The FDIC proposal is a constructive and important plan to encourage reworked mortgages while attempting to limit taxpayer exposure, but it does appear to have a few drawbacks.
First, the incentive provided for modifying mortgages actually makes foreclosure relatively more rewarding for many mortgage investors by guaranteeing up to half of the losses on foreclosed properties.
In that sense, policymakers could be playing with fire. Presumably, the up-to-50% guarantee would apply even to second-lien holders who now have zero incentive to foreclose since their investment would be wiped out.
Second, while the FDIC plan buys some time, it’s unclear how far it would go in easing the dead weight on the economy and household balance sheets of mortgages that far exceed home values. That’s because write-downs in principal don’t appear to be prioritized over other forms of loan mitigation. Thus homeowners remaining far under-water might still feel compelled to walk away.
Here’s an alternative idea that gives mortgage investors every incentive to maximize the long-term sustainability of loans through principal reductions and virtually eliminates any incentive to foreclose. It also could provide help to homeowners who haven’t defaulted on their mortgages, thereby helping to stimulate the economy.
What I’m proposing is that the appropriate government agency take over a portion of first-lien mortgages up to the expected foreclosure value of a home. Depending on zip code, this might be anywhere from 30% to 45% of the original purchase price.
This would cash out a big portion of the existing first-lien loan, with the government taking the place of the most-senior debt holders so that its loan would be fully backed by the expected foreclosure value of a home. The remaining private mortgage investors would now have nothing to gain from foreclosure and everything to gain from making the loan sustainable.
Next, on its share of the loan, the government would provide a low interest rate of about 5% and make it interest-only for the first five years. The homeowner would benefit from lower payments and the more junior debt holders would have to bear less of the burden of modifying the loan to make it affordable.
Finally, the government would use its position as senior debt holder to provide an incentive for loan modifications through principal reduction. For every $1 of loan principal reduced in the non-government portion of the original first-lien, the government would match with $1 in reduced principal.
The government would reduce its principal by, perhaps, $1 on the first $20,000 of second-lien loan principal reduced and 50 cents for every additional dollar of reduced principal.
This incentive should make reducing principal the default option for modifying mortgages, particularly if it leverages 2nd-lien principal reductions in a way that allows the government – at no extra cost – to match every $1 of reduced first-lien principal with $2 of government-reduced principal.
Here’s an example of how this might work. Say the government takes over 50% of a $320,000 first-lien mortgage and the homeowner has a $40,000 second lien. Now say the second-lien holder agrees to cut $20,000 in principal. In return, the government would provide $20,000 in principal forbearance, meaning it wouldn’t collect monthly payments on this principal but would still be in a position to recover principal once the house is sold.
If the remaining private first-lien holders decline to cut principal, the government would receive the first $160,000 when the property is sold, and it would give as much as $20,000 of this to second-lien holders, but only if the sale price is above $300,000. In other words, second-lien holders wouldn’t collect principal ahead of first-lien holders.
But if the private first-lien holders also agree to reduce principal by $20,000, the government would match that $20,000 and forfeit any present or future claim on the $20,000 in principal reduced to match the second-lien reduction.
Now if the home is sold, the government would collect the first $120,000 in principal, the private first-lien holders would collect the next $140,000, and second-lien holders would begin to collect if the sale price exceeds $260,000.
In return for the reduced principal, both the government and the lenders would be compensated with warrants to receive a portion of the future housing equity gains of bailed-out homeowners.
Whether or not this proposal is technically allowable under securitization contracts, this would be a fix that is fully consistent with the spirit of those contracts. All mortgage investors would be better off under this program – and certainly none would be worse off – as long as it is implemented carefully.
For example, it would have to be done in a way that doesn’t appear to give homeowners an option of simply paying the government portion of the loan and stiffing private debt holders. This could be handled, in part, by having one servicer collect the combined payment due to the government and current first-lien private investors.
This idea sprung to mind after pondering an RGE Monitor column written by Michael Jaliman. He advocated that the government provide up to 40% of the value of existing mortgages as work-out capital for the lenders. In return, as in this proposal, the government would receive a senior first-lien position to protect taxpayers.
However, Jaliman’s idea might be a non-starter for the most-senior first-lien mortgage investors because the work-out capital used to keep homeowners from foreclosure could come at the expense of these investors. As I see it, the best way forward for achieving a long-lasting housing fix that helps the economy now is for the government to replace these most-senior mortgage investors.
Even in the worst case that the homeowner defaults on the loan, the government would be in a position to potentially rent out the property to the current resident where possible, thus stemming the foreclosure crisis and protecting the interest of junior mortgage investors who could eventually gain from a recovery in housing values.
This idea is kind of a lite version of the plan developed by Columbia Business School professors Glenn Hubbard and Christopher Mayer. They called for the government to split losses with mortgage investors up to $100,000 in erasing all homeowners’ negative equity. Then the government would refinance at a favorable rate.
I like their concept, though it has yet to gain political traction. But the plan does raise some questions. Not least, should taxpayers pay a high price to bail out under-water homeowners – even those who can now afford their mortgages – and, on top of that, assume all of the risk of residential mortgages going forward?
That may indeed be the best answer. But the less-costly alternative I am offering would go a long way toward easing the housing crisis and stimulating the economy.
Jed Graham writes about economic policy for Investor’s Business Daily, but this column does not reflect the views of IBD.