MBS Values and House Prices
Atrios explains why he thinks the banks’ toxic assets probably aren’t undervalued:
The possibility that the assets in question are not fundamentally undervalued seems like a very serious possibility to me (I’d say a likelihood). Indeed, if one makes the seemingly plausible assumption that property values will continue to decline until they reach something in the neighborhood of pre-bubble trendlines, they’ve got a fair amount left to fall, which is one of several reasons the ‘undervalued’ assumption looks potentially suspect.
I think this is a bit off base. The assets aren’t backed by the houses, they’re backed by the income streams flowing from the mortgages. People don’t automatically default on their loans if their house falls in value. The relationship goes the other way ’round—people in danger of defaulting used to be able to avoid that scenario by selling their house. With prices way down, that doesn’t work any more and defaults are up. But how much defaulting we see over the next two years should have less to do with the price of houses (which is going down) than it does with the unemployment rate. People who don’t have jobs don’t pay their mortgages on time.
The result is a situation in which there’s no unequivocal answer to what the “right” price for mortgage-backed securities is. On our current trajectory, their value is extremely low since the economic outlook is so bleak. But if the administration’s recovery efforts—including this asset business—actually work, then the unemployment rate will be lower, the default rate will be lower, and the assets will turn out to be worth more than people are currently willing to pay for them.
I still think it would be better to do this in a way that didn’t have the “free money for financiers” structure to it. But on the narrow question of whether or not it will “work,” the gamble isn’t that the assets are “really” valuable and people just “think” they’re worthless, the gamble is that it’s the bad state of the economy that’s making them so worthless and that if you solve the bank capitalization problem the asset values will rise.
317 Responses to “MBS Values and House Prices”
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March 23rd, 2009 at 11:51 am
That is true, however being underwater on the mortgage greatly increases the chance of default.
Say you’ve got 100 mortgages and every year you can expect that 10 of the owners won’t be able to pay their mortgage. Now if all the mortges are at 100% LTV (the house is worth the amount of the motgage), then all the owners who can’t pay should be able to sell the house for the amount of the loan and pay back the bank the entire amount. On the other hand, if the houses are worth less than the mortgage, then the owners don’t have that option, they default, and the bank ends up either renegotiating the loan (and taking a hit), or they foreclose, and again they take a hit.
So the MBS value is based on the cashflows, but if the cashflows fail, the value becomes dependent on what the house is worth.
March 23rd, 2009 at 11:56 am
If someone is underwater on their mortgage, defaulting is the economically rational thing to do, at least if the mortgage loan is non-recourse (as most are). Of course, not everyone will do this, but a large proportion will. It’s strange how economic theories of rational behavior go out the window when it’s convenient for Wall Street.
March 23rd, 2009 at 11:56 am
Really good post, MY.
March 23rd, 2009 at 11:57 am
We do not know what the assets are made of. To say that they have a reassuring “stream” of mortgage payments flowing into them is to say that the particular security is structured that way. But it can be structured in any number of ways, and the banks have no incentive to sell of those assets with reliable “streams”. Atrios is right – we have just seen an uptick in housing sales from the massive increase in the foreclosure market, and another startling month over month price drop.
The proposed auction: a., is not of the bank’s good assets, but of its bad assets; b., if the bad assets had
streams that would make them viable over time, why sell them? Especially as the government is willing to put up 97 percent on any asset. Thus, c., you get the assets that are structured so that the streams don’t offset the negative effect of the way the particular asset was tiered.
You should go back to the Indy mac example. The losses are about 50 percent more than are envisioned in the Paulson-Geithner plan. IThe government is putting itself on the hook to get somebody to buy trash, and by making it a non-recourse loan, elevating the concept of jingle mail to a whole new level. If anything like the Indymac example holds true, the gov could end up on the hook for 800 billion dollars. Why? Why do this? Cui bono?
March 23rd, 2009 at 11:58 am
And housing prices still have a long way to fall – unless the Administration can somehow substantially boost real incomes very quickly.
People should buy houses with a price tag about 3x their annual income. The median annual household income in the U.S. is just above $45k. That means the median house should cost about $135k. But housing prices are still far above that. The bubble hasn’t even finished deflating.
March 23rd, 2009 at 11:58 am
> I think this is a bit off base. The assets aren’t
> backed by the houses, they’re backed by the income
> streams flowing from the mortgages. People don’t
> automatically default on their loans if their house
> falls in value.
Except that that is exactly what they have been doing for the last year, as documented by Atrios. If all the ARMs and Option ARMs were worked out, and unemployment stopped falling, we might be able to say we are getting back to ‘normal’ default behavior – but neither of those are currently the case.
March 23rd, 2009 at 11:58 am
If the value of these securities lies not in the value of the homes, but in the mortgages, how does this affect the potential of bankruptcy reform legislation that would permit cramdowns?
March 23rd, 2009 at 12:00 pm
“assets will turn out to be worth more than people are currently willing to pay for them…”
But what about the derivatives? How are THEY ever worth anything?
You lose a bet, the debt you owe is worth something. But the bet itself is worthless, and that’s what you’re talking about, right?
March 23rd, 2009 at 12:01 pm
“it’s the bad state of the economy that’s making them so worthless and that if you solve the bank capitalization problem the asset values will rise.”
The underlying value of a mortgage is, ultimately, the market value of the collateral behind it – the house. Historically median house prices have stayed within in a narrow range of between 2.5 to 3 times median income. Falling house prices therefore are a reversion to, not a deviation from, long term sustainable levels. Which is why a recovering economy isn’t going to make the MBS stuff more valuable.
March 23rd, 2009 at 12:12 pm
Anyone who thinks an unoccupied house doesn’t depreciate in value is a moron. Vandals break in — mice enter and start shitting over everything, rain blows in through broken windows and the floors start rotting ,etc.
A degree in philosophy is no substitute for not knowing how a chainsaw works. Ask anyone with real estate experience what they think those vacant properties in those vacant Florida subdivisions will be worth in three years time.
Who’s paying the insurance by the way? Or have the insurance companies wiped their hands of this mess?
Even fucking renters can destroy a place if you don’t watch them and knock their heads when needed.
March 23rd, 2009 at 12:15 pm
Free money for financiers is destroying the political structure. Has destroyed it really. It is one thing to see your life upset if not wrecked by financial power. Wall Street has lost all popular trust. It is another to have the government take their side.
My hope for Obama was that he could weather the political storm which was going to come from the depression. Exactly the opposite is now guaranteed. We are on the cusp of a political meltdown that will make Wall Streets look minor.
March 23rd, 2009 at 12:17 pm
How much foreign investment in real estate is there today compared to 15 years ago? My guess as a layman would be home prices need to drop to historical norms but if something changed globally where it’s now easier for foreign money to buy US real estate (condos, homes, etc.) because it’s a safe relative investment, then there might be something of a permanent bump in historic home prices in the US. Foreign people buy our stocks and bonds. Have they also permanently bid up our home prices a few percentage points?
I don’t know but it’s possible.
March 23rd, 2009 at 12:18 pm
In the old days, houses built with stone or brick retained some value due to the shell. But American houses are built today with all the structural integrity of a fucking beer can –even the expensive ones.
Ask a home inspector or real estate lawyer what happens to a house’s value when black mold sets in:
http://library.findlaw.com/2002/Oct/24/132371.html
March 23rd, 2009 at 12:20 pm
I second “Obama-not as tough as Steelers”. After a crappy post, MY comes up with a really thoughful and resonable one.
But what about the derivatives? How are THEY ever worth anything?
If you are talking CDS type instruments, these are insurance that the loans will not go bad. If the loans do not do bad, there is no insurance payout (so AIG is happy and ends up making money). Needless to say as MY said, if recovery starts soon, there is less probability of loans going bad en masse.
The underlying value of a mortgage is, ultimately, the market value of the collateral behind it – the house.
Again, as MY wrote the securitized products are sale of future cash flows, not of the underlying property. That is not to say there is no correlation between falling property prices and loan defaults. But most folks (if they have a job) would want to default on a loan just for the heck of it. Among other things, it messes up your credit score.
March 23rd, 2009 at 12:24 pm
Re “Among other things, it messes up your credit score.”
————
Ask people in a Depression if they give a hairy rat’s ass what their credit score is.
March 23rd, 2009 at 12:29 pm
Ask people in a Depression if they give a hairy rat’s ass what their credit score is.
Agreed. But we are not in a depression yet.
March 23rd, 2009 at 12:30 pm
Re DTM at 11: “Matt is right that home prices, default rates, the value of these MBS, and the value of derivatives thereof, are all dependent on short-to-medium term macroeconomic conditions,”
————-
Not really true. The value of Houses is directly dependent upon the LOCAL economy –not the national Macroeconomic environment. Even if we have a good national economy restored, those vacant Exurban subdivisions could turn to shit because there no local jobs.
Previously, the local jobs were ..ta da.. in construction, building the exurban subdivisions.
March 23rd, 2009 at 12:31 pm
In other words, you and DTM believe that home values continuing to fall, with defaults and unemployment continuing to rise over at least the next year — two nearly certain prospects that this plan, by the way, is NOT designed nor expected to prevent according to its own authors – will lead to a rise in the market value of these toxic assets?
March 23rd, 2009 at 12:32 pm
Re rum raisin: “Agreed. But we are not in a depression yet.”
———-
Concur. But if Geithner’s house of cards starts collapsing, it
will rapidly snowball into an avalanche.
March 23rd, 2009 at 12:33 pm
If your house is worth 75% of the amount of your mortgage, you might continue paying the mortgage for a while because it’s the right thing to do. And besides, you have to live somewhere, right? Then the time comes that you need to spend $2000 to fix your car, or the water heater blows, or you lose your job, and you say, I can’t afford to keep making these gift payments to the bank once a month.
March 23rd, 2009 at 12:41 pm
“But American houses are built today with all the structural integrity of a fucking beer can –even the expensive ones.”
And this is especially true of the junk built during the bubble. People were so crazy to buy a house (and many of those only for the purpose of flipping) that they were oblivious to quality issues. The builders knew it, and cut every conceivable corner, a process helped along by the greasing of local housing inspectors.
March 23rd, 2009 at 12:52 pm
I still think it would be better to do this in a way that didn’t have the “free money for financiers” structure to it.
Then what plan do you propose? Because AFAIK all the possible alternatives involve “free money for financiers.” The Krugman approach — one that I’ve generally favored up till now as it happens — involves a whole heapin’ pile of free money for holders of bank bonds. Sure, we’ll get shares in return. But does anybody really think the shares will eventually bring $1-$2 trillion to the treasury? So, we can spend a trillion or two on bank shares (which requires expending political capital on trying to ask Congress for all that money — with no guarantee the pleading will be successful), or we can spend a trillion or two on dodgy assets. I don’t see the big difference.
Now, it may be true that buying shares would end up being cheaper than buying assets, but even if that’s the case, it probably wouldn’t be a large difference. Another words, the difference could well in the end amount to, say, having a public debt equal to 90.4% of GDP as opposed to 88.2% of GDP. It’s just not worth getting worked up about.
My biggest concern now is about data: do they actually know — within a reasonable confidence interval — what the final tab will be? Is their data actually sound? If they don’t get that right neither approach will work. But if they do, either approach should enable the banks in question to resume healthy lending.
March 23rd, 2009 at 12:55 pm
What nonsense justification is this?
MBS are priced low because we cannot afford suburbia with the expenses we have. Investors know what the American citizen can afford in a global economy, no amount of derivation can change this.
If we want to make suburbia affordable again then we have to reduce the expenses of the homeowner. What does the homeowner spend money on besides housing? Transportation, government, and food; in that order. Make one or more of these cheaper for the consumer and MBS values go up and the problem is solved. Otherwise, wait for three years while consumers migrate to denser cities.
Nothing the progressives are doing decisively leads to the one solution or the other; and certainly accounting fraud will not solve the problem. Go back to Krugman’s “Stranded in Suburbia” essay.
March 23rd, 2009 at 12:56 pm
Treasury is going to be charging interest on its loans, and the FDIC is going to be charging fees for its loan guarantees, so depending on those rates and fees there could be little or nothing actually being given away for “free” by the public.
Gross has his arm so far up my ass he is squeezing my heart and demanding i type this nonsense
March 23rd, 2009 at 12:57 pm
The bad state of the economy is not dependent on bank capitalization. Our current recession may have been triggered by the liquidity/solvency crisis on Wall St, but it is now dependent on perceived jobs, income and wealth. A capitalized banking system may be necessary for a recovery, but it is certainly not sufficient.
March 23rd, 2009 at 12:57 pm
I personally wouldn’t refer to “market values”–there is no market for these asset right now.
Well, this raises an important point, and one that could well resurrect a Swedish plan: namely, is there a mechanism to force the banks in question to sell these assets if the price discovered for them is insufficiently high? Geithner’s plan obviously is intended to minimize the chances of such an occurrence, by maximizing the chances of overpaying, but I’d guess there’s no guarantee it will succeed (though my hunch is the plan is sufficiently generous to the banks as to make such an occurrence unlikely).
March 23rd, 2009 at 12:59 pm
some people certainly have invested a good deal of time and some effort to get their pov the financial situation recorded on the liberal blogs
March 23rd, 2009 at 1:02 pm
Fair enough. Let me restate the question then:
In other words, you and Matt believe that home values continuing to fall, with defaults and unemployment continuing to rise over at least the next year — two nearly certain prospects that this plan, by the way, is NOT designed nor expected to prevent according to its own authors – will lead to a rise in the cash flows associated with these assets?
March 23rd, 2009 at 1:03 pm
“First, I personally wouldn’t refer to “market values”–there is no market for these asset right now. I was using value in the sense of the value of the actual cash flows associated with these assets.”
I’m not sure I accept this premise. Markets equate supply with demand via clearing prices, but the banks have pursued a “don’t ask, don’t sell” policy because they’re afraid that if the crap were put on the market the clearing price would reveal things they don’t want known. Mark-to-market increases this fear for obvious reasons. But priced low enough, there would be buyers, as is always the case.
March 23rd, 2009 at 1:08 pm
Actually, those mortgage streams are only as valuable as what the investors on the open market will pay for them. The banks problem is that they cannot get anywhere near a “normal” price as those streams are now poorly seen by investors (many of those supplying these streams are underwater as they say and could default in the future). Also, changes on a number of fronts probably makes them much less valuable to private investors today than in 2005. Some changes, such as the slow economy, are not permanent. However, others are, like a readjustment in thinking on the fundamentals of pricing in the housing market, mortgage due-diligence requirements with subsequent changes to the ability of a home owner to resell, and risk mitigation in this investment arena, the things that Atrios probably was thinking about in his post. Alas, the inability to sell these assets makes the banks much less “liquid”. However, the banks have an incredible incentive not to sell them at a low price anyway because this incredibly generous Uncle Sam is willing to pay near full price.
As Joe Stiglitz pointed out over at tpm, the banks have the incentive to dump the worst assets onto the tax payer. So, all those toxic assets, interestingly enough, will be toxic indeed. In several years from now, we all wake up to find out that our poor Uncle Sam bought only cars with the bad engines, and everyone will be shocked, shocked! What bad luck. How could that happen when half the cars on the lot had good engines?
Atrios may have stated his analysis poorly, but I am afraid he is closer to the reality of the situation.
March 23rd, 2009 at 1:20 pm
Advocates of the banking plan are getting into circular reasoning. When labor productivity increases, because of Obama spending, then home owners will be more secure and the MBS values go up, banks are solvent and everyone is happy.
The bank fix does not fix the homeowner wealth or income problem, it merely supplies potential welfare for the banks until Obama’s productivity improvements come on line. But, what is Obama doing to make the home owner more productive? or otherwise reduce other expenses for the homeowner? I dunno, until that is explained, the bank fix is insurance by the government, nothing else.
Some of us think all we need to do is fix a accounting error. Not so, we are betting that Obama and Nancy have a secret technology to give us a permanent productivity boost.
March 23rd, 2009 at 1:44 pm
Matt, under _any_ state of the world these houses are over-valued. The Nasdaq has not recovered anywhere close to its 2001 bubble highs and likely won’t for decades because it was a _bubble_. The bursting of the housing bubble means that people who invested in housing have lost a lot of money. The banks want the taxpayer to take those losses instead of the banks. That’s the whole story. There’s no financial engineering double-bank shot that gets us out of this. Either the bank bondholders take the loss in a routine debt-to-equity swap or the taxpayers take the loss. If the taxpayers take the loss there’s that much less money available for progressive goals.
March 23rd, 2009 at 2:38 pm
40
What evidence is there that banks aren’t making loans because they don’t have any money? As opposed to realizing that a lot of the loans they had been making in the recent past were stupid. Are we trying to get the banks to resume making stupid loans?
March 23rd, 2009 at 4:25 pm
As Stiglitz has pointed out, TARP made no difference to the lending picture. Just as we have no reason to think the Paulson-Geithner plan will make a difference.
What we have is a plan the merges two improbabilities: a., that housing prices are going to get better, and b., that the money freed up by selling these undervalued assets will then go into lending again to the consumer. But in fact, if, as seems probable on every account, housing prices get worse, than we are saying, well, we have subsidized private investors who want to go long. But if they really wanted to go long, the market wouldn’t be in the state it is in..
We need to be working on the grassroots level to get the economy going again, and maybe in ten years the price of houses – at 3 times income – will be higher because – ta da! – income is higher.
This plan is an inverse Madoff plan – the fraud comes first, then comes the payoff. But in fact, if the economy did by some chance pick up, the private investor would have every reason to operate on the non-recourse part of the loan and move money to some other area, in which case housing prices – which are bound to lag in a rebound – are going to be on the government’s hands.
This is a historical giveaway of wealth to the wealthy. It will create a minibubble on wall street, but it won’t last long. The end of it will be the government assuming crippling debts at a time when it really is going to have to do major real public investing to make this economy work. This is like the failure of Clinton’s healthcare plan and his impeachment rolled into one.
March 23rd, 2009 at 4:30 pm
You can’t tell me Matt’s endorsement of the “Geithner Plan” isn’t driven by Journo-list groupthink coordinated by Brad DeLong….
March 23rd, 2009 at 4:45 pm
You sound like one of the shills who says that we shouldn’t be using mark-to-market on these MBSs. But the income stream that was assumed in the original MBS was based on very high rate resets. Even if you don’t lose your job, you can’t pay the higher rate. Up until a couple of years ago, this wasn’t a problem…you simply refinanced and kept the ball rolling. Now the ball has stopped. But the institutions who own the sliced-and-diced MBSs won’t let you renegotiate your mortgage, because that would entail admitting that the assets aren’t worth what you say they’re worth. They have to admit that mark-to-market prices are actually closer to the truth, and then they’re insolvent. So we’re at an impasse.
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My understanding is that these securities are “highly leveraged,” meaning that a 1% reduction in the relevant mortgage revenue stream could result in a much greater reduction in the return on the security, maybe 30% or more. At this point, many of the securities may be underwater. Of course this is why we need to know what exactly these securities are and get some reasonable estimates as to their value under various economic scenarios.
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