender.

It will be determined by reducing the First Mortgage amount to that level at which, given the market interest rate on the one hand and the Mortgagor's income stream on the other, the GNMA criteria are met, The difference between the principal amount of the First Mortgage and the the qualifying amount is the par amount of the Preferred Equity. We then set an interest rate which will accrue to the holder of the preferred position. Annually, the Preferred Equity will be paid down by the Mortgagor, given an improvement in his income position.

Upon sale, the Preferred position will receive the first money. the Mortgagor, after paying of his mortgage will receive the remainder. In the interim, no Home Equity financing will be permitted without the permission of the Preferred holder. The Mortgagor will be required to maintain his personal and business accounts with his Lender.



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