A plan To Limit Foreclosures

The Bush administration is working on a plan to help homeowners at risk of default. This would be the second time this year that legislators intervene to help homeowners; in July, President Bush already signed legislation to help borrowers to refinance at more affordable rates. For an academic analysis of that legislation and the way it impacted taxpayers, homeowners, and the financial industry, see  the recent paper by Mian, Sufi and Trebbi. Mian and coauthors argue that special interest campaign contributions from the financial services industry and local constituencies predict Congressional voting patterns when it comes to recent government interventions. Interestingly, the probability that one member of the House of Representatives voted in favor of the so-called “bailout plan” passed this October by Congress (Emergency Economic Stabilization Act) is affected positively by the political contributions from financial firms that ultimately benefitted from the legislation.

This work is a good example of the view (held by many economists) that political economy interventions are often made by self interested politicians who maximize the probability of being re-elected rather than society’s interest, and even vote contrary to their ideology in order to maximize re-election. The results of this paper are bad news for the next set of interventions the government is planning to undertake: there is a serious risk that future interventions will not be calibrated necessarily to solve the problems, rather they will be designed to favor some political contributors, or some specific constituencies. Nonetheless, despite the usual reluctance many economists have toward government interventions, this time a substantial fraction of them have urged an intervention to limit foreclosures. Why are so many economists recommending these measures?

Needless to say, any bailout has distortionary effects, but I will argue that a measure that deals directly with foreclosures could at least try to address one inefficient consequence of foreclosure in the midst of this particular financial crisis. Estimates suggest that less than 50% of the value of the house is recovered by the bank when a house enters foreclosure. Thus, massive foreclosures will have very negative effects on banks’ balance sheets. The quality and value of banks assets is crucially important for the health of the financial industry and ultimately for the global economy. As real estate prices deteriorate and homeowners face more foreclosures, the value of those assets will deteriorate further and in an uncertain manner. Since mortgages have been sold and repackaged in complicated instruments, nobody knows which banks are holding which mortgages, but everybody agrees that more foreclosures are not good news, on average, for banks. Deterioration in the value of the assets held by banks and uncertainty over their quality is something the economy does not really need at this time. The advantage of a government intervention, if properly designed, is to facilitate the process of renegotiation for homeowners close to foreclosures. These proposals aim at “saving” the 50% loss that financial institutions would incur if a house goes into foreclosure. While in traditional mortgages held by a local bank, the bank has an incentive to avoid foreclosure and to cut a deal with the homeowner, in the world of mortgage backed securities, this incentive is no longer there. The mortgages have been repackaged and nobody knows who has the right/incentive to renegotiate the agreement. A government intervention should then be aimed at reducing the cost of this inefficiency and facilitate the renegotiation. Some of the proposals add a form of subsidy to the homeowner, or the financial institutions at taxpayer’s money. According to some, a subsidy is needed to convince the parties involved to accept the renegotiation (see the New York Times for an example of reluctant participants), or simply because they believe that relief to homeowners will help the economy at large. The latter claim is much harder to verify and it raises the doubt that the subsidy from taxpayers to homeowners and/or financial institutions is driven by self interest politicians who favor their constituencies or special interest, as the work by Mian and his coauthors suggests. In analyzing all these proposals (and in the final proposal that the Bush administration will put forward), the important question to ask is whether the proposals minimize the cost for the taxpayer, while avoiding deteriorations in banks’ balance sheets due to foreclosures. The Economist has summarized and compared three of these proposals. It will be interesting to evaluate the final government proposal and analyze whether the proposal solves the existing inefficiencies, or rather serves specific constituencies or special interests.

Originally published at Kellogg School’s Finance Department Blog and reproduced here with the author’s permisison.

4 Responses to "A plan To Limit Foreclosures"

  1. Sid   November 7, 2008 at 8:41 am

    Paola:Treating the disease, not the symptoms: a comparison of solutions to buying defaulting loans of any type.There have been a variety of proposals for this line of attack, including recently by Martin Feldstein in the WSJ. I have also proposed a plan, outlined below. Following my plan is a précis of Feldsteins plan, followed by a comparison of both. There is great merit in a strategy of treating the disease and not the symptoms:Some pertinent data points;• Number of families who now hold a subprime mortgage: 7.2 million1• Proportion of subprime mortgages in default: 14.44 percent2• Proportion of subprime mortgages made from 2004 to 2006 that come with “exploding” adjustable interest rates: 89-93%• Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities: 93%• Number of subprime mortgages set for an interest-rate reset in 2007 and 2008: 1.8 million Valued at: $450 billionThere are 7.2 million subprime mortgages out there worth 1.3 trillion, of which possibly 70% of them have exploding rate mortgages, which means about 5 million have exploding rates. Exploding rate mortgages account for 93% of the bad mortgages, which means that possibly 4.5 million of these will go bad, or 63% of the total, at a value of $820 billion and an average value of $180,000. If the ARMs reset from 7% to 12%, the increase in monthly payments is about $590 per month. $590 per month times the total of 5 million is about 3 billion dollars per month. Therefore, $700 billion would pay for 233 months, or nearly 20 years of payments… and this without renegotiating the loans so that maybe they just go to… say… 9% with the government picking up the difference. The holders of all the CDO’s would then be able to value them, mark them back to market, solve their balance sheet problems… financial problems solved. From the housing markets point of view, it would relieve the pressure of the foreclosure spiral forcing down prices more than ‘normal’, and provide years for the economy to recover and housing to rebound. Furthermore, any homeowner who availed himself of the help would give up all or a part of the appreciation of the property over time, penalizing them for getting jammed up, but not penalizing the guy who is paying his mortgage and playing by the rules.If the sub-prime ARMS were renegotiated down to 9%, the monthly payments the government would be liable for would be an average of $225 per house per month, or $1.1 billion annually. The $700 billion under those circumstances would be good for 636 months, or 53 years…So in review, the proposal is to: Have the government guarantee payment of the loan by taking over the payment of the amount above the ‘teaser’ rate, leaving the existing mortgagee paying the original rate while the government pays the difference. Renegotiate that ARM rate down so the difference is smaller. In exchange for this, the original mortgagee gives up rights to appreciation in the future, penalizing him for a bad decision, not rewarding him for it.Benefits of the action: Stabilization of the housing market by ending foreclosures Small relative rescue price for the government, as the payments are monthly, not lump sum. Homeowners who can’t pay are saved and penalized, while homeowners who can are not penalized. The market in all mortgage related securities will be reestablished, as payment is now guaranteed, allowing all holders of all financial products based on the mortgages to have confidence in their value. Market liquidity and company balance sheets will be reestablished through the market itself.This would be a much cheaper and more effective way to solve the problem… renegotiate the exploding rate, paying the difference and profiting from the increase in asset value over time.The following is the proposal advanced by Feldstein in the WSJ:The Problem Is Still Falling House PricesThe bailout bill doesn’t get at the root of the credit crunch.By MARTIN FELDSTEINA successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities….We need a firewall to break the downward spiral of house prices. Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%….Consider a homeowner who has a mortgage equal to 90% of the value of his home. The 15% decline in the value of his house that may be needed to bring it back to its prebubble level would shift that homeowner into negative equity. Further price declines would make default attractive. But the 20% mortgage replacement loan would take the loan-to-value ratio to 72% from 90%, making it unlikely that prices would fall far enough to push him into negative equity. An interest saving that could be as large as $3,000 a year would provide a strong incentive to accept the mortgage-replacement loan, even if the individual thinks that he might temporarily have a moderate level of negative equity.Below is a comparison of the advantages of the two plans point by point:• No budget busting huge amounts of capital required in any one year, but rather nominal amounts in any particular year.o Feldstein’s plan would require huge outlays of capital, a trillion dollars by his own estimate, in order to protect the 5,000,000 threatened mortgages, which is a totally unnecessary budget buster• No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.o A benefit of both plans.• Slows the fall in house values, shoring up all real estate assets both residential and commercialo A benefit of both plans• Doesn’t penalize those who ‘play by the rules’o The Feldstein plan rewards those who for what ever reason can’t make their payments by making them eligible for a very cheap very long term loan. This penalizes those who are paying and is unfair on it’s face.• Allows Mark to Market rule to continue to be usedo A benefit of both plans• By establishing a value for all the mortgage-related assets, the markets in them will restart, liquidity problem solved.o This is less clear under Feldstein’s plan, as there still could be defaults. Payment is left to the original mortgagee, and what if they decided to take that $80,000 and pay off some other more pressing bill. Because of that threat, the trillions of dollars in derivatives would not be as secure and thus would not be as valuable. They may be as liquid, but at a risk induced lower price… not a good thing.• Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.o Feldstein’s plan does not recognize the need to lower the ARM (more appropriately an ERM – exploding rate mortgage) increases through a blanket one time renegotiation with all holders. This is equivalent to what happens when someone secures a better deal rescuing a company than the deal originally offered to the original stock holders… such is life.• The program could be expanded to include anyone who was threatened with foreclosure due to ARMs… not just sub-prime, but Alt-A, etc.o A benefit of both plans.• No bankruptcy interventions necessary.o A benefit of both plans.Advantages of this plan:• No budget busting huge amounts of capital required in any one year, but rather nominal amounts in any particular year.• No need to try and ‘untangle’ all of the bundled, sold, sliced and diced mortgages… they will be paid.• Slows the fall in house values, shoring up all real estate assets both residential and commercial• Doesn’t penalize those who ‘play by the rules’.• Allows Mark to Market rule to continue to be used• By establishing a value for all the mortgage-related assets, the markets in them will restart, liquidity problem solved.• Moral hazard: companies that participated in selling the bubble take a hit for their reckless behavior through the discount in the ARM through the revaluing downwards of their assets.• The program could be expanded to include anyone who was threatened with foreclosure due to ARMs… not just sub-prime, but Alt-A, etc.• No bankruptcy interventions necessary.THE FOLLOWING IS DATA ON THE SUB-PRIME MARKETThe Subprime Crisis IndexNumber of families who now hold a subprime mortgage:7.2 million1Proportion of subprime mortgages in default:14.44 percent2Dollar amount of subprime loans outstanding:$1.3 trillion3Dollar amount of subprime loans outstanding in 2003:$332 billion4Percentage increase from 2003:292%Number of subprime mortgages made in 2005-2006projected to end in foreclosure:1 in 55Families with a subprime loan made from 1998 through2006 who have or will lose their home to foreclosure inthe next few years:2.2 million6Projected maximum equity that will be lost through foreclosureby families holding subprime mortgages:$164 billion7Proportion of subprime mortgages made from 2004 to 2006that come with “exploding” adjustable interest rates:89-93%8Proportion approved without fully documented income:43-50%9Proportion with no escrow for taxes and insurance:75%102Proportion of subprime loans bundled into mortgage-backedsecurities made to speculators (those who own but don’t occupya home) in 2006:5%11Difference in delinquency rates between speculators and owneroccupants:0.1 percentagepoints, orvirtually nodifference12Difference in delinquency rates between subprime adjustablerateand fixed-rate mortgages:14.7 percentagepoints13Proportion of completed foreclosures attributable to speculatorsamong all adjustable rate loans made in 2006 and bundled insubprime mortgage backed securities:7%14Proportion of completed foreclosures attributable to adjustablerate loans out of all loans made in 2006 and bundled insubprime mortgage backed securities:93%15Percentage increase of interest rate on an “exploding”ARM resetting to 12% from 7%:70%16Typical increase in monthly payment (3rd yr):30% to 50%17Number of subprime mortgages set for an interest-rate resetin 2007 and 2008:1.8 million18Valued at:$450 billion19Proportion of 2006 home loans to African American families thatwere subprime:52.44%20Proportion of 2006 home loans to Hispanic and Latino familiesthat were subprime:40.66%Proportion of 2006 home loans to white non-Hispanic familiesthat were subprime:22.20%Subprime vs. Prime LoansSubprime share of all mortgage originations in 2006:28%21Subprime share of all mortgage origination in 2003: 8%223Subprime share of all home loans outstanding:14%23Subprime share of foreclosure filings in the12 months ending June 30, 2007:64%24Year-over-year increase in foreclosure filings on subprimeloans with adjustable rates (2nd quarter 2006 to 2007):90%25Increase in foreclosure files on prime fixed-rate loans during thesame period:23%26Proportion of subprime mortgages with prepayment penalties:70%27Proportion of prime mortgages with prepayment penalties:2%28Estimated proportion of subprime loans made by independentmortgage lenders not affiliated with a federally insured bankIn 2004 51%29In 2005 52%30In 2006 46%31The negative effects of subprime foreclosures are spreading.• Nearly 45 million homes NOT facing foreclosure will decline in value by anestimated $223 billion, with most of the decline hitting in 2008 and 2009, assubprime foreclosures lower the prices of surrounding homes.32• . Because of property devaluations caused by subprime foreclosures, 24states and 42 counties will lose over $1 billion each in local house prices andtax bases.33• More than 90 subprime mortgage lenders have gone out of business as ofJuly.34• Up to half of the 450,000 families whose subprime adjustable rate mortgageswill reset in the next three months will lose their home in foreclosure.35• Foreclosures cost lenders an estimated $50,000 per home in processing fees,liquidation-sale price cuts and other costs. “In 2003 this translated intoapproximately $25 billion in foreclosure-related costs for lenders alone—wellbefore the 2006 foreclosure spike.” 36

  2. Anonymous   November 7, 2008 at 9:40 am

    Paola,Why do you assume that nobody knows which banks are holding which mortgages? The servicers that manage the loans know precisely which investors own the note and even what institution acts as a vault to store the note. The information might not be organized in one single servicer but could be consolidated if the government requires it.

  3. Guest   August 6, 2009 at 10:08 pm

    今天。2009年8月7日12点34分56秒,按照老外的时间显示方式,会被显示为12:34:56 07-08-09,也就是123456789,对绝大多数人来说,这恐怕是这辈子唯一的一次碰上这样的事情。祝这一刻开心,一辈子开心!