US Treasury First Lien Mortgage Notes

The issuance of US Treasury First Lien Mortgage Notes would provide an effective, fiscally prudent and politically popular approach to stabilize the prices of mortgage backed securities. These notes would contain fully collateralized, transparent and uniform loans that provide work out capital directly to distressed homeowners.  Banks will issue and administer the government backed loans, which will be rolled up into a five year US Treasury First Lien Mortgage Note that will be offered at a discount.

Under the proposed First Lien Mortgage Note program, Treasury would purchase new loans from banks, issued to provide work out capital for mortgage payments, using funds authorized by TARP.  These targeted loans will provide homeowners with a capital reserve in an interest bearing escrow account that can be drawn upon to make mortgage payments and prevent loan delinquencies.  

Work out capital could be used by distressed homeowners to make mortgage payments under the terms of existing mortgages or as part of a renegotiation with mortgage service companies that includes interest rate and/or principal reduction.  Principal reduction or deferral could compromise the rights of mortgage holders under some state laws. One of the attractions of the present proposal to provide work out capital is that relief can be provided and foreclosures prevented under existing law.

The swift authorization by Treasury of First Lien Mortgage Notes   is an effective and financially prudent method of supporting the market for mortgage backed securities that could be done in conjunction with a limited implementation of Federal purchases of these presently toxic assets in a manner that does not put taxpayer money at risk. 

The prospect of guaranteed cash flows from a program for US Treasury  First Lien Mortgage Notes  would allow financial institutions to immediately maintain  these assets  on their balance sheet in a hold to maturity rather than a ready to trade account, without taking significant  loan impairment write downs.

Guaranteed cash flows to mortgage owners for a five year period will provide a five year breather of financial relief to homeowners and mortgage holders and allow homeowners and financial institutions to hold real estate based assets until an economic rebound strengthens the real estate market.

Administering this program will provide a needed new source of revenues for banks while preventing human suffering and social instability in the US. It will also increase public support for government spending for assistance to the financial sector by using TARP funds on  politically popular and economically sound measures to prevent foreclosures.

Foreclosures are an economic root cause of the falling market prices for real estate and mortgage backed securities presently causing distress throughout the financial system. The overhang of unsold inventories of houses together with the forced dumping of  foreclosed properties is depressing real estate prices.  Preventing foreclosures and directly supporting real estate prices has not been and should be a priority of policy makers.

Housing fundamentals will worsen as a result of the pronounced destruction of stock market wealth and consumer confidence from the unfolding financial crisis. This will lead to cutbacks in consumer spending and business investment which will increase unemployment leading to more homeowner distress and foreclosures.   

Nearly a million homes were sold through foreclosure this year and twice as many have started a foreclosure process. In addition, interest rates resets in 2009 on subprime and Alt A variable mortgages will trigger new foreclosures.  Unless swift action is taken to formulate an effective policy response that prevents new foreclosure filings,   the real estate market is set for another round of precipitous declines.

In a typical case, our proposed plan provides assistance to a homeowner X, with a mortgage of $200,000 and a current home value of that amount or less who is facing distress in meeting her payments. Under the proposed program, homeowner X would borrow $80,000, which would be escrowed for the sole purpose of making mortgage payments, if she could not. The government would take a first lien for $80,000 and the existing mortgage holder would subordinate its own first lien interest, in consideration for the assurance of having payments timely made.  

This option would be attractive to mortgage holders. Some economists are estimating that in the current market climate, foreclosure recoveries are averaging 40%.  In our hypothetical example a foreclosure, in distressed markets, would net $80, 000 and cause an immediate write off of $120,000. The opportunity for the MBS owners to account for the mortgage as a performing loan and the MBS security to be held till maturity, with the attendant cash flows from the escrow account and the strong possibility of an improved real estate market within the five year period envisioned, should make this highly attractive to the holders of mortgages and mortgage securities.

Under our proposal we set the interest rate for five year loans at 160 basis points above Treasuries, which provides a fair return to the taxpayer, money to pay transaction costs, and still provide a concessionary rate to homeowners, further enabling the mortgage workouts. According to Christopher Mayer and Glen Hubbard of Columbia Business School, the average historical spread of 30-year, fixed-rate mortgages over 10-year Treasury bonds is about 160 basis points. The US Treasury First Lien Mortgage Bonds would be sold to investors at a discount, as there will be no interest payments by borrowers until the home is sold or the mortgage refinances. This program will provide a five year period for homeowners to refinance or sell their homes.

The proposed program will be available for owner occupied homes. However an economically sound but politically unpopular case could be made for the wisdom of extending this loan program to owners of multiple distressed properties, assuming reliable appraisals insuring that taxpayer capital is protected by adequate collateral. If the program were extended to real estate investors it would, further stabilize real estate prices, allow them to potentially recoup their investments while paying a higher interest rate than the concessionary rate offered homeowners.  Their loans could be priced at 460 basis points above Treasuries.

Mitigation of home foreclosures will set in motion a virtuous cycle of improved cash flow, leading to higher valuations on MBS enabling more credit and enhanced economic activity. Unlike existing MBS’s these loans could be packaged into a new treasury instrument that is both transparent and fully collateralized.

Issuing Treasury Note that provide work out capital   to distressed homeowners by purchasing standardized loans, originated by banks, gives policy makers   a simple, rapid and systematic way to prevent foreclosures in the current environment.

The scenario that will unfold from creating this new loan facility will provide a breather from the vicious downward spiral of foreclosures, which in turn undermine neighborhoods, dramatically impacts housing values and lead to further deterioration in MBS prices, diminished capital adequacy ratios, leading to further bank insolvency and increased systemic risk to the financial system. Our proposed plan will unleash a virtuous cycle of market forces that will address a root cause of the current financial crisis at virtually no risk to the government or taxpayers, as the proposed government notes would be securely collateralized with first lien loans with a very conservative loan to value ratio.

2 Responses to "US Treasury First Lien Mortgage Notes"

  1. JohnRyskamp   October 15, 2008 at 11:44 am

    Blah blah blah. The problem is still that nothing can be valued.And guess what? Nothing will be able to be valued until there is a ban on housing evictions. Wake up.Just read my fabulous book, The Eminent Domain Revolt.Do you know a lawyer? Have one explain the book to you, because you are living in a Frankensteinian dreamworld.

  2. Sid   October 17, 2008 at 9:10 am

    Treating the disease, not the symptoms: a comparison of solutions to buying defaulting loans of any type.While I’m personally a staunch Obama supporter, the proposal made by John McCain during the second debate regarding the purchase of underwater mortgages has some merit. There have been a variety of proposals for this line of attack, including recently by Martin Feldstein in the WSJ. I have also proposed a plan, outlined below. Following my plan is a précis of Feldsteins plan, followed by a comparison of both. There is great merit in a strategy of treating the disease and not the symptoms:Some pertinent data points;• Number of families who now hold a subprime mortgage: 7.2 million1• Proportion of subprime mortgages in default: 14.44 percent2• Proportion of subprime mortgages made from 2004 to 2006 that come with “exploding” adjustable interest rates: 89-93%• Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities: 93%• Number of subprime mortgages set for an interest-rate reset in 2007 and 2008: 1.8 million Valued at: $450 billionThere are 7.2 million subprime mortgages out there worth 1.3 trillion, of which possibly 70% of them have exploding rate mortgages, which means about 5 million have exploding rates. Exploding rate mortgages account for 93% of the bad mortgages, which means that possibly 4.5 million of these will go bad, or 63% of the total, at a value of $820 billion and an average value of $180,000. If the ARMs reset from 7% to 12%, the increase in monthly payments is about $590 per month. $590 per month times the total of 5 million is about 3 billion dollars per month. Therefore, $700 billion would pay for 233 months, or nearly 20 years of payments… and this without renegotiating the loans so that maybe they just go to… say… 9% with the government picking up the difference. The holders of all the CDO’s would then be able to value them, mark them back to market, solve their balance sheet problems… financial problems solved. From the housing markets point of view, it would relieve the pressure of the foreclosure spiral forcing down prices more than ‘normal’, and provide years for the economy to recover and housing to rebound. Furthermore, any homeowner who availed himself of the help would give up all or a part of the appreciation of the property over time, penalizing them for getting jammed up, but not penalizing the guy who is paying his mortgage and playing by the rules.If the sub-prime ARMS were renegotiated down to 9%, the monthly payments the government would be liable for would be an average of $225 per house per month, or $1.1 billion annually. The $700 billion under those circumstances would be good for 636 months, or 53 years…So in review, the proposal is to: Have the government guarantee payment of the loan by taking over the payment of the amount above the ‘teaser’ rate, leaving the existing mortgagee paying the original rate while the government pays the difference. Renegotiate that ARM rate down so the difference is smaller. In exchange for this, the original mortgagee gives up rights to appreciation in the future, penalizing him for a bad decision, not rewarding him for it.Benefits of the action: Stabilization of the housing market by ending foreclosures Small relative rescue price for the government, as the payments are monthly, not lump sum. Homeowners who can’t pay are saved and penalized, while homeowners who can are not penalized. The market in all mortgage related securities will be reestablished, as payment is now guaranteed, allowing all holders of all financial products based on the mortgages to have confidence in their value. Market liquidity and company balance sheets will be reestablished through the market itself.This would be a much cheaper and more effective way to solve the problem… renegotiate the exploding rate, paying the difference and profiting from the increase in asset value over time.The following is the proposal advanced by Feldstein in the WSJ:The Problem Is Still Falling House PricesThe bailout bill doesn’t get at the root of the credit crunch.By MARTIN FELDSTEINA successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities….We need a firewall to break the downward spiral of house prices. Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%….Consider a homeowner who has a mortgage equal to 90% of the value of his home. The 15% decline in the value of his house that may be needed to bring it back to its prebubble level would shift that homeowner into negative equity. Further price declines would make default attractive. But the 20% mortgage replacement loan would take the loan-to-value ratio to 72% from 90%, making it unlikely that prices would fall far enough to push him into negative equity. An interest saving that could be as large as $3,000 a year would provide a strong incentive to accept the mortgage-replacement loan, even if the individual thinks that he might temporarily have a moderate level of negative equity.Below is a comparison of the advantages of the two plans point by point:• No budget busting huge amounts of capital required in any one year, but rather nominal amounts in any particular year.o Feldstein’s plan would require huge outlays of capital, a trillion dollars by his own estimate, in order to protect the 5,000,000 threatened mortgages, which is a totally unnecessary budget buster• No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.o A benefit of both plans.• Slows the fall in house values, shoring up all real estate assets both residential and commercialo A benefit of both plans• Doesn’t penalize those who ‘play by the rules’o The Feldstein plan rewards those who for what ever reason can’t make their payments by making them eligible for a very cheap very long term loan. This penalizes those who are paying and is unfair on it’s face.• Allows Mark to Market rule to continue to be usedo A benefit of both plans• By establishing a value for all the mortgage-related assets, the markets in them will restart, liquidity problem solved.o This is less clear under Feldstein’s plan, as there still could be defaults. Payment is left to the original mortgagee, and what if they decided to take that $80,000 and pay off some other more pressing bill. Because of that threat, the trillions of dollars in derivatives would not be as secure and thus would not be as valuable. They may be as liquid, but at a risk induced lower price… not a good thing.• Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.o Feldstein’s plan does not recognize the need to lower the ARM (more appropriately an ERM – exploding rate mortgage) increases through a blanket one time renegotiation with all holders. This is equivalent to what happens when someone secures a better deal rescuing a company than the deal originally offered to the original stock holders… such is life.• The program could be expanded to include anyone who was threatened with foreclosure due to ARMs… not just sub-prime, but Alt-A, etc.o A benefit of both plans.• No bankruptcy interventions necessary.o A benefit of both plans.In sum, there is merit in the strategy advanced by McCain… however, his methodology is poor and can be greatly improved upon.