On Wednesday, July 30th, President George Bush signed into law sweeping housing relief legislation that, at 694 pages, many industry participants call the most significant housing reform in decades. By doing so, he enacted a massive series of actions intended to benefit many economic constituencies who have been negatively impacted by the current credit crisis, including current homeowners, first-time home buyers, mortgage lenders, local communities, federal agencies Fannie Mae and Freddie Mac, and even tangentially-related sectors like the construction and appraisal industries.
While many politicians, including President Bush and Sen. Barack Obama, saw the bill as imperfect, a substantial number of senators and congressmen pushed for its passage. Their outspokenness led to the President’s reversal of his veto threat, as Republicans could not been seen as derailing a bill with so much potential impact on so many areas of the housing economy – particularly in an election year.
Today, the initial fanfare has faded and meaningful reflection on the law’s true potential has begun. Banking New York examines several of the law’s pivotal objectives in order to better understand the law’s eventual likely impact on both banks and taxpayers.
Helping the Borrowers and the Banks
The single most-prominent headline announcing this legislation was its potential impact on nearly 400,000 current homeowners at risk of imminent foreclosure due to their loan balances exceeding the values of their homes, creating negative equity.
In order for those estimated 400,000 homeowners to receive relief through lower-cost loans insured by the Federal Housing Administration (or FHA), lenders must agree to write down the value of the loan’s principal. Beginning on October 1st, the FHA received the green light to insure $300 billion of these loans. Not only does the law intend to help these specific consumers; its larger objective is to slow the rate of decline of housing values by reducing foreclosure rates and keeping people in their homes.
“The Banking Department has supported expansion of FHA, since it really takes federal resources to provide affordable refinancing on the kind of scale that is needed,” New York Banking Superintendent Richard Neiman told Banking New York. “Stabilizing borrowers is one part of helping the mortgage market recover – which helps both the industry and the consumer.”
Industry estimates peg potential foreclosures as high as 6 million over the next five years; this law provides short-term relief to only a fraction of those likely to foreclose. In fact, RealtyTrac reported in July that nearly 740,000 foreclosure filings (which include notices of default, auction sale notices and bank repossessions) were recorded in the second quarter alone – that’s one filing for every 171 U.S. households.
Banks hold the key regarding the extent to which this provision of the law will be utilized. Lenders will likely evaluate taking advantage of the FHA refinancing on a case-by-base basis. While refinancing with the FHA guarantees the avoidance of costly foreclosure expenses, doing so has significant costs of its own.
According Robert Davis, executive vice president of the American Bankers Association, banks are currently losing 25 percent of a home’s asset value in a typical foreclosure. Accepting the FHA backing, however, will require the lender to write-down a significant portion of the asset value – as much as 15 percent. Once the asset is written down, 10 percent is immediately allocated to the homeowner as equity, in order to give the borrower an economic stake in maintaining the house until an eventual market correction, and someday, a resale. The FHA then takes a 3 percent fee from the bank in exchange for its guarantee, essentially reducing the lender’s financial stake to 72 percent – or, in other words, a 28 percent loss. Finally, the loan then is officially owned by the FHA (who will likely repackage and resell it), depriving the lender of the asset on its books, ending its relationship with the customer, and eliminating any chance to participate in the recovery of the home’s value when the market turns.
Therefore, lenders will consider the FHA option on a case-by-case basis, taking this writedown option only when it feels certain that the writedown would be less expensive than the cost of a likely foreclosure. Said the ABA’s Davis, “It’s too soon to know to what extent banks will use this program. Using the FHA program would cause lenders enough loan loss to make them seriously consider whether they should keep the loan, modify the terms, and try to work it out.”
As a result of their precarious position, banks were very involved in the development of the bill. Until this bill was signed, banks had been using more traditional methods to keep borrowers away from foreclosure, such as by lengthening amortization periods to reduce current payment amounts. This lender relief is coming at a time when it seems to be most needed. Moody’s Economy.com has estimated that banks will lose $525 billion in failed mortgages originated through the end of 2007.
However, the law does more for banks than just provide relief for existing troubled loans – it also provides refinance guarantees for newly originated loans. This provision has been criticized by some industry observers, who argue that the law will encourage lenders to become even more reckless with their underwriting, knowing the government will provide a safety net for the banks. According to Superintendent Neiman, “This should not tempt lenders to make risky loans, as the FHA has good underwriting standards for the program, such as verifying the borrower’s income with the IRS.” The ABA’s Davis agrees, “The FHA was designed to lend to people with lower incomes, and with less secure or new credit histories. There are many limitations to protect the program.”
Freddie and Fannie
The key item for many industry leaders is the blank check granted to the Treasury to keep Freddie and Fannie floating through loans or stock buybacks. Without those institutions functioning effectively, a negative chain of events can result: loan guarantees will drop dramatically, meaning that new loans won’t be originated, potential buyers won’t have access to borrow money, and the supply of homes will skyrocket, causing further housing meltdowns.
In early September, after another wave of negative economic sentiment that saw both Moody’s Investor Service and Fitch Ratings cut its ratings on both Fannie and Freddie, Treasury Secretary Henry Paulson did step in. The U.S. Government seized control of the agencies through its Federal Housing Financing Agency, which was created by the housing legislation for just this possibility.
The takeover, in which both sets of chief executives lost their jobs, represents the largest economic rescue mission by the government in history. Although both firms were capitalized to the legal limit, after a period of intense governmental review, both were considered to be seriously undercapitalized for the current state of the market.
The government will receive senior preferred debt in exchange for its support. As the stock price fell to pennies per share after the news of the takeover, current stockowners were financially devastated. The government hopes to earn back its taxpayer-funded investment as the agencies and the market recovers, as it did when it supported Chrysler decades earlier.
With the current turmoil in the investment banking system, it will be interesting to see how the federal government’s role will evolve. While it certainly can’t bail out financial institutions indefinitely, Treasury may become a global dealmaker of sorts, bringing institutions from across the world into U.S. turnaround situations. (See Editor’s Note, below.)
Holding the Bag?
More subject to debate is whether this monumental housing legislation amounts to a major governmental bailout, with taxpayers once again funding the fix.
The law has essentially four key taxpayer-funded initiatives: (1) the FHA’s $300 billion in lender guarantees, (2) $3.9 billion in state grant assistance to purchase, rehab, and resell foreclosed properties, (3) $15 billion in tax cuts for low-income and first-time homebuyers, and (4) the financial safety net for Fannie Mae and Freddie Mac, which could reach $100 billion or more, by some estimates.
When all of these provisions are summed together, are we really talking about a $419 billion, taxpayer-funded housing bailout? It depends on whom you ask.
In the confusing, political world of Washington, all deals must be viewed through both philosophical and practical prisms. Idealists who bristle at the very concept of a bailout will answer that it is, indeed, a $400 billion bailout. They cite Washington’s inability to get smarter over time as the reason why these bailout mistakes are made time after time, resulting in taxpayers paying for the mistakes of others who were either reckless or careless.
They also rail against the $3.9 billion in grants for foreclosed property purchases, which was a key sticking point for President Bush, and a primary reason he initially wanted to veto the bill. Those who opposed this item argued that it was, in essence, a handout to lenders, rather than assistance to borrowers. Even supporters of the legislation, including the NY Banking Association, can’t determine the cost: “We are not able to speculate on how much the crisis will end up costing,” said Superintendent Neiman.
But as more and more analysis continues to be run, the price tag to taxpayers might be more affordable than first meets the eye.
While the $3.9 billion is capped (and may not even be entirely used by the states), some of the other estimates are “provisions” and “maximums” that are unlikely to be fully utilized. The Congressional Budget Office (CBO) estimates that only $68 billion of the authorized $300 billion in FHA loan guarantees are likely to be drawn.
Previously reported estimates from the CBO indicate that a government bailout could cost $25 billion; but rates the odds that the agencies would need a bailout at less than 50 percent. (It also projected a 5 percent chance that a bailout exceeding $100 billion would be needed. But that would be necessitated by a continuing and prolonged drop in housing prices.) Industry optimists argue that merely having the backing of the Treasury – without needing to call upon it – may be enough for investors to come back to the agencies.
At the end of the day, nobody really knows how much taxpayers will be paying, because nobody knows whether the other provisions of the law will be successful in stemming the housing losses. To those who supported the legislation, $25 billion to fix a housing crisis that has already precipitated $525 billion in mortgage losses is reasonable. In the larger scheme, $25 billion could be argued to be chump change. But to the minds of the anti-bailout faction, the question remains: exactly who is the chump?s
Robert Brannum is a freelance writer based in Boston with special expertise in the financial industry.
Editor’s Note: This column was written before the September 20, 2008 proposal of the tentatively-named Troubled Asset Relief Program by Treasury Secretary Henry Paulson. The fundamental points made in the column, we feel, are all the more pertinent at press time.