Cram Downs: A Bad Bank and Cram Downs are Diametrically Opposed Ideas.

While the market is intrigued by the nearly $1 trillion fiscal stimulus plan, a mortgage cram down bill has already passed the House.  It is amazing that it has taken this long to even get this thing going if the true premise of the politicians and policy makers was to save homeowners from losing their homes.  Of course, the money changers, the U.S. Treasury and Federal Reserve have been consumed trying to bailout their banker buddies without really focusing on practical applications that will work to stem foreclosures.

Banks and lenders despise cram downs.  In fact, the initial TARP bill had legislation discussing cram downs yet the lending industry lobbied hard to get it out of the bill and so it did.  Now, here we are months later talking about cram downs again yet $350 billion is already out the door into the pockets of banks without really doing anything to stem foreclosures.  That was the initial purpose of the TARP right?

At this point, we can only arrive at a conclusion that our policy leaders really have no idea what they are doing.  First, we are hearing rumblings that there will be bad bank which is completely in the opposite direction of cram downs.  Why?  We already discussed that we should get on with it and nationalize the banking industry instead of flushing money with TARP 1, 2, 3, and 4 as Nouriel Roubini has stated.  The reason the bad bank and cram downs are fighting for opposite goals is this:

(a)  Bad bank – benefits lenders, banks, and Wall Street the most while punishing tax payers.

(b)  Cram downs- benefits homeowners and punishes most lenders, banks, and Wall Street.

If you are wondering why things are so out of sync is because of things like this.  We have one bill that already passed with cram downs and with policy makers floating the bad bank notion out to see what response it gets.  Remember when the public rose up and pressured Congressional leaders in the House to vote down the initial TARP?  The reason it was voted down is because the public read it right and saw it for what it was as a big gift to Wall Street and banks with little main street impact.  The TARP gets passed anyway and here we are with 71,400 announced job cuts in one day and the economy still collapsing for most average American families.

Before we go on, it helps to explain what a cram down is. With new bankruptcy reform laws coming into effect in 2005, homeowners had the choice of Chapter 7 liquidation or Chapter 13 repayment plan.  After the reforms most people are now stuck with Chapter 13.  It is also the case that normally in Chapter 7 bankruptcy most people (not all) lose their home anyway so it wouldn’t apply here to begin with.

Chapter 13 itself is sort of like a big cram down to begin with.  The court develops normally a 3 to 5 year repayment plan based on the borrower’s debt, income, and other factors.  Normally, the unpaid remainder is discharged after the repayment period.  Yet in Chapter 13 the borrower can actually keep his home so long as he keeps up with the new modified payment.  Of course if the payment isn’t kept up, the lender will still have the ability to foreclose but they are now getting a more realistic chance to make the payment.

Banks and lenders hate this because it forces them to realize their losses.  That is, they will have to accept a lower payment by default.  That is why banks, lenders, and Wall Street are trying to ramrod the bad bank notion so they can unload their toxic debt here and leave the bill to the taxpayer.  We witnessed a 30 year housing bubble unlike any other so we really need to pause and think very hard whether we want to absorb this amount of debt onto the taxpayers balance sheet.  Just ask yourself this, why did financial stocks rally so hard simply on the notion of a bad bank?

Cram downs by default will force lenders to accept a lower payment structure than the one they had initially envisioned thus forcing them to recognize (rightfully so) losses.  Here is the thing, we are going to pay one way or another simply because that is the way things are moving.  If a major premise is keeping people in their homes, then cram downs are one of the few actually viable ways of making this work.  With $49 trillion in debt in our country, unfortunately we need to write some of it off but who pays the bill is the major question we will need to answer.

That is why with nationalization, we practically tie in the bad bank and cram downs all in one shot and save taxpayer money from more TARP like waste.  If we do nationalize, we should zero out the shareholders, bondholders, eliminate management, and finally start separating the good and bad from the bank.  Banks right now are simply looking out for number one and are doing everything they can to keep those toxic assets hidden until they can find a viable way to unload it to the taxpayer.  The burning of TARP capital is simply banks holding on to that hot potato.  Yet shareholders remain intact, bondholders are still intact, and management in many places is still there.  This is simply unacceptable.  The fact that we are talking about cram downs and a bad bank in the same week is preposterous.  This is like saying we want to be at peace and war at the same time.

What is more with cram downs is that it brings the home price to current market valuations.  Basically we are facing reality.  What happens is that if the value of the collateral goes down (which it has) then the court brings down the secured debt to the market value of the home.  The lender eats the loss as they should instead of trying to fling it on to the taxpayer.  If they cry that they would go bust because of this, then that is more reason to nationalize them.  Ultimately, we will get the same outcome but with nationalization, it will be cheaper.  Do we want a Japan like recession (which is the path we are heading toward) or do we want to go like Sweden that nationalized the banks for a few years while it cleaned up the mess?

Mortgage associations and lobbyist would like to scare you that rates will skyrocket if this happens.  So what.  They should go up because they will accurately reflect the inherent risk in mortgages and this is partly why we are in this mess in the first place.  Those low teaser rates never factored in the economic calamity we are currently facing.  Now, they are worried that risk is going to be priced in.  It should be.  Yet they want to have the best of both worlds; they want low rates subsidized by the government while off loading the risk to the bad bank.  Heads they win, tails they win.

Aside from helping homeowners, the more important aspect of cram downs is that it will bring lenders to realize the inherent risk with mortgages.  That is, you will never be able to make a $400,000 loan to someone making $46,000 a year.  They are kicking and screaming realizing that they will have to face sizable losses.  Cram downs make sense.  If we go down the bad bank path, you can rest assured we will have a lost decade like Japan while we sift through toxic assets for years and years.  Nationalize the banks and let us stop trying to pretend banks are solvent, they are not.

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5 Comments on this post

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  1. 8020 Financial said:

    “At this point, we can only arrive at a conclusion that our policymakers have no idea what they are doing.”
    That sentence is the best summary of the TARP I’ve seen so far.

    January 29th, 2009 at 3:29 am
  2. Bennett Brown said:

    If the cram-down is not available for those who committed “mortgage fraud’ then very few people will qualify. The majority of the 2005-7 loans were stated income and they are all fraudulent.

    January 29th, 2009 at 8:33 am
  3. gg said:

    Why has Citigroup (and only Citigroup) added support (on a qualified basis) for this bill?

    January 30th, 2009 at 11:22 am
  4. Jubilee Year said:

    Thank you for your insightful analysis. I call cram-downs by a different name: mortgage Jubilee. More and more people are seeing the obvious fact that debt levels will have to be written down. The farther we write them down, and the quicker, the better off for all of us. Please help spread the word: time for a modern Jubilee Year!

    February 6th, 2009 at 9:54 pm
  5. GC said:

    This article takes a very one-sided view of cram downs. Yes, they will make it easier for people to live in their homes, by reducing the amount they must pay the banks (forcing banks to realize losses). An entirely different issue, in my view, is whether this is desirable. Specifically, what sort of incentives and messages does this send with regards to personal responsibility? While the banks are at fault for blindly accepting poorly-unwritten subprime loans, NOBODY is blaming Joe Subprime for actively seeking a loan he had no business accepting. Listen, if I were defaulting on my house, I would like to see a politician do the convenient thing and reduce my mortgage. But I also would like to think that I’d never be so irresponsible as to take a loan that I had little/no realistic prospect of being able to repay. At the end of the day, the big-bad banks will be left holding the bag for Joe Subprime’s indiscretions, and this is partially OK (since, as mentioned, they blindly accepted these things). But cram-downs aren’t all good: they let people stay in houses they never should have been able to purchase, and thereby perpetuate a sense of entitlement and irresponsibility that we could all use less of.

    April 10th, 2009 at 11:47 am

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