In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Wednesday, November 21, 2007

Dear Mr. Paulson

by Tanta on 11/21/2007 09:20:00 AM

I see you're coming around to a view of the housing and mortgage mess that has a clear reality bias. You're not there yet, but the trend is inspiring. I want you to know that I'm from The Blogs and I'm here to help you.

First things first: why have mortgage lenders worked out troubled loans ever since the dawn of mortgage lending? Because lenders do what lenders do: seek maximum profits. If a loan was supposed to earn you a dollar, but isn't earning you anything because the borrower is not paying, and you have the choice of restructuring, and getting, say, 90 cents, or foreclosing, and getting, say, 70 cents, you restructure. It is possible that, end of the day, you really get 91 cents instead of 90 cents if you cloak it in fine-sounding rhetoric about keeping The Dream Alive and helping borrowers stay in their homes and stuff. (It costs maybe a penny to write boilerplate PRs like that; you get two cents in benefits from Happy Regulators; it nets out.)

How does this get complicated? Well, traditionally, one had to be able to say, with some reasonable degree of certainty, what the cost impact was of the two options. That involved both modeling--looking at your historical experience as well as putting together a complex calculation of all the overt and hidden expenses and recoveries of each situation--and individual loan examination. It never helped you to say that "loans of this type should behave this way." That's what you said when you made them originally. At this point, you have a loan that is refusing to behave the way loans of its type are "supposed to" behave. You just have to break down and look at the borrower, the property, and the overall situation, to see if this is possibly a 90 center or inevitably a 70 center.

That requires people with skills. Enough people with skills to look at a lot of delinquent or about-to-be deliquent loans fast enough to not miss your window of opportunity on that 90 cents. Time is money in this business.

The industry is telling you right now that they just don't have enough people with the right skills to be able to wade through all the problem (or potential problem) loans fast enough to make the workout/foreclose decision. There are two reasons for this. The first is inevitable: no one runs a servicing operation with that many extra people sitting around waiting for a mortgage crisis. The second is not inevitable but is surely predictable: once the crisis happens, lenders start laying off, not beefing up, because crisis means earnings are down and you know what that means. I'm guessing that you had some experience with that kind of issue at Goldman. Plus the whole thing is complicated by these complicated securities we cheerfully put these loans in, that now have a bunch of complicated rules for getting them out. You know how securities lawyers bill out, don't you?

This means that the industry cannot do what it needs to do to defend itself. It will continue to take 70 cents instead of 90 cents, because it does not have the resources to commit to this problem, or because if it did commit those resources, the extra cost of staffing up and training and recruiting and so on would make the 90 cents scenario no longer achievable. Eventually the recoveries either converge--it's just as expensive to work out as it is to foreclose--or they don't, but only because the RE market is diving faster than salaries for workout specialists are improving, so that you end up with the choice of 70 cents or 50 cents, then the choice of 50 cents or 30 cents, down to wherever this has to go to sort itself out. Equilibrium in the housing market or servicer bankruptcy, whichever comes first.

Meanwhile, of course, the intangible returns--the credit we get for pretending that this is about Helping the Poor or being Heroes to Homeowners--do tend to inflate. That's the hallmark of a first-class economic crisis. However, on the level of nice rhetoric they don't inflate enough to cover what the industry is spending. Concrete bennies have to be put on the table. Regulatory relief. Fun with reserve and capital calculations. Approval of mergers and acquisitions. You know the drill. This is about maximizing profit. You are going to have to do something that makes this profitable, if you're going to expect lenders to do it on a large scale. Your job, of course, will be to write the PR that says that all this "regulatory relief" to for-profit banks and mortgage companies is all about Helping the Poor and being Heroes to Homeowners. I suspect you're up to that task. There is no shortage of PR-writers in this administration.

All that, of course, is about the historical or traditional approach to workouts. We are, you know, in the aftermath of a historically unprecedented binge of making loans to people whose creditworthiness, capacity, and collateral were, shall we say, not the issue. We can, of course, apply good old-fashioned time-tested methods of analysis of these loans now, after the fact, to see if they qualify for a modification. It will inescapably have an air of ludicrousness about the entire process. I can't help you with that, buddy.

Or, we can process the workouts the same way we processed the original loans: fast and cheap, with lowest-common-denominator thresholds for approval that really don't depend on an honest evaluation of the cost/benefit compared to foreclosure. You have to admit that this would have a charming kind of "fighting fire with fire" quality to it. You'd get some big time bad press here. But if the point is to allow servicers to workout loans without having to spend any money--hiring those workout specialists who know how to examine the loan, compare all the costs, and make a defensible call--this plan has Genius. It's rather like that earlier plan we had for making mortgages to every conscious person in America without having to mess with nonsense like documentation and underwriters and stuff.

All that said, though, it does seem like you might want to be kind of cautious about how many goodies you put on the regulatory table in order to get the lenders to play ball. I for one am not sure you can afford to cover all the checks your mouth is writing any more than the lenders can. It sounds to me like you probably need to hire a bunch of regulatory relief workout specialists who can put some dollars and cents on your options here.

I must say I'm enjoying having you a few inches closer to the reality-based community. I hold hopes that someday you and The Blogs will actually inhabit the same economic planet. That would be like so totally cool.

Thank you for your time and attention to this matter.