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Paul Krugman in his New York Times blog wrote,

… there’s still a huge spread between mortgage rates and rates on federal debt … the spread between conventional 30-year mortgages and 10-year Treasuries  … was historically stable at about 150 basis points, but has been nearly double that lately.

This market behavior is significant for what it portents. Investors, i.e. the market, voting with their dollars are saying that they do not have as much confidence in the mortgage industry as they did prior to 2008, despite efforts like TARP.

CNN reports in When mortgage rescues go bad, that U.S. Comptroller of the Currency (OCC) found that 53% of borrowers who had their mortgages modified in the first half of 2008 were already at least two months delinquent again.

Unfortunately this was not the whole story, there is some more to this story.

Michael Van Zalingen, director of home ownership services for Neighborhood Housing Services of Chicago, says that one-third of his clients modifications wound up with housing payments equal to a whopping 50% or more of their gross incomes. That is, many of these modifications are resulting in higher real dollar payments! 

A Credit Suisse study reported redefault rates of only 15% when modification results in lower real dollar payments.

Looking at these news items I have to agree with the FDIC Chairperson, Sheila Bair’s plan to modify more than two million loans. The only real way to resolve this mortgage mess is to go back in and rework all delinquent loans until acceptable outcomes are reached. 

Lets look at the consequences:

a. Interest Rate Reduction:
If, as some estimates put it, there are about $500 billion in toxic loans, then a 100 basis point reduction in loan rates results in $5 billion loss of income to investors per annum.

b. No Rate Adjustment:
If we don’t do anything than, at a default rate of 53%, a standard severity of loss of 35%, and an average house price ($250,000) depreciation of say, 20%, will result in total loss of 53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion.

Options (a.) and (b.) clearly explains what market spreads are showing. The undesireable consequenses of not reworking the ‘expensive’ mortgages, is in fact less expensive that not doing so.

I do hope banks figure out what the market is pointing to before it is too late, otherwise we may have a second mortgage/banking implosion in 2009. 

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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