Author: Daniel Indiviglio

A new report surfaced today that Apple is readying its iPhone for other service providers beyond just AT&T. Of course, this is not the first time we’ve heard such rumors. In fact, it seems like every few weeks another article pops up on some tech blog or Apple fan site about how the iPhone will finally be unlocked from AT&T. So what makes this one different? Maybe nothing, but it’s reported by the Wall Street Journal, not some random blog. So let’s see what it says.

Is It Real This Time?

The WSJ reports:

Apple Inc. plans to begin producing this year a new iPhone that could allow U.S. phone carriers other than AT&T Inc. to sell the iconic gadget, said people briefed by the company.

The new iPhone would work on a type of wireless network called CDMA, these people said. CDMA is used by Verizon Wireless, AT&T’s main competitor, as well as Sprint Nextel Corp. and a handful of cellular operators in countries including South Korea and Japan. The vast majority of carriers world-wide, including AT&T, use another technology called GSM.

I know any Verizon-lovers who have iPhones probably all just fainted, but now that they’ve regained consciousness, note that the article also says this:

Verizon Wireless, owned by Verizon Communications Inc. and Vodafone Group PLC, declined to comment. An AT&T spokesman said: “There has been lots of incorrect speculation on CDMA iPhones for a long time. We haven’t seen one yet and only Apple knows when that might occur.” Apple declined to comment.

These responses are neither surprising nor revealing. If Verizon is in talks, it wouldn’t comment, as doing so could anger Apple. If Verizon isn’t in talks, it still wouldn’t comment, as it has no incentive to preempt investors buying its stock and dumping AT&T’s based on a rumor. Of course AT&T similarly has a strong incentive to continue denying it knows anything about such plans on the part of Apple.

Are We Sure It’s Verizon?

What’s a kind of worst-case scenario for iPhone lovers if Apple does decide to expand to other service providers? That it only branches off to T-Mobile. That would also be an odd choice since T-Mobile isn’t as popular as other service providers like Verizon and Sprint. But T-Mobile is on GSM, though it operates at a different frequency band than AT&T. Still, that would probably be an easier fix than converting the device to CDMA — Verizon and Sprint’s network type.

Still the article specifically claims that the phone is being developed for CDMA. So what if Apple chose Sprint instead of Verizon? I think that would also be an odd choice. It may, however, satisfy some users who simply hate AT&T. Ranked third by size in the U.S., Sprint is pretty big. But unless Apple has some strong reason to shun Verizon further, I’d have to believe that if the iPhone is developed to run on CDMA, then Verizon would be a carrier.

If This Is True. . .

If these sources are accurate, then this is very bad news for AT&T. I would predict a mass exodus of iPhone users to Verizon as soon as their contracts expire. It’s no secret that many iPhone users despise AT&T, and many believe Verizon has a superior network.

Of course, there’s no proof that Verizon would be any better. Some claim that the iPhone’s network problems with AT&T might not be the service providers’ fault, but could be caused more by the iPhone’s design and/or its users’ data-hogging lifestyle. If that’s the case, then it’s unlikely switching to Verizon would help much. Those same users might just slow its network down instead.

If it is a data usage issue, there could be a sort of false perception for a year or two that Verizon’s network is better just because, at first, the iPhone traffic will be split between the two networks, so each may notice improved service. Of course, Verizon will get all the credit, because its users will notice how much better their phones are operating on its network. Again, this is bad news for AT&T.

It’s hard to see any scenario under which AT&T isn’t harmed by Apple opening up the iPhone market to Verizon, unless the latter’s network turns out to be utterly horrible. As an iPhone user myself, I would probably switch, as I always had better luck with Verizon before purchasing my iPhone almost two years ago. I suspect I would not be alone.

Not long ago, I wrote an article arguing that cyber security was similar to national security, so we should consider allowing tax revenue help pay for public-private partnerships to fight cyber attacks. I argued that cyber security is a public good. I have always viewed hackers who seek to infiltrate the computers of unsuspecting Internet users to be terrorists. Yesterday, I accidentally stumbled on a little more proof for that argument.

I was researching unemployment benefits for a post I was working on. In doing so, I did a Google search for “ny state unemployment benefits expire”. I looked through the first link (from the NY State Labor Dept website), and didn’t find what I was looking for. Then, I went back, and stupidly clicked on the second. DO NOT TRY THIS AT HOME! In seconds, the attack began, with windows trying to force me to install binary files, etc.

Luckily, I was not dumb enough to think, “Gee sure, I’d love to install this file from a website that I’m not familiar with.” But unable to stop the windows from popping up again and again, I quickly force-shut down my computer. A visit from IT and two full system scans later, it looks like my quick shut down paid off, and I was uninfected.

But think, for a moment, about who this webpage is intended for. It was supposed to explain what you do if your unemployment benefits run out. Not many people these days are worse off then those who are scared their paychecks they rely on from the government may stop, yet that’s exactly who the creator of this web site is attempting to attack. Real nice. Now tell me that’s not a terrorist of a rather miserable order.

Of course, I should also note that this particular hacker was not the most intelligent. If you want to steal someone’s identity, you probably don’t want to aim for someone who is pretty much guaranteed to be relatively poor. If you are worried about your unemployment benefits, you probably don’t have as much money to steal as, say, someone researching private yachts online.

Finally, I am a little disappointed with Google. For a company who seeks to fight against evil, having the second website listed in a search about unemployment benefits being a malicious site is pretty bad. I’d imagine it would strive to do a better job of weeding out such trash.

I just wrote about some problems I see with the Treasury’s new effort to prevent foreclosures for unemployed Americans. But because I’m a fair journalist, I think it’s also important that I write about the good in the Treasury’s announcement from last Friday: its principal reduction plan. It makes a lot of sense. Here are four smart aspects of the plan, with one caveat.

115% LTV, not 100%

The idea is to reduce principal down to 115% of the loan-to-value ratio. In other words, if a home is worth $100,000 currently, then the mortgage value can be reduced as low as $115,000. Why not all the way down to what the house is worth? Because the borrower just needs enough incentive to feel that the mortgage is a good enough deal to stick with. Even though it will remain underwater, an LTV of 115% is far more reasonable than one of something like 150%.

This is also good from the lenders’ point-of-view. If they foreclose on the home, chances are they’ll be lucky to get the market value. So if the borrower does end up paying, writing it down to 115% of the home’s value is a pretty good deal for the lenders. A little bit of premium also protects the lenders if the housing market’s recovery is steeper than most people anticipate.  

Graduated Principal Reduction

Another nice feature is that the principal reduction will be gradual. It will occur in steps over three years. This will have two nice side-effects. First, it will encourage good behavior on the part of the borrower to continue paying.

Second, banks presumably won’t have to declare the principal loss all at once. I’ve mentioned that one of the big problems with principal write-downs is that lenders would have to take a big loss immediately. So I suggested it might be a smart idea to allow them to take the loss gradually. This provision appears to do exactly that. Lenders will more easily be able to stomach the loss, since it won’t come all at once.

Retroactive

Also clever: the program is retroactive to any homeowner who has already gotten a modification under the HAMP program. Re-default is a particularly likely outcome for these previous modifications if it left the homeowner well underwater. This feature could prevent some of those re-defaults.

Strong Incentive to Lenders

Finally, the Treasury is making it pretty worthwhile for the lenders to go along. They’re paying them as follows for the forgiven principal:

I’m a little unclear when a lender would collect 21 cents as indicated, since the mortgages are only supposed to be reduced up to 115%. But 15 cents on a dollar is pretty nice: remember, in foreclosure these lenders would be lucky to get the market value, which means a full loss on that principal. And that doesn’t even get into the other costs involved in foreclosure.

As for the second liens, six cents on a dollar might not seem like much. But for most of these second mortgages, the alternative is zero if the house goes into foreclosure. So that makes six cents look pretty darn good. Though, it would probably be even more attractive if the associated loss on second liens could be gradual too.

*(See update below)

One Worry: No Stick?

I do, however, have one pretty significant worry. The fact sheet (.pdf) says the following about when a bank should do a principal reduction:

If NPV is higher under alternative approach, servicer will have option to use it.

This assumes that the servicer wants to use it. It appears to give the servicer the discretion of whether to use the old HAMP method or rely on principal reduction. That’s a little surprising, because if lenders aren’t on board, it could pose a problem. However, the benefits are pretty significant, so I would think that many lenders will gladly participate.

Update: As a commenter points out, apparently this schedule is for 2nd liens, which I misinterpreted since the Fact Sheet says “The following schedule will be available to lenders in exchange for all principal write-downs under HAMP at the time of a loan modification.” But in an earlier bullet point refers to 2nd liens, so I suspect he is right. This results in two changes:

First, there’s far less incentive for lenders to write down principal. As far as I can see, there’s no longer any carrot from the government for the lender to reduce principal at all. It will be a total loss. So I doubt we’ll see too many principal write-downs after all.

I asked Treasury, and they indicated that the schedule does, in fact, apply to 1st mortgages, as I originally thought. Vindicated! It also, however, applies to 2nd liens. So part of the following still applies:

Second, It does still provide a much greater incentive for 2nd lien holders, however. And 2nd liens are a pretty big problem. , so the point isn’t completely lost. Perhaps the Treasury believes that 1st mortgage holders don’t need an incentive to modify mortgages, while the 2nd lien holders need a huge incentive? I just worry the Treasury may be overpaying for worthless 2nd liens, however.

I was out Friday, so I haven’t had a chance to write about the Obama administration’s new foreclosure prevention efforts (.pdf) announced that day. I am reviewing the details now and have a few observations. As you might expect there are some good ideas and some bad ideas. The temporary assistance for unemployed homeowners is a curious one. It’s well-intentioned, but I worry about three problems.

In case you don’t know about this new aspect of the foreclosure prevention plan, it seeks to allow homeowners to pay less for three to six months if unemployed. It makes sense to try to prevent foreclosure for the unemployed, since they’re the major driver for home defaults now, as the subprime problem is really one of the past.

No Carrot

Most of the foreclosure prevention efforts involve either a carrot or stick. As far as I can see, this aspect involves no carrot — just a stick. Servicers and lenders don’t have any incentive for deferring the payments of unemployed homeowners. But they are required, if participating in HAMP, to make these deferrals.

Treasury has told me in the past that servicers will be fined if they disobey the rules. But I have to imagine that servicers and lenders won’t be too eager to do these deferrals. And if HAMP has taught us anything, it’s how little progress is made when servicers and lenders aren’t eager to do something. So the Treasury had better have a very strong enforcement mechanism in place if it expects this program to work.

Moral Hazard

In order to qualify for the program, you must be delinquent on your mortgage. So if you’re unemployed, but can pay your mortgage due to your unemployment benefits and savings, your logical response would be to stop paying. You could pay as little as nothing for up to six months. Why wouldn’t you want to pay less while unemployed? But, it does seem a little odd that a program would encourage those who can pay to stop doing so.

What Happens After Deferral?

This is probably my biggest worry: what happens if the borrower doesn’t find employment by the end of the deferral and still can’t pay the mortgage? I suspect this will be a very common problem, given that unemployment is expected to remain high throughout 2010 — which has another nine months (the deferral can only be up to six months). According to the fact sheet, the borrower can apply for a HAMP modification at that time. Yet, if the homeowner fails the net present value test, then a modification will be denied. The borrower can then participate in other HAMP initiatives, like the short-sale program. But the foreclosure would ultimately have just have been delayed, not prevented.

Perhaps the goal here is to just prevent foreclosure for those Americans who are only unemployed for a short period of time. If that’s the case, however, I don’t believe it will manage to prevent many foreclosures caused by unemployment, since most unemployed Americans will likely be jobless for more than three to six months.

In these tough times, many unemployed Americans are feeling forced to settle for jobs well below their experience level and pay grade. The New York Times has an article about this today, using several such new hires as examples of workers who are overqualified for their jobs. This is a pretty serious problem for the economy for a few reasons.

First, I should mention a little more about the Times article. It is by no means an exhaustive or compelling argument that overqualified workers are invading job openings everywhere. In fact, it essentially relies on two workers’ stories and a few interviews at one of the firms where its main character, Don Carroll, works. It would have been nice to see the Times talk to some head hunters, temp agencies or large firms’ HR departments for more concrete data. But to be fair, statistics showing the overqualified worker problem are very hard to come by. I checked, and the Bureau of Labor Statistics has nothing that could help.

But since the contention seems fairly obvious, given the turmoil in the labor market, let’s take it for granted that many Americans are feeling compelled to take jobs for which they’re overqualified. Carroll is a former financial analyst with an MBA from a “top university” who now works a job which had a posting specifying “bachelor’s degree preferred but not required.” Why is it such a problem when people like Carroll are willing to take whatever they can get?

Less Qualified Workers

First, it’s bad for the workers with weaker resumes who are more appropriately qualified for these jobs. This is especially worrisome for younger workers or recent graduates. It will stunt their career development. Many managers would jump at the chance to hire someone with 10 years experience for an entry-level job. Training will certainly be much easier. It’s hard to imagine performance wouldn’t be better too, as long as you weed out anyone with a chip on their shoulder from being too qualified.

That leaves workers with shorter experience or less-developed skills out of the work force for an extended period of time. Indeed, this data from a recent Gallup poll appears to indicate this pretty clearly, regarding education level:

As you can see, underemployment and unemployment are much higher for those with less education. If the labor recovery is painfully slow, then these Americans will suffer disproportionally. That might suggest education and job training programs should be getting more attention from Washington.

Slower U.S. Growth

Second, it’s bad for the broader U.S. economy when Americans take jobs below their experience level. With more workers failing to work at their greatest potential, the nation’s economy won’t flourish to the same extent it would if employment better reflected workers’ experience levels. Stunting the experience of less-experienced workers has the same effect. Combined, these factors will cause the economy to essentially take a step backward.

In theory, this could end up having a muted effect. There aren’t currently job openings for highly qualified workers in some industries, which is why they’re settling for lower-level positions. But once those jobs return, these workers may choose to leave the jobs they held during the recession for which they were overqualified. In many cases, I’m sure they will try. But they will now be competing with other workers with their same experience level who hadn’t been laid off and hadn’t taken jobs that took them off their career path. So it may prove difficult for these workers to get back on track, even when more appropriate jobs for their experience become available.

This overqualified workers problem is another reason why this recession will be long-felt. Some damage to the labor market will be permanent, even though most jobs lost will eventually return.

One of the big problems during the financial crisis was that banks didn’t have adequate capital bases. As a result, losses threatened their existence when credit dried up. So it seems righting this wrong would be an obvious goal of new financial regulation. A Bloomberg article today claims that this significant issue has been overlooked, as the two bills floating around Congress fail to call for specific changes in capital requirements. Is the legislation too weak in this regard? I don’t think so.

Here’s how the article begins:

In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

What the Bills Say

I don’t think this is a fair assessment of the reform proposals out there. It’s sort of true that neither bill has a specific number listed as a new capital requirement banks will face. But that’s because it isn’t really Congress’ role to set this standard. In fact, capital requirements should be set by regulators and must be done globally, to ensure competitiveness.

Both proposals do, however, say that the new systemic risk councils will set heightened capital requirements for big financial institutions. Here are the bills explaining the roles of their new systemic risk regulators. First, the House bill (.pdf):

The stricter standards imposed by the Board under this section shall include–
(i) risk-based capital requirements and leverage limits, . . .

The Senate version (.pdf):

The recommendations of the Council under subsection (a) may include–
(A) risk-based capital requirements; . . .

This make sense. Once you have a regulator with a strong understanding of macroeconomic risk, it can put in place appropriate capital requirements. I should also note that the House bill goes even further, slapping a 15 to 1 leverage limit ceiling on these firms. Even though that’s not technically a capital requirement, it will serve to ensure that these firms keep their borrowing within reason, unlike they had prior to the financial crisis.

Resolution Fund

I actually think there’s an even more important factor to consider, however. These bills would both create a new resolution authority, which would control a big fund (paid for by big banks) to cover the costs of winding down large institutions that fail. So long as banks can fail, capital requirements become less of a political concern. Beyond protecting taxpayers from losses, it’s really the job of management and shareholders to make sure banks have enough capital to withstand a severe credit crunch. If a bank can’t, then it will fail. As long as its equity and debt holders are the only ones to suffer in that scenario, the government probably shouldn’t be too concerned how much capital it had leading up to its failure.

So these bills do contain explicit language which will lead to stricter capital requirements for large financial institutions. But more importantly, they seek to make the failure of any firm possible without a catastrophic shock to the broader economy. While I too would have liked to have seen regulators act more quickly to set higher global capital requirements, given the fragile state of banking, new requirements will have to be slowly phased in.

There are many advantages for big banks these days, given their implicit government guarantee. They achieve lower borrowing costs and are more attractive as counterparties for some financial products like swaps. Some of their advantages may change with new financial reform, some may not. An article from Reuters Breakingviews asserts that the relatively lower interest rates big banks pay their savings accountholders is another luxury that the government guarantee provides. The article contends this is because consumers see big banks as safer. I don’t really agree, but we’ll know soon if this thesis is right.

This article’s assertion presents a sort of extremely pessimistic view about Americans’ rationality. Since the FDIC insures all deposits up to $250,000, if you’ve got less money than that in a savings account, then it doesn’t matter at all if the government guarantees your bank’s existence. All that matters is that it guarantees your deposits — and it does so long as it’s FDIC-insured.

Still, the article provides strong evidence that there’s quite a distinction in savings interest rates between big and small banks:

The interest rates paid on those deposits vary widely. In the fourth quarter of 2009, institutions with more than $100 billion of assets paid an average of 0.77 percent annual interest on deposits, according to F.D.I.C. data. By comparison, institutions with less than $10 billion of assets paid an average of 1.73 percent. That difference — nearly 1 percentage point — is one measure of the benefit that big banks enjoy from implicit government backing. They can pay less for deposits to customers happy with this assurance.

So, if Americans are stupid and think that a bank failing will mean their savings will be lost, then the article’s thesis is right: big bank’ protection from bankruptcy drives their lower savings interest rates. After all, few Americans have savings accounts larger than $250,000 (or $500,000 for a married couple with a joint-account). That’s an awful lot of cash to have in a savings account. And unless you’ve got more than that in an account, it’s irrational to worry about your bank failing. But the article then goes on to argue its point:

Big banks might argue that lower deposit funding costs reflect other advantages. For example, they offer more services and the convenience of more branches and A.T.M.’s than smaller banks. But that was the case before the government stepped in to save giant banks from the damage inflicted by subprime mortgages starting in 2007. Figures from the F.D.I.C. show that banks in all size categories paid 3.6 percent to 3.65 percent on deposits in the last quarter of 2006.

I’d like to see some data from well before 2006 (and I tried getting it from the FDIC, who tells me that they don’t track it, so I’m not sure how the article managed to get this data from that source). I wonder if there could be another reason to blame having to do with the housing bubble. For example, maybe the desire to originate as many mortgages as possible up to 2006 could have driven parity in savings interest rates for all banks at that time. Even big banks wanted all of the deposits they could get so they could write more mortgages. Indeed, some of the bigger banks were offering extremely high-yielding savings accounts to attract more deposits. (I should know; I had one with one of the biggest banks out there that paid something like 5% in 2006.)

So instead, I suspect that the current disparity has more to do with the other advantages the article mentions. I know that’s why I use a large financial institution, despite the fact that I despise most big banks. I don’t want to deal with the inconvenience of a less robust offering of services or branches/ATMs. And sadly, I have less than $250,000 in my savings account, so I would have no fear of any smaller bank failing that is FDIC insured.

Of course, the article’s thesis will be easy enough to test in the months that come. When financial regulation passes it will likely provide a non-bank resolution authority to end the too-big-to-fail problem. Then, even irrational banking consumers should realize that big banks can now also fail, and this perceived safety as a reason for choosing big banks for your savings will be eliminated. At that time, we should see better parity between big and small bank savings interest rates. If we don’t (and I don’t think we will), then it is those additional advantages like more locations and greater convenience that drives the variance in rates after all.

Last week, I wrote about the financial reform battle in the Senate. It’s shaping up to be a fascinating political struggle. Since then, I learned more about strategies being mulled over by Senate Banking Committee Chairman Christopher Dodd (D-CT) and Republicans to get a bill passed. All seem dedicated to the cause: it’s just a question of how to get there.

Political strategy is exceedingly difficult to pull out of Congressional staffers, so I didn’t have much luck in getting many on-the-record statements. But here’s a summary of what I’ve managed to piece together. Just keep in mind that strategies are still evolving, especially on the Republican side of the aisle.

The No Mark-up Plot Thickens

I covered the decision not to mark-up the bill in the Senate Banking Committee in my prior post. I said that Dodd mostly drove the speed. I still think that’s right, but I didn’t adequately address what was going on in the Republican camp. They weren’t all seeing the situation eye-to-eye. In particular, Senator Shelby (R-AL) wanted to forgo mark-up, while Senator Corker (R-TN) wanted to use the committee to revise the bill further. Ultimately, Shelby’s strategy won out, and Corker was not pleased. But he now says that he will “fold in behind” the Republican leadership and work with them to pass a bill.

Making It Dodd’s Bill

Shelby was convinced that offering amendments in committee would be a fruitless endeavor. He now may be seeking to work with Dodd to craft a broad bipartisan amendment to offer when the bill hits the Senate floor. If that happens, Shelby could potentially bring something like half of the Republicans in the Senate with him. From what I hear, the ideological divide between the two parties isn’t as great as you might think — nothing like it was with health care reform. If several changes are made, many Republicans could jump on board.

Dodd might really like this approach. It’s his final term in the Senate, and there’s little doubt that he’d love this to be his bill — not House Financial Services Committee Chairman Barney Frank (D-MA) and Treasury Secretary Timothy Geithner’s bill. Remember, even if Dodd loses half-a-dozen liberal Democrats, if he gets 20 or so moderate Republicans, a bipartisan bill will easily pass.

And if he gets bipartisan support in the Senate, it would be very difficult, politically, if the House and White House reject his changes — even though they might be tempted to pull the bill further left. If they did, when the bill goes back to the Senate after conference, then those Republican votes would be lost and Dodd would have to hope a few decide to stick around.

If Compromise Doesn’t Work

If Shelby and Dodd can’t produce a bipartisan push, then neither Dodd nor Republicans will likely be pleased. That would mean that Dodd will be forced to pick off a few liberal Republicans to vote and essentially agree to the House/Treasury version. The bill would then ultimately contain very little of his influence.

Sticking Points

So what are the issues that Republicans are most concerned about which might produce a bipartisan bill if Dodd agrees with some changes? Here are a few big ones:

Systemic Regulator

I hear that Republicans are okay with the idea of a systemic regulator. But they don’t like the idea that there will be a list of firms that this authority specifically regulates. The market may interpret these firms as still being too big to fail or being generally safer than smaller firms. Republicans may worry that these firms could still be bailed out and may have a competitive advantage.

Resolution Authority

Republicans also want the language in the bill to better ensure that the new resolution authority won’t simply provide bailouts at its own discretion. In my reading of this section of the Senate bill, it doesn’t appear to provide bailouts. Corker has also said he thinks this language is already strong enough. But other Republican leadership isn’t satisfied, though I’m unclear on the exact changes they want to see here.

Consumer Financial Protection Agency (CFPA)

From what I hear, Senate Republicans aren’t planning on trying to kill the CFPA. At this point, it sounds like they’ve accepted that this new agency or bureau will be created. Instead, they might fight for parity between the CFPA and the new systemic regulator. For some tasks, the systemic risk council requires a two-thirds majority, which means it might be difficult for this regulator to assert itself over the CFPA if there’s some conflict. Republican might insist that consumer protection isn’t given priority over systemic safety and soundness.

Senator Shelby’s pre-markup vote speech (.pdf) and a statement by Senator Judd Gregg (R-NH) from a few weeks ago sketch out this list of demands.

Derivatives

One wild card is derivatives. This section is not even finished yet, but Gregg is working on it along with Senator Jack Reed (D-RI). If they come up with something Republicans can stomach, their votes may follow. Of course, that assumes the new section will ultimately take the place of what Dodd had originally written, which is what passed in committee as a placeholder for the upcoming bipartisan section.

Timing

Finally, it remains unclear when the bill will hit the Senate floor. Last I heard, Senate leadership still hadn’t scheduled it. But there’s a long session after Easter recess, and it could get a two-week chunk of that time. If it doesn’t, then the Senate will probably consider it by July.

Late Thursday, it leaked that the Obama administration is planning to broaden its foreclosure prevent program. The details, however, remain somewhat unclear. At this point, we know the new initiatives will include principal reduction and payment deferrals to help Americans who are unemployed, underwater or have second liens avoid foreclosure. When the details are revealed on Friday, here are some questions to ask:

How will payments be deferred or shrunk for the unemployed?

For quite a while now, the subprime mortgages haven’t been the big problem: unemployment has. Even if you’re a prime borrower, it can be hard to pay your mortgage if you lose your income. From what we know, the Treasury will allow some unemployed Americans to defer or shrink their monthly payments for several months.

Will the government be footing the bill for these altered payments or have banks agreed to temporarily defer or shrink them? Obviously, the latter would be fantastic news for both borrowers and taxpayers. Also, what if the borrower still doesn’t have a job once the deferral period expires?

How much funding will be provided for principal reductions on underwater mortgages?*

The median home price for existing homes is $165,100, according to the National Association of Realtors. Let’s say the average struggling underwater borrower has a loan-to-value ratio of 130%, which isn’t outlandish. If you use that average home price and the 115% LTV the program will use, then the underwater borrowers will have a mortgage of about $215,000 reduced to $190,000. So the banks will have to post a $25,000 loss per modification. The government will need to make it worth their while to reduce principal and take the associated losses immediately. They may want to cover at least 20%, which would be $5,000.

If the Obama administration is putting aside $14 billion (as reported), then up to 2.8 million could be modified, under the above assumptions. Of course, if the payment to banks or the number the Treasury hopes to help is higher, so is the cost.

How will they more effectively encourage the modification of second liens?

According to the Washington Post’s source, the new program will double the amount the government pays to lenders that help modify second mortgages. I’m a bit unclear if this means the servicers or the lenders/investors. I’m guessing they mean the latter, because a servicer probably need less incentive. Again these lenders/investors will need to be compensated well to withstand the losses that will result from writing off the second liens immediately, instead of waiting for foreclosures to take place.

What are the carrots/sticks in place?

Will the Treasury force servicers who are participating in the HAMP program to comply with these new initiatives? If this is significantly more aggressive than HAMP — and it may be — then lenders may put up a fight. There’s a reason why, up to now, most haven’t offered many principal reductions on first and second mortgages or provided unemployed borrowers with deferrals. They don’t want the immediate losses. So either the Treasury needs to find a way to coerce lenders to go along with these changes or offer them better rewards to comply.

Could it cost taxpayers more?

The Post also says that the Federal Housing Administration (FHA) will be involved. I’m a little unclear why. It could be that the Treasury hopes to encourage lenders to take part in these new initiatives by slapping a government guarantee on the modified mortgages through the FHA. While most of the carrots would be paid by the $50 billion in bank bailout money already set aside for modifications, I’m not as convinced losses from FHA guaranteed re-defaults would utilize this funding. If they those losses aren’t covered, then taxpayers could end up footing the bill for any FHA guaranteed re-defaults. And unless the principal reductions are extremely aggressive and unemployment declines rather quickly, re-default rates could be very, very high.

*Edited the numbers here shortly after posting, after seeing Reuters’ report (which they claim beat the Post’s) that the underwater mortgages will be reduced down to 115% LTV and $14 billion would be spent.

Earlier, I wrote about Special Inspector General of TARP Neil Barofsky’s audit findings on the Treasury’s foreclosure prevention program (HAMP). He concluded that it wasn’t working out very well. In a hearing today, Assistant Secretary for Financial Stability Herbert M. Allison, testified about changes to the program the Treasury hopes will make it more effective. A few may help a bit, but big problems are still looming.

These changes are part of something called Supplemental Directive 10-02, which as far as I can tell, isn’t online yet.* But Allison did summarize the principles behind its four main parts at the hearing.

Forced, Early Consideration

First, servicers must proactively determine whether borrowers are eligible for HAMP as soon as two payments have been missed. Then, they must actively solicit the borrowers to seek their participation in the program. This is a departure from when the onus was generally on borrowers to request participation in the program.

No Foreclosure Referrals

So the borrower’s eligibility has been evaluated — what happens next? According to Allison’s testimony:

The guidance would prohibit foreclosure referral for all potentially eligible loans unless the borrower does not respond to solicitation, was not approved for HAMP, or failed to make their trial modification payments. Servicers must also certify to their foreclosure attorneys that a borrower is not eligible for HAMP before a sale may be conducted.

That’s a significant change. The broader explanation is that all servicers participating in HAMP must ensure that a delinquent borrower is ineligible for or uninterested in the program prior to starting foreclosure.

Timeframe

A borrower is determined to be eligible; now what? Allison explains:

Servicers will be required to provide borrowers with clear written communications explaining the concurrent foreclosure/modification processes and stating that a foreclosure sale will not take place during the trial period. If a borrower is found ineligible for HAMP, a foreclosure sale cannot be scheduled sooner than 30 days after the date of a Non-Approval Notice so that the borrower has a chance to respond.

That 30-day period matters because it gives the applicant more time to respond and potentially fix inaccuracies or correct technicalities. Obviously, if a borrower simply didn’t qualify, then more time wouldn’t change things.

Alternative Programs

Finally, the Treasury intends to push other programs to prevent foreclosure. One of those includes a relatively young program that encourages banks to modify second liens. I’ve written about this problem in the past, noting that a second lien often holds up modification. Another program would encourage short sales. I’ve written about this one too. Even though a short sale would still force the borrower out of their home, it’s generally preferable to foreclosure.

Will the Changes Help?

I see almost all of these new rules hinging on one very problematic issue: enforcement. As I understand it, HAMP is voluntarily to any banks that paid back their bailout money. Those big banks own or service most of the mortgages in question. So what power does the Treasury have to compel banks to follow these rules? They would be subject to financial penalties.

But, as I understand it, the banks would still have the option of simply opting out of the program. Then, they would just have their own mortgage modification programs to work with, and could play by their own rules instead. The Treasury probably believes that banks won’t do this, but if the problem here is that banks and servicers are really at fault for purposely not offering more modifications, then wouldn’t they consider exiting the program to avoid that very outcome?**

If the banks do agree to these new rules will they help? The first three could, but I’m a little unconvinced that there are that many people out there who would qualify for modifications that aren’t already attempting to utilize the program and fighting to bring trial modifications permanent. So they might produce more modifications, but I don’t think the result will be drastic, especially if servicers find the rules too extreme and begin pulling out of the program. 

As for the alternatives, those are probably the most promising. It’s too early to tell how successful the second lien program will be. But if it works, then it could help. In my prior post I discussed some of the strange consequences of the short sale concept. I’m not entirely convinced the carrot the program dangles above banks/servicers is big enough to induce many more short sales that wouldn’t have happened anyway. But insofar as it encourages short sales as an alternative to foreclosure, I’m on board.

What’s noticeably absent from these changes in HAMP? Any responses to SIGTARP’s concerns about re-default mentioned in my earlier post. Borrowers may still be too deep in other debt to afford the modification, could fail to afford payments when they reset in five years and might ultimately decide to walk away if underwater. Principal reduction is the way to best deal with most of those problems, an option the Treasury is so far mostly resisting.

A Final Point of Interest: The Cost

One interesting piece of information that Allison offered was how much has been spent so far on the 168,708 modifications made permanent through February. They cost was $57 million. But those same modifications are estimated to cost an additional $775 million over the next several years. That amounts to $338 per loan initially and $4,932 per loan ultimately.

I find this confusing, because the program is meant to spend $50 billion and help three to four million homeowners. That would imply that the Treasury should be spending between $12,500 and $16,667 per loan. They’re only at a fraction of that.

I don’t mean to imply that lower cost for permanent modifications is bad news. But perhaps if the Treasury offered more money to secure greater principal reduction, for example, banks would be more willing to make modifications. $5,000 to $10,000 could go a long way in convincing banks to forgive more principal, and the program would remain within budget.

* Treasury sent it to me, so here it is.

** Got a response from Treasury. They tell me that once a servicer signs the contract for the program, they must adhere to all guidelines. I’m still a little unclear if that means they must stay in the program. It seems kind of strange that a program could change rules regularly, yet require a servicer to stay in it because of the initial contract. But it sounds like they don’t worry about servicer participation.

Bloomberg has a pair of good articles dealing with consequences from the compensation limit push that began on Wall Street. The hard times and public outcry over high pay has prompted all executive pay to suffer. But economic uncertainty has led CEOs to demand a higher proportion of cash. Separately, Wall Street firms’ decision to defer more pay has made one kind of already messy situation a little more chaotic: divorce.

CEO’s Get More Cash

About a week ago, I wrote about how CEOs were paid less in 2009 than in 2008. But there was also a change in compensation mix. CEOs wanted to make sure their pay didn’t suffer if stocks ran into trouble. A higher proportion of cash probably also made them more willing to grudgingly accept lower overall compensation. Bloomberg reports:

“When the economy is reeling, the most stable form of pay isn’t stocks, it’s cash,” said Sam Pizzigati, an associate fellow at the Institute for Policy Studies in Washington who has written about executive compensation and shareholder activism. “In rough times, the surest thing is cash, and that’s what they went for.”

Bloomberg also includes the data of how compensation has changed for 81 U.S. CEOs, which I’ve put into the following to pie charts that show how the mix has shifted:

As you can see, the mix changed from 28% to 33% in cash awards, and equity dropped from 59% to 52%. In terms of average pay, this amounts to cash compensation increasing by about $260,000 per CEO — even though their total pay declined by $910,000.

If there’s any lesson about pay that the market should have learned from the crisis, it’s that long-term profits should be in focus. Thus, the trend above should disturb us: it’s the opposite of what we would like to see. A higher emphasis on equity in compensation mix does a much better job of encouraging executives to care about long-term risk and reward.

Messy Divorces

On Wall Street, however, the industry has begun to adjust to the complaints about cash bonuses ignoring long-term risk. As a result, bankers have been forced to accept more deferred compensation. Bloomberg says:

Shifts in incentive compensation will affect most financial services workers who make more than $200,000, or about 50,000 people in New York, New Jersey and Connecticut, said Alan Johnson, president and founder of compensation consultant Johnson Associates Inc. in New York. About 50 percent of pay is being awarded in restricted or deferred compensation, said Paul DeLucia, a partner at Options Group, a New York-based executive search and compensation consultant firm.

That deferred pay often takes around three years to vest. This makes evaluation of these bankers’ assets more challenging. When does that matter in particular? In divorce settlements. According to Bloomberg:

Divorce settlements for executives such as bankers who rely on bonus payouts are becoming harder to negotiate as some firms give employees less cash and more long-term incentive awards including restricted stock and deferred money. That makes the bonuses more difficult to value and divide, said Eleanor Alter, a New York-based divorce attorney.

How do you sort through an evolving net worth in a divorce? If a banker files for divorce a month after getting awarded a deferred stock bonus of $500,000, how does his ex-wife get half? How much child support must he pay? These questions aren’t easy to answer. The value of that bonus may change with the stock price. In some cases, a portion could even be clawed-back if the firm runs into trouble again.

Obviously, more difficult divorces aren’t a reason to reconsider deferred compensation: it’s a good idea for better economic stability. So lawyers will have to continue working through this mess until they figure out a fair way to divide up assets. Of course, another idea would be for banks to include some additional non-cash benefits as bonus compensation: maybe perks that enhance work-life-balance like more time off or complimentary marriage counseling could help to prevent some of those divorces.

A few weeks ago, I wrote about the Obama administration not getting enough credit for the stock market’s performance. An article today from Bloomberg suggests a reason why: most Americans don’t realize that their portfolios are much better off than they were a year ago. This is not only a political problem but also one for economics: until consumer sentiment increases, spending will remain low, and the recovery will be a slow one.

Here’s what Bloomberg says:

By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago.

During that period, a bull market has driven up the benchmark Standard & Poor’s 500 Index more than 73 percent since its low on March 9, 2009.

In other words, even though only three in 10 say their portfolio has improved, they’re wrong. Most stock portfolios have a strong correlation to the S&P 500 and that’s up a whopping 73%.

Americans have become so pessimistic about the economy that the vast majority of those who own stocks don’t realize their wealth has actually increased significantly over the past year. This means the wealth effect won’t work. That’s an economic concept that says, when people perceive they are richer, they spend more. It’s not working out here because perception does not reflect reality.

I suspect most of the reason why stems from the extremely high underemployment. In the latest Gallup poll, this number was up to 20%. When one out of five Americans struggles to make ends meet, almost everyone will witness economic-induced suffering among even their close friends and family. People see the grave problem our economy faces with underemployment, and it overshadows the substantial gains in wealth felt by many Americans.

So we’re caught in a catch-22. Americans will remain pessimistic and spend less until employment improves, but employment will struggle so long as spending remains low. In a normal recession, the wealth effect might help. But this time around, it doesn’t appear to be doing much.

Special Inspector General of the Troubled Asset Relief Program (SIGTARP) Neil Barofsky is making trouble for the Treasury again. This time, he’s complaining about the Obama administration’s Homes Affordable Mortgage Program (HAMP), designed to curb foreclosures. Today, he released a report detailing the depths of its failure — much of which have I’ve documented in past posts as well. A hearing will follow this morning. The Republican side of the House Committee on Oversight and Government Reform, led by Rep. Darrell Issa, has also been diligent in noting problems with the program, including a report (.pdf) issued about a month ago on HAMP with many of the same findings. In short, HAMP isn’t working nearly as well as anticipated, and there’s reason to believe that even its meager success will turn out to be fleeting once re-defaults begin to hit.

Barofsky’s report is 57 pages, so I can’t get into it very deeply here. But you can read the whole thing here (.pdf). I’d like to focus on his recommendations.

Better Clarity on Performance

I’ve complained about this one quite a lot. The report says:

To permit informed debate on the program’s value and effectiveness thus far, Treasury must unambiguously and prominently disclose its goals and estimates (updated over time, as necessary) . . .

One such problem that should be corrected: HAMP’s constantly evolving monthly reports? That sounds familiar.

Better Performance Metrics

Next, SIGTARP takes issue with the Treasury measuring its success by trials extrended instead of permanent modifications. That also sounds familiar. The report says:

Measuring trial modification offers, or even actual trial modifications, for that matter, is simply not particularly meaningful. The goal that should be developed and tracked is how many people are helped to avoid foreclosure and stay in their homes through permanent modifications.

I agree. It recommends more specific goals to focus on other aspects of modification like servicer processing times, modification to servicer loans in default or total foreclosures ratios, rates of borrowers falling out of the program prematurely and re-defaults.

Public Service Campaign

This is one of the few recommendations that I don’t really agree with. The report worries that troubled homeowners aren’t aware of HAMP. I don’t have extensive experience with those facing foreclosure, but those who I have talked to in that predicament are well aware of HAMP. Indeed, they’re desperately seeking any option that could help their situation. It’s become relatively common knowledge that the government is trying to prevent foreclosures, and by knowing that it’s pretty easy to make your way to details of the program with a few phone calls or mouse clicks.

Income Verification Changes

SIGTARP doesn’t like that the Treasury provides flexibility for income verification at the discretion of the servicer. There’s a worry that some servicers might have inadequate methods for income verification or even experience a general desire to accept weak verification due to the pressure to modify mortgages. I think this is sensible. Re-default could be a problem if servicers aren’t all requiring legitimate income verification.

Significant Re-default Risk

Speaking of which, SIGTARP is very, very worried about re-default. In its initial summary, the report says (my formatting):

Looking forward, even if HAMP results in the estimated 1.5 to 2 million permanent modifications, the program will not be a long-term success if large amounts of borrowers simply re-default and end up facing foreclosure anyway. Several aspects of HAMP’s design make it particularly vulnerable to re-defaults.

– First, a borrower’s non-mortgage debts (which could prevent a homeowner from staying current on even modified mortgage payments) are neither factored into the modified payment calculation nor will they exclude borrowers from participating in HAMP.
– Second, borrowers may be unable to meet the increasing monthly payments if their income has not increased commensurate with the interest rate adjustments that begin once the five-year modification period is concluded.
– Third, even if borrowers receive a HAMP permanent modification on their first lien, for the estimated 50 percent of at-risk borrowers, the total monthly mortgage payments might still be unaffordable if the second lien is not also modified or extinguished; only recently has Treasury been able to sign up servicers to Treasury’s second lien program.
– Finally, given the prevalence of negative equity in mortgages eligible for modification, re-defaults resulting from negative equity, including strategic defaults, may be a factor as borrowers decide that it makes more economic sense for them to walk away from their mortgages notwithstanding the lower payments.

These are all very serious problems. The first renders the affordability calculation essentially useless. The second basically makes the modified loan a kind of option adjustable-rate mortgage — and we know how badly those can turn out. The third I have worried about before; again, it could mean that the modification is not affordable for the borrower. The last fear boils down to borrowers not wanting to be underwater: principal reduction is the only way to deal with this problem if you want to be more confident that you can prevent foreclosure.

Will we see any changes based on the SIGTARP report? Time will tell, but Treasury only agreed with the report’s first three findings. So don’t expect any changes to the last two. In other words, look for lots of re-defaults over the next few years.

(Nav Image Credit: morisius cosmonaut/flickr)

Consumer credit scores were the topic of discussion today at the House Financial Services Committee. In a hearing with a variety of different witnesses, the group considered how the scores impact borrowers. Do they have a positive or negative effect overall?

How Credit Scores Help

I would go with positive, though the current system needs some reform. Sandra Braunstein, Director, Division of Consumer and Community Affairs for the Federal Reserve, explained why scores are good in her prepared testimony:

In recent decades, consumer credit markets have become national in scope, and credit has been made available to a broader spectrum of consumers. The development and use of credit scores has greatly facilitated these trends. Credit scores rank-order individuals by their credit risk; those with poorer scores are predicted to perform, on average, worse on their credit obligations than those with better scores.

The existence of a sophisticated consumer credit scoring system allows for a more robust credit market. Imagine the difficulty in assessing risk for lenders if they didn’t have credit scores to work with. All would have to develop their own proprietary scores to compare one borrower to another. Big finance companies often do this anyway, but the landlord of a small walk-up in Brooklyn probably doesn’t have the resources or know-how to do so. A credit score allows for a consistent rating of borrowers.

Without credit histories being kept by the credit rating agencies, then consumer credit would be even worse off. Then lenders would have to rely on the word of prospective borrowers about other debt they have outstanding and how good they are at paying their bills. Credit fraud would be a lot more common and losses would be much harder to avoid. Credit would be less available and more expensive, across-the-board.

How Credit Scores Work

Back in November, I wrote about FICO providing a little bit of direction regarding how credit scores are calculated. A representative from credit score guru FICO also testified (.pdf). Tom Quinn, Vice President of Scores explained the characteristics of what makes up a score:

– Payment History (35%)
– Amounts Owed (30%)
– Length of Credit History (15%)
– Pursuit of New Credit (10%)
– Mix of Credit (10%)

Quinn also says:

The score “rank orders” consumers by the likelihood that they will become seriously delinquent (90 days or more) on a credit obligation in the next 24 months. The higher the score, the lower the risk.

While that probably holds true in general, the rating methodology above doesn’t really convince me that a score will always directly correspond to default probability. For example, imagine an heiress to some huge fortune who just graduated college and always acted responsibly. She never had a loan in her life, so would have a very low credit score, despite the fact that it was highly likely she would pay her bills. In fact, it’s pretty likely that someone with a very high credit score will also have a considerable amount of debt, since a “mix of credit” and “length of credit history” matter. Yet, if such an individual had a high income, but no savings, and then sudden unemployment could easily cause default.

Of course, I doubt FICO would call their system perfect. I just hope most finance companies recognize that good risk management would incorporate credit score, but not rely on it.

Reform

So it’s good that we have a system to track consumers’ credit histories and provide ratings. But where might some reform be sought?

Paying for your Score

I also railed against the idea that consumers have to pay to obtain their own credit score back in November. FICO charges $15.95 for access to your score. Another witness at the hearing, Evan Hendricks, Editor/Publisher of the Privacy Times, suggested (.pdf) suggests:

Consumers should be entitled to one free credit score per year, and it specifically should be for a credit score that is used by a majority of lenders. (Not a so-called “educational” score.)

I agree. It seems like a reasonable “right” that consumers to have access to their own score for free.

Better Conflict Resolution

Another good change would be if consumers had more power to protest the claims of creditors. Hendricks explains a problem related to this that I ran into myself just after college involving a student AMEX card (Never again!):

The Big Three (credit bureaus) sometimes fail to satisfactorily resolve consumers’ legitimate disputes because instead of truly reinvestigating disputes, they electronically notify the creditor of the dispute, and then permit the creditor to dictate the results via the creditor’s e-response.

This means if you have a dispute with what a creditor says, then all you can do is note that dispute on your report, which often won’t repair damage to your credit score even if your complaint is legitimate. Obviously, the creditor often won’t admit they’re wrong, unless the facts are overwhelming. Few people are willing to actually bring a big finance company or bank to court for credit history disputes, so that’s a problem.

Both of these rights look like obvious places for Congress to pursue reform. I was disappointed to see the consumer credit rating industry completely overlooked in last spring’s credit card regulation bill. Perhaps an amendment could be added to new financial reform proposals?

It looks like Bank of America may have finally begun to realize that reducing principal is the only hope for successfully modifying underwater mortgages. I’ve written several posts over the past month about the necessity that banks start thinking about using this tactic on their own, if they really hope to modify many mortgages going forward. It can be a smart loss mitigation strategy, even if philosophically repugnant. The government has been pretty reluctant to force banks to do reduce principal, since the associated losses could cause harm to the banking industry. It’s interesting to see BOA begin this program without strong coercion.

According to the press release, for the mortgages that qualify, BOA will actually prioritize principal reduction above interest rate reduction. This is a huge shift in modification methodology. Forgiving principal used to be rarely used — as a last resort. Not all mortgages will qualify. In fact, BOA estimates that only 45,000 mortgages will be eligible for principal reduction under the new program (costing BOA around $3 billion in principal), but the bank is clearly opening the door to this new approach.

This comment by Barbara Desoer, president of Bank of America Home Loans is an important point:

At the same time earned principal forgiveness helps homeowners, it also recognizes and addresses the interests of mortgage investors by ensuring that forgiveness is tied to the homeowner’s performance, reducing the probability of a future default under the modified terms, and adjusting the total amount to be forgiven in light of any gains in property values that might occur in an economic recovery.

So what loans qualify for principal reduction? Those that would have qualified for its National Homeownership Retention Program that are at least 60-days delinquent and have current loan-to-value ratios of 120% or higher. Participants must also prove their credit worthiness over time:

– An interest-free forbearance of principal that the homeowner can turn into forgiven principal over five years resulting in a maximum 30 percent decrease in the loan principal balance to as low as 100 percent LTV.
– In each of the first five years, up to 20 percent of the forborne amount will be forgiven annually for borrowers that remain in good standing on their mortgage payments.
– Forgiveness installments for the first three years are set at the 20 percent level.
– In the fourth and fifth years, the amount of forgiveness will be dependent upon the updated value of the property, so that the LTV will not be reduced below 100 percent through principal forgiveness.

This is a pretty sensible approach, because it reinforces the idea that principal reductions will only be provided to borrowers who continue to pay. The plan also protects BOA from losing money over potential appreciation over the next five years. BOA avoids the problem of strategic defaulters as well. Those are homeowners who can afford payments but choose not to because they’re unhappy their house is now worth less than their mortgage. BOA intends to make sure borrowers prove they can’t afford their original payments prior to modification. All-in-all, it seems like a pretty smart approach.

I have two final observations: First, I’m fascinated to see BOA decide to do this without the federal government demanding it. The bank must have discovered that it’s better off with fewer foreclosures, even if that means conceding some principal. Could the rational market actually be working? Second, I wonder if this will prompt other banks to also begin implementing more principal forgiveness. BOA is a hugely significant bank to take this step. Since its acquisition of Countrywide, it has become the biggest mortgage lender around.

Update: I just received an e-mail from Massachusetts Attorney General Martha Coakley’s office explaining that this principal reduction program was also part of a settlement with MA that mandated principal reductions. So the program isn’t entirely voluntary! More info here.

Yesterday, I reported that existing home sales had declined for three straight months. Today, we learn that the news isn’t any better for new home sales. In fact, it’s worse according to the Commerce Department. In February, new home sales declined for the fourth straight month, falling by 2.2%. Again, this highlights the theme that buyer demand is quite weak, especially for new homes.

First, here’s a chart of home sales since January 2009:

Numbers are seasonally adjusted. And here’s a nice one provided by the Commerce Department that goes back further, to get the big picture:

The 308,000 annualized rate of new home sales for February is just a small fraction of total home sales, as yesterday’s report indicated approximately 5 million annualized existing home sales. It’s also the lowest number of monthly annualized new home sales as far back as the Commerce Department’s data goes — since 1963. In fact, prior to 2010, no month’s annualized rate ever fell below the 325,000 mark. January’s rate of 315,000 was a new low until February. To give you some idea of the historical perspective, the annualized rate of home sales for 1963 was 560,000.

There’s not much good news here, but anyone trying to be optimistic might note that the 2.2% decline in February was the smallest drop since October. So there’s some possibility that the decrease in new home sales might be settling around the 300,000 annualized rate. Of course, the home buyer credit’s expiration in April could also help boost sales for the next two months.

Interestingly, months of supply of new homes are fewer than they were a year ago. In February 2010, there were 9.2 months of supply of new homes, compared to 11.1 months of supply a year ago. This might seem counterintuitive, considering fewer new homes are selling now. But this likely indicates that new home construction has declined to help push down the market’s supply, despite even weaker sales. But construction hasn’t slowed enough, as months of supply have been increasing since October, when it hit a low of 7.3 months.

At least, that’s what a new Bloomberg poll (.pdf) says. Interestingly, the article accompanying the poll focuses on American’s hatred of Wall Street, even though Congress, corporate executives and insurance companies all scored less favorably than Wall Street. The broader poll has some interesting political consequences, particularly for financial reform.

First, I put the full results of what I was referring to above in a chart:

As you can see Congress gets the most unfavorable response at 67%, while small business lies at the other end of the spectrum with an impressive 79% of Americans approving. I am kind of surprised that only a little over half of respondents had unfavorable views of Wall Street and banks. I also wouldn’t have expected the Federal Reserve to fare so well — only 31% had an unfavorable opinion. It looks like the public relations campaign the central bank began last year worked pretty well, as a Gallup poll in July showed only 30% thought it was doing a good job then. Now, 42% approved of the Fed according to this poll.

Consequences for Financial Regulation

Let’s go back to Wall Street for a moment. Even though only 57% had an unfavorable view, just 2% had a very favorable view. So while it doesn’t appear that a huge majority of Americans dislike Wall Street, very few love it. Banks didn’t fare much better. So does this indicate Americans want financial reform? Luckily, Bloomberg asked a few more questions to clarify matters. Here are those results (click on it for larger version):

Let’s start with the last two questions above. A tiny 18% portion thinks that the White House has done enough to address the financial crisis. Only 12% believe banks have responded adequately. If that’s not a mandate for financial reform, I’m not sure what is.

With that said, I found the first statistic in the chart above a little shocking. Only 24% appear to be in favor of a new, independent consumer financial protection agency (CFPA). Most respondents would prefer existing regulators are enhanced instead. Since the creation of a CFPA is the most controversial portion of the financial reform proposals floating around Congress right now, it looks like Republicans have little political reason to compromise on creating a new, independent CFPA. Doing so appears even less popular than health care reform, which they fought as intensely as possible.

In a separate poll question (not shown), Bloomberg asked whether individuals from Wall Street banks who helped caused the crisis should be punished by the government through “limiting their compensation or banning them from working in the industry.” Fifty-six percent thought so. The same proportion separately said that big financial companies “enrich themselves at the expense of ordinary people and have a negative impact on the economy.” A majority of Americans want to see change in the financial industry.

From this, I think it’s clear that financial reform would prove politically popular, but that doesn’t mean any reform would please Americans. In particular, a new, independent CFPA isn’t what most people want.

Taxes

The poll also asked about taxes. It presented a number of different taxing options for the future and asked people which they thought should be considered or taken off the table. The least popular? Raising the tax rate on the middle class by 2%. Only 34% of respondents wanted that considered. The most popular was to remove the cap on Social Security taxes so those with incomes above $107,000 will pay more. Seventy-eight percent want that option considered. As you might expect, anything involving taxing the rich was fairly popular, while any option where the middle class or elderly would feel the tax did poorly.

Spending

There was one poll question that stood out as having the grimmest consequences for the economic recovery. Only 2% of respondents said that they planned to spend more in the next couple of months. That would indicate that any increased spending we’ve seen recently should quickly plateau. Virtually no one has plans to increase their spending soon. In fact, 28% said they will spend even less. These results indicate that the recovery will be a slow one.

It’s all well and good to talk about how great it would be, in theory, if firms were no longer guaranteed to be too big to fail by the U.S. government. But it’s also useful to consider how regulatory reform, including a non-bank resolution authority to make sure firms could fail, will actually change the market as we know it. The Financial Times’ Alphaville blog had a nice post by Stacy-Marie Ishmael on this yesterday, merging the thoughts of Moodys, S&P and Barclays. In short, big banks will be worse off pretty immediately. But that shouldn’t come as a surprise.

Here’s what Barclays says, via FT Alphaville:

Resolution authority increases the risk of bank bonds because it reduces the probability of future government bailouts and increases the uncertainty of recovery upon failure. We expect bank spreads to remain wider than industrial spreads as financial services reform moves toward enactment…

Over the past few days, I’ve argued that a resolution authority might actually provide systemically relevant firms with some completive advantage. I still think that’s true, but I also think Barclays is right to assume that banks will initially face higher borrowing costs — depending on how the resolution authority actually works.

The assumption that I think Barclays is making is that the debt of these firms will not be part of the bankruptcy costs paid for by the resolution authority. That’s probably right — at least I wouldn’t think debt obligations would be paid in full, if at all. That means that this debt goes from having an implicit government guarantee, as it does currently, to being subject to failure. And as GM’s and Chrysler’s bankruptcies have shown, the U.S. government tends not to treat creditors too nicely when it controls bankruptcy.

So by how much will big bank debt ratings be affected? FT also provides this nice chart from Barclay’s report:

As you can see, the government’s implicit guarantee is having a real effect on big banks’ borrowing costs currently. That’s bad for competition. As soon as these firms are subject to failure, that should change.

The big question that remains, then, would be just what costs of failure will be covered by the resolution authority, as these banks will retain some competitive advantage if certain kinds of costs or relationships are protected. Even if their debt loses any government backing, other products, like derivatives, may be fully or partially guaranteed by the resolution fund to ensure market stability despite a big firm’s default. That might not affect the big banks’ ratings, but it will definitely increase other firms or customers’ willingness to do business with them, instead of their smaller, non-systemically regulated competitors.

I just complained about how the government does too much to prop up some industries. Perhaps the most obvious example of this over the past few years has been residential real estate. Washington bailed out Fannie and Freddie, offered a home buyer tax credit and spent billions to prevent foreclosures, to name just a few of numerous tactics used to prop up housing. Another way it has done this for nearly a hundred years is through mortgage interest deduction. By allowing taxpayers to deduct their mortgage interest from their taxable income, they have a greater incentive to buy a house. Is this a good idea?

An article by Agnes Crane from Reuters Breakingviews argues against this concept today, and I largely concur with her analysis. I don’t see any compelling practical or even philosophical reason why home ownership should be encouraged by the government. There is neither shame in renting nor virtue in owning.

But when you look at the details of mortgage interest deduction up close, you begin to see how ugly it really is.

Arbitrary Taxation

First, think about what it means when a homeowner manages to pay less in taxes than a renter. Assuming they both had the same income and their other deductions were identical, the homeowner gets an additional tax break merely because she chose to purchase a home. How is that fair? That would be like if the government arbitrarily decided that the diamond industry was worth supporting, so it allowed anyone who happens to buy jewelry containing diamonds to deduct the expense from their taxes.

Encourages Greater Indebtedness

Oddly, the incentive increases with greater indebtedness. Generally, the bigger the mortgage, the more interest you pay and the more taxes you can write off. No wonder America loves debt so much.

Lowers Tax Revenue

Also, think about what it means when a homeowner pays less in taxes due to the credit. That lowers tax revenues. If we lived in a world where the government had an easy time paying for all of its spending, then that might not much matter. But that’s the opposite of the world we live in. The government can’t afford to allow people to have a tax break for purchasing a home as its own debt continues to expand.

Regressive Taxation

Finally, the deduction leads to regressive taxation. The richer you are, the bigger a mortgage you can afford. That will result in more interest deduction and a lower effective tax rate. Crane begins to make this point in her analysis:

The high income needed to take advantage of this tax benefit undercuts the claims of supporters that tax deductibility of mortgage interest promotes home ownership, which almost all Americans seem to assume is a good thing. In fact, it is a distortion in favor of those who need the least help.

Precisely right. And homeowners with smaller mortgages and lower incomes will likely end up taking the minimum deduction anyway, as the amount of interest they pay often won’t exceed the $11,400 standard deduction for a married couple. So their effective tax rate will be unchanged while that of wealthier Americans could be lowered substantially through a hefty mortgage interest deduction.

Unfortunately, repealing the mortgage interest deduction is politically toxic. It isn’t easy to tell the millions of homeowners who have enjoyed taking the credit each year for decades that it will suddenly disappear. This is also the wrong time to make home ownership less attractive, as the broader economic recovery will benefit in the near-term with a stabilized housing market.

But once the economy is fully healed and debt reduction eventually ramps up — and it must — the mortgage interest deduction seems a prime candidate for elimination. Doing so would bring in hundreds of billions of dollars in additional tax revenue each year.

Today, housing finance was the subject of a hearing conducted by the House Financial Services Committee. Most of the discussion focused on Fannie Mae and Freddie Mac. Testifying first was Treasury Secretary Timothy Geithner. The Treasury has already made clear that it has no intention of offering a plan for fixing the government-sponsored mortgage entities (GSEs) this year. So, the two-and-a-half hours of testimony mostly consisted of Geithner providing some high level analysis and philosophical thoughts, instead of offering any tangible reforms for Fannie and Freddie.

His full testimony can be found here (.pdf). But the real fireworks began with the questions and answers. First, Democrats and Republicans bickered among themselves about whose fault it was that the GSEs had grown so out of control. The truth is that both parties are to blame. Anyone in Congress who wanted to shrink Fannie and Freddie was part of a small minority prior to the crisis.

When it came to questioning Geithner on the GSEs, the committee members seemed pretty underwhelmed with the answers he provided. A few wanted more specific plans of action for fixing the GSE problem, which the Treasury isn’t ready to provide. This led to a few heated exchanges between Geithner and several representatives. The Treasury plans to collect information this year to determine what action should be taken. It will then present a plan for Fannie and Freddie sometime in 2011. Geithner maintains that it would be unwise to try to reform the GSEs prior to a full housing market recovery.

So what are some of those philosophical principles? Here’s one that I find particularly important, from Geithner’s testimony:

Avoidance of privatized gains funded by public losses. If there is government support provided, such as a guarantee, it should earn an appropriate return for taxpayers and ensure that private sector gains and profits do not come at the expense of public losses. Moreover, if government support is provided, the role and risks assumed must be clear and transparent to all market participants and the American people.

The key implication here likely has to do with the fact that Fannie and Freddie were private corporations with an implicit government guarantee. When they ran into trouble the government was forced to step in, to the tune of hundreds of billions of dollars. So you had a situation where the GSE’s investors and executives were making a great deal of money at the ultimate cost of taxpayers. Let’s hope that whatever the Treasury comes up with next year avoids this problem.

But I actually see this point as more broadly defined than this simplistic interpretation. The government has very much been in the businesses of propping up private business at the cost of taxpayers for decades — even in times of economic prosperity. The bailouts during the financial crisis weren’t unprecedented from a philosophical perspective as much as they were in their size and transparency. Whenever the government props up an industry, taxpayers foot the bill. And when it comes to housing, even if the government somehow manages to privatize the GSEs, it still will likely continue to prop up residential real estate in other ways. (More on this in my next post on the mortgage interest deduction.)