Wednesday, July 7, 2010

Minyanville: Why Bailout Money Should Have Gone to Underwater Homeowners

Robert Barone, head of Ancora West, argues in Minyanville that $2 trillion bailout money that went to the likes of AIG, Fannie and Freddie, Citigroup, GM and Chrysler and TARP recipients should have gone to homeowners who owe more than their homes are worth ('underwater').

In his article, he cites one recent case of J.P. Morgan Chase modifying the mortgage of one of his clients (who didn't even ask for modification) by 27%, resulting in win-win situation for both the bank and the underwater homeowner client of his:

JPMorgan's Generosity

In June, one of my clients was forgiven a substantial portion of the loan on his primary residence by JPMorganChase (JPM). It appears that JPMorgan is doing this for the sub-prime and Alt-A loans it inherited from its FDIC-assisted purchase of Washington Mutual (WaMu). In my client's case, a $250,000 principal reduction was given on a $937,000 principal balance (originally owed to WaMu). The mortgage holder didn't communicate with JPMorgan or ask for any consideration, and had always been current on the loan. The existing interest rate was 2.5% (variable rate loan). In exchange for the principal reduction, JPMorgan asked for a 5.0% fixed-rate 25-year amortizing loan. The client's monthly payment stayed the same.

Recall that JPMorgan received a large amount of FDIC assistance. (While FDIC insurance funds are technically not directly from the taxpayer, they are indirectly, as banks raise their fees to pay for regulatory expenses.) This action by JPMorgan appears laudable. After all, the shareholders of JPMorgan appear to have gained from FDIC assistance. So, some giveback appears appropriate. However, let's not so quickly attribute this to JPMorgan's generosity. JPMorgan "purchased" WaMu's assets at a huge discount to face value. While I don't know the exact terms, let's, for the sake of this example, assume 60% of face. So, JPMorgan was holding my client's mortgage on its books at a $562,000 value. Under accounting rules, JPMorgan could only recognize a "profit" after my client had first paid down the $562,000 carrying value. That would be 12 years away at the current payment. JPMorgan knows this homeowner is underwater, and, while it probably wouldn't lose money if a foreclosure occurred, it would have foreclosure expenses and market wait time. But, by forgiving $250,000 of the $937,000 balance (or 27%) but doubling the interest rate, JPMorgan immediately recognizes more interest income on its financial statement (2.5% of $937,000 = $23,425 while 5.0% of $687,000 = $34,350). In addition, my client can now sell that home at market (about $800,000). If the home does sell, the client ends up with some equity, and JPMorgan recognizes an additional $125,000 in income ($687,000 principal balance less $562,000 carrying value). No foreclosure. No downward pressure on the neighborhood's home prices. Everybody wins!

The way the bailouts were done, it takes this kind of circumstance to actually get an appropriate outcome. Had the $2 trillion in bailout funds been used to benefit the underwater homeowners to begin with, I doubt the housing market would be in its current funk. As a nation now committed to bailouts, the operative rule ought to be: "Any use of taxpayer money must directly benefit taxpayers."
So, JPM purchased the mortgage at a discount at $562,000 (he uses 60%, but could even be less). By cutting the homeowner's mortgage by 27% to $687,000, JPM is still above cost. JPM offers the client 5% fixed rate instead of variable rate of 2.5%. The homeowner takes it, as it gives him the security of fixed rate (and low) on a significantly reduced mortgage. JPM is happy as it secures the fixed-rate interest payment which is more under the new reduced mortgage than under the old, underwater mortgage with variable rate. The homeowner now have equity in the house, which can be sold for $800,000. If the owner sells the house, he will have money in the pocket, and JPM also pockets the profit ($687K minus $562K).

It looks like a sound business decision on the part of JPM to me. Why wouldn't any other banks, particularly the big ones like Bank of America and Citigroup who greatly benefited from the taxpayer-funded bailout, come to their business senses and do the same?

Earlier in the article, he cites the numbers from CoreLogic: 24% of all homes with mortgages (confirmed in May by Zillow's 23% estimate) are underwater. According to CoreLogic, that's 11.3 million of the 47 million homes.

So $2 trillion could have helped these 11.3 million homeowners at the average $176,991 per homeowner.

How about the argument that these homeowners shouldn't be rewarded for their mistakes? Barone has this to say:
Some will object that this favors the certain population segment that made a judgment error and took on too much debt. I argue that this segment is victimized by economic conditions in the same way as those who lose their jobs during recessions are victimized by economic conditions. This year, according to the Bureau of Labor Statistics, we're giving the unemployed $14 billion in unemployment benefit disbursements. Furthermore, "earmarks" on legislation channel taxpayer funds to the benefit of very narrow and specific groups. So, the singling out of a segment of taxpayers to receive benefits isn't something new.
Well, I agree. It would have been a much better use of $2 trillion dollars if the government had to spend on something, although J.P.Morgan Chase and other big coming to the senses by their own profit motive (i.e. market solution) is much preferable to me.


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