One Way or the Other, Uncle Sam Will Bail Out Mortgages

We're in the middle of the continuing crisis and there are regular announcements of collapse and catastrophe. I'm going to tell you a secret: you can't trust anyone's predictions of collapse and instant bankruptcy. But you can get a lot of insight simply by doing the sums.

The original banking crisis was a real, major crisis -- do not doubt it -- but it was also a transient effect of the way that we do banking along with the imposition of FAS 157, the "mark-to-market" rule. I wrote extensively about that at the time. But what brought it about was a longer-term issue, the collapse of the "housing bubble" -- like all such, an episode where people presumed that an asset would continue growing rapidly and so exposed themselves to risk to get out with a bucket while it was still raining soup. Then, for any number of reasons, the market stopped charging ahead. The economy in general picked up and the Federal Reserve raised interest rates to deal with potential inflation at just about the time people with balloon loans wanted to refinance; of course, payments on adjustable-rate loans went up as well. This meant that home values stopped going up, mortgages got harder to get, the bubble burst, and the snowball was rolling, leading to the banking crisis last year.

Now the value of homes in general has dropped by something like 15-20 percent, and in some really hot areas like Las Vegas it's dropped 35-40 percent. Those assets have two owners: the banks that hold the mortgages and the people who pay the mortgages. I don't care how you deal with it, but the fact is that what used to be a value of X is now something around 0.6X in those places. What's more, if a bank forecloses, it usually costs about half the total to get rid of the house, so the houses, net, are worth about 0.3X to the banks.

Thus, it's better for the bank to write down the loans to keep them active than have walkaways. Make a new mortgage that writes off the loss in value and, believe it or not, both sides of the mortgage take a hit: the bank writes down the asset, the customer loses their equity such as it is and loses on the other end, because the house won't be worth as much when the mortgage is paid off.

So, one way or the other, the value will get written down. But if the bank writes it down, though, that makes their balance sheet look worse -- it looks like an expense, a write-off. If the write-off is big enough, the bank becomes illiquid or even insolvent.