Sunday, February 7, 2010

Job Creation Funding #4: Housing Crisis Financial Relief: “The Double Deduction 90% Double Drop Down”

The US housing crash has been devastating. I think the related government financial rescue plans for this extremely complex issue have not been very effective and also very costly, particularly the housing tax credit programs, which are nothing but temporary, very expensive, US federal deficit increasing, piecemeal band aids.

This proposal addresses financial relief for the housing crisis broadly and I think is an effective initiative in starting to get to the core of solving this devastating multi-faceted problem,which negatively impacts so many people, and which is intertwined with the very troubled jobless recovery picture, with both sky-high unemployment and underemployment, and with very little hope of much improvement on the horizon for quite a while.

All present US government housing crisis plans I am aware of cost the US government tons of money, with a lot more downside potential, but with no upside potential. My proposal here takes a different approach, and in fact, actually should reduce, by a substantial amount, the US Government Federal Deficit over the next ten years. And the potential upside to the US Government could well be off the charts. In fact, I think the total amount raised here could well be enough to cover the present projected TARP funding shortfall. Could that be possible? Read on.

The first part and bulk of this proposal relates to all financial institutions holding home mortgage loans on principal home residences, in which there aren't second mortgages, and where the principal balance of the mortgage loan is more than 90% of the Fair Market Value (FMV) of the home. Thus, this would include all under water mortgages and also ones only slightly above water, which are less than 10% above water. Toward the end of this article, I also have a proposal for the many underwater home mortgages in which there are second mortgages.

First, the US government sets up a US Federal Government Infrastructure Bank to facilitate this whole financing process.

This proposal would apply only to 2010 and relates to any financial institution that sells to this US Federal Government Infrastructure Bank the entire portion of any mortgage loan that exceeds 90% of the FMV of the related home. The selling price would be equal to the excess of the mortgage loan principal balance transferred over the Loan Loss Provision (or Expense) that the financial institution has already reflected in its income statements through the most recent audited financial statements (Dec 31, 2009, in most cases).

If this Loan Loss Provision reflected on the books doesn’t represent the financial institution’s best estimate of its loss on its mortgages, then this financial institution better clean up its books and also fire its external auditors.

Let me give an illustration of how this proposal would work.

Say on Jan 28, 2010, Wells Fargo has a mortgage loan receivable on its books with a principal balance of $300,000. The related home has a FMV of $200,000. The interest rate is say 8% fixed and the remaining mortgage term is say 15 years. Also, assume Wells Fargo has already recorded a Loan Loss Provision on this loan cumulatively of $90,000 in its audited income statements, and thus probably also has included $90,000 in its Allowance for Loan Loss on its audited balance sheet at Dec 31, 2009.

The principal loan balance transferred, or sold, which only can be the maximum under this Double Deduction 90% Double Drop Down proposal, is $120,000 (i.e. $300,000 minus 90% X $200,000). The selling price would be $30,000 (i.e. this $120,000 minus the $90,000 Loan Loss Provision).

Wells Fargo should have no income statement impact on this mortgage sale. It is very important to companies to not get income statement earnings hits for transactions like these. For you financial types, Wells Fargo’s accounting journal entry to record the sale is simply:

DR…Allowance for Loan Loss…90,000
…..CR…Mortgage Loan Receivable……120,000

And after this sale, Wells Fargo is left with a first mortgage with a principal loan balance of $180,000, with the interest rate remaining at 8% fixed, with the term still for 15 years, and with as security, a home with a FMV of $200,000, and thus its initial loan principal balance after sale is precisely 90% of the FMV of the home….thus, the first 90% Drop Down.

The US Infrastructure Bank acquiring this mortgage loan gets a second mortgage on this same home, with a term of 10 years, which also is the CBO scoring period. It reduces the $120,000 loan principal amount down to $30,000, its purchase price. Whew, the homeowner here is elated. But there’s more to this story.

The US Infrastructure Bank charges no interest to the homeowner in the first year, when the US economy is so weak. In the second year, it charges only interest for 50% of the interest rate the home owner is paying to Wells Fargo. Thus, interest for the second year would be $30,000 X 50% X 8% = $1,200, or $100 per month. In the third year, it charges only interest for 70% of the interest rate the home owner is paying to Wells Fargo. Thus, interest for the third year would be $30,000 X 70% X 8% = $1,680, or $140 per month.

For the next seven years, when hopefully the housing crisis is completely over and the US economy is running on all cylinders, the interest rate is 90% (thus, the second 90% Drop Down) of the interest rate paid to Wells Fargo on the first mortgage, or 90% X 8% = 7.2%. The $30,000 is payable monthly with 7.2% interest compounded monthly as an annuity over 84 months (or 7 years), with the resultant monthly mortgage payment of $455.72.

If all of these payments are made, the US Infrastructure Bank would net a positive cash flow over the next ten years of $11,160, the cumulative interest received. And also the $30,000 loan principal was repaid. Thus, the US government would have a reduction in its federal deficit of $11,160 related to this loan over the next ten years. Thus, the total interest income of $11,160 represents a cumulative 37% return on the $30,000 loan bought.

If you wanted a higher total income return than that, then it would be necessary to step up the interest rates used over the 10 year term.

For instance, if you just matched Wells Fargo’s 8% interest rate over the entire 120 months (or 10 years), you would get total interest income of $13,678, or a 46% return. And then if you stepped up Wells Fargo’s interest rate to 9% over the entire 120 months, you would get total interest income of $15,603, or a 52% return.

Now let me address the front end CBO scoring of this entire program.

There will be some loans that won’t be repaid, and these would reduce the positive CBO scoring. However, for all loans combined, the US Infrastructure Bank should have substantially positive net cash inflow, and thus there should be some pretty substantively positive, in the aggregate, CBO scoring on the front end. The cumulative interest received should trump the cumulative loan how much? up to $50 bil, is my best guess.

And with its second mortgage, the US Infrastructure Bank has some very nice credit protection, particularly since after the sale, the first mortgage loan is initially only at 90% of the FMV of the home, and as loan payments are made, this 10% cushion will grow, thus also benefiting the credit protection of the second mortgage-holding US Government Infrastructure Bank. And then this cushion will also grow for any subsequent home price appreciation over the ten-year period.

Wells Fargo gets no earnings charge on its income statement from the partial mortgage loan sale. And economically, it benefits because it now has a Mortgage Loan Receivable on its books at 90% of the FMV of the home., and also pocketed $30,000 of cash.

If you wanted to incentivize the first mortgage holder even more, here’s what I would consider doing and it would be at no CBO scored cost to the US Government over the next ten years.

In the above illustration, if Wells Fargo hasn’t received a federal income tax deduction for the $90,000 Loan Loss Provision yet (which should be the usual situation), they should be allowed to deduct the $90,000 in 2010, the year the partial mortgage loan is sold. And then I would also consider letting Wells Fargo deduct it again in the same year….thus a Double Deduction…call it perhaps a Housing Crisis Financial Relief incentive. And then, in the tenth year, this second deduction of $90,000 would turn around and be added to Wells Fargo’s taxable income, or alternatively, 25% of this $90,000 is included in taxable income in each of years seven through ten.

Financial institutions certainly have large enough Allowance for Loan Losses to tax incentivize…..after all, Bank of America’s is now at $37 bil and Wells Fargo’s is at $25 bil…Whew! To be fair, these banks have already suffered their loan losses economically, they just haven't yet been allowed a related federal income tax deduction on these economic loan losses.

A very key control here relates to the verification of the amount of the Loan Loss Provision when the partial mortgage loan is sold. If a financial institution wants to game the system, it could try to minimize the amount of the Loan Loss Provision it claims it has already recorded on its books on this loan being sold.

Thus, I would require at least three checks. First, the financial institution’s CFO must sign a certification of the accuracy of the Loan Loss Provision already recorded on the books for this loan being partially sold and further that this amount also accurately reflects his best estimate of the loan loss related to this mortgage loan. Second, the GAO should audit the company’s computation. And third, the CBO should review and verify the GAO’s audited conclusion.

And then if these three checks weren't considered sufficient, a fourth check could be for a CPA firm to attest to the financial institution CFO's Loan Loss Provision assertion related to the mortgage loans sold.

A second option for this proposal would be to instead of setting Wells Fargo’s mortgage loan receivable after partial loan sale at 90% of the FMV of the home, it could be set at a lower 80%.

What this would do is to increase the selling price of the partial loan. On the downside, that would give the US Federal Government Infrastructure Bank more downside risk because it would be paying more. However, it would also give it more interest income upside. An additional advantage with using this lower 80% is that the Loan Loss estimate would be a bit more accurate.

And using this lower 80% would also be more beneficial to the homeowner because more of his loan would be transferred to the US Infrastructure Bank, which has more favorable interest terms than does Wells Fargo, the first mortgagor.

I think the incentives here would be very effective ones to motivate financial institutions to transfer a lot of these underwater mortgage loans to the US Infrastructure Bank. If even more of an incentive is needed, it would be really easy to accelerate, for federal income tax purposes, even more of these loan loss tax deductions. And when you design these additional accelerated tax deductions to turn around over the ten-year period, they wash out in CBO scoring.

And I would also consider front-loading the amount of the accelerated loan loss federal income tax deductions to spur early in the year 2010 home mortgage loan sales. To illustrate, if the 2010 annual loan loss deduction would normally be $90,000, the tax deduction could instead be sauced up for loans sold in the earlier quarters of 2010, in a quarterly pattern like this:

1Q 2010 mortgage loan sales.....$120,000
2Q 2010 mortgage loan sales.....$100,000
3Q 2010 mortgage loan sales.....$ 80,000
4Q 2010 mortgage loan sales.....$ 60,000

And then the taxable income turnaround of the above amount would occur in the latter part of the ten-year CBO scoring period.

This program would work not just for fixed interest rate mortgage loans, but also for floating interest rate loans. The US Infrastructure Bank would just apply the applicable above percentages to the floating interest rates charged by Wells Fargo, the first mortgagor.

I think I would set up this proposal so that smaller community banks are given an additional incentive to sell these partial mortgage home loans to the US Infrastructure Bank. One way to do this is for the US Infrastructure Bank to give banks below a certain total assets size, say a 5% to 10% price premium for their home loan sales made under this program. Thus, these smaller banks would be getting an attractive GAAP earnings uptick on mortgage loan sale. And this premium would not be passed on to the homeowner.

From an operational perspective, there could be several ways the US Federal Government Infrastructure Bank could work. All of the loan administration work could be done by new government workers at this new US Federal Government Infrastructure Bank. Or, the loan administrative work could be done by segregating all of this loan work by the financial institution making the mortgage loan sale to the US Infrastructure Bank. Or alternatively, the loan administrative work could be outsourced to Fannie Mae and Freddie Mac…, do they both ever need revenue bumps, or outsourced to any companies in the private sector.

And the real beauty of this overall proposal is that you not only get tons of Job Creation Funding from the substantially positive CBO scoring, but you also get a substantial amount of Juice added to the US Economy….just think of all the cash going to the banking system from these sales of clearly troubled part of these mortgage loans. This cash will be available to be lent out to businesses, particularly to smaller businesses, and also will be available to finance new and existing home sales. Further, the private banking system gets significantly strengthened by getting rid of the toxic parts of so many of its mortgage loans.

To be able to move the needle on these many underwater home mortgages even more, I think I also would consider addressing all home mortgages that have second mortgages and where either the first mortgage alone, or where in combination with the second mortgage, create an underwater situation. If their accounting is proper, the financial institutions holding these second mortgages should have already recorded a 100% loan loss provision for most of these underwater loans. Thus, they would have no income statement accounting hit if they were to forgive the entire principal balance of the second mortgage loan. In those cases where there is not a 100% loan loss provision already on the books, then my proposal would be to permit the financial institution holding the second mortgage to sell this loan to the US Infrastructure Bank for the excess of the loan principal balance over the loan loss provision already recorded. The US Infrastructure Bank would then roll this homeowner loan acquired into the loan acquired from the first mortgage holding bank. To incentivize the second mortgage financial institution to totally forgive, or in some cases to sell, the loan amounts of these underwater mortgages, I would consider giving these financial institutions some amount of additional upfront federal income tax loan loss deduction for the loans they forgive or sell. And then these amounts deducted upfront in the first year by the financial institution would turn around and be taxable income in say the latter four years of the next ten-year CBO scoring period. Therefore, these financial institutions would receive a significant economic benefit to forgive or sell these loans and at no CBO-scored cost to the US government. And by eliminating the second mortgage on the loans, this will permit many more partial principal loan sales of first mortgage loans to the US Infrastructure Bank. Thus, by also including home mortgages with second mortgages, the total positive CBO scoring should increase to substantially above $50 bil.

I fortunately don’t have an underwater mortgage, but I think if the US Government can bail out AIG, Fannie Mae, Freddie Mac, General Motors and many other mainly financial companies, surely the US Government can also help out its many US citizens with underwater mortgage loans, who have been financially devastated by the housing market crash, caused in large part by the very same companies the US Government bailed out. And if this proposal here is handled properly, with very strong incentives, I think the CBO scoring upside to the US Government over the next ten years could be up to a total of $50 bil. And if these large financial institutions unreasonably and greedily decide to not participate in this program, then I think the US Government should consider stepping up their Tax Deposit percentages and/or accelerating the dates of the required tax deposits of these companies’ open IRS tax audits, both included as part of Job Creation Funding #3.

Further, I think this proposal would be dynamite to the very troubled US jobless recovery, and particularly light a fire to the very depressed housing market, and to the smaller bank community, as well as to many small businesses. Underwater homeowners are not doing much in the way of consumer spending now. With the fiscal relief provided by this proposal, these homeowners will be much more likely to step up their consumer spending, thereby spurring the US economy.

And frankly, I really can't understand why the US Government isn't doing more to help these economically desperate homeowners, who are scared to death of losing their homes.....and many have even already lost their homes. If the US Government would just apply some wise real-world business creativity on this critical issue here, it could solve a huge chunk of this problem. I am certain that my proposal here is just one of many out there that would help. The fact that the US Government is dragging its feet on this issue, is just not right.