The issuance of US Treasury First Lien Mortgage Notes would provide an effective, fiscally prudent and politically popular approach to stabilize the prices of mortgage backed securities. These notes would contain fully collateralized, transparent and uniform loans that provide work out capital directly to distressed homeowners. Banks will issue and administer the government backed loans, which will be rolled up into a five year US Treasury First Lien Mortgage Note that will be offered at a discount.
Under the proposed First Lien Mortgage Note program, Treasury would purchase new loans from banks, issued to provide work out capital for mortgage payments, using funds authorized by TARP. These targeted loans will provide homeowners with a capital reserve in an interest bearing escrow account that can be drawn upon to make mortgage payments and prevent loan delinquencies.
Work out capital could be used by distressed homeowners to make mortgage payments under the terms of existing mortgages or as part of a renegotiation with mortgage service companies that includes interest rate and/or principal reduction. Principal reduction or deferral could compromise the rights of mortgage holders under some state laws. One of the attractions of the present proposal to provide work out capital is that relief can be provided and foreclosures prevented under existing law.
The swift authorization by Treasury of First Lien Mortgage Notes is an effective and financially prudent method of supporting the market for mortgage backed securities that could be done in conjunction with a limited implementation of Federal purchases of these presently toxic assets in a manner that does not put taxpayer money at risk.
The prospect of guaranteed cash flows from a program for US Treasury First Lien Mortgage Notes would allow financial institutions to immediately maintain these assets on their balance sheet in a hold to maturity rather than a ready to trade account, without taking significant loan impairment write downs.
Guaranteed cash flows to mortgage owners for a five year period will provide a five year breather 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.
Administering this program will provide a needed new source of revenues for banks while preventing human suffering and social instability in the US. It will also increase public support for government spending for assistance to the financial sector by using TARP funds on politically popular and economically sound measures to prevent foreclosures.
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. The overhang of unsold inventories of houses together with the forced dumping of foreclosed properties is depressing real estate prices. Preventing foreclosures and directly supporting real estate prices has not been and should be a priority of policy makers.
Housing fundamentals will worsen as a result of the pronounced destruction of stock market wealth and consumer confidence from the unfolding financial crisis. This will lead to cutbacks in consumer spending and business investment which will increase unemployment leading to more homeowner distress and foreclosures.
Nearly a million homes were sold through foreclosure this year and twice as many have started a foreclosure process. In addition, interest rates resets in 2009 on subprime and Alt A variable mortgages will trigger new foreclosures. 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.
In a typical case, our proposed plan provides assistance to a homeowner X, with a mortgage of $200,000 and a current home value of that amount or less who is facing distress in meeting her payments. Under the proposed program, homeowner X would borrow $80,000, which would be escrowed for the sole purpose of making mortgage payments, if she could not. The government would take a first lien for $80,000 and the existing mortgage holder would subordinate its own first lien interest, in consideration for the assurance of having payments timely made.
This option would be attractive to mortgage holders. Some economists are estimating that in the current market climate, foreclosure recoveries are averaging 40%. In our hypothetical example a foreclosure, in distressed markets, would net $80, 000 and cause an immediate write off of $120,000. The opportunity for the MBS owners to account for the mortgage as a performing loan and the MBS security to be held till maturity, with the attendant cash flows from the escrow account and the strong possibility of an improved real estate market within the five year period envisioned, should make this highly attractive to the holders of mortgages and mortgage securities.
Under our proposal we set the interest rate for five year loans at 160 basis points above Treasuries, which provides a fair return to the taxpayer, money to pay transaction costs, and still provide a concessionary rate to homeowners, further enabling the mortgage workouts. According to Christopher Mayer and Glen Hubbard of Columbia Business School, the average historical spread of 30-year, fixed-rate mortgages over 10-year Treasury bonds is about 160 basis points. The US Treasury First Lien Mortgage Bonds would be sold to investors at a discount, as there will be no interest payments by borrowers until the home is sold or the mortgage refinances. This program will provide a five year period for homeowners to refinance or sell their homes.
The proposed program will be available for owner occupied homes. However an economically sound but politically unpopular case could be made for the wisdom of extending this loan program to owners of multiple distressed properties, assuming reliable appraisals insuring that taxpayer capital is protected by adequate collateral. If the program were extended to real estate investors it would, further stabilize real estate prices, allow them to potentially recoup their investments while paying a higher interest rate than the concessionary rate offered homeowners. Their loans could be priced at 460 basis points above Treasuries.
Mitigation of home foreclosures will set in motion a virtuous cycle of improved cash flow, leading to higher valuations on MBS enabling more credit and enhanced economic activity. Unlike existing MBS’s these loans could be packaged into a new treasury instrument that is both transparent and fully collateralized.
Issuing Treasury Note that provide work out capital to distressed homeowners by purchasing standardized loans, originated by banks, gives policy makers a simple, rapid and systematic way to prevent foreclosures in the current environment.
The scenario that will unfold from creating this new loan facility will provide a breather from the vicious downward spiral of foreclosures, which in turn undermine neighborhoods, dramatically impacts housing values and lead to further deterioration in MBS prices, diminished capital adequacy ratios, leading to further bank insolvency and increased systemic risk to the financial system. Our proposed plan will unleash a virtuous cycle of market forces that 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 very conservative loan to value ratio.