The number of residential mortgage foreclosures has not been so great or alarming since the Depression, according to all available information. Estimates vary, but the number of foreclosures will likely exceed two million in 2008 and may reach as high as three million. Further, mortgage debt today exceeds the market value of the underlying residence for more than 10% of all residential properties. That translates to slightly less than nine million homeowners.

Preventing foreclosures is critical to the duration and depth of the present economic slowdown. About preventing disclosures, history may offer some guidance. In 1933, the Roosevelt Administration established the Home Owners’ Loan Corporation (HOLC) to purchase residential mortgages in or near default and then rewrite the mortgages on more liberal terms designed to help prevent foreclosure. The HOLC funded itself by borrowing in the capital markets and from the U.S. Treasury. It bought and rewrote more than a million mortgages over its 18-year life, closing operations in 1951. Roughly 20% of all borrowers whose mortgages it purchased and rewrote did declare bankruptcy, regardless of its best efforts at debt counseling and budgeting for distressed borrowers.

Something similar to the HOLC may be essential to stem the tide of foreclosures, or at least move these high risk mortgages out of the private sector, as a critical step in providing relief to the relatively frozen credit markets. But there will be a price. Lenders and residential mortgage debt holders will receive less than face value for the debt obligations they sell to a government organization. That means further write-downs and losses for commercial banks and other financial institutions. However, to the extent banks and other financial institutions can rid their books of high-risk debt, it should work to inject some life into the credit process.

There will also be a cost to the long-suffering taxpayer, if a resurrected HOLC in one form or another cannot operate at a profit. Only time will tell.

Given some lines of thought about the issue, certain distressed residential mortgages would be ineligible for government purchase, such as:

• Mortgages on second homes or vacation homes;
• Mortgages obtained via borrower deceit or falsified documents; and
• Mortgages in excess of a stated dollar limit.

In effect, the purchase and refinancing scheme would apply only to mortgages on owner-occupied residences under a specific dollar amount.

The HOLC worked very effectively, by all accounts. But keep in mind that it usually takes Congress an inordinate amount of time to act, especially in today’s very fractured political environment. And there will be considerable resistance to an obvious bailout for several major financial institutions that lobbied so vigorously in the past for less regulation and restrictions in the financial markets.

The National Association of Realtors recently estimated that the average decline in single-family home prices in 2007 throughout the U.S. was 5.3%. But single-family home prices in several specific markets seem to be holding up quite well – at least so far.

For example, the National Association of Realtors recently released data indicating that median prices (not mean or average prices) fell in 77 metropolitan areas in 2007 but increased in 73 metropolitan areas.

Keep in mind that the median home price is the halfway point among all houses sold over a period of time. The mean home price is the average of all houses sold over a period of time. The median could be positive while the mean is negative.

In a February 15, 2008 article, the New York Times reviewed housing price data from three sources – mortgage data from the government, data from the National Association of Realtors, and information from DataQuick – and concluded that single-family home prices were increasing at the end of 2007 in as many as 60 of the 150 metropolitan areas.

However, these favored metropolitan areas generally lie outside the heavy population and economic mainstreams, such as Oklahoma City, Oklahoma, Durham, North Carolina, Bismarck, North Dakota, Midland, Texas, Spokane, Washington and Salem, Oregon. They are markets with limited constraints on land available for growth and have followed a more traditional economic expansion in which home prices tend to reflect the cost of labor, the cost of materials, and a reasonable profit margin for the builder. Since the housing price bubble failed to emerge in these markets, there is little pressure for correction.

Nonetheless, virtually all of these markets report declining sales volumes. The slowdown in sales may tend to mask underlying forces at work, which signal a pending fall in both median and average home prices. Slower sales suggest weak buyer demand at existing asking prices. That, in turn, may foreshadow a fall in single-family home prices.

In other words, the housing price malaise impacting the more populous metropolitan areas may be spreading to outlying regions – in spite of positive home price movements in these selected markets at the end of last year

We’ve all becoming increasingly aware of derivatives in their various forms and manifestations, such as interest rate swaps, forwards and futures, options, and collateralized debt obligations. But now we might be required to learn more than we ever wanted to know about yet another derivative – whose value is, of course, derived from or based on some related event – called a credit default swap.

Let’s take a case in point. In a recent securities filing, American International Group, Inc. (AIG) reported it would take a $4.88 billion charge to earnings related to a decline in the estimated value of its credit default swaps. That charge is roughly five times the estimate mentioned by the company in December 2007 as a possible charge to fourth quarter earnings.

A credit default swap is similar to credit insurance, and AIG is the world’s biggest insurance company. It sells credit default insurance to parties such as commercial banks that want to protect investments in corporate bonds, in residential mortgage-backed securities, in commercial mortgage-backed securities, in leveraged buy-out debt, or in a variety of other assets. In effect, the insurance buyer transfers or swaps the risk of default in these investment assets for the fees it pays the insurance seller to indemnify it against that risk of default.

For the insurance seller to make money, it must accurately assess the risk of default for the investment assets in question. Apparently, AIG underestimated the dollar amount of defaults for those assets it contracted to insure by $4.88 billion – not an insignificant sum.

If AIG were the only party selling credit default insurance, this might be a matter of passing interest in turbulent times with few wider ramifications. But the credit default swap market is immense, and AIG is only one of numerous participants. The value of all credit default swaps in 2000 was estimated at $900 billion. Today it approximates $45 trillion, more than twice the market value of all publicly traded equities and roughly 10 times the value of all U.S. Treasury bills and bonds outstanding.

Further, it’s an unregulated market in which a credit default swap contract is arranged privately between two parties rather than through a regulated exchange for such derivative instruments. In addition, one party to a contract may sell or assign its interest to another party without notification. Consequently, if a default does occur, the insurance buyer may have difficulty identifying the party currently responsible under the terms of the contract to satisfy the claim. The current insurer, in turn, could be far less financially robust than the original insurer.

Large commercial banks buy as well as sell default insurance via credit default swaps. For example, JP Morgan Chase has $7.8 trillion in credit default swaps, followed by Citigroup and Bank of America at $3 trillion and $1.6 trillion, respectively, according to information in a recent New York Times article by Gretchen Morgenstern.

Obviously, the insurer must accurately assess the risk of the investment assets it insures and price accordingly. The fee and premium income can evaporate rather quickly if it fails to do so, as the AIG experience illustrates.

On January 25th, the Office of the Comptroller of the Currency closed Douglass National Bank, a small community bank in Kansas City, Missouri, which represents the first bank failure in 2008. The failure was hardly unexpected. In March 2006, the OCC had cited Douglass National Bank for unsafe and unsound banking practices. The bank continued to post losses throughout 2007.

According to Gerard Cassidy, an analyst for RBC Capital Markets, the Douglass National Bank failure is one of many that will occur over the next two years. He estimates that between 50 and 150 U.S. banks will fail by 2010, primarily smaller community banks with heavy real estate emphasis and exposure. If so, such a failure rate would be the highest experienced by the U.S. banking industry since the early 1990s. In 1993 alone, 50 U.S. banks failed.

To place Cassidy’s prognosis in perspective, however, note that more than 2,000 U.S. banks failed in the ten years prior to 1993. To add further perspective, note that between the Great Depression years of 1930 and 1933, more than 9,000 banks failed.

Smaller banks with heavy concentrations in construction loans for residential housing seem most vulnerable to failure. As home prices and sales decline, builders may find themselves unable to carry the debt burden in the absence of sufficient cash generation from new home sales. John Dugan, the Comptroller of the Currency, stated recently that his office was increasingly concerned with identifying unreasonably low reserves for bad debts among banks with large real estate exposure.

With respect to larger commercial banks, Cassidy did not rule out failures among banks with assets exceeding $75 billion, which seems highly unlikely at the moment but may become a more pressing possibility if the economic downturn becomes severe and protracted.