Is the Panic Overblown?

Every headline feels like an explosion. But is the root cause of this mess--the housing crisis--really that bad? Is the U.S. overreacting?

Read on for some illuminating statistics from the Federal Reserve that shed fresh new light on the number of borrowers and homes that are really in jeopardy in the housing crisis.

As banks sit staring morosely at a moldering dustheap of damaged mortgage bonds, two experts who have examined housing data now say a better bailout would be to rescue borrowers directly, which would put a floor under these Kryptonite securities.

First the Headlines

*Central banks around the world have ordered interest-rate reductions in a synchronized move to fight the global credit crisis contagion, with the Federal Reserve slashing the federal funds rate to 1.5%. The rate cut comes after the Fed, for the first time, said it would lend directly to nonbanks by providing unsecured lending in the commercial paper market, as the commercial paper market has contracted to $1.6 tn from $2.2 tn a year ago. Companies use the commercial paper market to fund their day-to-day operations.

*Three weeks ago, two money funds broke the buck, having lost up to 3% of their investors' money on supposedly high-grade bond investments in financial institutions like Lehman Brothers and Washington Mutual.

*Panicked investors yanked $200 bn out of the $3.3 tn money funds market, fleeing to government-backed Treasurys. The Treasury Department then announced a temporary guarantee of some existing money market investments, though not enough to stop investors bolting.

*The government enacted a $700 bn bailout bill to buy Kryptonite, mortgage-related securities from damaged banks, but capital is slow in coming to these companies as the Treasury must now take time hiring portfolio managers and setting up its auctions to buy hundreds of billions of dollars in murky securities.

*Thirteen federally insured banks and savings and loans--including two major thrifts--have failed this year, and more collapses are expected, reports note. The deposit insurance fund is now at $45.2 bn--below the minimum target level set by Congress and the lowest it has been since 2003, reports indicate.

*If a major bank went down, the Federal Deposit Insurance Corp. could be forced to borrow money from the Treasury. The FDIC approved a proposed increase in premiums that will more than double the average paid by U.S. banks and thrifts next year to replenish that fund.

*Meanwhile, news that would have grabbed headlines around the country has flown under the radar screen due to the chaos. U.S. auto makers got a sweet $25 bn loan bailout--in return, they are supposed to use the loans to make more fuel-efficient cars, leading taxpayers to wonder, "aren't they supposed to be doing this on their own anyway?"

More Borrowers Under Water

The Wall Street Journal reports that about one in six U.S. homeowners are "underwater" on their mortgages, meaning they owe more on their loans than their homes are worth--raising the possibility of a rise in defaults and more pressure on an already hurting economy.

The WSJ reports that about 75.5 mn U.S. households own the homes they live in. After a housing slump that has drove values down 30% in some areas, roughly 12 mn households, or 16%, owe more than their homes are worth, according to Moody's Economy.com. The comparable figures were roughly 4% under water in 2006 and 6% last year.

A Better Bailout

Republican presidential candidate, Senator John McCain, has proposed that the government buy bad mortgages and rework their terms to keep people in their homes, an idea that is already in the government's $700 bn bailout bill, under section 110 of the new law.

That section says that the government will buy "troubled" assets, including mortgages, and then modify their terms to "minimize foreclosures."

In an earlier blog, I noted a similar idea from R. Glenn Hubbard, former chairman of the President's Council on Economic Advisers under President George W. Bush, and Chris Mayer, an economics professor at Columbia Business School. Their plan aims to directly put a floor under housing--and in turn, distressed mortgage securities at the white-hot core of the crisis--by bailing out borrowers (see "Forget the Bailout: Here's a Better Way").

Specifically, they propose that the government let all borrowers refinance their loans into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac.

The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth, the two say, adding that lower interest rates will mean higher overall house prices.

Under this plan, homeowners would have to forfeit their right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home.

Similarly, economist Edward Yardeni suggests the government use the $700bn "in a way that is most likely to end the credit crisis immediately. Let's buy up all the subprime and alt-A mortgages that were delinquent or in foreclosure as of August 2008. That's all we have to do. We should have done this six months ago. I don't think it is too late to do it now."

The Plan is Doable

Yardeni dug into the Fed's Web site and found "a gold mine of information on these nonprime mortgages" gathered by the mortgage market research firm FirstAmerican CoreLogic.

Here are the housing stats he found, and the math behind his plan. The numbers are revealing:

*The number of housing units in the U.S. is 115.9 mn.
*The number of subprime and alt-A mortgage loans was 2.92 mn and 2.26 mn in August.
*The average mortgage balance of subprime and alt-A loans was $183,917 and $321,572, respectively.
*The number of interest-only subprime and alt-A loans were 335,035 and 627,022.
*The percentage of subprime and alt-A loans with adjustable rates were 62.9% and 53.1% respectively.
*The average current interest rate on adjustable subprime and alt-A loans was 8.81% and 6.55%.
*The percentage of ARMs resetting in the next 12 months was 30.5% for subprime loans and 4.9% for alt-A.
*The percentage of all subprime mortgages that were "troubled"--delinquent by 60+ days or in foreclosure--was 25.7%. The comparable percentage for alt-A was 11.9%.

What's Really at Stake

Based on the above data, Yardeni figures that:

*The values of subprime, alt-A, and all nonprime mortgage loans was $537 bn + $726.8 bn = $1,263.8 bn.
*The "troubled" nonprime loans totaled $138 bn + $86.5 bn = $224.5 bn.
*Over the next 12 months, resetting subprime and alt-A mortgages will be $163.8 bn + $35.6 bn = $199.4 bn. Some of these must already be included as "troubled," while others will undoubtedly become troubled when they reset, especially if they are tied to Libor, which has soared.

Yardeni notes: "Can you believe that we are going through all this turmoil over a measly $224.5 bn in nonprime mortgage loans that were noncurrent in August! Such a small amount of toxin has poisoned so many securities."

So Yardeni suggests: "Let's surgically remove the toxic assets from the mortgage-backed securities" by having the government "purchase as many of these mortgages as possible."

He adds: "In exchange for their toxic nonperforming nonprime mortgages, portfolios will get cash from" the government.

"That should increase the marketability and the market value of such portfolios even if it is difficult to root out all the toxic assets," Yardeni adds, noting that the government "would have plenty of money left over to purchase other distressed assets, like leverage corporate loans, if necessary."

The government's implementation issues with this idea "should be easily and rapidly surmountable given the urgency of stopping what is increasingly turning into a global financial and economic collapse," Yardeni says, but notes that the new bailout bill gives Henry Paulson, Secretary of the Treasury, sweeping new powers that could get this idea enacted rapidly.