With President Bush's signature on the landmark GSE/housing bill guaranteeing Fannie Mae and Freddie Mac, it is time to insure that the potential liability of trillions of dollars facing the American taxpayer does not turn into an actual obligation.
The mortgage crisis has left the landscape dotted with threatening sinkholes. Even under normal circumstances, a bad loan leaves the borrower and servicer alike in a difficult position. Now, however, the housing slump has made foreclosure an even more expensive option for the lender.
Confronted with a mounting number of distressed mortgages, servicers may lack the resources to examine each loan with the care it deserves and so end up hurriedly rewriting loans on less than optimal terms. This not only is a loss of potential income but also creates a risk of investor lawsuits against the servicer, either for failing to exercise "good judgment" in dealing with each loan or for violating investor covenants that limit the number of loans that can be rewritten.
The inability to identify and evaluate bad loans properly has particularly broad ramifications now. As the number of bad mortgages grows, the portfolios that bundle a large number of loans become harder to value and harder to sell on the secondary market. These portfolios' assets cannot be confidently valued are often sold at prices lower than their true value.
Since it is by selling portfolios that the lender raises more money to lend, the loss of confidence in mortgage portfolios means that mortgages become harder to get, the housing market continues its downturn, and the whole cycle is poised for another go-around.
But the danger of blindly writing off huge mortgage portfolios at government expense is that you create a mind-set that, when the private sector fails, the government (read, the taxpayer) picks up the tab.
To view these portfolios as the financial equivalent of slag is a mistake because the portfolios do not lack worth. What makes them problematic is the difficulty of valuing them by conventional means. Sophisticated statistical techniques, though, can help predict borrower behavior based on a broad range of factors and, so, identify the loans that are best positioned for renegotiation and their optimal terms.
By applying these techniques across all the distressed loans, the servicer can make decisions that reflect the needs of the portfolio as a whole. Access to such techniques has become particularly urgent now because the housing bill's provision to protect homeowners facing foreclosure depends on lenders' willingness to rewrite loans. This willingness, in turn, depends on the ability to accurately value distressed loans.
Rather than continuing an argument over which sector will end up taking the fall, a rational valuation technology can supply a solution that benefits everyone.
- Homeowners could keep their homes at affordable terms.
- Servicers could optimize their cash flow while satisfying both investor covenants and the requirements of fiduciary responsibility.
- Secondary-market investors could value a mortgage portfolio with some confidence and make rational purchases.
- Primary lenders, now able to sell portfolios, would have more money to put out to loan.
- The general public would be spared the bill for bailouts and enjoy a more open and rational credit market.
The distressed mortgage portfolios are not slag; their value can be found with the correct analytical tools and a broad partnership of all stakeholders intent on finding the value. This leads to a more nuanced role for the regulatory sector and a more demanding — yet more profitable — role for the business sector.