Bloomberg carried an interesting story yesterday about a private firm taking advantage of an arbitrage opportunity in the mortgage market. The firm, NewOak Capital, purchased an underwater mortgage (loan exceeded the value of the home) from a lender at a substantial discount. NewOak was able to pay down the principal enough to refinance into a conforming loan and still make a profit. Ultimately, the homeowner got a huge boon — lower principal and lower payments — at the expense of the lender. However, this is not a total moral hazard situation — this only worked because the homeowner was responsibly paying the higher mortgage and thus had good enough credit to refinance. The lender was able get a decent bid for a loan that was not trading, so comes out ahead of where it was while paying the price for what ultimately was a bad lending decision. NewOak made a profit which they deserved for their effort and risk — they had no guarantee that they would be able to successfully refinance the homeowner. AND — it cost the taxpayer nothing. I repeat — it cost the taxpayer nothing.
This is a good example of the type of private sector solution that government policies should be encouraging. If these types of transactions become more commonplace, pricing of underwater mortgages will improve as the arbitrage profit narrows. More importantly, the market will start establish clear pricing parameters for underwater mortgages. This lack of clarity of is a significant part of the banking sector’s problems — we can’t even know the true condition of bank balance sheets pricing for these types of mortgages is established.
There’s a very hopeful message as well as a warning embedded in this story. The hopeful message is that private sector solutions are arising, these cost the taxpayer nothing and help on a number of fronts in reliquifying the industry. The warning is to recognize that government policies can get in the way of these constructive ventures. Of particular concern, there is a movement to eliminate or relax mark-to-market accounting rules. This would eliminate any incentive lenders have to move forward on these questionable loans. These loans have a value — it is almost certainly not 100% of face value, but is it also almost certainly not zero. Arbitrage transactions such as NewOak’s go a long way toward establishing “floor” values and starting the critical process of price discovery.