Credit and Class War

I'm having some trouble getting my head around many different aspects of the big financial crisis. In particular, the whole sub-prime mortgage business seems to be screwing over a lot of folks of modest means. But on the other hand, it's hard to see how making credit unavailable to folks of modest means would really be a good thing for them in general. A lot of the liberal commentary on this seems to basically take the form of saying, well, these poor folks just shouldn't be able to get loans. Max Sawicky (whose "left" credentials are more impeccable than mine) laid out the dilemma the other day:

Easier credit benefits the working class, since it faces borrowing constraints. Available credit can make possible otherwise infeasible home purchases, higher education, and business start-ups. Inevitably in this context you will see predation, but defining predation is not so easy. An obvious case would be lenders providing loans with inadequate disclosure of terms. Even with full disclosure, however, the borrower could make unwise financial decisions. In fact, we know that many always have and always will.

In general the line between predation and offering easy terms bundled with potentially dire consequences seems a blur to me. The lender needs some combination of spinach and dessert for the business to be worthwhile. It makes no sense to attack lenders for covering their backsides to justify the wider availability of credit. Well it makes political sense sometimes to say stupid things.

Right. The trick is that given a collapse of this magnitude, it's all but inevitable that the public sector will do some bailing out. What one wants is, at the margin, for the largest possible portion of the bailing to go to people with the most objective need rather than the most political clout.

Comments

I think Paul Krugman had the right idea -- fewer bailouts, more workouts. In other words, don't help out the lenders; instead, offer the beleaguered mortgagees the chance to keep their houses with stretched-out or softened payment terms.

Posted by Barry | August 21, 2007 1:41 PM

Easy credit has masked the standard of living decreases that people would have given the stagnation in real wages.

And this doesn't even begin to address some of the most abusive loaning practices (payday loans, car title loans, rent to "own") that target low income people and the working poor.

Posted by a b | August 21, 2007 1:43 PM

Echoing Barry, a big part of the problem is that when the mortgage has been packaged and bundled and sold off to a hedge fund, the hedge fund doesn't give a rat's ass about the faceless homeowner, and doesn't know anything about them.

When a local bank held the mortgages, it wasn't in the bank's interest to have a bunch of defaults in their town dragging down property values.

By being more familiar with their borrowers, they would be able to determine if some just needed the terms of their debt renegotiated, and which borrowers were in deep enough trouble to be written off as losses.

Posted by Jon H | August 21, 2007 1:49 PM

Re "What one wants is, at the margin, for the largest possible portion of the bailing to go to people with the most objective need rather than the most political clout"
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ha ha ha ha ha. You guys crack me up.

To see why, replace the vague phrase "the most political clout" with

"to those who give huge piles of money to those Members of Congress who will dictate the terms of the bailout".

Then ask yourself just how likely that is.

In Matthew's dreams, a naked Angelina Jolie would be climbing all over him -- but he shouldn't hold his breath waiting for it to happen.

Posted by Don Williams | August 21, 2007 1:52 PM

I'm not very happy about the idea of bailing people out. I bit the bullet and live in a small house because that's what I can afford. I guess I should have lied on my application instead and gotten a balloon loan so that I could get bailed out when I had to foreclose.

Posted by chicagoan | August 21, 2007 1:52 PM

i think max makes some very sensible comments here; still, i think there is an easy part to this.

the working poor do not benefit from buying a house they can't afford. when mortgage brokers engage in what amounts to fraudulently issuing a mortgage to people who really can't afford one, that should be a straightforward matter to address with criminal sanctions.

which doesn't solve the problem of the poor souls who got sucked into a bad deal, for which some kind of workout does make sense.

meanwhile, though, matthew is still having a problem grasping the inter-connected nature of the difficulties here. at the core is a problem of mortgages, but thanks to securitization, leverage, and lots of smart people believing in the greater fool theory, there are many "problems" linked back to the original one, and most of them are not susceptible to a "bailout."

the best single discussion i've seen yet is this one:

http://economistsview.typepad.com/economistsview/2007/08/four-views-on-w.html

Posted by howard | August 21, 2007 1:54 PM

Swacky demonstrates once again why economists need balance in considering public policy. Let me say it again: human beings are not rational actors, especially in aggregate.

You didn't have to be paying much attention over the last several years to know there was a lot of predatory lending going on. If you look at how incentives were structured, you basically had mortgage salespeople doing what salespeople do -- getting people of modest means to make terrible financial choices so they can score a commission, the same old old snakeoil hustle.

The issue isn't whether or not poor folks should be able to get loans, or whether or not there's "disclosure." The issue is how debt is marketed and sold as just another product, which covers a gamut of issues from NINJA mortgages do credit cards to payday loans.

Same phenomena as with pharmaceuticals. If you pump a few billion into propagandizing for something, more people do it. Why? Because rational choice theory is a lie.

Posted by Josh Koenig | August 21, 2007 1:57 PM

chicagoan, i'll tell you what: when you see people with mortgages actually "bailed out," you let us know, wouldya? what is being suggested is that foreclosures arising from the circumstances jon h has described admirably aren't good for anyone (even you and your smart buy, because if the worst hits and, oh, a million people are foreclosed on, don't think your house value won't be affected for the worse), and therefore we need to try and find a way to do what traditional lending institutions faced with this kind of condition always did: they tried to work it out, first. (hate to disillusion you, since you appear to be a "sinners in the hands of an angry god" type from the article i just linked to, and apparently you think large numbers of foreclosures are just desserts, no further questions asked.)

Posted by howard | August 21, 2007 1:59 PM

In Matthew's dreams, a naked Angelina Jolie would be climbing all over him -- but he shouldn't hold his breath waiting for it to happen.

I never know what to make of attitudes like this. Do they moneyed have an enormous political advantage in this country? Of course. Is it difficult to get legislation passed that favors the poor at the expense of the rich? No question. But that doesn't mean that it's impossible, nor does it mean that, however hard or impossible it might be, we should just abandon discussing it.

Posted by Freddie | August 21, 2007 1:59 PM

If we want to make housing more affordable for poor people, the most economically efficient way is usually through direct subsidy. Allowing a housing bubble to expand based on the systematic extension of dubious credit is going to cause long term headaches that overwhelm any short term benefits felt by the poor.

Posted by blah | August 21, 2007 2:02 PM

There's a big difference between easier housing credit and other forms of credit. Easier housing credit drives up the cost of housing for everybody in the community. Even responsible people who don't get in over their heads are adversely affected.

What about people who get in over their heads? Are they acting irrationally? People often make decisions by looking at others in similar circumstances and seeing what happens. It's a much more efficient decisionmaking process than trying to develop a technical expertise on every single topic that may affect you. If you are surrounded by companies willing to lend, real estate agents telling you it's OK, and friends who are doing the same thing without any immediately obvious consequences, you might rationally think that it was fine.

Posted by norm | August 21, 2007 2:14 PM

Re Freddie's comment "But that doesn't mean that it's impossible, nor does it mean that, however hard or impossible it might be, we should just abandon discussing it. "
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No, but what we should do the next time we get a Democratic President and Democratic control of both Houses of Congress is change the basic rules of the game to give the people more power -- tightly regulate campaign financing so that the Congress is less of a whorehouse, restore the Fairness Doctrine to use of the PUBLIC airways (the ones that Rush Limbaugh and Bill O'Reilly use) , and move some money from the superrich back to the people who fight this country's wars.

As opposed to letting Hillary cause a massive trainwreck which ensures no healthcare for millions of people for decades.

Plus we might suggest to Hillary that a President's irresponsible behavior hurts innocent people far more severely than it hurts the President. Although I kinda think she might already know that.

Posted by Don Williams | August 21, 2007 2:40 PM

Great responses -- howard, blah, and others are all right on the money, and I'm not sure why Matthew is blurring the tremendous difference between easy access to credit, on the one hand, and predatory lending, on the other. Programs intended to make it easier for working-class people to buy homes and acquire equity don't generally feature teaser rates and sky-high APRs that kick in after 2 years. There is simply no reason for us to reward financial institutions for having deliberately suckered people into situations where they were unable to repay their loans, in order to reap huge interest rates and penalties. We should outlaw predatory lending and funnel money to working people who've been entrapped by it; in this fashion, we punish the bad guys without harming the innocent. We can't allow financial institutions to use average Americans as hostages (bail us out, or we'll take away their homes).

Posted by brooksfoe | August 21, 2007 3:05 PM

Contract terms should be standardized and tested on people of low IQ to make sure the terms are understandable. If a term is too complicated for a person of, say, 70 IQ (excluding about fifteen million Americans) to answer pertinent questions about it, then it should be considered inherently predatory.

Posted by turkey | August 21, 2007 3:21 PM

Isn't there an operations research principle to the effect that the proof is in the pudding? Just as thousands upon thousands of Jewish seniors in Miami/Dade who voted for Pat Buchanan in 2000 when they wanted to vote for Al Gore weren't morons (their butterfly ballots were an artifact of criminal moronism), foreclosure rates surpassing one in five or one in four are strongly suggestive of the fact that these unfortunate borrowers were operating in a credit environment that had, virtually undetectably, broken down. For genereations, poor people were used to the idea that they never got a free lunch from creditors--so when the sharks started tossing them red-meat, no-cap, no-int, whistlin'-dixie loans and mortgages, they figured their "betters" knew what they were doing. I find that a lot of the lefty blogoshpere (John Aravosis, e.g.) just don't get this and start raving about liberal paternalism when one tries to point it out....

Posted by elle loco | August 21, 2007 3:22 PM

It seems very simple to me. Credit for capitol accumulation is good. Capitol for depreciating assets that don't allow for capitol accumulation bad.

Thus borrowing to buy a car for getting from point a to b in order to work is a good thing. Borrowing to buy above the actual utility value of the car is a bad idea.

People think that it is neccessarily a good thing for people to have access to more credit than they can afford. That's not a good thing. It is in part what's got us in this mess. Banks kept throwing credit at unworthy borrowers.

If there wasn't so much easy credit out there people might actually look at the material circumstances of their lives and realize that the republicans are full of it.

Posted by Parmenides | August 21, 2007 3:33 PM

I suppose you could call this a reverse bailout: In Bush World, when you're poor and you lose your house to foreclosure, your world of pain has just started. It's a perfect Catch-22: You lose everything, but at least your debt is forgiven, but because the debt is forgiven, it's income, and now you have a new debt to Uncle Sam, one with penalties and interest added, because of the time that elapsed since you "earned" that income.

It all makes perfect sense in Bush World, though. What else is the I.R.S. to do? The rich are off limits. Middle class people fight back. So why not go after the poor and disadvantaged? I.R.S has to collect taxes somewhere.

Posted by Madison Guy | August 21, 2007 3:38 PM

B made a point that was largely missed, and I think it's critically important.

We're in a situation where income inequality has skyrocketed. It's reaching an extreme point, where the productivity gains of the past 6 years have accrued almost entirely to the top 1 or .01% (or some ridiculous stat like that).

Why haven't working people demanded their fair share of the pie? Part of why not is easy credit. Borrow money to meet your discretionary (and in some cases, basic) needs, and you don't feel the lack of the raise you deserve so strongly. You can still buy the widescreen TV, you just buy it on credit, like everyone else you know.

And when the bills start coming due, your poor credit situation makes you less able to demand their fair share than before. Firms won't hire people with bad credit, so the fear of being fired becomes stronger.

On a macro scale, the cycle becomes self-reinforcing. Increasing income inequality means the have-mores are looking for new things to invest in, and some of that surplus goes into things like bizarre refinancing schemes targeted at making money off the very population they haven't been giving increased wages to.

This is not to say the other points aren't (arguably) more important.

But I think nobody is saying that easy credit is be terribly pernicious on an individual level and in terms of economic stability when it's coupled with rising income inequality. Working people start substituting credit for wage increases, and an increasingly wealthy investor class makes increasingly stupid bets as it runs out of sensible things to invest in and tries to find ways to make money off this appetite for credit.

Of course, it works for rich people because they either make money off the people they're fleecing, or they bet huge, lose, and get a government bailout from Uncle Ben Bernacke. Pretty much a win-win. For about a generation.

Posted by anonymous | August 21, 2007 4:29 PM

howard: "what is being suggested is that foreclosures arising from the circumstances jon h has described admirably aren't good for anyone . . ., and therefore we need to try and find a way to do what traditional lending institutions faced with this kind of condition always did: they tried to work it out, first."

Okay, so we stipulate that lots of foreclosures are bad for eveyone. And that when banks used to hold onto their notes, there were corresponding incentives to re-structure the loan. And even that securitization of mortgages created a significant problem where the incentives to make more loans (fees now and commissions) significantly outweighed the disincentives (risk of default). What do you propose we do?

I'm not even asking what you think the mechanism is to resolve this--I don't expect any one person to figure that out--but what's your desired outcome? And how does that outcome avoid creating (obvious) problems for investment and finance far beyond the US housing sector?

Posted by zaleriana | August 21, 2007 4:33 PM

People think that it is neccessarily a good thing for people to have access to more credit than they can afford. That's not a good thing. It is in part what's got us in this mess. Banks kept throwing credit at unworthy borrowers. - Posted by Parmenides

And yet somehow the money being lent is getting spent, which means our economy has the resources to support these people, without them getting into such debt, at the level in which they are living.

Moreover, the money getting spent means that it's going back into the economy -- the worst that should be happening is that more money going after the same amount of goods and services should lead to inflation, in which case the crisis wouldn't be so bad as people would inflate out of their debts, so to speak.

That is, if I spend $x1 and you spend $x2, etc. ... for a total sum of $X being spent, even if I make only $y1, you make $y2, etc., for a total of $Y being made ... well, then in the next round, since $X was spent, $X should be made collectively by society, which means there should be no additional deficits accumulating as long as the distribution of the $X is reasonable. Even the interest on the $X-$Y debt in the one "over-extended" round of trading is going to someone who spends and/or invests it, so it goes back into the economy (of course, it may be that the $X is worth no more than the $Y was in the first round ... but that's inflation, which should be the worst-case scenario and even then the upside is that the $X-$Y debt doesn't mean so much anyway ...).

So, given that the debts just keep piling on for so many people, somehow the money is coming from somewhere and going to somewhere without it being meaningfully distributed by the economy? I might not be an economist, but I did major in math and something just doesn't add up.

I guess that's what Parmenides is getting at with the "lay bare the contradictions" paragraph at the end of his (or her) post?

Posted by DAS | August 21, 2007 4:51 PM

zaleriana, excellent questions one and all, so let me stipulate up front (as i've said in several other comments on earlier matthew threads about this topic), by and large i don't honestly know the "desire" outcome, partly because it depends on the scale of desirability.

the easiest thing for me to say (as i implied above) is that i would want to amp up the penalties on fradulently issued (or obtained) mortgages, so that there is a real penalty that could serve as a disincentive.

From a social perspective, i would guess that most of the subprime mortgages made in the past couple of years shouldn't have been issued, and i would want to ease the inevitable pain to the (roughly, iirc) 1M - 2M households as the threat of foreclosure looms ever larger, primarily through the reintroduction of some kind of workout mechanism (whose mechanics i can't possibly imagine right now!) for anyone who no longer has a financial institution to deal with.

From a securities standpoint, i suppose i'd want to amp up penalties on knowingly securitizing assets with no reasonable expectation that they are "good" (sort of a sarbanes-oxley proactive diligence with associated criminal penalties), and i'd live with the loss associated with a lesser pace of securitization that arose.

From a capital standpoint (prof delong, at his spot, noted that historically you need a precipitating event, such as capital flight, for what we've seen in markets the last 2 weeks, and i commented back that we're seeing "capital disintegration," which is close enough), i'd let it all go, and if some hedge funds and others took on too much leverage for the quality of the underlying assets, nuts. I believe that there are no tranches of sub-prime backed mortgages out there that are worth zero, but since the market doesn't know how to value the tranches right now, everything locked up.

if some hedge funds et al fold, some other people will ultimately make a ton of money on the fire sale of those assets, and just as i'm prepared to live with capital disintegration to some, i'm prepared to live with capital gains for others.

and on a social policy basis, my desired outcome is to reduce the casino mentality that governs our socioeconomic lives these days while making the tax system more progressive, but frankly, i just wrote several paragraphs on that and decided that it's such a bigger issue that i deleted them.

it's really not very satisfying, is it? that's the problem with genies let out of bottle (see iraq, war-torn): there really aren't any good solutions after the fact. if you've got any better ideas, i'd love to hear 'em.

PS. i still recommend the economist's view link i cited at 1:54.

Posted by howard | August 21, 2007 5:42 PM

Can we all take a deep breath here? Let's suspend the lefty reflex to find "victims" and throw money at them for a moment, and consider what is happening.

The credit crunch isn't being caused by lots of mortgage defaults; in fact, there are very few defaults right now. About 15% of sub-prime mortgages are in default, as are about 3% of alt-a mortgages, but these make up about 2% and 8%, respectively, of the mortgage market. What is driving the current credit crunch is that the demand for mortgage-backed securities has dried up.

Normally, this would fix itself as sellers lowered their prices until a market-clearing price equalized supply and demand, restoring liquidity. What's happening today though is that highly-leveraged hedge funds are trying to hold off marking their mortgage-backed securities to the market, because when that haircut hits their books they'll be on their way to bankruptcy. Eventually, though, a few funds will capitulate and go belly-up, and investors will buy up their quality mortgage-backed securities at big discounts (like Citadel did with Sowood's assets).

All this effects the retail mortgage market because if mortgage lenders can't get their loans securitized and sold, they can't make additional loans. As far as individual mortgage borrowers, a government bail out probably won't happen, and it shouldn't. Most of the sub-prime borrowers bought their houses for no-money down with piggy-back loans, so they have no assets that need to be bailed out; there's no conceivable workout that could keep a family in a house they can't afford with a rational mortgage without massively subsidizing America's most expensive housing markets, which isn't going to happen.

No new federal regulations of mortgage lending are necessary. There are already plenty of state laws on the books regulating "predatory" lending (though much of what has transpired could as easily be called predatory borrowing). Absent an ill-advised bailout, the markets will sort themselves out. Mortgage lenders that survive will tighten their credit standards. The lowered availability of credit will be balanced by more rational real estate prices. Owners of $1 million 3 or 4 bedroom houses are in a similar position as some of the hedge funds: they know what they own isn't worth what they paid for it, but they are afraid to see the real market-clearing price. Eventually, they'll capitulate too. Prudent middle income Americans will no longer be able to get mortgages for 6 times their income, but as the real estate bubble deflates, they won't need to.

Posted by Fred | August 21, 2007 5:47 PM

If we want to make housing more affordable for poor people, the most economically efficient way is usually through direct subsidy.

Absolutely. But this isn't about housing per se: it's about home ownership as a line of credit. Having that mortage during good (or even mediocre times) is a big step up from the title loan and the payday loan: it's the college fund and the holiday fund. Even in downturns, before the era of bundling and securitization, it offered a degree of security, because local lenders would sooner restructure than foreclose.

There have been studies on the inverse correlation between home ownership and social safety nets. In many ways, it's self-perpetuating: if the housing ATM becomes the path to financial security, then the consequences are generally a tax code and legal framework that benefit home-owners. Of course, that's inflationary, but the greater fool argument kicks in.

Erin Burnett got stick from the left for saying that some people shouldn't be buying homes. Whatever her motives were, there's some truth to that argument, because a healthy rental market, both public and private, has social as well as economic benefits.

And yes, what 'b' said: easy credit means you don't feel quite so stiffed for wages, until the bills mount up.

Posted by pseudonymous in nc | August 21, 2007 6:15 PM

Erin Burnett got stick from the left for saying that some people shouldn't be buying homes. Whatever her motives were, there's some truth to that argument, because a healthy rental market, both public and private, has social as well as economic benefits.

Pseudo,

The logical economic decision is to rent when the cost of renting is less than the cost of owning, after quantifying the tax benefits of the mortgage interest deduction. When I bought my modest place 7 years ago, the cost to own it (with an 20% down and an 8.5% mortgage) was about the same as the cost to rent a similar place. The tax benefit from the mortgage interest deduction after one year was enough to make up for the closing costs. If I didn't already own this place, I'd sooner rent it than buy it today, since after the 120% price appreciation, it would cost more to own it.

Over the last several years, exotic mortgage loans (2 and 28, negative amortization, balloon loans, etc.) enabled imprudent, conspicuously consuming, home buyers to (at least temporarily) own homes which they would never have been able to afford to rent, because the mortgages gave them artificially low payments for the first few years. Up until about the beginning of '06, they could still unload the house in most cases for more than they paid for it, but it was still imprudent to try to live above their means.

Erin Burnett, for the uninitiated, is easily the smartest female anchor on CNBC. Not hard on the eyes either.

Posted by Fred | August 21, 2007 6:38 PM

fred, as you say, take a deep breath. if the problem were only a handful of foreclosures, there wouldn't be a problem.

the market is anticipating a considerably worse foreclosure problem, because the market, while manic depressive, is not an idiot.

btw, if you are fraudulently induced to make an investment, the proper word is "victim."

Posted by howard | August 21, 2007 7:00 PM

ps. pseduonymous, i meant to ask: who are these assorted lefties giving erin burnett stick for saying not everyone should own a home? i've seen plenty of lefties make that argument - it's the bush administration that thinks it's pushing an "ownership society."

and fred, i'm going to assume that you're last comment at 6:38 was a clever play on chris matthews.

or at least, i'm going to hope....

Posted by howard | August 21, 2007 7:04 PM

I think we are giving these home buyers too little credit. Sure, realtors and lenders encouraged irresponsible behavior by telling people they could refinance or flip the home in a couple years, but these people still signed off on it. To suggest that the buyers didn't know better is an insult to their intelligence. What they did was take an opportunity to live above their means for a few years with the hope that their houses would appreciate and everything would be okay. I don't think they deserve a government bail out any more than the hedge funds or lenders do.

Posted by a renter | August 21, 2007 7:23 PM

Attention Matt. False premise.

I'm having some trouble getting my head around many different aspects of the big financial crisis. In particular, the whole sub-prime mortgage business seems to be screwing over a lot of folks of modest means. But on the other hand, it's hard to see how making credit unavailable to folks of modest means would really be a good thing for them in general.

Your jumping from too easy credit to none at all, or to not take your words so literally, really hard to get.

The opening of the mortgage market thru the securitizion of them by the GSE's did open up the possibility of home ownership to many who in earlier times had little hope of home ownership. It worked pretty good. However the GSE's became cumbersome behemoths whose implied but not real backing by the government allowed them to borrow at unrealistically low rates which was a market distortion. Then too they ended up with books of retained mortgages worth trillions of dollars thus holding potentially hundreds of billlions of potentially bad loans which was all backed by a teeny tiny bit of capital. They were and are unsound. (Few are following the bad melodramas of Fannie Mae and Freddie Mac. They have had armies of accountiant going through their books for three years now and still there is no clear statements of what their balance sheets show)

Since they were so woefully undercapitalized they were forced by the oversight authority to sell a lot of their mortgage securities. (The Chinese Central Bank has purchased some $500 billion of this GSE paper, stupidly.)

When the GSE's were forced to cut back the 'free market' stepped into the breach. Thousands of mortgage companies arose almost overnight.

Here is how they worked. First remember that all mortgages can be bundled and sold to say a pension fund or other entity and that no matter how crappy the borrowers were these mortgage securities all ended up with AAA ratings. With the AAA rating any fiduciary could buy the worst crap and call it top notch. (That's why you are hearing and will be hearing a lot more of how the ratings agencies are a scam). So if you can get someone to lend you money short term you can make the mortgage loan. Wall Street and major banks were falling all over themselves to loan to these guys.

The mortgage guys borrowed short term. Made the mortgage loan, bundled the mortgages and sold them off, pricing in a nice little profit for themselves. Wash, rince, repeat. There is no incentive in this system for making sure the borower can pay back the loan. They could give a shit. Little wonder that so many loans were made to people who shouldn't have gotten them. Not just poor and near poor people but greedy speculators and solidly middle class people who bought just a bit more of a house than they could afford because they KNEW the price would rise and they could make a profit. Too boot many of these people took out Adjustable Rate Mortgages. At the bottom of a 20 year trend of lower interest rates, spurred on by Greenspan.

As time went on more and more grifter mortgage brokers, or just stupid ones entered the field and more and more people got on board the housing bubble. Everyone was going to be rich.Prices were rising sharply, and probably would forever. No, this last wave of lenders produced the last wave of suckers. Something every bull market needs.

Sub prime isn't even the biggest in dollar term problem in mortgages. Alt A loans already are bigger in terms of losses. Mortgages are not the whole problem by a long shot in the credit markets. . All manner of modern securitized debt instruments are shit. Shit with a AAA rating.

Debt has been the lifeblood of the Morning In America era. Total credit has been in a bubble mode for two decades. Most are too close to it to realize how unprecidenthttp://www.crestmontresearch.com/pdfs/i%20rate%20Gross%20Debt.pdf

Posted by rapier | August 21, 2007 7:25 PM

Botched the above link

Total credit market debt

http://www.crestmontresearch.com/pdfs/i%20rate%20Gross%20Debt.pdf

Posted by rapier | August 21, 2007 7:26 PM

Let’s remember here that a lot of people who took out these risky loans were not poor or middle class homeowners: they were speculators pure and simple, people looking to make a fast buck (or rather a few 100K worth of bucks) in the latest get rich quick scheme. Frankly, I think they deserve what they’re getting, as do the financial institutions that enabled them.

Re: an increasingly wealthy investor class makes increasingly stupid bets as it runs out of sensible things to invest in

We have certainly not run out of sensible things to invest in! The trouble is (see above) too many people want to make money fast, rather than doing it the old fashioned way, investing for the long term.

Re: Normally, this would fix itself as sellers lowered their prices until a market-clearing price equalized supply and demand, restoring liquidity.

Problem is, too many homeowners, tantalized by visions of 100K+ profits, are refusing to get with the program by lowering their asking price. The crisis would be over tomorrow if everyone did that, but too many people just won’t (and yes, I know, some owe too much and so can’t)

Posted by JonF | August 21, 2007 7:38 PM

The inability to accurately place a value on these arcane financial instruments (all slapped with 'AAA' on them) and to accurately judge their risk is why everyone is stampeding to gov't bonds. It's fleeing to the known and the safe.

The best paper writing on this has been the FT.

Posted by grumpy realist | August 21, 2007 7:45 PM

jonf, the least of our problems is the speculator group, whatever its size.

they're going to be the ones who don't want a workout.

and since, as i noted, any solution should be rooted in a workout scenario, that'll take care of that....

Posted by howard | August 21, 2007 8:28 PM

Re: You lose everything, but at least your debt is forgiven, but because the debt is forgiven, it's income, and now you have a new debt to Uncle Sam

What are you talking about? Neither bankruptcy nor foreclosure have tax consequences. The only sort of debt remission that has tax consequences is if a debt is forgiven outside the bankruptcy court and without repossession of collateral. In foreclosure after all you "breaking even", in principle: you escape the debt, but lose the collateral.

Posted by JonF | August 21, 2007 9:16 PM

sorry, jonf, you're not familiar with the ins and outs of the tax law as it applies here (it is hard to keep up, i know, but still, before leaping into the categorical, you ought to double-check).

from the nytimes, august 20 (forgive my inability to master even the simplest commands like ital):

Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show.

Despite the setback, Mr. Stout was relieved that his debt was wiped clean and he could make a new start. He married and moved in with his wife, Denise.

But on July 9, they received a bill from the Internal Revenue Service for $34,603 in back taxes. The letter explained that the debt canceled by Wells Fargo upon foreclosure was subject to income taxes, as well as penalties and late fees. The couple had a month to challenge the charges.

For those who struggle to pay their bills, who watch their housing payments rise out of reach with their adjustable-rate mortgages, who lose a job or who fall victim to illness, losing one’s home can feel like hitting bottom. But one more financial indignity may await as the fallout from the great housing boom ripples across the United States.

“Getting that tax bill,” Mrs. Stout recalled, “my first thought was that I needed to see my family doctor to help me with my stress, because we had a big mortgage and other debt and then here came the I.R.S. saying we owe this.”

Notices of unpaid taxes, unanticipated and little understood, will probably multiply as more people fall behind on their mortgages, said Ellen Harnick, senior policy counsel at the Center for Responsible Lending, a nonpartisan research and policy center in Durham, N.C.

Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.

The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.

http://www.nytimes.com/2007/08/20/business/20taxes.html

or just do a search on foreclosure and income tax and you'll see all kinds of discussions of this matter.

Posted by howard | August 21, 2007 9:43 PM

OK children, time for some straight talk.

The people most at risk for foreclosure aren't really going to lose anything. They got no down payment loans at "teaser rates", and as a consequence have no skin in the game. In reality they were just renting the homes until the ARMS reset to the "real" rates. But for the "predatory lending" they never would be in the houses in the first place. Let's call a bailout of these folks what it really is - subsidized housing. At this point, the USA can hardly afford to find yet something else to spend its (i.e. China's) money on.

Bailouts create moral hazard no matter how noble the intent. This mess is just another example of what happens when greed and stupidity collide. It's no more noble than that.

Posted by kafka | August 21, 2007 10:54 PM

btw, if you are fraudulently induced to make an investment, the proper word is "victim."

Maybe I'm not following, but who was "fraudulently induced to make an investment"? The homeowners received the money from the mortgage, which is the opposite of investing money. The banks were the investors (in homeonwers' debt), not the other way around.

Posted by Al | August 21, 2007 10:55 PM

Al, you're not following, although admittedly i was shorthanding.

historically, owning a home was regarded as a hedge against inflation.

during the housing asset bubble, owning a home began to be regarded as somewhere between an ATM machine and an investment.

and so by the time we got to the last couple of percent of households enticed into the housing market (all those record-setting number of homeowners), the basic pitch being made in many, many cases (perhaps as many as a million or two) was: "we don't need to verify your income and you've got nothing to worry about anyhow: by the time this ARM resets, your house will have gone up in value and you'll be able to refi."

which is to say, people were fraudulently induced to make an investment (perhaps you'd like it better if i said "fradulently induced to make a supposed investment").

as i said to jonf, it will be easy to tell the ones who willingly participated in the fraud in order to become real estate millionaires: they'll be the ones uninterested in workouts.

anyhow, there's another key point, which is that the banks weren't "investors." mortgage brokers were making deals and then packaging the mortgages up - this is the key disconnect in the market, since there is no one to individually structure a workout with. in fact, did we only have traditional mortgages, granted by banks who did their due diligence, the housing market would have popped earlier and we'd have much less of a problem.

Posted by howard | August 21, 2007 11:12 PM

kafka, first of all, will you please (you're about the third in this thread) to show us who is proposing a bailout of indivdual mortgagees? one longs to see.

and second of all, read the link i provided to johnf: in fact, no, there will be a cost above and beyond what you so blithely call "subsidized housing."

and third of all, please provide us the evidence that all the buyers in the sub-prime and alt-a markets in the past couple of years were saying "i know, i can get a great deal here for a couple of years until the ARM resets." one wonders how you know such a thing?

Posted by howard | August 21, 2007 11:14 PM

"Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show."

How often does that happen? When a bank forecloses on a house, no one buys it, and then the bank buys it for $1? I'm guessing it happens somewhere between seldom and never. Howard, do you really think this man-bites-dog story is broadly representative of anything?

Posted by Juan | August 22, 2007 12:04 AM

Howard: Burnett got stick at Digby's place for her comments, which she made at the same time as Matthews' creepy come-closer stuff, and has repeated a few times on CNBC.

I think there's an myopic undercurrent in what she said, given the rent/buy ratio in NYC and environs, but the basic premise holds. Digby's commenters inferred that she meant 'you little people don't deserve to own a home'; I'm more generous, and think she meant it's not smart personal finance for certain people to seek a mortgage, with all that entails.

Posted by pseudonymous in nc | August 22, 2007 12:21 AM

kafka -- ah, but why were the houses so expensive? That's the better question.

Posted by Kimmitt | August 22, 2007 12:31 AM

People knew that they would have to refinance their ARMs before they started floating, they just figured that their houses would appreciate sufficiently that they'd have equity and be able to. Even the worst lenders didn't pretend that the rates wouldn't adjust. So the home buyers bet that the market would keep booming and they would be okay. And just like stock buyers 6 years ago, it's biting them in the ass.

Some investors are going to lose money on their investments. Some lenders and realtors are going to lose their jobs (with tight credit, there will be fewer and smaller deals). Some homeowners will lose their homes. All were greedy and took undue risks or encouraged others to take undue risk for their own gain. Those are the breaks. I don't understand why any of these groups should be treated with kid gloves.

Posted by a renter | August 22, 2007 12:35 AM

Juan, i have no idea how frequent this particular set of numbers is, but perhaps you haven't been following (i'll start with that premise): what this story represents is, you know, the law, the actual reality of what happens in a foreclosure situation, despite jonf's certitude to the contrary.

in addition to the nytimes article, which i had only read yesterday, as i noted to jonf, i did a search on foreclosure + income tax, and you get dozens of cites that discuss the same basic reality. here, for instance, is a quote from the very first cite (written 2 years ago, btw):

When you abandon property, you voluntarily and permanently give up possession with the intent to terminate your ownership. An abandonment represents a total loss of your investment or interest in the property. If the property is business or investment property you may have a deductible loss. And the loss may be an ordinary loss (as opposed to a capital loss) even if the property is a capital asset. The amount of the loss is the adjusted basis of the property at the time of abandonment. Abandonment of personal property, such as a home, is not a deductible loss for federal income tax purposes.

An abandonment may lead to the property subsequently being foreclosed on or repossessed. In this case, the gain or loss would be determined according to the rules for foreclosures and repossessions.

Cancellation of Debt
If there is a debt that secures the property, such as a mortgage loan, and as a result of abandoning the property, that debt is cancelled, the amount of the cancelled debt constitutes ordinary income to the person who was personally liable for payment of the debt. This ordinary income for the cancellation of the debt is separate from the ordinary loss for abandonment of the property. Pledging the underlying asset as security for the payment of the debt is not necessarily the same as being personally liable for payment of the debt.

So in the case of abandoned property, it would be possible to have both an ordinary loss, for the abandonment of the property, and ordinary income for the debt that is cancelled, if you are personally liable.

The loss on the abandonment is for the adjusted basis in the property, which could be the purchase price or another basis, depending on how the property was acquired. There could be adjustments to the original basis, such as increases for additions or permanent improvements, and reductions for depreciation deductions or casualty losses.
The income is for the cancelled balance of the debt. This could be the balance of the original mortgage loan to purchase the property. Or the debt could be another type of loan secured by the property that is abandoned.

http://www.googobits.com/articles/2340-income-taxes-on-the-abandonment-foreclosure-or-repossession-of-property.html

I mean, i could go on, but really, what's your point? i've cited reality - that the notion that we just had loads of people saying "what a great deal, i'll hang around until the ARM readjusts and skip with no conequences" simply isn't true.

pseudonymous: i suppose we ought to get our terms straight. i love digby's site as much as anyone, and certainly there is an excellent group of commenters there, but i have no idea if the people whom you are referencing are leftists or populists or cranks or what have you. this is the "oh, someone at kos said something horrible in a comment so the angry left must really be losing its mind this time" school of comment.

when i reference the left, i mean people who one way or another are connected with left politics, not random commenters. as i say, the "ownership society" is a right-wing notion, and i've seen loads of lefties point out that home ownership has a lot of negatives for working people....

which is to say that i've got nothing against burnett at all: home ownership has certain very real positives, but like so many other things that fit that bill (marriage, children), it's not for everyone (indeed, i'm even against the home mortgage interest deduction, although i don't see how to eliminate it without an enormous market dislocation).

Posted by howard | August 22, 2007 12:38 AM

howard, you want to increase the penalties for fraudulent loans - do you include home buyers who knowingly signed off on a document stating that they had a higher salary? They were known as "liar loans" for a reason.

Posted by a renter | August 22, 2007 12:49 AM

a renter, i'm touched by your utter certainty that every single person in the last couple of years who received a mortgage fully understood what he or she was getting into, but i'm curious what makes you so sure?

and stocks are owned by roughly 1/2 of the population (not the 68% that currently - although not for long! - own houses), and the median stock ownership is 5 digits, so when the dot-com stocks went bust, the impact was relatively modest.

a million or more foreclosure over the next 12-24 months: not so modest, which is why thinking through some basis for allowing people a workout makes more sense than the sinners in the hands of an angry god approach you favor....

Posted by howard | August 22, 2007 12:56 AM

howard,

I sure a FEW people were duped, but I think it is insulting to think that a sizable fraction of the millions of people facing trouble are so naive that they can't be trusted to read and understand a contract. I've read the first few pages of an ARM before and it isn't that tough to get the idea.

As for the workout thing, I think it's reasonable if done properly. In the old days, the banks would work something out because it was better for them to make less on the mortgage than to have to dump a bunch of houses into a bad market. I think this is a generally good thing as long as it is done with the consent of and at the expense of the owners of these debts. What I really don't want to see is the government bail out any of these people. I haven't enjoyed the fruits of this boom, so I don't think I should help pay the costs for it.

Posted by a renter | August 22, 2007 1:08 AM

This is just another case of smart wealthy people creating excessive complexity for their own benefit that not-so-smart not-so-wealthy people have a harder time understanding. And then the taxpayers in general are expected to bail both groups out.

Posted by Steve Sailer | August 22, 2007 1:41 AM

Re: Despite the setback, Mr. Stout was relieved that his debt was wiped clean and he could make a new start.

The case you cite is a clear case of debt amnesty which does interest the IRS. You don't give the details of this very unusual situation, and I suspect something else was involved, perhaps a court judgment against Mr Stout creating a debt that was technically separate from the mortgage debt.
Normally foreclosures do not involve tax consequences and debt written off in bankruptcies never does. Somehow in the case you cite there was a debt amnesty. Usually foreclosures do not involve this as they are an equal, if involuntary, trade: the house for the debt wheret he house is automatically assumed to be equal to whatever is owed on it. However I suspect that Mr Stout could have fought this tax judgment and won.

Re: The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.

In this much you are correct. A short-sale (assuming the mortgage holders forgives the difference) does create taxable income.

Posted by JonF | August 22, 2007 6:28 AM

I remember when rules and regulations were around to protect us hapless humans from our own stupidity.

But then we all, seemingly by osmosis, suddenly understood all the intricacies of leveraging and risk and CDO's and points and pre-payment penalties and yadayadayada.

It was a miracle!

Posted by believer | August 22, 2007 8:34 AM

This is one of the more lucid explanations of the credit crunch I've seen yet, replete with handy charts and an idea of how it will be resolved: The Panic of 2007.

Posted by Fred | August 22, 2007 8:37 AM

It is rational for an individual to take a mortgage in a market where housing prices are continually rising and where houses can be easily sold. If you cannot make the payments, sell the house and you might even end up with a net plus.

The problem is what is rational for an individual may no longer work when everyone does it, for instance, if the housing market is booming only because of easy credit which will dry up once there is an uptick in defaults.

Also, one can ask - for just how long can prices continue to rise? How does one make sure one can exit the market before the crash? What the result of a rational calculation is really depends on the time-scale and the amount of context one can put into that calculation. There is no fault in the rationality, the problem lies in the incomplete information.

Posted by Arun | August 22, 2007 8:57 AM

a renter, roughly speaking, a couple million new households got mortgages in the past couple of years: in a universe that large, you're going to get a whole variety of behaviors.

but what you are most assuredly not going to get is everyone reading through and understanding the documents in full: it is most assuredly not insulting to note that (i, for instance, have owned 3 different pieces of property, including our current home, and i have never read and understood the entire batch of documents i signed).

what i think i should hope is clear by now: i'd like to see some form of workout (just like we used to have before mortgages got securitized and there was no longer a link between mortgage institution and homeowner). anyone who was merely engaging in lying to become a real estate magnate will have no interest and will get no opportunity.

Jonf, i don't know what your issue is. you made a blanket statement that was simply wrong: pretending there must be some other circumstances around here if i keep looking hard enough simply won't do, you know. do a little homework. your notion that there is some "debt amnesty" special case is incorrect, and you've seized a sentence out of context to try to make the claim (that is, the homeowner in question here believed he had wiped his debt clean. the reality is explained clearly in the ny times article; it is explained clearly in the second link i gave you; and it will be explained clearly in any other reasonable writeup you click through to if you do a search on the subject. admit you were in error: it's really not so hard.

Posted by howard | August 22, 2007 10:10 AM

fred, the mauldin article is quite good, although his belief in a deus ex machina of warren buffett taking over moody's (and paul volcker taking over something else) is a little hero-worshipping.

if you note at 5:42, i pointed out that hedge funds will make a ton of money eventually out of this, but first they have to be able to value the underlying assets. my belief is that mauldin is too optimistic about how rapidly that can be done.

but the point of this whole thread is what about the homeowners themselves: they are the only ones who need help of one form or another. all the other players can sink or swim on their own.

Posted by howard | August 22, 2007 10:25 AM

amusingly enough, i just came across a post at barry ritholtz' site in which there is a good discussion about whether mortgage brokers actually complied with truth-in-lending disclosure and what happens if they didn't:

http://bigpicture.typepad.com/comments/2007/08/coming-soon-tru.html

Posted by howard | August 22, 2007 10:54 AM

"This is just another case of smart wealthy people creating excessive complexity for their own benefit that not-so-smart not-so-wealthy people have a harder time understanding. And then the taxpayers in general are expected to bail both groups out."

Steve Sailer, that was even weaker than your Christopher Hitchens post. Are you feeling OK? You usually make pretty solid points, backed by evidence you've marshaled. This post suggests you don't know anything about the credit crisis but feel compelled to opine anyway.

Come on, Sailer. I'm rooting for you. Here's a tip for you: do a little research on African Americans and sub-prime mortgages, and tie that into a discussion of black IQ and tendencies toward immediate gratification, conspicuous consumption, etc.

Posted by Juan | August 22, 2007 11:02 AM

howard,

I'm not saying everyone will understand all the intricacies in some ungodly number of pages. But the first 3 or so include the relevant info in big type. If millions of people who signed these things didn't know what they were signing, doesn't that implicitly mean that these millions of people aren't competent to engage in a contract? Like it or not, most of the people taking out these loans knew they were risky, but signed anyway.

I think a useful regulation going forward would be to include a schedule of mortgage payments over the life of the mortgage under several interest rate scenarios (covering historically high, medium, and low rates). Maybe some will think twice about what might happen if things don't go smoothly.

Posted by a renter | August 22, 2007 1:34 PM

Re: Jonf, i don't know what your issue is.

My issue is that you are misleading people and I have a particular loathing for disinformation of any kind, even when it is being used in causes I might approve of. The case you cited involved highly unusual circumstances. Normally individuals who suffer foreclosure do not owe additional taxes. I have known three people who have gone through foreclosure (granted one of these before I was born); there were no tax consequences involved, because a foreclosure does not normally involve a debt amnesty since the borrower is not allowed to keep the house (duh!). Perhaps the fact that the case you cited involved a borrower who abandonned the property prior to foreclosure is what makes the case different. But that is rare: most people who are foreclosed on are living in their homes, or actively maintaining them if the property is rented out. Also, your comment that this tax issue is due to Bush administration policy is flat out wrong: debt amnesties have been on the IRS's tax radar for decades.

(Note to the poster who was surprised at the $1 sale: this is NOT unusual. If the foreclosed property does not sell at initial offering, then the lien holder formally purchases it for a very nominal sum, like a dollar, so that legal ownership can be established and it becomes a Real Estate Owned asset (REO) until such time as a buyer can be found via other means. Damaged or distressed property may stay on a lender asset list for years in some cases.)

Posted by JonF | August 22, 2007 2:07 PM