I read a report in Reuters today that was titled "Homeowners Redefaulting After Getting Aid" and I now have the unfortunate right to say to the FDIC, "I told you so."
The FDIC plan to restructure mortgages seemed dangerously underdeveloped when I first analyzed it in my article "When a Government Becomes a Bank, Anyone Else Concerned with Moral Hazard (part 1 of 3)." In this 3 part series I analyzed 2 proposals for readjusting troubled mortgages, the worst of the two being the FDIC's loan guarantee program. The basic argument I tried to convey is the loan guarantee does not address the essential problem troubled borrowers are facing: Troubled homeowners are over leveraged, at best they can afford their loan principle at a "teaser rate" which the current market cannot provide, even with a government guarantee. Without addressing this core issue the FDIC program is going to fail, miserably. This Reuters article reports that over half of all restructured mortgages have failed within the first 6 months; it is just proving my point.
I am disappointed the FDIC program did not take into account some nice aspects of the second program I profiled in "When a Government Becomes a Bank," which extended the term of the loan. The term focused plan was part of the depression era Home Owners Loan Corporation program. It allowed principles to be extended over a longer period of time, thereby reducing the monthly debt service to a manageable level. This is still a viable solution if the market is willing to look at a much longer time horizon. If not, this may be the best government driven solution I have heard so far, and presumably would have significantly less risk to the taxpayer.
I see this recent statistic as the start of a colossal blunder by the FDIC and I am worried that it may shake congress' confidence in Henry Paulson and Ben Bernanke's (who were weary of the FDIC plan as I pointed out in "Nice to Know Henry Paulson Agrees a Loan Guarantee Will Not Work") economic recovery vision. The Reuters article is already showing signs of grandstanding by politicians, citing Rep. Barney Frank (D) who chairs the House Financial Services Committee as saying that he would agree to release the remaining $350 billion only if "they (the Bush administration) made it clear they were wrong in refusing (to use) it for foreclosure relief...Foreclosures are getting worse." The problem is not a resistance to help foreclosures, the problem is the FDIC plan is fundamentally flawed, and does not address the central over leveraged issue. Someone needs to either guide the private market to provide term extending debt packages, or seriously explore a government driven alternative in order to make any real change in foreclosure rates.
In light of these new statistics I tried to find any FDIC projections for default rate, which were unavailable, but I did uncover a new shocking detail about the plan. From a press release from Nov. 20, 2008 which highlights a speech given by FDIC chairman Bair to the Johns Hopkins Cary Business School:
"We'll accomplish this (the loan guarantee program) at no cost to the taxpayer or the deposit insurance fund. The TLPG is being offered under the systemic risk exception in our statute. Fees for the guarantee have been structured to cover our expected costs. However, in the unlikely event of a shortfall, the difference will be made up through a special assessment on all insured institutions, consistent with the procedure contained in our statute."
A very relevant, yet not widely publicized detail. In this case the taxpayer is saved, new burden for default is put on the already distressed financial sector. So if I understand the reasoning:
1. The banking sector cannot afford the losses they are taking on defaulting mortgages. Therefore:
2. The FDIC will "guarantee" the mortgages. But
3. The guarantee will be paid for by the banks that are FDIC members. Therefore:
4. Banks are again guaranteeing themselves.
Is this madness?! This is not a government guarantee at all, this is spreading the losses out among all banking institutions through a government created utility. I won't even begin to address the free market problems and backward incentive structure this creates, it will have to be put into its own installment. How did this plan get approved?
Everyone cross their fingers that Obama has someone a bit better for the FDIC, this plan is a fast sinking ship.
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