The economy and investors are currently bracing for the ramifications of one of the most unprecedented actions ever taken by the federal government, which is set to alter the landscape of the U.S. financial system. In theory, a government-created entity designed to offload toxic assets from the balance sheets of financial institutions has the potential to stabilize the beaten-down credit markets, which in turn might alleviate pressures in the housing market. In addition to the government-financed takeover of troubled assets, the Treasury also plans to expand its previously announced program to buy agency mortgage-backed securities and have the government-sponsored enterprises (GSEs) increase their purchases of mortgage-backed securities in the open market.
In the words of Treasury Secretary Paulson, removing these assets from financial institutions will help to “restore confidence in our markets and our financial institutions so they can fuel continued growth and prosperity.” The government has essentially taken the stance that committing hundreds of billions of dollars of taxpayer monies is worth avoiding the unknown of continued financial institution failures.
While the preliminary commentary indicates that the government is focused on purchasing up to $700 billion of residential and commercial mortgages and securities from financial institutions, there is much uncertainty about what the plan might ultimately entail. Furthermore, there is mounting speculation that the government could pursue a second housing stimulus bill including the re-implementation of down-payment assistance, a larger tax credit, and a freeze on foreclosures.
The bailout plan could target three potential areas: the purchase of mortgages and securities; the purchase of foreclosed homes; and the purchase of AD&C loans.
In my view, the primary roadblocks to a housing recovery are confidence, consumer credit quality, and deflating home values—not liquidity. The government has already taken numerous steps to infuse liquidity into the secondary mortgage market with little impact on housing fundamentals. This government bailout will not address the credit problems or accelerating job losses plaguing the market; however, it will lower mortgage rates and might improve confidence for buyers who have been on the sidelines. The Catch-22 for these buyers is the inability or unwillingness to sell existing homes at depressed prices, particularly as about 10 million (or 20 percent) of mortgage holders have zero or negative equity.
I currently estimate that there are approximately 800,000 to 1,000,000 foreclosed homes owned by banks and other financial institutions. Assuming that the government can judiciously purchase the foreclosures, hold them until the market is much stronger, absorb the carry costs, and avoid the moral hazard of additional foreclosures, the benefit to the housing market would be significant. At the very least, perception alone would be a boon to confidence. However, I believe that this would result in an enormous drop in existing-home sales as real sellers would be unwilling to sell into a down market at depressed comps from previous foreclosure prices.
If AD&C assets are taken off of lenders’ books at some level of discount, it is likely to result in an acceleration of impairments taken by builders. Additionally, I believe it is highly unlikely that banks will immediately re-enter the still-risky real estate lending business simply because it has been cleansed of troubled loans.
Unanswered questions include: How will the value of purchases be determined? Is this a one-shot offer? Are non-bank financial institutions such as hedge funds, insurance companies, and municipalities able to participate? How will the government ensure that fresh capital is reallocated to the housing market? And, does the government understand the risk?
As Congress considers another housing stimulus plan, I believe that, if implemented, the return of down-payment assistance and a larger tax credit that does not require repayment would be most effective toward stabilizing the market. I believe that freezing foreclosures or loosening underwriting criteria would be harmful to the medium-term health of the market and carry heavy moral hazard risks.