YES WE CAN SAVE HOMES!

In high school, my AP Lang professor had a quote on her wall; it read something to the effect of, "how do I know what I think about something until I read what I say about it."  The best part about having a blog is that I can write down what I think, and try to make sense of it after reading it.  This is my attempt to do that with respect to Obama's housing initiative that was revealed yesterday: 

Surprisingly, the plan doesn't suck.  The financial incentives for the lender and the borrower to modify the loan and then timely service the debt are promising.  I've separated my thoughts pursuant to the three different aspects of the plan

FIRST

Some quick facts about the plan for delinquent borrowers or those that are at imminently at risk of defaulting:

• Banks are encouraged to modify delinquent loans.  They are given $1000 each time they successfully modify a loan, and $1000 for each year (for up to 3 years) if the borrower stays current on the loan.  There is a greater incentive to modify a loan where the borrower is imminently at risk of defaulting as compared to a loan where the borrower has already defaulted.
  • In order to successfully modify a loan, the plans calls for banks to reduce the monthly payment of the borrower to 38% of the borrower's monthly income.  After that, the government and lender, together, will subsidize a reduction of monthly payments (by lowering interest rates) even further - to 31% of monthly gross income. 
• Delinquent borrowers can get $1000 in principal reductions for 5 years if they stay current on their modified loan

I'm not positive about the definition of "successfully modify a loan" though, so don't quote me on it.  The details of the plan in the WSJ are a bit sketchy, and to some extent, I assumed they meant what I wrote since they scattered the details of the plan over 4 different articles.  But, as always, I think I'm right.

I like this plan for delinquent borrowers because it:

• Encourages lenders and borrowers to modify the terms of the loan on their own, and it keeps the borrower in the home. 
  
  • Keeping the borrower in the home will reduce the inventory of homes that are on the market currently, and ultimately, put an end to falling (and possibly a start to rising) home prices.  To the extent that falling home prices is the root of the credit crisis (banks are not lending and have substantial losses because of defaults), the credit crisis will end.  
• Requires the banks to actually reduce interest rates to some extent.
  • In order to drop the monthly payment of the borrower from 38% to 31% of income, the bank, with a subsidy from the federal government, must actually reduce interest rates on the loan.  Notably, this is different from the requirement that the bank reduce the monthly payment to 38% of the borrower's monthly income; to meet that requirement, the bank can simply extend the period of the principal payments over 40 years rather than 30 years.  To meet the requirement that the bank reduce monthly payments to only 31% of the loan, the bank must actually reduce interest rates on the loan.  I think there is a universal feeling that banks screwed up in the past few years, and to the extent that the second requirement of interest rate reductions makes them pay, I like it.
• Gives the borrowers an incentive to remain current on their modified mortgage
  • Borrowers are given interest rate reductions as noted above and principal reductions if they remain current.  To the extent that borrowers have a small amount of negative equity in their home, this should end that plague.  Not only is their principal reduced, but as home prices rise, these borrowers will again have a positive equity in their home
• Targets the right people
  • I like how it targets delinquent borrowers and those that are at imminent risk of default.  This is going to the core of the problem.  I also like how there is a greater incentive to modify before default as compared to in default. 

I generally don't like the idea of government subsidies, but we're obviously going to have some type here, and these aren't that bad.  I realize that the plan will only help homeowners who have a monthly payment that is close to 38% of their monthly income; banks will not attempt to modify loans of borrowers who have lost a substantial portion of their income or who are now unemployed.  That makes sense; we're not looking to have the government or banks save everyone.  For those whose loans are not modified and are required to foreclose, yes, that will suck. I'm truly sorry, but we can't save everyone.  I wish I could find more things about this plan I don't like, but I think its a great idea.  I'm sure there are things I haven't thought of, and if you can think of some, post a comment please.

 SECOND

Some quick facts about the plan for current loans:

• With respect to those borrowers who are still current on their payments but have little or no equity in their home, the government will offer a method to refinance your loan with today's low interest rates. 
  
  • This feature will only be available for those whose loans were already owned or guaranteed by Fannie Mae or Freddie Mac.  That means that this would part of Obama's plan would only help people who bought homes and borrowed only 80% of the purchase price; it wouldn't help people who borrowed 100% of the purchase price. 

I like the idea of helping responsible homeowners, and to the extent that this plan only helps people who borrowed what they thought they could afford (80% of the purchase price), I like it.  But I have more worries about this part of the plan than other parts.  First, what happens if I purchased a home and paid 20% down, but Freddie or Fannie didn't buy or guarantee my mortgage?  Why should I not be eligible for a cheap refinance simply because the government chose not to buy my mortgage?  Or does the government own/guarantee all qualifying mortgages, making my objection moot?

Second, I'm not so sure that people who borrowed only 80% of the purchase price of their home really were that responsible.  They may have saved up 20% of the price, but should have realized they would have had trouble meeting the mortgage payments after purchasing the home.  For example, suppose Edward saved up 20k and bought a 100k home, with monthly payments of 1500 for 30 years.  Lets say his monthly salary was also only 1800 a month; should we really give help him out?  Shouldn't he have known he was going to be underwater almost immediately? This objection may be mitigated though, by the notion that Edward has probably already lost his house.

THIRD

Finally, I'd like to briefly comment on the idea of bankruptcy judges cramming down new loan terms in bankruptcy.  Supposedly, this is the stick with which the Obama administration will attempt to get lenders to agree to modify loans.  Just a quick comment - don't most foreclosures happen outside of bankruptcy?  That is, doesn't the borrower just walk away from the house and the lender get it?  If so, then a cram down feature may not help unless it gives the borrower leverage to threaten bankruptcy unless the bank modifies the loan.  To this extent, I'm not so sure how genuine a threat this is.  Bankruptcy will forever tarnish the credit ratings of a borrower, and throw any other loan he has into default as well.  I need to think this feature out more, and so I'm holding writing more about this. Also, I've been reading and typing for about an hour now, and should have better things to do.

A. Lincoln

I meant to update my blog on Thursday of last week, but due to my living out of a duffel bag while travelling and having intermittent internet access, I wasn't able to publish an update.

Here is what I wrote (keep in mind I intended to post it on 2/12/09):

Two hundred years ago today, this country's greatest President and most humble citizen was born in a small town in rural Kentucky.  Long before the white temple on the right was built in his honor in Washington DC, he led this country - his country - in a war "greater than that which faced Washington."  Lincoln was to be tested in office time and again: Union commanders were ineffective on the battlefield despite their overwhelming advantages of manpower and machinery; his son Willie passed away in the midst of the Civil War; his wife went insane; he had to (perhaps unconstitutionally) suspend the Writ of Habeas Corpus in an effort to preserve the Constitution....  Lincoln unquestionably made errors of judgment in office; he was not perfect and would never claim to be so.  Still, he worked tirelessly to preserve the Union, and in doing so, he forever sealed the fate of freedom for all mankind.  Our noble experiment did see a new birth of freedom, and today, more than ever, that beacon shines from the Lincoln memorial.

Some people have asked me why I admire Lincoln so much.  I like to say and to think that he was the only President in the history of the country to have lived and died for his country.  His ultimate sacrifice will not be forgotten.  In his memory, I'm heading down to DC to pay my respects.

Federal Government to Start ETF; Symbol: WTF

I initially started drafting a post on Saturday with respect to the bailout plan that Treasury Secretary Tim Geithner was set to reveal this afternoon.  Things changed over the weekend, though; Geithner started backing off his promise to create a bad bank that purchased the toxic assets of other financial institutions.

Things changed again yesterday, when I heard that Geithner was delaying the revelation of his commandments until Tuesday.  And this morning, things changed again when I read in the WSJ that Geithner had decided to start a private bad bank, that would allow private investors to invest in quasi-governmental institution that purchased the toxic assets of financial institutions.  This is a great idea, but from what little I can understand about it, not only ETF behemoth Proshares beat the Treasury department to the idea, so did Adam Smith and every other capitalist. 

I don't get the how this bad bank is going to do anything that cannot be done right now anyway; private investors at the moment can buy the toxic assets of banks (see Merrill Lynch last year) right now without government intervention.  The problem is the banks don't want to sell at fire sale prices because they think the assets may someday be worth something, and investors think the assets are worth pennies (or even less) on the dollar.  How is this new, private, bad bank going to change that?  How is it going to get over the issue of pricing these bad CDO's?  Their nearly impossible to value largely because of the illiquid market for them. 

Investors won't overpay, the WSJ reported, because if they did, "they'd stand to lose money; but they also wouldn't underpay, since the selling banks wouldn't be willing to part with their assets too cheaply."  Wow.  Is this my reading for Business Strategy for Lawyers, or is that the most obvious thing I've ever heard?  The problem is that no one knows what these things are worth, and its hard to accurately price them. 

I've got two side notes to make as well

• Two weeks ago, I heard Proshares indicate they wanted to start an actively managed ETF that purchased mortgage assets from banks at steep discounts.  Isn't this what the federal government is going to propose on Tuesday?  Maybe they team up with Proshares, the first mover in the market...
• The government keeps indicating that mortgages can be modified.  I'm wondering to what extent the servicer of the mortgage (the bank that collects the money on behalf of the investors of the CDO) has the power to modify the terms of the mortgage.  There was an article in the WSJ a few weeks ago where Jamie Dimon indicated that he could modify 88% of mortgages that his bank serviced, even though JPM wasn't the actual owner of those mortgages.  I would have thought that since the investors in the CDO's are/were the ultimate owners of the mortgage, it would have been more difficult for the servicer to modify the terms of the mortgage without their consent.  I guess not?

New Things...

In the past 4 weeks, I've heard that Microsoft is coming out with a cell phone, that Apple is coming out with an iPhone Nano, and that Amazon is set to introduce its new kindle. 

The amazon rumor I believe, but what features can apple strip away from its iPhone to come out with a new, cheaper phone?

I Don't LUV It

 

Yesterday, a friend of mine asked me what I thought about Southwest Airlines (LUV).  I told him that I didn't like it and that Southwest was a poor buy.  I did some research on the company yesterday and this morning, and I still wouldn't buy it.  I have to admit, though, that I was impressed by LUV's 10k for 2008.

Here's why I wouldn't buy it though:

• Its trading at a P/E ratio of 28.30.  You might think that's high, and you'd be right except for the fact that almost every other airline has negative earnings.  Still, an price-to-earnings multiple of 28 isn't great, even if Southwest is still growing.

• In 2008, 78% of Southwest's fuel costs were hedged at $51 per barrel.  This was a genius move by Southwest.  The average price of a barrel was West Texas Intermediate was around $72 in 2007, and somewhere near a $100 bucks in 2008 (I couldn't find the exact value).  Despite their fantastic hedges, Southwest's average cost for a gallon of jet fuel rose from 1.80/gallon to $2.44/gallon in 2008.  In the 4th quarter of 2008, Southwest realized that its hedges would be a liability rather than an asset (crude dropped by about 70% since its all-time high in July).  It sold off its hedged position, and only has 10% of its fuel hedged between now and 2013.  Also, as a consequence of the higher price of crude on its hedge, Southwest estimates that it will be paying16 or 17 cents above market for each gallon of jet fuel until about 2011.  In actuality, this isn't that bad; its competitors also have hedged positions that are out of the money.  Still, airlines operate on razor thin margins and one of Southwest's greatest advantages in the past was its cheap fuel. Now that that is gone, I'd rather sit on the sideline than put my money into any airline. 

• Virgin America is really trying to go head-to-head with Southwest.  Its matching some of Southwest's fares and routes on the West coast.  Although I've never flown either Southwest or Virgin America, I hear that Virgin America is much better (ask Suleman Ali).  Virgin can kill Southwest on the routes where they compete against each other. 

I was going to compare Southwest to Delta, but Delta hasn't released its 10K yet for 2008.  When they do, and when I remember to look at it, I'll try to update.

Until then, stay away from Southwest.