Financial Reform Doesn’t Address Our $10 Trillion Problem

George Gombossy asked for my thoughts on the new financial reform legislation. I have many, which I intend to share periodically going forward. But I think it’s important to place the legislation in the context of the big picture, which for me is framed by the numbers.

The financial crisis was caused by the rise in home mortgage debt, which doubled, from about $5 trillion at the end of 2000, to close to $10 trillion at end of 2006. That was too much, too fast. The rise in debt came both from new home buyers and from cash-out refinancings. Clearly, the value of the debt exceeded the value of the real estate collateral. By how much? The topic remains open to debate. http://www.federalreserve.gov/releases/z1/current/accessible/d3.htm#footnote108/z1r-4.pdf

Home mortgage debt is huge. For some perspective, the debt of the federal government grew from $3.4 trillion to $4.9 trillion during the same six-year period. So by the end of 2006, home mortgage debt was two times the federal debt. But the relative dollar amounts understate the magnitude of the problem. Treasuries can be rolled over, and the government always has the option of printing money. Our national finances are managed by seasoned professionals in the Department of Treasury and the Federal Reserve.

Home mortgage debt isn’t rolled over indefinitely; it’s supposed to be paid down. The $10 trillion in mortgage debt is owed by about 48 million homeowners, of which about 14 million have negative equity or near negative equity. Right now, many of those 14 million homeowners feel overwhelmed and do not know what to do.

Are they all to blame for taking out mortgages they could not afford? Not necessarily. If you put down a 20% deposit and took out a traditional prime mortgage loan in Arizona in between 2003 and 2007, the debt probably exceeds than the value of your home. The rate of home price appreciation, after the loan is booked, is the most important factor in minimizing losses.

This $10 trillion in mortgage debt affects all of us, even those of us who rent our homes. Because the dollar amount is so big, it affects government finances and the well-being of the national economy. About half of that amount, $5 trillion, is owed to government-sponsored entities like Fannie Mae and Freddie Mac. If homeowners default and cause Fannie and Freddie’s finances worsen, our government faces a day of reckoning. If we consider the option of not bailing out Fannie and Freddie, foreign government bondholders, notably the Chinese government, can react in ways that are against U.S. economic interests.

Also, if we allow massive home foreclosures, a glut of properties on the market may precipitate a further downward spiral and a loss of confidence in the economy. A big part of the federal deficit was caused by the bailout, and a big part was caused by reduced revenues from a declining economy. If we want to deal with the deficit, we need to deal with managing this mortgage debt. Click here to get the details on homeowners under water.

By itself, financial regulatory reform does not fix this problem. The only way to deal with it is to find out what’s going on with each distressed borrower. It’s a very time consuming and labor intensive job, which is why no one wants to do it. It requires a face-to-face meeting with the borrower, plus independent verification of a borrower’s employment and income, his financial assets and obligations. It requires figuring out if the borrower would be motivated to continue servicing the loan if it were reduced to an amount below the property’s current market value.

Each delinquent mortgage loan is a multi-layered story. Some borrowers took out mortgages as part of a flipping scheme. Some, who took out a loan they could not afford, were deceived by dishonest mortgage brokers. Others took out a fully-documented 80% loan on a house that lost 50% in market value. All the evidence shows that mortgage fraud went viral during the real estate boom.

The root cause of the mortgage meltdown, and most other financial scandals, was that everyone piggybacked off of somebody else’s due diligence, which was never performed properly in the first place. As a substitute, investors relied on credit ratings and financial models that were fatally flawed.

Now that millions of borrowers are in trouble, everyone acts as if the situation can sort itself out on its own. In my opinion, if we really want to take charge of the problem, the federal government should temporarily hire 20,000 people to perform actual due diligence on these borrowers and loans. The private parties who contributed to the situation don’t have the same incentive to do things right. They’re conflicted.

Once we know where things stand, we can at least begin to deal with the problem in an orderly manner.

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3 Comments on "Financial Reform Doesn’t Address Our $10 Trillion Problem"

  1. Horace Maneur | July 24, 2010 at 3:07 pm |

    As a homeowner with first hand experience of predatory lending and predatory mortgage servicing, I was appalled to read your view that borrowers were cause of the financial crisis. How can you so naively suggest that borrowers sit down with lenders and mortgage servicers to identify and resolve their issues? Clearly you have not been following experiences of borrowers who attempted to do just this in the HAMP program. I’ll give you a clue. Most of them were ignored, stonewalled or falsely promised mortgage modifications, only to be foreclosed on, often without notice.

    The financial crisis was not caused by the rise in home mortgage debt. Mortgage debt markets collapsed because lending practices of US banks were allowed to spin into exotic debt instruments that immensely increased risk. Speculators buying CDS insurance bet that significant defaults would occur while deal makers, prop traders, predatory lenders and servicers all colluded to insure that they would. CDS enabled speculators to stack bets on the same mortgage bonds and CDO’s. This is no different than allowing many parties to buy insurance on the same house, waiting for one of them to drop a match.

    Don’t even think of blaming this conflagration on borrowers when you know full well how profitable mortgage defaults were for those shorting subprime. It’s not the borrowers’ fault that too many leapt into this feed trough at the same time with excessively leveraged bets. Not only do we continue to experience fallout from derivatives casinos as it erodes infrastructure across the US, we are paying for it on scale never before imagined.

    Mr. Fiderer, you really need to educate yourself on predatory lending and servicing fraud before laying it on borrowers. There is much factual material to be found in settlements and ongoing litigation with lenders and servicers. Read up on it. Then tie it in with deal makers constructing CDOs designed to fail. Maybe then you’ll get the picture and realize that the whole scheme was designed from top down to profit from mortgage defaults. Borrowers were just pawns in the game.

    • David Fiderer | July 24, 2010 at 10:34 pm |

      Mr. Manueur
      I agree with much of what you say, and, if you read the piece again, you’ll see that I don’t place any blame on the victims of predatory lending. The lion’s share of the mortgage fraud was conducted by people who preyed upon unwitting consumers. The point of the piece is that the government cannot wait around and place the onus on beleaguered borrowers or conflicted banks or servicers to sort out the problem, that the government should take a proactive role and find out what is going on with all at-risk borrowers, instead of making them wait in line to persuade the government or someone else that they are deserving of help.

  2. $10 trillion…? It’s actually over $13 trillion and climbing, thanks to Obama and his supporters.

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