This post first appeared in the November edition of Cirios Trends: Getting to the Bottom of the Housing Market

Of the myriad debates ongoing at a time when economics and
politics are seemingly two heads of the same freakish snake, the role government should play in directing economic actions dominates an already ideologically charged arena.

And nowhere is the issue argued more hotly than in the trenches of the housing market.

Government, some say, should come to the rescue of Main Street, vindicating the evils of Wall Street greed and excess run amok. Who else will look out for the little guy if not our elected representatives?

Others disagree, fingering Washington as one of the primary culprits in an economic landscape characterized by artificially low interest rates, lax regulation and a political class that was in bed with the corporations it claimed to be policing.

In housing, it’s no secret that government involvement in the market has reached new heights. Virtually every mortgage written today is backed by some branch of the federal government, be it via the FHA, Fannie Mae or Freddie Mac. Tax credits to first time buyers spurred a flurry of purchase transactions this summer and fall, and inventory levels have been kept low by ongoing foreclosure moratoria.

Interest rates remain stubbornly low, despite fears of inflation and a collapsing US currency.

As a result, in some of the hardest hit real estate markets, prices seem to have stabilized, as supply has dropped to, in some cases, less than a month of inventory.

At the heart of the debate, and a point which is widely under-reported in the mainstream press, is the effect of decades of aggressive policies aimed at encouraging lower income Americans to buy homes.

These directives created a deeply liquid and profitable arena into which Wall Street moved, seized upon, and ultimately cannibalized. That Congress is now actively leading a witch hunt to track down the “guilty” is highly ironic since only with the implicit blessing of Washington could Wall Street have committed its crimes.

Look at the graph in the top right corner of this page. Taxpayers are increasingly being asked to cover losses which Washington is unloading from the private sector onto the public balance sheet. This liability will be a drag on the economy for years to come.

One unfortunate result of this crisis is that Americans with less than ideal credit are seeing access to banking services stripped away at an alarming rate. And while justified in some cases, there is a place in our economy for non-prime lending, if done right.

As big banks withdraw from this arena, smarting from losses of a similar shape to the graph above, small, niche lenders can step in and fill the void. Opportunities abound, if you just know where to look.

This post first appeared in the November edition of Cirios Trends: Getting to the Bottom of the Housing Market

This piece first appeared on Minyanville.

By Andrew Jeffery

Reality, it appears, is a dish Washington believes is best served, never.

Late Friday evening on October 30th, long after most Americans had shut off their computer screens and turned their attention to more important things — namely, Halloween — banking regulators dropped a silent, rotten egg onto the financial system.

Despite an alarming increase in the number of troubled commercial real estate loans gumming up bank balance sheets, the Federal Reserve, FDIC, and Office of the Comptroller of the Currency issued new guidelines Friday easing the burden this souring debt will have on lenders. Regulators are encouraging banks to modify loans, rather than foreclose and repossess property, even if the value of the building has fallen below the amount of the loan.

Loan workouts, regulators argue, can be beneficial to both lender and borrower, and are preferred to foreclosures, which drag down prices. But one look at the earlier-to-crash residential real estate market quickly proves this notion as a fallacy.

In many of the hardest hit real estate markets, ones which imploded well before ill-fated mortgage modification attempts were launched, true price discovery was given a slim opening to take hold. Now, as prices have fallen back to more affordable levels, traditional homebuyers and real estate investors have stepped back into the market, helping to stabilize prices.

Sure, there’s still a healthy dose of government intervention propping up the housing market as a whole, but only through these fresh starts can markets begin a genuine healing process.

Well-to-do markets, on the other hand, have not yet had their requisite dose of price discovery, as corrective market mechanisms are being prevented from functioning. Foreclosure moratoria (ongoing) and modification efforts (floundering) are simply kicking the proverbial can down a long proverbial road.

So too in commercial real estate, as landlords face increasing vacancies, falling rents, and, according to the Wall Street Journal, $1.4 trillion in maturing loans over the next five years. Around half of these are said to be underwater, and thus cannot be refinanced at current price levels.

Regulators’ answer, not unlike the failed mortgage modification programs introduced by the Bush and continued by the Obama Administration, is to allow big banks like Citigroup, JPMorgan, and Bank of America to forestall the recognition of losses, trying to delay the inevitable bursting of the commercial real estate bubble.

With Wall Street’s collective eyes focused on Monday’s headlines — CIT’s bankruptcy, Goldman Sachs picking up tax credits from Fannie Mae and Freddie Mac, and of course the Yankees a single win away from their twenty-seventh World Series title — regulators are hoping investors will ignore the stench of this well-timed announcement as just another holdover from Halloween revelry gone awry.

And while the new guidelines may bolster efforts to make the banking system look healthier than it actually is, it’s further proof that rumors of a legitimate economic recovery are, in fact, greatly overestimated.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Looks like all those option adjustable rate mortgages (ARMs) weren’t such a good idea after all: 1% teaser rates and loans that grow, rather than shrink, over time just aren’t meant for questionable borrowers buying overpriced homes.

Newport Beach-based Downey Savings (DSL), the fifth largest originator of option ARMs, was seized by federal regulators late Friday. The scraps were sold to US Bancorp (USB) for a song, which included almost $10 billion in deposits. Pomona First Federal, another Southern California lender highly levered to the real estate market, was also taken over by Minneapolis-based US Bank.

According to Bloomberg, the 2 failures will cost the FDIC more than $2 billion to clean up. US Bank agreed to assume the first $1.6 billion in losses from the banks’ loan portfolios, but anything above that will be split with the FDIC.

Each of the 5 biggest option ARM writers have now collapsed. Countrywide was purchased by Bank of America (BAC) in July; IndyMac collapsed into the arms of the FDIC just a few weeks later; Washington Mutual was scooped up by JP Morgan (JPM) in September; October saw Wells Fargo (WFC) best Citigroup (C) for the right to buy Wachovia (WB); now Downey is gone.

It didn’t have to end this way.

Traditionally meant for savvy borrowers capable of managing multiple payment options, Washington Mutual is often cited as having invented the option ARM in the early 80s.

The loan gives a borrower a series of payment choices, the lowest of which is so tiny the loan balance increases each month instead of being paid down. ARMs also typically include a teaser rate – sometimes as low as 1% – which can last anywhere from1 month to 5 years.

Ideal for real estate investors, salespeople with choppy income or families hopping between 1 and 2 earners, the flexible payment options and strict underwriting guidelines made option ARMs some of the best performing loans on the market.

But that was then.

As securitization took off, interest rates fell and the housing market heated up, lenders turned these once-safe loans into jet fuel for their ballooning mortgage businesses.

Option ARMs came to epitomize the irresponsible lending that ran rampant during the boom. Lenders abused their ability to qualify borrowers at absurdly low rates, jamming them into homes they could never afford once their mortgage payments rose.

Due to their complexity, mortgage brokers and loan officers rarely bothered to make sure borrowers fully understood the loan terms. A complete explanation would have lasted hours, providing adequate cover for the fraud already so prevalent in the business.

Banks loved option ARMs because accounting rules allowed them to book the fully indexed mortgage payment as income, even if the borrower made the minimum payment each month. That meant a juicy bottom line, even if cash barely trickled in the door.

Mortgage brokers and loan officers loved option ARMs because they could earn fat commissions on loans that were easy to sell – since they never had  to explain them.

And borrowers loved option ARMs because they could buy their dream homes, rationality be damned.

Option ARMs flourished in boom states like California, Florida, Arizona and Nevada since homeowners could simply sell or refinance their way out of any problems as home values kept rising. Delinquencies remained remarkably low, creating years of “historical” data upon which to base assumptions about future loan performance.

Back in New York, Bear Stearns pioneered Wall Street’s foray into Option ARMs. The mortgage gurus at Bear figured out how to turn them into highly profitable mortgage-backed securities.

After that, it was a race to the bottom. Bear, Countrywide and IndyMac literally competed for business based on who could buy the loans faster – and with less scrutiny.

When home prices stopped rising, however, it all came crashing down.

Faced with a rising loan balance, higher monthly payments as teaser periods ran out and falling property values, borrowers were stuck. Defaults rose, losses mounted and banks couldn’t unload the paper without taking significant hits. Instead, they chose to hold on and try to ride it out.

We now know how that strategy ended.

As I have written previously, in the face of unprecedented government intervention, the free market has still managed to punish the mortgage boom’s worst offenders. Not every guilty party will be brought to justice, but the firms that have failed thus far were deserving of their fate.

To be sure, not every employee at the likes of Bear, Lehman, Countrywide and Downey were culpable, but when the dust settles, the weak hands will have been truly cleaned out. Banks that maintained even marginally prudent lending standards are now reaping the benefits.

This fact gives me hope – hope that despite their best efforts, bureaucrats will always lose in their battle against the free market.

By ANDREW JEFFERY

This post first appeared on Minyanville.

With millions of homeowners falling behind on their monthly payments, one in 6 underwater, and countless more struggling to keep up, politicians and banks alike are jumping on the loan modification bandwagon.

A modification – or “mod,” as it’s known in the industry — is simply the bank agreeing to change a borrower’s loan to make it more affordable. Mods usually result in a lower interest rate, principal forgiveness or some combination thereof.

For banks, adjusting loan terms is a way to keep cash coming in the door - even if it’s less than they’d been hoping for when they originally wrote the loan. For troubled borrowers, mods can provide an alternative to default and eventual foreclosure. It’s for these reasons that FDIC Chairman Sheila Bair and big banks like JPMorgan (JPM) and Bank of America (BAC) are aggressively promoting mods as the best way to fix the housing market.

The flood of troubled mortgages has also fostered a cottage industry that caters to distressed borrowers. Some are honest folks aiming to help struggling borrowers by using their mortgage expertise and contacts to negotiate better deals on behalf of their clients.

Others, however, are less upstanding.

According to Mandana Nejad, a real estate attorney and founder of Silver Lining Legal Group, a loan modification firm based in California, troubled borrowers have a lot to be wary of.

“Most loan modification companies are compromised of former lenders and brokers who put homeowners in these horrible loans in the first place,” says Nejad. ”Meanwhile, credit repair and debt consolidation firms are simply out to collect fees, regardless of whether or not they can actually successfully modify a loan.”

Last year, the Bush administration formed HOPE NOW, a government-led effort to get banks and the loan servicers who collect payments on their behalf to step up loan-modification efforts. By most accounts, results were underwhelming, as HOPE NOW counselors often asked for too much, and banks gave too little.

Data show that mods done at the outset of the mortgage crisis ended up in default, despite the lower payments. Without proper screening criteria, mods simply delay the inevitable.

For a mod to work, lenders and borrowers must be able to find common ground. Falling home prices, job losses and massive fraud at the time of origination have exacerbated the challenge of finding new loan terms that make sense for both parties. To complicate matters, if a loan has been packaged into a security, loan servicers are obligated to follow predetermined modification standards set by myriad third-party investors.

Borrowers looking to handle modifications on their own face a maze of legal and bureaucratic complications - not to mention the stress of negotiating to save one’s own home. Nejad tells her clients that anyone can attempt to modify their loan themselves, but doing so requires knowledge of the best strategies for success.

Banks treat mods almost like a fresh loan. In order to get the best deal, borrowers must submit a complete application, write a compelling hardship letter, include verification of income, and often support the home’s current value with an appraisal.

While this is no easy task, troubled borrowers shouldn’t run out and answer the first debt consolidation or mortgage relief advertisement they hear on the radio.

Upstanding modification firms should offer:

• Money back guarantees with no exclusions
• At least one experienced attorney assigned to each case
• Direct access to the borrower’s lender(s)
• No more than a 50% charge up front
• Verifiable success stories, not just web testimonials

Still, successful mods require lenders to take losses. Armed with billions in bailout money, banks are now in a better position to allow their borrowers more affordable loans, even if it means more writedowns and less interest income going forward.

Time will be the true arbiter for the success of Bank of America and JPMorgan’s recent plans, but as pressure mounts to seriously curtail foreclosures, more and more federal money will be thrown at the problem. Other banks are likely to follow suit.

Wells Fargo (WFC) has yet to announce a plan of its own, but – given its recent purchase of Wachovia (WB) and its inheritance of a massive portfolio of California option-ARMs – we shouldn’t have to wait too much longer.

While mods are by no means the magic bullet many are searching for to fix the housing mess, they do offer a way for lenders to retain a cash-generating loan – and borrowers to keep their homes.