Saturday, March 15, 2008
Much Ado About Nothing
"We've seen some puzzlers over the years, but we never expected to see a [Fed] Chairman talking down the capital cushion of the nation's banking system. ... Voluntary loan modifications aren't doing enough to stop foreclosures, declared the chief steward of the U.S. financial system. 'In this environment,' he said, 'principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.' ... Bernanke's broadside might well hamper these volutary workouts by signalling to other borrowers that they needn't do anything at all", Editorial at the WSJ, 6 March 2008.
These must be the end times, I agree with Helicopter Ben (HB), disagree with the WSJ and say it is making, with apologies to Shakespeare, much ado about nothing. Does anyone at the WSJ understand discounted cash flow analysis? I'll illustrate with an example. Suppose A buys a house for $300,000. It's value rises to $400,000 and he refinances taking all the equity out with a 30-year fully amortized loan at 6.5%. My HP-17B says he makes 360 monthly $2,528.27 payments. Now the house drops in value to $320,000. A decides to walk away from the house, in effect "selling it to the bank". The WSJ apparently thinks the bank should "modify" the loan by reducing A's interest rate to say 4%. That reduces A's monthly payment to $1,909.66. However, the bank could reduce A's principal balance to $302,129 ($1,909.66 / $2,528,27 X $400,000). What's the big deal? This is an accounting issue. In the second instance the bank records a $97,871 ($400,000 -$302,129) loss. Economically I see no difference. The cash flows are what they are. You can apply whatever discount rate you want to them. HB's point is, I think: the homeowner is less likely to walk away from a house if he feels he has some equity in it. If the bank reduces the homeowner's principal balance it appears he has $17,871 in equity ($320,000 - $302,129).