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THE MIAMI MIRROR TRUE REFLECTIONS

El Punto Final
by David Arthur Walters November 20, 2008 MIAMI BEACHThe economy is worsening and the number of foreclosures has increased and is expected to get larger. At this time, the vast majority of homeowners, the Forgotten Homeowners, are simply making their payments and may continue to do so until the government comes up with a program that awards them with a loan modification to default on their loans. Not much has been done in the way of foreclosure relief. A mere few thousand mortgage loans have been modified, and a quarter of them are in default again. The chief bureaucrats are bickering over what approach to take, and how to persuade private holders of mortgages to voluntarily cooperate with any such approach. Thus far no government official that we know of is championing the one loan modification that has been crucial to the resolution of similar problems in the past; in fact, authority for that modification is provided in the Paulson Bailout Bill: reduction of loan principal. Across-the-board reduction of loan principal, when the amounts owed are much larger than the collateral is presently worth, is naturally anathema to lenders, especially when the value of the collateral is expected to recover any time soon. But the borrower may not expect such a recovery; and in any event he
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might not want to pay for lost equity he can no longer borrow on: he might prefer to just walk away and rent a place to live, and perhaps re-enter the market when he stands to gain some equity instead of lose his shirt. Analysts were rightly worried all along about the effect speculators were having on condominium construction and prices in Miami and other markets. Speculators, who never intended to live in the units they purchased, were flipping their condos for substantial gains even before they took title. Buy now, pay later, is the old standard refrain. Credit standards were incredibly low, and now the bill has come due with a vengeance for those people who do not have the cash or further credit to pay it. Many working stiffs feel cheated out of the homes they never would have been able to obtain without lowered credit standards; they blame the realtors and lenders for their predicament, and might vandalize their homes before moving out. But a speculating immigrant, a practical nurse in New York, bought three luxury condos in Florida on speculation, she blames the collapse on the vagaries of the market and the alignment of the planets; she would take another chance at good fortune if she had the credit to make another wager if the tide were rising again. Let us not forget that there is a speculative factor at play even when people purchase residences to live in, and also think of the purchase as an investment. Ordinary people are actually speculating on a rise in prices because, despite recent experience, real estate prices may stagnate for decades. It is not, as our generation has said, always better to own than to rent.
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Naturally, there are more speculators and investors in higher income brackets than in the lower brackets. Lower income homeowners find compensation enough in simply having their own home to live in, and may take pride in it to such an extent that they are often, paradoxically, less likely to default than those who think of their residences as more of an investment than as a home-sweet-home. One Charles W. Calomiris not only believes in reduction of loan principal but he also believes taxpayers should pick up the tab for part of the writedown. His views are well worth noting, as he is the Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business, and has enjoyed such positions as Professor at Columbia's School of International and Public Affairs, Research Associate of the National Bureau of Economic Research, and was a Senior Fellow at the Council on Foreign Relations, CoDirector of Project on Financial Deregulation and Arthur Burns Scholar in International Economics at the American Enterprise Institute, and Member of the Shadow Financial Regulatory Committee. His has some hands-on banking experience he was Chairman of the Board of a troubled bank, the Greater Atlantic Financial Corporation, a position his esteemed father, William Calomiris, a Washington, D.C. real estate magnate, left him and has written erudite tracts on banking crises. His papers, "Consequences of Bank Distress During the Great Depression" (with Joseph Mason), in the American Economic Review (June 2003), "Fundamentals, Panics, and Bank Distress During the Depression" (with Joseph Mason), in the American Economic
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Review (December 2003), are well worth reading. We first encountered him in his October 14, 2008 Forbes Commentary, How To Prevent Foreclosures. A more modest proposal than that of Sen. McCainwould follow the example of the successful Mexico Punto Final plan of 1999, which resulted in substantial debt write-downs very quickly and the resolution of much financial gridlock in that country. The government would share losses borne by lenders from mortgage principal write-downs on a proportional basis. For example, taxpayers could absorb 20% of the write-down cost borne by lenders on any mortgage so long as it is agreed through a voluntary renegotiation between lenders and borrowers, and so long as doing so creates a sufficient write-down for borrowers to be able to qualify for refinancing. He explains that lenders would be far more apt to modify the principal amount if the cost of doing so is shared by taxpayers in such a way that the total cost to the bank is less than what it would be if the bank foreclosed. We note well Professor Calomiris interest in deregulation and his association with the American Enterprise Institute, a neoconservative think tank with which the Bush administration has so many ties, and we wonder why he would therefore propose such a monumental intervention by means of government funding of mortgage principal write-downs. The cynical leftist might fall back on the great right-wing conspiracy theory, that the neoconservative agenda made wildly popular by Ronald Reagan, who in 1988 said that "The American Enterprise Institute stands at the center of a revolution in ideas of which I, too, have been a part, was to unleash Greed and
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eventually bankrupt the government, leaving it with just enough funding to wage war and protect the property of baron robbers from peasants and proletariat. On the other hand, perhaps the professor, who is, after all, a professor at Columbia, is simply being objective, and is just as sincerely concerned as Henry Paulson is with closing the gap between rich and poor by broadening the homeowning middle class, voluntarily. However that may be, the evidence seems to support the notion that reduction of principle might go a long ways towards alleviating the foreclosure crisis. For example, take the 2000 study, The Mexico Mortgage Market Boom, Bust and Bail Out: Determinants of Borrower Default and Loan Restructure After the 1995 Currency Crisis published by the Joint Center for Housing Studies at Harvard University. Secretary Paulson might find work authored by Natalie Pickering, an Associate at Goldman Sachs at the time, pleasing, for it seems that "the best and brightest" in finance are associated with that illustrious firm. He has been severely criticized for stacking his recovery team with Goldman Sachs associates because that investment banking firm, lead by his good self, were instrumental in bringing on the financial ills we presently face. But the causes may better effect a cure, if the homeopathic approach has merit, so let the wizards have at it. We take brief excerpts from Dr. Pickerings paper for good health: This paper examines borrower choice to default or restructure mortgage loans under the initial phase of the [Mexican] government relief program called The Accord for the Assistance of the Banking
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System or ADE. It uses microdata from a commercial bank to test whether it was borrowers net equity or ability-to-pay that primarily drove them to default or restructure. Under the assumption that it was primarily an ability-to-pay problem that drove default, the ADE provided borrowers with an interest rate subsidy, and later a monthly payment subsidy, if they restructured their loans. However, the results here show that it was borrowers net home equity that primarily influenced the decision to default or restructure and that lower income borrowers were both less likely to default or restructure, choosing instead to continue paying under their original loan contracts. The ADE program was an inappropriate policy response to borrower default. Higher relative wealth and income were actually associated with higher default rates as well as higher restructure rates. Low income borrowers were more apt to continue paying on their original loans. The results provide new evidence in the longstanding debate on the causes of mortgage default. Over the years this debate has centered on the question of whether the borrowers net equity position in the house or ability to pay drives default. Cunningham and Capone (1990) were among the first to synthesize the evidence in the United States, and they concluded that for both fixed and adjustable rate mortgages, equity was of greater importance than ability to pay in predicting default. Subsequent research has conceptualized default as a financial put option and focused on the so-called ruthlessness with which borrowers exercise this option.

THE MIAMI MIRROR TRUE REFLECTIONS

The results presented here reveal that discounts directly off the loan balancenot payment discounts--were needed from the onset of the crisis to encourage restructure and stem default. In fact, such balance discounts were ultimately granted in a much later borrower relief program called El Punto Final (January 1999). This study points out that it was possible to predict, based on data available as early as May 1996, that balance rather than payment discounts would be a more effective policy measure. It also shows that payment discounts had a regressive distributional effect. This sort of discussion would normally put the average reader to sleep, but given the severity of the present crisis and the impact it might have on his well being, the patient is advised to stay with us for another dose: Nearly two decades of research on mortgage pricing have shown that default should be viewed as a contingent claim attached to the mortgage contract. Lenders sell a put option when they originate a mortgage that explicitly allows the borrower to relinquish the home at the price of the mortgage. When the value of the outstanding loan exceeds the value of the house, the put is in the money and a rational, wealth-maximizing borrower will default. Mexican mortgage holders have largely responded, as financial theory would predict, by exercising the put option to default on their loans. The ADE program, by giving payment discounts, did not affect borrowers negative equity and did not address the root cause of default. In fact, the results presented here show that this policy decision was also regressive in that lower income borrowers were
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less likely to participate in the program choosing instead to continue paying on their current mortgages. High and medium income borrowers were more likely to default or to restructure and thus receive the benefits of these discounts. Many loans fell into delinquency subsequent to restructuring. Some claim that because payments rose with inflation under the restructured contracts, borrowers became delinquent again when they were unable to keep up with payment increases. Others point out that the ADE program only provided borrowers with an opportunity to defer foreclosure, but borrowers participation in the program did not represent a greater willingness to pay. Later evidence suggests that many borrowers did restructure only to fall into delinquency again. Foreclosure deferral was a plausible motivation for this behavior, but payment increases were not. A more likely reason is that since many borrowers were still in a negative equity position following restructure, they were rationally exercising the option to default even subsequent to the ADE.This is not to say that default was only brought on by negative equity. Borrowers have suffered payment problems due to a decline in income under the old and new contracts alike. In addition, the systemic rise in default has made foreclosure even more difficult for banks. Moral hazard has plagued the mortgage market, creating excessive administrative burdens for banks and courts alike. Many borrowers, recognizing that banks are unable to possess their properties without an extended and costly court case, have chosen nonpayment as a means to obtain a discounted settlement with the bank. The results of this study
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would suggest that higher income borrowers, who here show a propensity to default even when holding positive equity in their homes, are more adept at receiving these discounts. Again this leads to a regressive outcome for resolving the delinquency problem. The results of this study point out that basic research on the causes of borrower behavior in the mortgage market would have aided the government in designing a relief program that better addressed the causes of default and benefited lower-income borrowers. Direct discounts off the balance of the loan would have been a more effective policy for stemming default and encouraging restructure. Eventually, nearly three years later, the government did decide to support banks in granting such discounts through a program called Punto Final. By this time, however, borrowers had grown to expect a new relief program each time delinquency rose. Strategic default was well cultivated in the market making it ever harder to attain positive results even from a well-designed program. Successive policy failures, such as that of the ADE program, helped nurture a culture of non-payment. Only betterdesigned policy initiatives t hat take into consideration the causes of borrower choice can reverse this trend. El punto final is the final point, the final reckoning, meaning in our context, the last chance. Professor Calomiris puts the Punto Final plans best foot forward in Forbes, but elsewhere, in a paper on financial debt restructuring, A Taxonomy of Financial Crisis Resolution Mechanisms: CrossCountry Experience, World Bank Policy Research Working Paper 3379, August 2004, with scholars
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Daniela Klingebiel and Luc Laeven, serious doubts were expressed. Both financial doctor and patients should find the following brief excerpts edifying if they are not to big to swallow: "As an example of government sharing of loan losses, we consider the Punto Final Program in Mexico. The Punto Final Program in Mexico For three years, the FOBAPROA program initiated in 1995 had failed to reduce the amount of past due loans and to provide debtor relief. In a final attempt to offer debt relief, the government initiated in December 1998 the Punto Final program, which was a governmentled debt-relief program targeted to mortgage holders, agribusinesses, and small and medium-sized enterprises (SMEs). The program offered large subsidies (up to 60% of the book value of the loan) to bank debtors to pay back their loan..." "Although both the Punto Final program and the FOBAPROA program combined an element of loss sharing between the government and the financial institutions, there were four key improvements of the Punto Final program vis--vis its predecessor. First, loss sharing was geared toward small loans, as the discount offered was higher for smaller loans. Small borrowers are a desirable group to target, since assisting them improves competition in the economy, and since assistance channeled to these borrowers is less likely to result from their political or economic power over governments or financial institutions. Second, the loss sharing arrangement offered an incentive for banks to restart lending to SMEs and individuals because it linked the size of government assistance to the amount of new lending by the participating bank. Third, the program may have
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made more effective use of taxpayers' resources, because it relied on borrowers' willingness to participate, and it required borrowers to pay part of their outstanding loans. Borrower self-selection, in principle, can reduce the number of participating borrowers, and reduce taxpayers' cost of resolution per borrower by requiring borrowers to repay part of their loans. Just as important, self-selection may ensure that participants are more likely to be those that were "worth helping." The borrowers willing to repay part of their loans should be those that value access to credit in the future, which also tend to be more value-creating borrowers. The FOBAPROA program, in contrast, had not been selective, and had greatly benefited large borrowers at high cost to taxpayers, irrespective of the desirability of assisting them, and even if those borrowers were not in default. Fourth, unlike its predecessor, the Punto Final program offered to quickly resolve ongoing disputes between creditors and debtors, and thus made it easier to analyze the balance sheets of participating borrowers and banks going forward. Resolving the uncertainty about how much of their preexisting debts would be repaid is a key requirement for analyzing the balance sheets of borrowers when making new loans. Debt resolution, in theory, should help to make credit available to creditworthy firms. Despite these potentially attractive features, it would be premature to declare the Punto Final program a model of successful restructuring." "The selectivity that comes from conditional programs like Punto Final can result in better targeting of taxpayer resources toward borrowers
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that were worth saving, because of the type of borrowers that will self-select into the program. In the case of Punto Final, resource savings and effectiveness probably were enhanced by the fact that the program focused primarily on SMEs and other small borrowers, which are less likely to be entwined in the too often corrupt iron triangle of banks, conglomerates, and government officials. Furthermore, by linking assistance to new credit supplied by banks, the Punto Final program helped to further its goal of restarting the credit supply process more than an across-the-board subsidization of write 21 downs would. Finally, because conditional subsidization requires borrowers to share somewhat in the costs of financial sector subsidies, the adverse incentive effects of these subsidies for future borrowing and lending behavior will be less than for unconditional subsidies of write downs. For all of these reasons, conditional subsidization of loan losses through a program like Punto Final seems superior to across the board subsidization of loan write downs by bank" "If the goal is a large-scale restructuring of the financial system, the microeconomic advantages of selectivity must be traded off against the macroeconomic advantages of large-scale improvements in corporate debt capacity and bank net worth. For that reason, to be effective, the Punto Final model would have to be applied to a significant share of the population of borrowers (not just SMEs). The strengths of Punto Final, however, are mainly confined to assistance to SMEs, where concerns about corruption in the implementation of selectivity, and concerns about inefficient use of resources to
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prop up powerful conglomerates may not be as great. Finally, we note that conditional subsidies and across-the-board write down subsidies share some of the same limitations. Neither approach distinguishes among banks with respect to the allocation of assistance. Indeed, banks that made the worst lending decisions prior to the crisis will receive the most assistance after the crisis. Thus neither approach does much to address the adverseselection and moral-hazard problems of providing assistance to insolvent banks." "It is difficult to assess the effectiveness of the Punto Final program, not least because it was preceded by, and coincided with, numerous other financial support and debtor relief programs. After all, the Punto Final program, as its name indicates, was intended to finalize the bailout of the banking sector and the debtor relief program in Mexico. There were also other positive developments: growth, increased banking sector income, and foreign entry into banking, which improved the condition of banks and the supply of credit during this period. Nevertheless, despite the difficulties of attribution, we note that the banking system did show some improvements in indicators of asset quality, profitability, and capital adequacy during the years 1997-2000, and that Punto Final may have played a role in those improvements.... Past due loans to total loans excluding FOBAPROA decreased from 17.6 percent in 1997 to 8.5 percent in 2000. The improvements in asset quality largely reflect the conclusion of debtor relief programs through the Punto Final program (IMF 2001a). 20 However, even with additional debt relief offered under the Punto
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Final program, bank lending did not restart as expected. Bank credit to the private sector has contracted from about 19 percent of GDP at end1998 to 10 percent of GDP at end-2000." "We were unable to undertake a microeconomic analysis of the Punto Final program to determine the extent to which the allocation of assistance was executed fairly and efficiently owing to a lack of available data. That lack of data, in part, seems to reflect the political climate of Mexico and the political controversies that surround debt relief programs." Must something be immediately done to ameliorate foreclosure pain in the current crisis? Federal Deposit Insurance Corporation Chairwoman Sheila Bair thinks so: "The root cause of the current economic crisis is the failure to deal effectively with unaffordable loans and unnecessary foreclosures," she testified at the TARP oversight hearing. Conservatives might think that the root cause of the crisis was in making the unaffordable loans in the first place, and that the best way to deal effectively with the unnecessary crisis is to foreclose on the collateral, sell it, and write off the balance. The ulterior aim of writing and selling mortgage-backed securities and other collateralized debt obligations, and then the so-called insurance derivatives called credit default swaps, was to offload the risk onto someone else willing to take the gamble. Mission accomplished; let the gamblers fall under the load, not the taxpayer. Why not take a page out of the neoconservatives playbook, before the neocons cowered and ran to Congress for a handout, and let them fail? If we heed the ambiguities proffered by Steve Forbes and the like, government is damned
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whether it intervenes or not, and it probably only prolongs the pain when it does. Maybe the foreclosure issue should be put on the back burner for now: When questioned, Secretary Paulson said he had to save first things first. First of all, the financial system had to be saved, and, for the time being at least, that mission had been temporarily accomplished. "Congress passed legislation to deal with financial instability, and that is what we are doing," he said in response to complaints at the November 18 TARP oversight hearing. Well, we must admit that, if the worst case scenario for foreclosures came true, and all those debtors foreclosed upon were thrown out of their homes and had to rent some place to live or live under viaducts, more people in the United States would still own their own homes than in any other country in the world. Eventually the foreclosed homes, given falling real estate prices, would be purchased by someone else. But if the banking system went down, that would be the end of the world as we know it. Policy architects must consider the greatest happiness of the greatest number; undoubtedly pain will be keenly felt by some in order to achieve that end, so let the sacrifices be voluntary. We should not worry so much about the administrative inconsistencies, or bother to call leaders like Secretary Paulson hypocrites instead of pragmatists for changing course in midstream because the facts have changed: we certainly would not call a man a hypocrite for changing his clothes! Facts that seemingly fly in the face of policy should
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be conveniently written off as political misconceptions of divine providence or justified as Gods unfathomable mysteries. After all, " A foolish consistency is the hobgoblin of little minds."(Emerson). Mr. Paulsons actions do not really vary from the overarching policy: "Congress passed legislation to deal with financial instability, and that is what we are doing," he rightly declared, as we can see if we reread the Purpose of the Act above. The Secretary Treasurer acted as he thought best, and acted according to the discretion delegated. The overseers and inspectors general may complain as they like but they may not undo what has been done. His behavior was bound at the outset to be consistently inconsistent in a sense, because history never precisely repeats itself. History, after all is said and done, is always a mistake, for only Nothing is perfect; the Ideal can never be truly realized in this absurd dimension given the limitations of our fundamental categories. Whatever we have done, we might be sorry for it, but it could have been much worse. We are moving on, looking forward to our El Punto Final with high hopes for the afterlife.

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