Two days ago, FNMA announced their new policy regarding strategic defaults; it’s a mortgage death penalty: seven years before the offender is eligible for another FNMA loan. Finally, they got one right. Yes, you read that correctly; if you make your profession in the business of real estate, Wednesday’s announcement is cause for celebration on more than one level. I’ll explain why in a moment, but first let’s dispense with the two primary arguments in favor of strategic foreclosure we see over and over again from the bubble-heads on the left:
Already we’ve got Shahien Nasiripour on The Huffington Post (I know, that’s an easy target – but it’s usually wise to start slow and thoroughly warm-up one’s disdain muscles) trotting out the tired argument about how the average homeowner should be allowed to default because the corporations that hold mortgages do it themselves. Mr. Nasiripour would apparently like to see individuals and large corporations share the same default outlook. I wonder if he would also prefer that homeowners negotiate their own individual, custom loan contracts; pay much higher commercial insurance premiums; price home loans on the specific risk of the homeowner rather than a pooled risk; and so on. Either he hasn’t thought this all the way through, or he’d actually like to see the cost of home ownership much higher than it is now.
The other misleading argument is neatly presented by Ezra Klein at The Washington Post. Actually, kudos to Mr. Klein because he not only presents the other misleading argument, but he also manages to mislead us on the very definition of a strategic default. The essence of the second argument, in his own words: “…a mortgage is a specific contract. It says that if the borrower stops paying, the bank forecloses on his or her house.” Not quite. The contract specifies foreclosure as one (and there may be more) remedy available to the bank if the borrower breaks the contract. The point of the contract itself is a promise by the lender to loan money at a rate and term that will not vary from what’s specified in return for a promise by the borrower to repay the loan as specified. That’s not such a difficult concept is it? It’s one promise in exchange for another. To suggest that the remedy portion of the contract is it’s main clause is a bit like saying the point of an offensive play in football is to penalize the offense if they commit a penalty. Uh, no… that’s not quite it. And more to the point: if the contract were simply an agreement stipulating the borrower can pay or not pay as they see fit, just so long as the consequences are spelled out; then we should have no problem with the lender maintaing freedom to raise the rates or shorten the term as they see fit, just so long as the consequences are spelled out. Sound good? As for his misleading definition, I’ll let you click on the link and read for yourself. Suffice to say that if the homeowner has “…a major downward shock to income (a member of the family loses their job, for instance),” then we are not talking about a strategic default. As a matter of fact we’re talking about the exact opposite of a strategic default aren’t we Mr. Klein? But why should the facts matter…
Almost one year ago exactly I wrote a post On Mortgages and Moral Compunction. It generated a thoughtful (and thorough) discussion that is well worth reading – just make sure you’ve set aside an hour or so. The point of that post is the main reason for celebration in this one: moral compunction has historically been priced into the model for residential lending (not true, Mr. Nasiripour, for most commercial loans – one reason for their higher cost). Specifically:
There is no real mystery to how mortgage rates are priced. Mathematicians create models of mortgage “behavior” based on the 4 C’s: Capacity, Capital, Collateral and Credit. Of these four, Credit is really what we’re talking about here. Your income, your assets and the property’s value are theoretically objective but your credit… well, it’s not really credit that’s being measured here is it? It’s your Character; your likelihood to honor your debts, although lenders don’t like to say that because it has a snooty, superiority quality. Make no mistake though, character is most definitely being evaluated during the loan process. So the question seems to be: How do these mathematicians change the models to reflect a decrease (or abandonment) of moral compunction?
FNMA’s announcement should severely decrease the number of strategic defaults. We celebrate this first, because a drop in strategic defaults (which drive rates higher to account for the lack of moral compunction) should make it less likely that we see those rate increases (though it could be argued that it’s already too late). We also celebrate the stabilization of housing prices that accompany less foreclosed and vacant homes. Finally, we might choose to celebrate this as the first big step toward reopening a secondary mortgage market. As Fannie and Freddie (and to a lesser extent FHA) continue to swing toward the austerity end of the mortgage scale, the need – and accompanying profit potential – for a private secondary market increases. A rebirth of the private secondary market benefits homeowners, lenders, agents and the economy as a whole in a myriad of ways beyond the scope of this article. But it is reasonable to say that this last outcome, while speculative, could be the biggest reason of all for celebration of FNMA’s efforts to reinforce the nation’s ethical backbone.
Brian Wilson says:
uh, no. How do you define a strategic default versus someone who by your implication has a “justified” default? Is there an arbitrary debt to income ratio where you draw the line between a good foreclosure and a bad foreclosure?
June 25, 2010 — 8:26 am
Brian Brady says:
Brian, I think you’re missing the point. Let’s start with the premise that a healthy private mortgage market (no gov’t backing) is vital to a real estate recovery. If you favor government-sponsored, centrally-planned economic activity, stop here; this comment isn’t for you.
What Sean describes, quite accurately, is that the Fannie is backing off of the more risky borrowers, leaving an opportunity for private market solutions to serve them. That’s how the birth of non-prime lending was spawned.
If there is a profitable market to be served (N.B.- “if”), there will be a solution. If that market is not profitable, removing government subsidies will save taxpayers money
June 25, 2010 — 8:54 am
Jim Klein says:
Nice essay, Sean. Plenty of facts, all of them accurate AFAIK. Of course me, I had this constant echo in my head, “Pragmatism, pragmatism…”
I especially liked the part about Klein using words to make things as they aren’t. Everything I’ve heard from this guy sounds like it’s from outer space; I wonder if I could bribe him to change his name!
I guess what sticks in my craw is the final phrase…”reinforce the nation’s ethical backbone.” Besides the gargantuan grammatical mis-reference (not wholly different than Klein’s misrepresentation insofar as it uses words to imply something is there that isn’t there), there’s the question of whether even this would be a “reason to celebrate.”
I’m not so sure. I see nothing to celebrate about FNMA–its design, its operation and its effect–and the plans that are in the cooker sound worse than rotten. I understand that you’re saying, “Well at least it’s doing something right in this instance,” but I find that a very dangerous argument on these types of matters.
If a serial killer were to develop a new math theorem in prison, should we celebrate the serial killer? And in that case, at least we’d have the theorem to celebrate! Here, we don’t even have that, owing to the /method/ by which these things are enforced. It reminds me of parents hitting their kids…it may be a good thing what they’re trying to teach, but they’re also teaching that you teach by hitting. I don’t see any way to avoid that, and I see an analogy here.
Still, speaking of you personally, I understand that you’re just saying /any/ good is good, and that itself is awfully good! What I’m not convinced of, is that any good is to be found in the non-good closet.
June 25, 2010 — 8:56 am
Travelare says:
Leaving open for discussion is the definition of strategic default. Who’s wisdom reigns supreme. Certainly not those in government. Private sector? Case by case basis? Whom shall we rely upon to define this catch all phrase or just proof that income has been lost. If that is the case this rule won’t stop a thing. All those scandalous brokers, buyers and etc I am sure have already come up with a workaround.
June 25, 2010 — 8:57 am
Brian Wilson says:
Brian, I know where you are coming from on this but as long as there is a “prime” marketplace for mortgages based on government regulations, standards, and supplements, you can never have an equally “prime” private market. It’s the same argument about having a government marketplace for health insurance next to a private market.
But that is not what I was reacting to. I was reacting to the character judgment made on people who make the decision when it is time to stop throwing good money after bad on a home loan that turned out to be a bad investment for them.
June 25, 2010 — 9:32 am
Jeff Brown says:
Most of the debate about this and almost every other topic can be made briefer, if only all participants bought into the reality that words mean things.
What cracks me up is that the libs forced banks to give bad loans in the first place through Barney Frank’s efforts, then when that same policy bites ’em on the butt, they react as anyone who values solid lending principles.
HIlarious.
June 25, 2010 — 9:42 am
Brian Brady says:
The character judgment was priced into prime mortgages (and still is), Brian. In lending, we see people who assiduously meet obligations, regardless of the market circumstances, to have greater “character” (at face value) than those who don’t. Diligent underwriting requires explanations for those who don’t or can’t meet their obligations. The “don’ts” are considered to have less character than the “can’ts”.
It’s always easier to explain compunction by making it personal. You lend money to three cousins, to start ice cream stores, in various locations. All of them fail.
Cousin #1 loses the business because a major chain moves in down the street and sells better ice cream for less money than he can. He defaults, takes on two jobs, and starts the process of an extended repayment of his debt to you.
Cousin #2 loses the business for the same reason as #1 and tells you that you took a risk and it didn’t work out.
Cousin #3 walks away from a marginally profitable store because he can make more money as a plumber. He explains that his default is rooted in “good investment analysis” and that you, as the lender, should have done your due diligence better.
All three cousins made the right decisions but which one, in your eyes, exhibits the greatest degree of “character” towards you?
June 25, 2010 — 10:24 am
Sean Purcell says:
For those walking through the forest yet bumping into trees, can we just stipulate that there is a difference between someone who can pay their mortgage but chooses not to because they don’t like the current value of their asset, and someone who can’t pay their mortgage because they lost a job or a spouse or suffered some other form of financial hardship? Can we further stipulate that we’ll leave it to greater minds than ours to define this difference? And finally, can we stipulate that – as with all things government related – most of us will disagree with and not like that definition? There. Now we can go back to celebrating the various benefits of having less people default on their mortgages! (Which was, after all, the point of the article).
June 25, 2010 — 11:03 am
Brian Wilson says:
Brian, smart question and 3 scenarios. I guess where we see this differently is you think someone’s motives should be judged rather than just the outcomes. A lender-borrower relationship is a risky investment on both ends – a business relationship. This is not a personal blood-oath.
The lender judges the borrower based on the facts you mentioned and earns a profit on the arbitrage between the level of risk and the highest yield that he can negotiate based on market demand for that loan. If the borrower defaults, it is not personal. It is a not a statement of his character. It was an outcome that was priced into the cost of the loan and averaged out over a volume of loans underwritten by the same objective standards.
I thought this was the Fraternal Order of Real Estate Libertarians blog… let the private lenders make their own risk evaluations and decide their risk vs. reward tolerance without more de-facto regulations through secondary market guidelines.
June 25, 2010 — 11:15 am
Sean Purcell says:
@Jim – I share most of your same fears about FNMA… actually I fear every aspect of the government. When I write articles I have to put on one of two hats: either I wear my Anarchy hat and point out the impossibility of making free gold from government lead; or I put on my “inside the tent” hat and write about government things as if they had actual answers and weren’t inherently evil.
Admittedly this takes balance, dexterity, giant rationalizations and a heaping, rotting pile of delusion, but it wouldn’t be nearly as much fun to just ignore things like FNMA’s announcement because FNMA itself lives in the closet with all the other boogie men. 🙂
BTW, what is your objection to the “nation’s ethical backbone”?
June 25, 2010 — 11:21 am
Sean Purcell says:
…you think someone’s motives should be judged rather than just the outcomes… If the borrower defaults, it is not personal. It is a not a statement of his character.
Motives are the very essence of what we’re discussing here. Not a statement of his character that he chose not to honor an obligation? The ends do in fact justify the means? I have to ask Brian: what exactly is your definition of the word character?
June 25, 2010 — 11:32 am
Brian Wilson says:
Character is doing the right thing when no one is watching.
I don’t think a government bureaucrat or a private underwriter has the standing to make the judgment about what is in someone’s heart when they make a financial decision for his family. Even God waits until a man dies before judging him.
June 25, 2010 — 11:44 am
Sean Purcell says:
I think you should look up the definition for character.
Lenders aren’t “judging” people… and God isn’t lending money.
June 25, 2010 — 12:03 pm
Brian Wilson says:
Sean, we’ll just agree to disagree. FYI, I learned that definition of character from West Point so it has some merit. Great article. Thanks for the exchange.
June 25, 2010 — 12:19 pm
Brian Brady says:
“I guess where we see this differently is you think someone’s motives should be judged rather than just the outcomes.”
Brian, why do VA loans have the lowest default rate? Moreover, why doesn’t USAA insure those who don’t meet their membership criteria?
June 25, 2010 — 3:00 pm
Brian Brady says:
“I thought this was the Fraternal Order of Real Estate Libertarians blog…”
I think it probably is.
“let the private lenders make their own risk evaluations and decide their risk vs. reward tolerance”
We do. Lenders thisnk motive matters.
“without more de-facto regulations through secondary market guidelines.”
Can’t investors make the same risk/reward judgments lenders do prior to purchasing loans? Actually, they already do. Terms for non-recourse loans are much less advantageous that ‘conforming” loans.
I think you object to a government agency making the value judgments best reserved for private lenders. On that we would agree. The government has no business in real estate lending whatsoever.
June 25, 2010 — 3:09 pm
Sean Purcell says:
@Brian Wilson – I always enjoy a fun exchange of ideas. Thanks!
June 25, 2010 — 3:23 pm
Jim Klein says:
On the character vs business question: “Can’t we have both?”
Sean asked,
> BTW, what is your objection to the “nation’s ethical backbone”?
Besides the improper noun for the adjective, I’ll offer this quip. It’s because I honestly don’t know if I’ll find a better example of it at the NASA labs or at the strip joint on the seedy side of town. That’s why I don’t look at it that way…I see nothing but individuals out there.
June 25, 2010 — 7:46 pm
Greg Swann says:
> It’s because I honestly don’t know if I’ll find a better example of it at the NASA labs or at the strip joint on the seedy side of town. That’s why I don’t look at it that way…I see nothing but individuals out there.
Without getting into the meta issue at a metaphysical level, every actuarial model attempts to use a (false) idea of collective behavior to predict individual performance. Credit ratings don’t predict character, but, rather, the propensity for future compliance based on patterns of past compliance history.
A high-C (in the DISC system of personality profiling) might be a rock-solid bill-payer for high-C reasons and yet conclude that continuing to pay on a bum mortgage is a bad idea.
A high-D might pay on time for reasons of time-efficiency and yet walk on a hopeless mortgage in pursuit of more productive uses of finite funds.
The error, which FannieMae is trying to mitigate, is presuming that people pay on time for the same reason that well-trained dogs take such delight in peeing outdoors and not on the carpet: In order to win the approval of higher ups in the social pack.
This is Our-Mister-Beasley thinking — “If you want an exception to the rules, you’ll have to get the approval of our Mr. Beasley” — the sort of dominance-by-sneer-power I discuss in Reasons to be cheerful, Part 2.
The consumer credit system has always been based on this kind of dominance-by-social-distancing: My office, my paperwork, my desk, I sit, you stand — hat in hand. It worked a lot better in Dickenisan England than it does in post-TARP America. The other side of this is the entitlement mentality, scavenging for grievances in order to rationalize theft.
The solution, obviously, is for individual people to engage each other honestly, as equals. It seems likely to me that we (considered contrafactually as a species) will do this, in due course — just as soon as we’ve failed at every conceivable specious alternative.
June 26, 2010 — 2:50 pm
Jim Klein says:
Hey Sean, I thought of another quip for you. It’s just a crack, since obviously I understand what you meant.
“You should wear two hats when you find yourself with two heads!”
June 26, 2010 — 7:28 am
Sean Purcell says:
Jim, loved the two-headed quip, still lost on the alleged grammatical error. The phrase in question is: possesive noun – adjective – noun. I’m completely missing what’s improper.
On the broader question, I suppose one might see ethical backbone at NASA and a seedy strip joint… to the degree it exists at all. I was certainly taking a little literary license, as I don’t believe there exists any “universal” sense of character, ethics or morality. My (strained?) point was in relation to the risk pooling that is the basis of any kind of underwriting.
June 28, 2010 — 8:11 am
Sean Purcell says:
…every actuarial model attempts to use a (false) idea of collective behavior to predict individual performance.
I don’t agree. Actuarial models attempt to predict likely outcomes over a bell curve, not individual performance. This is simply a statistical model for spreading risk or developing cost (which is only another way of expressing risk).
Credit ratings don’t predict character, but, rather, the propensity for future compliance based on patterns of past compliance history.
You choose to use the word compliance, which conforms to your “dominance-by-social-distancing” desciption, but we can just as easily (and perhaps more accurately) use the word “action.” We (most of us as individuals and actuaries as a profession) observe the behavior and actions of the past (more subjectively in the former case, objectively in the latter) and make decisions about how a person or group of persons will behave and act in the future. We thus define their character in our perception (there being no actual, objective character).
The solution, obviously, is for individual people to engage each other honestly, as equals. It seems likely to me that we (considered contrafactually as a species) will do this, in due course — just as soon as we’ve failed at every conceivable specious alternative.
This intrigues me, and I’m assuming you could go into more detail. How, in a system of voluntaryism (I apologize for that descriptor – you have a better one but I can not recall it right now), does risk get spread? Or does it? To suggest that we all deal with each other honestly begs the question: what happens when a person does not engage honestly? We shun them… which is exactly what FNMA is proposing.
June 28, 2010 — 8:36 am
Greg Swann says:
> How […] does risk get spread?
How about a big frolicking down payment? How about performance bonds? The system you have in place does not predict character, but it would be stupid if it did: Character is not a fungible asset. A sanely negotiated commercial contract would acknowledge the equality of the parties — you have money you want to lease out, I have a temporary need for that money and I am willing to pay a premium to gain access to it — and would assure the interests of both parties. You wrote loans for which you took no reliable sureties, and now you’re left holding a great big bag full of false impressions of character. Does that strike you as being sane and reasonable?
Just to distinguish Fannie/Freddie from the realm of true sanity, a sane mortgage — written today, after Fannie and Freddie have screwed everything up — would require at least a 50% down payment. If you would prefer something like 20%, get the government out of the mortgage business.
June 28, 2010 — 9:08 am
Greg Swann says:
A little more (I’m waiting on a title company):
> We (most of us as individuals and actuaries as a profession) observe the behavior and actions of the past (more subjectively in the former case, objectively in the latter) and make decisions about how a person or group of persons will behave and act in the future.
The point is, this is a faulty analysis. It assumes a static market, and thus it is dashed when, as now, the market changes dramatically.
> We thus define their character in our perception (there being no actual, objective character).
As I said, I don’t want to get into the metaphysics of character, but it remains that you’re not testing for character in any case. You’re testing for past compliance behavior without regard to motive. When you’re wrong about the market and wrong about the borrower’s motives, your loans go bad.
When I wrote that first comment, it occurred to me that it might be possible, via database mining, to come up with some reliable ciphers for character. Even then, you’d just be crowd-sourcing. You would still know nothing about individual motives. But credit reporting is a very long way from database mining for reliable ciphers for character, in any case.
Your system failed, first, because you — abetted by the state — removed all the failsafes. Only then did you discover that your model for predicting future compliance behavior was drastically wrong.
When your theories and actual entities and events come into conflict, it’s not the actual entities and events that are wrong.
June 28, 2010 — 10:11 am
Jeff Brown says:
Aw, gimme a freakin’ break. We make judgments all the time based on consistent past behavior for a reason — it’s proved to be a reliable predictor of future behavior in like circumstances. The rest is happy talk while dancing around the Kumbaya fire.
Those who try to sway us otherwise would, I guarantee you, change their tune if they were lending their money — and the income from that money mattered to them big time. Words mean things — many will benefit greatly by ending their pretensions to the contrary.
Giving your word means something — or it doesn’t. If your record indicates the latter, than go pound sand, because a lender with three digits in their IQ before hitting that pesky decimal point will send you packing.
They remind me of those who insist collectivism has always failed only because it hasn’t been executed correctly. Again, please — give us all a freakin’ break.
June 28, 2010 — 8:51 am