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Sunday, December 09, 2007

Bailouts and Bailins

by Tanta on 12/09/2007 10:18:00 AM

CR did a wonderful post yesterday clearing up some of the myths and misunderstanding about the Hope Now/"Paulson Plan." I just want to follow up on one of them, the issue of whether this is a "bailout."

We will never establish consensus on that point as long as anyone uses the term "bailout" to mean just any post-hoc action that could benefit someone. CR is using the term somewhat more specifically, in the sense of providing actual taxpayer funds to subsidize mortgagors or make whole mortgagees. In that latter specific sense, the Paulson Plan does not represent a "government bailout."

Several people have noted that it does seem to rely on the availability of government-insured refinance loans (FHA and FHASecure), and it proposes, certainly, the development of government-sponsored bond programs (the "government" in the latter case would be states and counties and cities, not the federal government, as far as I can tell).

I therefore thought it would be helpful to remind everyone what the difference is between a "government-insured" loan and a bond program. FHA does not buy loans. It does not provide capital to make loans with. It is not entitled to any interest income from performing loans. It does not service loans. Ginnie Mae securitizes FHA loans, but Ginne Mae doesn't buy loans either. It "wraps" pools of loans with its guaranty.

So FHA gets nothing out of performing loans except the required insurance premium that the borrower pays. Premiums are held in the MMIF (Mutual Mortgage Insurance Fund) and used to pay out for claims on defaulted loans. We don't need to get into all the technical parts of that today. The point is that the general goal of the FHA MMIF is to be revenue-neutral. Whether it is or not at any given point in time depends on how well the premiums were priced and how well the loans perform. For a long time the MMIF has been a "negative subsidy" on the federal balance sheet, meaning that it actually is in the black. It may well not continue to be in the black, but my point is that what's in the black isn't "profit" from interest payments made by mortgage borrowers. FHA doesn't own any loans. What's in the black is insurance premiums collected in excess of claims paid.

Bond programs are different. There are a jillion flavors of them, but in essence they are public versions of securities: they actually do buy loans, pool them, and issue bonds to investors who receive the principal and interest payments from the loans. Typically, they are set up to buy low-interest (below market) rate loans, because they are issued by governments and everything gets favorable tax treatment. It is possible that the loans in a bond program pool also have some other kind of credit enhancement like FHA insurance, private mortgage insurance, or second liens.

But the bottom line issue here is that insofar as the loans do perform, the bond program's investors do receive the interest income. The bond issuer is ultimately at risk if the loans default and there is not enough principal recovered to make the investors whole.

But in both cases--government-insured loan programs and bond programs--private investors are providing the capital. Of course cities and states and counties can themselves invest in mortgage securities, and we see that they have. But that's hardly the traditional way of doing a mortgage-backed bond issue: the idea there is to get someone else to provide the capital, since the issuer is providing the credit enhancement.

The federal government does not have any program in which it directly buys mortgage loans, or directly invests in mortgage loan pools. The lending capital in this context is always coming from the private sector.

So to get back to the "bailout" question: at the simplest level, what's going on here is that loans that were "insured" (or credit-enhanced) by the private sector are being refinanced into loans that are insured or credit-enhanced by the public sector. Therefore the risk is moving off the private balance sheet and onto the public one. The rewards--such as they are these days--are still firmly in the private sector. In that sense, you could call this a bailout: it's moving the risk of default.

On the other hand, it only works if investors are still willing to buy Ginnie Mae securities or municipal bonds. There has to be some capital supplied. The idea here is that nobody's stupid enough to buy high-risk mortgages right now without government guarantees. So far--and I do stress so far--not even FHA has been willing to go down the road of upside down loans to borrowers who can't qualify with income docs. That's why the whole Paulson Plan is about, in essence, what to do with those loans. So FHA is "taking out" some pretty weak loans, but it isn't taking the weakest ones. The weakest ones get "the freeze" or the foreclosure. That is why this Plan is usefully described as not a government bailout. If FHA or municipalities would take all the toxic waste, we wouldn't need this Plan; servicers would just be busy refinancing. The Plan exists because there is a big pile of loans that do not qualify for any of those refinancing opportunities.

Some people are getting confused by the extent to which The Plan talks about refinances. We already had FHASecure and plain old FHA before this Plan; the Plan did not invent those options. The Plan is about designing rules of thumb for quickly sorting out the loans that don't qualify for refinances, and doing something about them. In that sense it's no more of a "bailout" than what we had before The Plan.

Now, as I noted last week, Paulson's "total package" includes lobbying for "FHA Modernization," which would certainly increase the number of loans FHA could "take out" and decrease the number of loans the private investors have to live with somehow. There are many reasons not to like that; even if you do like the idea of FHA taking on more of the problems, though, the answer here would be to expand FHASecure, which is a new program specifically designed to refinance troubled loans. Changes to the regular old FHA warhorse program would allow more "take outs," but it would also apply to new loans, and we'd have it forever (because there's never the political will to tighten FHA requirements during the next boom), and so FHA would be in the front of the mess next time, with no "dry powder."

"FHA Modernization" might be a kind of bailout, but it's not, in my view, really much of a bailout of existing, defaulting mortgage securities. It's a "reflation" of the mortgage origination industry and the RE market (existing and new). That's the only rationale for pressing for FHA Modernization rather than pressing for easing restrictions on FHASecure. As I said, there are precious few investors who will put money in mortgages right now without a government (or quasi-government) guarantee. Ignore the spin: FHA Modernization is about making new purchase money loans, not about refinancing old problems. That is not an "investor bailout"; it's life-support for loan originators and builders and sellers of existing homes.

We should, I guess, pause over "sellers of existing homes," because we have a vocal subset of the commenting community who keeps arguing that borrowers in trouble should just be counseled to mail in the keys and be done with it. I take it the idea is not to have the banks and REMICs own that REO forever; the idea is that the REO would be sold at a much lower price to new borrowers. Who quite possibly can't get financing right now because the mortgage market is stalled and all appraisals are now in question. So even at a lower price, you need financing for these new borrowers. Enter "FHA Modernization."

There are many kinds of "bailouts," and they don't all depend on not foreclosing on current owners. I frankly am more worried about FHA Modernization becoming a "bailin" than I am FHASecure being a "bailout."