Foreclosures are an economic root cause of the falling market prices for real estate and mortgage backed securities presently causing distress throughout the financial system. Foreclosures of homeowners depress the US housing market and lead to the deterioration of neighborhoods. This becomes a vicious cycle leading to further distress for the financial system and the economy, increasing unemployment, bringing about more foreclosures and a deeper recession which will trigger another systemic risk to the financial sector from credit default swaps.
Work out loans to distressed homeowners will address a root cause of the current financial crisis at virtually no risk to the government or taxpayers as the proposed government notes would be securely collateralized with first lien loans with a conservative loan to value ratio. The provision of work out capital places a far smaller burden on the Treasury and will have a greater impact then other leading economic proposals.
The overhang of unsold inventories of homes together with the forced dumping of foreclosed properties, is dramatically depressing real estate prices. Unless swift action is taken to formulate an effective policy response that prevents new foreclosure filings, the real estate market is set for another round of precipitous declines. Worse, as neighborhoods deteriorate and unemployment rises, the damage will likely be more than just economic.
Nearly a million homes were sold through foreclosure this year. Twice that number are currently somewhere in the foreclosure process. In addition, interest rates reset in 2009 on subprime and Alt A variable mortgages will trigger a new round of foreclosures. According to Moody’s, as many as 7.3 million homeowners are expected to default on their mortgages within the next two years. Our proposed work out loans should be a key part of any policy response.
The issuance of US Treasury First Lien Mortgage Notes, as we propose, would give policy makers a simple and systematic way to prevent foreclosures in the current environment. These loans are fiscally prudent, politically acceptable and can be implemented immediately under existing law and with funds already authorized by TARP.
Under the new program, government backed loans to provide work out capital to protect distressed homeowners from foreclosure, would go into a capital reserve in an interest bearing escrow account which could be drawn upon to make mortgage payments and prevent loan delinquencies. This option would be attractive to homeowners wanting to keep their homes and to mortgage holders. Economists estimate that in the current market climate, foreclosure recoveries are averaging less than 50%.
The loans would be issued in an amount of no more than 40% of the existing mortgage. They would be collateralized by a first lien interest, to insure full protection to the taxpayer. The existing mortgage holder would be required to agree to subordinate their mortgage. In exchange, workout capital will be available to service the existing loan and to prevent an immediate and substantial cash write off. The mortgage holder can keep otherwise bad loans on their books as a performing loan, generating cash flow. Mortgage backed securities, which own a portfolio of loans, can be kept in hold to maturity accounts without taking large losses for loan impairment.
A bank would be required to certify that a homeowner was in diminished financial circumstances to qualify for a loan. The program could be open to unemployed or underemployed homeowners who do not have significant assets as well as homeowners with regular incomes who cannot afford increased payments from mortgage price resets. With the amount of the loan capped at 40% of the principal amount of the existing first mortgage, there should be sufficient equity to collateralize the loan. However, new appraisals could be required as appropriate.
The work out capital could be used in conjunction with negotiated interest rate and principal reduction. Making work out capital available does not preclude sharp reductions in principal and interest rates to prevent homeowners with negative equity from walking away from their homes.
Loans would start coming due after a six year period, providing homeowners ample time to sell the property or refinance. This would provide six years of financial relief to homeowners and mortgage holders and allow homeowners and financial institutions to hold real estate based assets until an economic rebound strengthens the real estate market.
Interest rate for six year loans would be set at 260 basis points above Treasuries, (100 basis points above the historical spread of 30 year mortgages over Treasuries) which provides money to pay transaction costs and cover any losses, while providing a concessionary interest rate to homeowners.
The loans could be rolled up into a six year US Treasury First Lien Mortgage Note that will be offered at a discount. The loan portfolios could be purchased by the Treasury with cash or in a swap for Treasury Notes. Unlike existing mortgage backed securities, these workout capital loans would be transparent and fully collateralized. Conforming programs could be offered in other nations with strongly collateralized real estate loans rolled up into an instrument similar to Brady Bonds.
Preventing foreclosures and directly supporting real estate prices has thus far not been a priority of policy makers. This potentially catastrophic oversight must be corrected.