Bad News for the Fed’s Plans: Mortgage Modification is not Working

The Federal Reserve wants to lower long-term consumer interest rates. To this end, it has cut its policy rate to zero; engaged in any number of asset swaps with lending institutions; and, recently, begun outright purchases of GSE debt to put more direct pressure on mortgage interest rates. These policies, particularly purchases of GSE debt, seem to be working: mortgage interest rates have recently fallen to near record lows.

Of course, the Fed does not want to lower interest rates just for the sake of having lower rates. It wants to increase economic activity. And, in particular, it wants to help the housing market. The link is clear: lower mortgage interest rates raise housing affordability. Cheaper housing boosts demand. We observed a tepid increase in housing activity in February, whether a statistical fluke or a real turning point we shall see as the spring data comes in.

The average homeowner, through refinance, can take advantage of the Fed’s program and lock in for 30 years very low interest rates. A one percentage point reduction in interest rates will reduce the payments of an average homeowner about 10 percent per year. This cost reduction will push some households to buy a first home or to move up to a larger home. [Of course, this savings comes at an upfront cost of about 3 percent of their outstanding mortgage (personal survey of 10 mortgage issuers based on median house price and 80% down – prime borrowing only), raising the average debt level of the household sector.]

The Fed’s program, however, is likely to help the marginal homeowner only slightly. It seems to me that, at this moment in time, the most important marginal homeowner is the household that can no longer afford their house. When they stop making payments, their house eventually contributes to the inventory of unsold homes, lowering house prices and pushing more households to foreclosure.

It might be hoped that the lower interest rate would ease the payment burden of at risk households and reduce the number of foreclosures; however, new data from the OCC and the OTS indicate that interest rate reductions are not sufficient to substantially reduce the number of delinquent mortgages.

A reduction in mortgage interest of 1 full percentage point reduces the payment burden of households by about 10 percent. Data released in the OCC’s Mortgage Metrics report, reveal that more than 30 percent of mortgages modified such that the payment is reduced by less than 10% re-default within a few months of the modification.

Mortgage Metrics

The picture below is taken from the Mortgage Metrics report. The data are surprising: mortgage modification does not work at reducing mortgage delinquencies. After 9 months, more than 60 percent of modified mortgages are in default. And, we don’t know how many of the modified loans would have continued making payments in any event: not all delinquent loans go into foreclosure.
I think this number, by itself, goes a long ways toward understanding the low level of workouts from banks. Banks were likely aware of the low success rate and are therefore hesitant to undertake the effort needed to modify a loan. [I hope the State of Florida is paying attention. This applies directly to their new forced mediation programs.]
As striking as the relatively high level of defaults, the percentage of loans defaulting increased over the first three quarters of 2008. Over this time frame, the government, in the form of moral suasion, pushed lenders to increase the number of modifications. They responded; the number of modifications rose from 208 thousand in Q1 to 301 thousand in Q3. Apparently, however, to get this increase the lenders had to seek a broader pool of modification candidates and the deterioration of that pool is then predictable.

Perhaps one of the main problems with loan modification is that the majority of actions do not reduce the household’s mortgage payments. A whopping 32 percent of modifications leave the household with higher payments after the action. It’s clear to me why loan modification does not work if the payments don’t go down.

But what’s perhaps more surprising is that even loans with a reduction of 10 percent or more in payments still default at very high rates. After 9 months, 26 percent of loans in this category are delinquent. This number is going to worse over time because later vintage modifications do not perform well.

Here are my thoughts: I suspect, but do not know, that most of the loan modifications either reduce the interest rate faced by the household or extend the term of the mortgage. I suspect that very few of the modifications try to adjust the principal and that almost none of them ensure the household is actually above water following the modification. Households with negative equity positions are going to default in disproportionately large numbers.

By the way, for the first time in this cycle, the number of prime mortgage serious delinquencies is greater than that of any other category and the default rate on prime mortgages more than doubled between the first quarter and the fourth. I don’t think we are done with this housing cycle yet. Remember, the labor market did not take its nose dive until the fourth quarter. The serious delinquencies induced by this fall will not show up until at least the first quarter and more likely the second.

Larry Summers and Federal Reserve Independence

Warning: This post is speculative. It contains my thoughts and concerns only. It is not economic analysis.

Larry Summers, one of the President’s chief economic advisors, gave a speech at Brookings today. The speech was mostly exactly what one would expect: lots of talk about how the administration’s bail out is going to work and a few assertions that it might already be working. We could go through these but you would not find my views surprising.

Two paragraphs in the introduction to the speech, however, are of note. Here is the first:

Economic downturns historically are of two types. Most of those in post-World War II-America have been a by-product of the Federal Reserve’s efforts to control rising inflation. But an alternative source of recession comes from the spontaneous correction of financial excesses: the bursting of bubbles, de-leveraging in the financial sector, declining asset values, reduced demand, and reduced employment.

Two causes of recessions? The Fed and bubbles bursting. You do not have to be a real business cycle economist to think there might, just might, be other reasons. For example, Hamilton seems certain that at least some of the 70’s and 80’s downturns were a result of oil shocks.

Ignore the bubbles part. Why is he saying that the Fed has caused the majority of the post-war recessions? Notice, he says this without any of the usual hedge words or qualifiers. He states it categorically as if it is fact. This is not an accident. It is the written text of a speech and the written text of speeches of White House officials is vetted. Even if Summers truly believes the statement, why put it in the speech.

Before I go on, here is the second paragraph.

Our single most important priority is bringing about economic recovery and ensuring that the next economic expansion, unlike it’s predecessors, is fundamentally sound and not driven by financial excess.

“unlike it’s predecessors” The phrase jumps out. Is he saying that all previous economic expansions have been fundamentally unsound and driven by financial excess? All of them? Or does he just mean the economic expansion since say 1987 when Greenspan took over the Fed?

He is very carefully and almost in so many words saying that not only does the Fed cause recessions but the periods where the Fed has seemed to shepherd the economy along robust expansion paths, are actually the precursors to bubbles, making the Fed responsible for all recessions.

Here is what I fear. (Let me emphasize again: this is not analysis it is just my own personal thoughts on the matter.) These statements are intended to subtly begin the process of undermining the Fed. I have a hunch the administration would like a Fed with even more expansionist views on monetary policy. Perhaps one that is a bit less independent and a bit more willing to print.

I hope I am misreading the statements: I don’t think I am. I will be watching Summers’ speeches a bit more closely from now on. This is a dangerous path they are walking.

The Recovery and Reinvestment Plan

As regular readers know, I have been both for and against Obama’s stimulus plan. This morning the transition team released details of their economic analysis: the Job Impact of the American Recovery and Reinvestment Plan. We are being sold a bill of goods and I don’t like it.

Let me start my analysis with this quote from Obama’s speech last Thursday.

I don’t believe it’s too late to change course, but it will be if we don’t take dramatic action as soon as possible. If nothing is done, this recession could linger for years. The unemployment rate could reach double digits. Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. We could lose a generation of potential and promise, as more young Americans are forced to forgo dreams of college or the chance to train for the jobs of the future. And our nation could lose the competitive edge that has served as a foundation for our strength and standing in the world. [emphasis is my own]

And from a little farther along in the speech

There is no doubt that the cost of this plan will be considerable. It will certainly add to the budget deficit in the short-term. But equally certain are the consequences of doing too little or nothing at all, for that will lead to an even greater deficit of jobs, incomes, and confidence in our economy. It is true that we cannot depend on government alone to create jobs or long-term growth, but at this particular moment, only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy – where a lack of spending leads to lost jobs which leads to even less spending; where an inability to lend and borrow stops growth and leads to even less credit.

These are scary words. I am one of those who believe that this recession is going to be bad. I assumed when I read this speech that Obama’s economic agreed with my assessment; in fact, I assumed they had a much gloomier outlook than my own. The release today contains details of the team’s economic analysis.

Take a look at Table 1 on page 5. For the moment, just focus on the first line of the table, labeled without stimulus. According to the analysis, real GDP at the end of 2010 will be $11,770 (annual rate, chained 2000 dollars). From the rhetoric in the paragraph above, I expected their estimate of the decline in GDP to be greater than 10 percent. After all, losing the potential and promise of a generation is a Great-Depression-like event. Instead, Obama’s team is actually expecting GDP to rise 0.5 percent over the next two years (real GDP in 2008:Q3 was $11,712. An annual growth rate of 0.25 percent is very weak: it is not catastrophic.

So first, they want to spend almost $1 trillion dollars to save the economy from slow growth. But there is more. Take a look at the next line; it gives the level of GDP at the end of 2010 with the stimulus. They assume that GDP will reach $12,203 billion. That is, the stimulus will increase GDP by 3.7 percent relative to the non-stimulus baseline.

If they spend $775 billion on the stimulus, they will be spending 5.3 percent of GDP today to boost GDP by 3.7 percent over two years, all to save us from an assumed period of slow growth.

We can do the same analysis with their jobs numbers. According to their analysis the stimulus will save or create 3,674,000 jobs. That is a lot of jobs. I am not quite sure why we are going to lose so many jobs if GDP is going to remain more or less constant, but let’s assume these numbers are correct. At a sticker price of $775 billion, these jobs cost $210,941 dollars each. Median household income in 2007 was $50,233. I am not sure this is a good deal. Which would the median household rather have a job today or $210,941 today followed by a four-year unemployment spell.

We can skip the next several sections—do they really expect us to believe they are so good they can predict who is going to get the jobs—and move to the appendix. The appendix is (allegedly) using estimates of fiscal spending multipliers from FRB/US the Federal Reserve’s economic forecasting model. In the first paragraph, the report says “We considered multipliers for the case where the federal funds rate remains constant.” This assumption seems innocuous. The Fed’s interest rate is at essentially zero and is expected to remain there for a long period of time. But this assumption means that the large increase in government spending has zero effect on the interest rates of any maturity or type. Since no prices move, private consumption and private investment (within the model) cannot react to the government spending. They hardwire into their estimates that the private sector is not crowded out: the only effect of government spending comes through increased income. You don’t have to be a hard-line Ricardian to think that spending a trillion dollars might have some impact on private decisions.

Misusing the multipliers is a serious mistake. The economic team is clearly trying to use the stature of the Federal Reserve to boost the credibility of their estimates. They are either intentionally deceiving us as to the likely effectiveness of their plan or (and much worse) they do not realize the severity of their mistake.

The Stealth Bailout

Over the last three months, the balance sheet of the Federal Reserve has exploded. While Congress debated the $700 billion TARP and later the $35 billion request from the auto companies, the Fed has quietly lent, directly and indirectly, over $1.3 trillion to banks, firms, money market funds, and foreign central banks. This is real money. The increase in the balance sheet is over 10 percent of GDP. To put this number in further perspective, the Bank of Japan during its entire five-year Quantitative Easing Period, expanded its balance sheet by around 6 percent of GDP; and at the time, the BOJ’s actions were considered large (see this note from the SF Fed). This is a bailout; it is not a temporary lending program.

Two programs make up over half of this expansion: the Term Auction Facility (TAF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity (ABCP MMF). Both of these programs were implemented in an attempt to foster liquidity in the lending market. Both of the programs swap assets from private-bank balance sheets and put them on the Fed’s balance sheet. The first program is designed to take assets off bank balance sheets, holding them in the Fed’s vaults until markets “normalize”, potentially allowing the banks to lend more, especially to each other. The second program is designed to try and breathe some life into the ABCP market.

There are two principal problems with the Fed’s program. First, the sheer size of the balance sheet puts taxpayers at substantial risk. Second, the Fed’s purchases are distorting the market and preventing market solutions for some of these problems.

Balance Sheet Risk: Although the loans are collateralized, they are non-recourse. Essentially, this means that if the assets go bad while the Fed is holding them and the bank decides not to pay back the loan, all the Fed gets to do is keep the worthless assets. If the Fed were taking only the safest assets maybe this would be a good idea, but the list of collateral accepted at the discount window is stunning.

Take a look at the spreadsheet on this page. The sheet lists the collateral acceptable for the TAF. The list is long and I don’t want to give a full rendering but here is my key takeaway: the Fed treats U.S. Treasuries on the same footing as Municipal bonds, asset-backed securities, and mortgage-backed securities (both private label and agency). Either the Fed thinks the U.S. government is likely to default or they are overvaluing some of the other assets. Even scarier, the Fed will accept securities for which there is no market price, taking them on at between 60 and 80 percent of their face value.

Default rates on some of the assets the Fed is accepting are very high. Some of the assets might be safer than they appear, but I have a feeling that the banks are going to err on the side of handing over their worst assets, keeping the safest on their own balance sheet. For example, even though the Fed accepts U.S. government securities as collateral, the banks are not using their store of Treasuries as collateral. Even as the Fed’s balance sheet has expanded, its holdings of U.S. government securities fell by almost half, from over $800 billion to under $500.

Because the Fed’s balance sheet is now so large, very small default rates can lead to very large losses. If only 1 percent of the assets held default, the Fed would lose close to $13 billion. In truth, the default rate is likely to be much larger. And, we will likely never know the full extent of losses. Because the Fed does not publish its counterparties, it can hide even substantial losses. Given the mix of collateral, it is beyond the pale that none of the assets currently held have defaulted, yet the Fed has not disclosed a single loss.

Market Distortion: Most of the emphasis so far on distortions has remained in the arena of moral hazard: if you bail out companies, they will take riskier positions in the future. The market distortion I worry about is more subtle and more important.

The Fed is working in markets that are not functioning well. Many of the assets held by the banks, especially the ones without market prices, have fallen in value. The Fed envisions its purchases of these assets as supporting the market and adding liquidity. However, if the assets are actually being sold at too high of a price, the Fed’s purchases do not induce private parties to step into the market: the Fed’s actions preclude a private market.

Even if there is just a possibility that the assets have declined in value, the Fed becomes the only viable market. Private buyers will only purchase the assets at a discount. Private sellers don’t need to discount the assets because the Fed will take the assets as collateral at near face value. The normal market process cannot proceed as long as the Fed remains active.

The Fed’s commercial paper program is an excellent example of this effect. Since the end of October, the Fed has accepted $318 billion of asset-backed commercial paper. Over the exact same time period, asset-backed commercial paper outstanding rose only $43.9 billion. Private holding of the paper have actually fallen by $275 billion—one-third of the total fall in private asset-backed commercial paper has occurred since the Fed began its purchase program less than two months ago. At the very least, the Fed’s program is not helping and it is likely hurting price discovery.

More importantly, because the Fed and the Treasury have been so aggressive in expanding their programs, the market distortion extends to assets they are not currently buying. It seems that no class of assets is permanently off the table.

Why sell at a discount if the Fed might begin buying the asset next month? The housing market is the best example of this effect. We will get hard data over the next week, but anecdotes indicate that home purchases fall sharply in November. I believe one of the main reasons was the indication from Treasury that they might begin a program to force mortgage interest rates on housing purchases down to 4.5 percent.

In the face of temporary uncertainty (whether policy driven or macroeconomic), postponing sales, purchases, and investment is often an optimal strategy.

Takeaways: While Congress and the White House have been focused on the implementation of TARP and the debate over whether or not to bail out the car companies, the Federal Reserve has quietly been conducting the largest bailout in the history of the United States. The program might be helping the U.S. economy, it might be creating terrible long-lasting distortions, or it might be actively hindering adjustment. I don’t know, and to a large extent without more transparency, the answer is not knowable, especially without full disclosure.

I will add two thoughts.

Since the Fed has implemented the program the economy has gotten noticeably weaker. Signs of macroeconomic stress have become omnipresent. We do not know the counterfactual, but it seems to me that the burden of proof lies on those who believe the economy would have deteriorated even faster in the absence of the Fed’s actions.

The Fed needs to stop treating this recession as a liquidity crisis. If we were merely facing an ordinary liquidity crisis, the Fed’s actions should have already worked: liquidity crises like bank runs are easy to resolve. Firms and Banks need to take a realistic look at their balance sheet, mark down assets that still have some value, and write off the rest. Some institutions will go bankrupt as a result but those firms are already bankrupt they are just refusing to admit it and are staying in business only with large fiscal transfers. (By the way, NorthGG is one of the strongest advocates for this adjustment in prices. I recommend reading his comments here.)