Fix this economic mess

By Ray Metcalfe

The economic collapse our nation is experiencing today was experienced before by the oil producing states when the price of oil fell below $10 per barrel in 1986.

Louisiana and Texas were hit hard but Alaska was the state hit the hardest. On average, between 1986 and 1990, real property across Alaska fell to less than half of its former value. Rental properties fell by two-thirds. Some condos fell to 20 percent of their original cost.

In perspective, during the Great Depression of the 1930s, one-fourth of the banks in the U.S. failed. In Alaska, between 1986 and 1990, three-fourths of Alaska's banks failed. As a commercial real estate investment broker for 35 years, I have made a living studying and predicting the economics of real estate. When Alaska's economy collapsed, I watched as real estate and/or the mortgage backed paper (mortgages and/or notes secured by deeds of trust) that came with it moved through paralyzed and collapsing banks into the hands of an overwhelmed FDIC and back into the marketplace.

I saw a few become very rich while thousands lost everything. One person bought his non-performing mortgage (a nonperforming note secured by a deed of trust) from the FDIC for 1 percent of what he owed on his mortgage - from his originating bank. Five years before buying his note, the bank had been in disarray and was unable to deal with foreclosing on his property when its rental income ceased to meet his required payments.

Two years after that, the FDIC took over his bank. Three years after the takeover, he bought a "non-performing note," - his own mortgage, one of those "toxic securities" we now hear about - paying one cent on the dollar for his note which originated five years earlier with a three million dollar face value.

Bottom line: He collected market rents while not paying a dime on his mortgage for five years. At the end of those five years, he bought his own nonperforming three million dollar note which was secured by the deed of trust - previously recorded as an encumbrance against his property - stamped it paid in full and recorded the payoff of the note he had given the no longer existent bank five years earlier.

I tell this story to make the point that the federal government is going to spill more of that $750 billion than they deliver to their targets; and the unscrupulous will find a thousand and one ways to bump the public's money pail only to catch its spillage.

In 1986, I forewarned my clients of Alaska's pending collapse. Since 2004, I have been warning clients of the coming nationwide real estate meltdown that we are now experiencing. In short, my experiences during Alaska's mid-'80s meltdown gave me the kind of knowledge needed by those looking for answers today.

THE NATIONAL PONZI SCHEME

The coming of today's collapse was obvious to anyone who understood why rising home prices had outpaced inflation and rising wages ever since HUD, Fannie Mae, and Freddie Mac stopped assigning appraisers and began allowing mortgage companies to pick their own appraisers.

At the same time, they also deregulated the rules which had previously spelled out what closing costs buyers paid and what closing costs sellers paid, at closing.

Those two deregulation measures set the stage for a nationwide 'Ponzi style' pyramiding scheme twenty years in the making that was pre-destined for collapse. As buyers and sellers negotiated agreements for sellers to pay all of the buyer's traditional closing costs - if the buyer would agree to increase the purchase price by an equal amount - prices rose each time a closing occurred by creating new (higher) comparable sale values for the next seller to look to.

Subsequent sellers would repeat the process by looking at the last sale as the starting point for pricing their property, not taking into account that recently upped comparable sale had included the buyer's closing costs. New buyers would come along, again and again asking for their closing costs to be added to their loans. And each time they closed one, a new high mark came available as a comparable sale for the next appraisal.

As each borrower came in for financing, carrying a contract with an agreed purchase price equaling about 2.7 percent more than the last comparable sale, lenders would steer their appraisal business to those appraisers willing to finagle an extra 2.7 percent, to cover the added closing costs - even though the value could not be supported by the latest comparable sales.

With 'marketing times closings' averaging about 60 days, such practices pushed home prices up at the rate of about 17 percent per year, thus creating the monumental nationwide Ponzi scheme that is now collapsing.

As home prices rose faster than wages, it became impossible for wage earners to meet the payment schedules of a conventional mortgage. The mortgage industry's solution was to invent mortgages with low payments that buyers could afford on the front end, followed by escalating future payments - and promises of eventual huge payoffs for the investors to whom the mortgage industry sold their overrated mortgage backed securities.

However, wages stayed the same as the scheduled payments went up; and the promised payoffs to investors could not be met.

The folly of such practices was obvious to some; but for a small fee, investment banks like AIG were offering to guarantee investors that the mortgage industries mortgage backed securities would pay off as promised.

Something similar happened in Alaska between 1980 and 1984 when Wisconsin-based mortgage insurer MGIC Investment Corp provided "pool" mortgage insurance for Alaska Housing Finance Corporation. MGIC insured Alaska Housing Finance Corporation against losses in the event of default.

But there was one very important difference. MGIC was regulated. When Alaska's housing market collapsed, MGIC paid Alaska Housing around two hundred million dollars. Although tiny by today's standards, at that time it was among the largest such payouts on record.

When AIG began insuring loans, they avoided the insurance regulators that regulated MGIC by calling the product they were selling "credit default swaps" rather than insurance. Government regulators - who were less than enthused about regulating - determined that if it wasn't called insurance, they didn't have to regulate it.

By avoiding the regulators, AIG avoided the limits on the ratios between promises to pay and cash reserved for payout in the event that a large number of their promises to cover losses came due. The premiums rolled in - the bonuses rolled out.

AIG's insurance enabled interested short-sighted AIG executives to pour millions in bonuses into their pockets, as "whiz kids" with impressive degrees designed new mortgage instruments and more ways to get rich by digging America's financial hole deeper and deeper.

The lack of government regulation enabled investment bankers across the country to sell more policies that they could not cover if they ever came due. 'Make money for your company, get rich through bonuses, and get out soon, leaving someone else holding the bag when things collapse,' was likely the game for many executives, who must have known the damage they were doing.

Eventually, this national Ponzi pyramid scheme began to crumble. AIG and others imploded as they discovered they had insured more failing mortgages than they could cover. The only winners were the middlemen who donned their golden parachutes and took safe flight when the pyramid they built began to collapse.

JUST THROW MONEY

Treasury Secretary Henry M. Paulson's bailout program has thus far propped up this failing program, throwing good money after bad, postponing the unavoidable corrections in the real estate market. Those AIG employees who hadn't gotten out in time to deploy their golden parachutes turned to Congress and got a second chance to collect million dollar bonuses as payment for their part in nearly bankrupting our country.

Paulson's bailout has put the same whiz kids who invented this harebrained scheme back in the driver's seat. They argue that the problem stems from crumbling home values. Their solutions propose that taxpayers pick up the bill - as they use government money to hold home values out of reach for the average taxpayer.

President-elect Obama is correct in that the bailout needs to target the middle class; however he has yet to figure out how to do that. Providing incentive for lenders who hold their own mortgages is a good idea. But renegotiating loans becomes very difficult for mortgage securities that have been repackaged into derivatives, dividing interests in each mortgage into the hands of multiple owners who are often foreign investors with little understanding of our society and how our mortgage industry works.

Owner refinancing with incentives for lender workouts on principal reduction is the best answer. Congress should create an "Office of Mortgage Workout" empowered with a quiver of carrots and arrows to encourage cooperation.

THE BOTTOM IS YEARS AWAY

On December 14, CBS 60 Minutes News Magazine critiqued an oncoming second wave of defaults on higher quality mortgages. To be sure there, will be a third, a fourth, a fifth, a sixth, and a seventh, and eventually those waves will swamp commercial markets as well.

As home values plummet, owners of homes with higher and higher quality mortgages will walk away. First, mostly owners of newer homes with newer loans - as they will be upside down in their mortgages before those with seasoned loans secured by their older homes. As home values drop, people with older loans, good income, and good credit, will walk away from thirty year fixed rate conventional loans after securing larger homes for half the monthly cost of the home they abandon.

Rents will drop as bottom feeders pick up bargains on homes and offer them for rent for less than apartment dwellers are paying for half the space. As rents drop, apartment buildings will begin to flood the foreclosure market; once again, the newest and most recently mortgaged will go first. Renters who remain employed at the same income will see the opportunity to move into single family homes or larger spaces in nicer neighborhoods for the same or less than they had been paying.

Older buildings will go into foreclosure as Vulture Funds and Bottom Feeders acquire nearly new buildings and send crews into poorer neighborhoods to knock on doors and offer nicer quarters for the same price to those who appear to keep a tidy apartment and pay on time. As millions of renter class still employed Americans migrate upward into nicer rentals or home ownership, the oldest and least desirable neighborhoods will become worthless ghost towns as there will be no population to move up and into them. This downward spiral will continue until this process plays out and it will be years beyond that before construction returns to a steady growth.

MITIGATING STEPS

The most immediate step Congress could take to mitigate the hemorrhage and put money back into the cash strapped banks would be to pass a federal statute restoring the credit of those who lost their homes due to escalations of their adjustable rate mortgages that have put their payments beyond reach.

Barring credit bureaus, banks, and mortgage companies from factoring late payments and foreclosures on adjustable rate mortgages into the credit ratings of otherwise creditworthy borrowers would mitigate much of the injustice done by predatory lenders, while enabling millions of good Americans to purchase housing from the banking industry's unwanted inventory of foreclosed homes.

The circulation of credit and capital would be stimulated in all fifty states, the natural forces of the marketplace would direct both credit and capital to the places that need it most, and every dime the federal government put into the newly created mortgages would be soundly backed by good and sufficient collateral.

That nagging question Treasury Secretary Paulson couldn't answer, the question of "what are those toxic assets worth" would be answered for him by the marketplace. Those once passive investors duped into buying those "AAA" rate bundles of time bombs called mortgages watched their securities turned toxic. Now they own the real thing. They own thousands of foreclosed homes that they are ill-equipped to manage, maintain or resell.

The value of those "toxic assets" equals the much reduced resale value of the real estate that once backed them. Current practices will prevent millions of willing and able buyers from relieving scores of willing and anxious sellers of their unwanted homes. Current practices will keep working Americans in tent cities while thousands of homes sit vacant.

THE BAD BANK IDEA WAS TRIED BEFORE

Recent news accounts suggest that the FDIC is considering a so-called bad bank. A super bank of sorts, conceived to absorb the "toxic paper." That has been tried before. In 1987, the FDIC engaged New York based Hallwood Group Inc. to "rescue" two, then later a third failing Alaskan Bank. The FDIC threw in $295 million and Hallwood Group raised another $65 million through stock offerings to create a new statewide bank. Hallwood Group named its new bank Alliance Bank, opening its doors in November of 1987 with $1.3 billion in assets, including about $360 million in fresh capital.

It took 18 months for Alliance Bank to collapse under its own weight. The FDIC ended up doing with Alliance Bank what it could have done at far less expense with the three banks that formed Alliance Bank 18 months earlier. They took possession, made their depositors whole and liquidated its assets.

Hallwood Group also attempted to rescue banks in Texas with similar results. Between 1982 and 1992, Texas economy saw 506 banks fail, including seven of Texas's largest.

With almost 9% of America's population compared to Alaska's tiny ½ of 1%, Texas offers a more statistically supportable facsimile of what the entire country may be in for this time. If recovery time remains the same and the bank failures are proportional our nation may be looking at as many as 5,622 bank failures over the next ten years.

Bailing out banks is a bad idea. However a repeat of the above may not be what President Obama has in mind. The FDIC should be taking banks over, sending their management packing, and liquidating their assets the moment they see their net worth has reached negative territory. How many examples of bad managers distributing undeserved bailout money amongst themselves do we need to see before we recognize how bad their management was?

ONE GOVERNMENT AGENCY GOT IT RIGHT

Corrupt deal making and golden parachutes were also king with far too many of Alaska's asset liquidation efforts. However one government agency got it right. HUD created in effect, a sales window through which they presented a steady stream of properties for the real estate industry to market.

Without favoring any person, agent, or company, HUD engaged the entirety of Alaska's real estate industry by offering all real estate professionals an equal opportunity to market every property. All properties were widely exposed to the consuming market by HUD, All licensed agents were invited to bring offers to HUD, all properties were consistently sold to the highest bidder, and HUD made it all easy by providing thirty year fixed rate financing with low down payments and a simplified standardized one page fill in the blanks "HUD Home" sales contract.

BEST RECOVERY

While other government agencies were cutting sweetheart deals with insiders and giving away property to the connected at taxpayer expense, HUD established an open door transparent policy that consistently fetched top of the market while making buying opportunities available to thousands of under privileged Alaskans who may never have otherwise owned investment properties or homes.

RESTORING CREDIT

Those who blame most of the credit crisis on the extension of sub-prime credit to owner occupant home owners fail to recognize that many responsible homebuyers were given mortgages designed to blow up in their face. Eliminating all forms of sub-prime and failing to restore the credit of victimized borrowers will unnecessarily deny millions of Americans the buying opportunity of a lifetime. Set some reasonable guidelines and re-empower the buying power of those Americans who lost their homes but still have their jobs. Congress should act to give them their credit back. Restoring their credit will give them access to the property that banks are so desperate to sell, put money back into cash strapped banks, and likely prevent hundreds of banks from falling into the receivership of the FDIC.

While addressing the credit issue, there are a few related issues that Congress should address. Congress should place caps on the increases of existing adjustable rate mortgages. In the creation of new mortgages, Congress should either cap the spread between allowable escalations of the mortgage interest rate and the federal funds rate in place at the time of closing, or eliminate adjustable rate mortgages altogether.

In recent years, mortgage companies have been allowed to require their customers to sign for personal liability at the same time they sign a deed of trust or mortgage. Congress should eliminate this practice of allowing mortgage companies two bites of the apple with secured credit. Mortgages are like marriages. When things go wrong, there is a strong likelihood that both parties bear some responsibility.

When mortgage payments are not met, lenders should have to choose one of two methods for recovery. They should have the option of taking their collateral back or suing the borrower for what is owed. Lenders should not have the option of suing the borrower for a deficiency after having sold their property in a foreclosure auction. Such rights reduce incentives for responsible lending as well as incentives for lenders to negotiate when things go wrong.

Foreclosure auctions requiring cash at auction for uninsured and sometimes questionable title seldom bring anywhere near market values. Sticking the already strapped borrower with the deficiency that would have likely been far less had Congress given lenders the proper incentive to cooperate with any of a wide number of alternate methods of recovery is counter productive. Foreclosure laws across the nation are remnants of the day when a notice could be tacked to the post office wall and everybody in town knew who owned the house or farm in question. Foreclosure methods are long over due for modernization and all parties involved would come out much better if they were.

BEST SOLUTIONS

Work with the borrower to devise a refinance for the homes they are qualified to keep or marketing strategy for the home they cannot afford. In the absence of reasons not to, borrowers should be allowed to remain in the property while assisting the bank in marketing the property for whatever the market will bear. Banks should be faced with choosing between foreclosures without recourse to the buyer for deficiencies, or accepting the proceeds of sale in lieu of payment in full, or sale proceeds plus any agreed deficiency payment.

The incentive for the borrower should be the bank's agreement to refrain from impugning the borrower's credit. The incentive for the bank should be the probable reduced recovery available through a non recourse foreclosure auction, or a lawsuit against a borrower who may or may not have the assets to attach if a judgment is granted.

As nationwide mortgage companies came into existence and began selling mortgages over the Internet, they also began to ignore consumer protections and restrictions passed by state legislatures. Mortgage companies doing business across state lines should face penalties for ignoring the consumer protection aspects of state lending laws.

To address the Appraisal issues raised above, Congress should restrict the selection of appraisers for HUD, Fannie Mae, and Freddie Mac direct loans and/or insured loans to qualified appraisers selected at random from a roster maintained by the home offices of HUD, Fannie Mae, or Freddie Mac. To avoid a repeat of the Ponzi scheme described above, those select appraisers should also be required to adjust for value when sellers pay more than 50 percent of the closing costs associated with closing their sale.

WHERE'S THE TALENT TO FIX THIS MESS?

It's out there in the small banks and mortgage companies that didn't participate in the get rich schemes and aren't in need of a bailout today. They are recognizable by their lack of obscene opulence, million dollar bonuses, and golden parachutes. They are the un-cool gadfly whistleblowers who refused to profit from steering their clients over financial cliffs. They are the ones who had the integrity to say no even though the profits were big.

In 1986, Alaska's lenders were faced with issues they had never had to deal with before. Every solution began with experiments and/or acts of desperation. Some lenders recovered far better than others. Some lost far more than they had to. In a part two to this column, I will explain the difference.

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