In this week’s economic/market commentary, Contango Capital Advisors’ Investment Strategy Group observes that the US economy is unlikely to improve significantly until the massive residential mortgage problem is somehow resolved. It also notes that what may seem to be a solution to some could prove to be a nightmare for others.

The economy is unlikely to improve until the US sorts out the problem of residential mortgages.

In part, this is because we won’t see significant new residential construction so long as a foreclosed house can be purchased for about two-thirds the price of an equivalent new-build. Primarily, however, it is because positive equity in homes is a prerequisite for improving the situation of households.

Labor mobility has been hobbled by the inability of people to sell homes and move to places where the prospect of better – or any – work exists. Their current homes are underwater or their remaining equity is now insufficient to roll over to a new home given the much tougher mortgage standards put in place after the 2008 financial collapse.

Ten Years After

Even more fundamentally, for most Americans, equity in their home is the largest part of their net worth and ought to be the foundation for their retirement. Home values are more or less back to where they were a decade ago, while homeowners are a decade older and a decade closer to needing that equity for retirement. A significant increase in consumer speeding scarcely seems likely if a big chunk of the population needs to save as much as it possibly can to replace what it has lost.

Two ameliorating strategies have been suggested. The first is simply to allow people who are current on their mortgages, but who have little or no equity, to refinance at today’s much lower rates. The rationale is that such a measure won’t lower credit quality – the resulting payment obligations would be lower and therefore more likely to be met. In addition, it would free up more money, whether for spending or rebuilding savings.

The second is to write down the principal value of the mortgages, leaving homeowners with positive equity, using the concept of “shared appreciation.” Then, if a home were subsequently sold for its newly positive equity value, the proceeds would be split between the homeowner and the lender that made the concession. The idea is that, as the economy improves over time, some- perhaps much- of the concession would be returned to the lender.

On the Flip Side

These are good ideas but, remember that one person’s liability is another person’s asset. Every penny that goes to an underwater homeowner comes from someone else.

If interest payments on mortgages are cut, then the owners of the mortgages – the ultimate lenders – receive less. If the principal of a mortgage is reduced, the lender’s net worth is also reduced. And, contrary to the apparent opinion of “Occupy Wall Street,” these owners are not individual millionaires and billionaires. Instead they are the more prosaic life insurance companies, pension funds and mutual funds holding what investors – largely middle class – have viewed as “safe fixed-income assets.” Some of these mortgages stand behind consumer deposits held by banks. And because many of these mortgages have been packaged into securities or guaranteed by Fannie Mae and Freddie Mac, ordinary taxpayers may be the most affected.

Mortgage debt is the nation’s largest component of outstanding debt. But from the savers’ perspective, the mortgage loans and the bonds in which they have invested represent the largest component of the nation’s financial assets. A significant write-down of interest owed and/or principal would constitute an equivalent reduction in aggregate financial net worth. Should that occur, who will pay your pension or provide your promised life insurance benefits?

Under most circumstances – and this is one of them – wherever there are winners there are losers. And the “solutions” on the table today clearly cut both ways. Just as clearly, the uncertainty surrounding residential mortgages and the challenges accompanying them continue to affect investors – and should inform their decisions. For example, before allocating money to pooled products like mutual funds or “black box” products such as some insurance vehicles, investors would do well to determine just what makes that particular security tick, how it’s managed, and the level and type of risk to which it is exposed.

The opinions expressed above are solely those of Contango Capital Advisors and do not necessarily reflect the views of Zions Bancorporation, its affiliates or its management.

IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), which operates as CB&T Wealth Management in California. Contango is a registered investment adviser, a nonbank affiliate of California Bank & Trust and a nonbank subsidiary of Zions Bancorporation. Some representatives of CB&T Wealth Management are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company(WNTC), a subsidiary of Zions Bank and an affiliate of Contango. Investment products and services are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bank, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value or amount invested. CCA1011-0182R