A Housing Fix with the Right Incentives

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.

3 Responses to "A Housing Fix with the Right Incentives"

  1. Guest   November 18, 2008 at 10:49 am

    As expected, the G-20 Economic Summit in Washington turned out to be a total bust. None of the problems which have pushed the global economy to the brink of disaster were resolved and none of the main players who gamed the system with their toxic securities were held accountable. Instead, the visiting dignitaries gorged themselves on stuffed quail and roast rack of lamb before settling on a toothless “Statement on Financial Markets” which accomplished absolutely nothing. The one noteworthy clause in the entire document is a two paragraph indictment of the United States as the perpetrator of the financial crisis. At least they got that right.The contagion started on Wall Street and that’s where the responsibility lies. It was the result of the Fed’s reckless low interest rates and lack of government oversight. This allowed market participants to create massive amounts of leverage via speculative bets on under-capitalized debt-instruments. The resulting collapse in value of all asset-classes across the spectrum has created a gigantic multi-trillion dollar capital hole in the global financial system which has precipitated violent swings in the stock markets, tightening credit, currency dislocations, soaring unemployment and deflation. Almost all of todays economic woes can be traced back to legislation that was promoted by key members of the Clinton and Bush administrations. (Many of who will now serve in the Obama White House) The G 20s statement puts the blame squarely where it belongs; on the Federal Reserve and Wall Street.http://www.globalresearch.ca/index.php?context=va&aid=11022

  2. Anonymous   November 18, 2008 at 11:40 am

    Here’s another idea: Expect people to be responsible for their decisions. Radical, I know.

  3. Guest   November 18, 2008 at 8:22 pm

    America has decided to let everyone live at the lowest common denominator. If your idealistic world of living in your Mcmansion is now crumbling around you then it is most assuredly your fault. We are at a point where the more successful or the more wise decisions you make, the more you are required to help those who are lazy and make poor decisions. Bailing out the reckless homeowners is just another example of encouraging those who make poor decisions and milk the system to do so at the expense of us who are responsible and do what is right, and fair. America is saying that if you have screwed up we’re going to help you out and let you off the hook. Better yet, the worse the decision, the more you benefit!This obsession by our leaders to keep homeowners in their home will mark the end of whatever is left in this country resembling prudence and morality. I support saving all homeowners not just the irresponsible 3 million living in Mcmansions.Congress and Sheila Bair’s obsession with this spend-only bailout rewards the reckless and punishes the prudent. Consider the lesson it imparts to promote bailouts to the reckless. City by city, neighborhood by neighborhood, people who live beneath their means and manage money carefully will see more careless neighbors supported by federal decree. And what about the 30 percent of this nation who were smart enough to rent? Or how about the large percentage of us who gave plenty of warnings to these same people the government now wants to redistribute my taxes to so they can stay in a house twice the size the home I live in. The backlash to the 700 B bailout package was not only because of the bailout of wall street but also the bailout of the reckless homeowners and their relentless ATM / HELOC spending. As it is now these people can live in their home for over a year rent free while they find a home they should have been living in from the start.We are becoming a nation of people who feel it is not only okay but justified to cheat, lie, and swindle each other and the rest of the population. Personal responsibility is discouraged by the government and the mainstream media. Our nation is eating ourselves from within just to keep a facade of prosperity. Hope is being replaced by anger and desperation. Welcome to the new dawn.