Up until now, policymakers in Washington have approached the mortgage debt crisis with two goals – helping those on the verge of foreclosure and easing credit for refinancing (as well as home buying).
In effect, the proposed and implemented solutions target those at the shallow end of the pool (those who retain equity) and the deep end (those swamped by debt), but leave out those in the middle (the millions of households who are up to date on under-water, or soon-to-be under-water, mortgages).
This narrow and reactive policy approach is likely to produce at least two negative economic outcomes.
First, it gives those in the middle a perverse incentive to default on their mortgage and potentially give up income in order to qualify for relief. Second, by failing to help middle-household balance sheets overburdened by mortgage debt to deleverage, current policies miss a critical opportunity to ameliorate a deep consumer retrenchment.
A proactive policy that helps keep those in the middle from winding up on the deep end is critical, both to minimize perverse incentives and to counteract the adverse feedback loop of declining spending producing job and income losses, which in turn lead to lower spending and home prices.
While there are other levers for stimulating demand, including potential tax cuts to help households, those measures will have much less impact if our mortgage debt crisis is left to fester. What we need is a comprehensive approach to our housing mess that achieves seven essential policy goals.
1) Aid broad household deleveraging
2) Target the most help where it is most needed
3) Minimize perverse incentives for borrowers
4) Maximize incentive for constructive behavior from lenders
5) Aid financial sector liquidity
6) Provide for a constructive approach to loans that go bad
7) Mop up excess housing supply by incentivizing risk-taking
These goals – certainly the first six – are ones that should generate little disagreement. Yet there has been no public discussion in Washington of a comprehensive approach to our mortgage crisis. Rather, the ideas gaining traction in Congress might only address one or two of these goals.
If we seek to design an efficient policy that counters the broad damage that excessive mortgage debt is inflicting on the economy, rather than just trying to prevent mortgages in default from resulting in foreclosure, I believe that policy will lead in the logical direction that I proposed in a recent RGE Monitor column (but with one important change).
What I’m proposing is that the appropriate government agency take over a portion of first-lien mortgages on all homeowner-occupied properties up to roughly the expected foreclosure value of a home. Depending on zip code, this might be anywhere from 30% to 45% of the original purchase price – or more for those who didn’t buy near the height of the bubble.
On its share of the loan, the government would then offer a roughly 3.5% rate, making it interest-only for five years. (I had originally said 5% but that would accomplish far too little. A much-lower rate wouldn’t really be a subsidy since the loan would be fully collateralized and Treasury yields have plunged.)
Refinancing a big portion of the first lien at a low, interest-only rate – even for those with negative equity who wouldn’t otherwise have a refinancing option – will achieve several important goals.
Most importantly, the government will take an important step in boosting household cash flow. Secondly, by providing help to all mortgage holders, the government will limit a sense of unfairness that only irresponsible behavior is being rewarded.
As for the financial sector, it will get an infusion of liquidity as the government buys out the most-senior mortgage-debt holders. Plus, junior debt holders will initially receive all principal payments, and they would have to bear less of the burden of modifying the loan, to the extent necessary, to make it affordable.
With the government now owning a share of the loan up to the foreclosure value, private lien-holders would have no incentive to foreclose and every incentive to maximize the sustainability of the loan.
What is more, as senior debt-holder, the government will be able to leverage its position to provide incentives for junior debt-holders to modify loans through principal reduction in a proactive fashion, as I’ll explain below.
Finally, if the loan does eventually go bad, the government – as major stakeholder – will be in a position to facilitate the most constructive outcome (including renting to the current resident where appropriate), while protecting the investment of junior debt holders.
What are the alternatives to my proposal if we want to provide a refinancing option for seriously under-water homeowners? One would be to buy out existing mortgages at par, but that would expose taxpayers to excessive risk while bailing out investors.
Another approach offered by Columbia Business School professors Glenn Hubbard and Chris Mayer would have the government split the cost (up to $100,000) with lenders of wiping out the negative equity of all homeowners and then having the government refinance the loan at a low rate. But that, too, would require a costly bailout, not just of banks but even of homeowners who can afford their payments, which may not be the most efficient way for the government to spend scarce resources.
Former Bush economic adviser Lawrence Lindsey suggests that the government refinance at 4% any mortgage that the homeowner is willing to make into a full-recourse loan. But that would, in a sense, ask under-water homeowners – especially those in hard-hit areas – to double-down on their bad housing bets and pray that they don’t get laid off and risk losing any 401(k) balances.
Of all the proposals, it would seem that only my approach is a realistic and efficient way of enabling under-water homeowners to refinance, thereby aiding household deleveraging and financial sector liquidity, while enabling a constructive approach to loans that go bad.
Now I’ll turn to the incentives in my proposal for loan modification. Consider that current programs and other ideas with broad support in Congress (including the FDIC loss-sharing plan and loan cram-downs by bankruptcy judges) are primarily targeted at loans on the verge of foreclosure.
Not only do these programs largely ignore the importance of a proactive solution to aid households before they become distressed, but they provide a perverse incentive to borrowers to default on their mortgages in order to qualify for help.
(The FDIC plan, by agreeing to take up to 50% of losses on restructured loans if a property forecloses, also provides a perverse incentive to lenders by making foreclosure more rewarding.)
A proactive approach to restructuring loans could help limit the scope of the economic downturn, limit perverse incentives and direct help where it is most needed. But we’ve seen that the private sector, because of the often competing interests among mortgage investors, is unwilling to take the necessary steps without government involvement.
Here’s how my proposal would incentivize a proactive approach to modifying loans.
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.
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 both the second-lien holder and remaining private first-lien holders agree to cut $20,000 in principal. The combined $40,000 reduction in principal would be matched by the government, leaving a $280,000 mortgage, with the government’s remaining $120,000 portion carrying a rate of roughly 3.5% with no interest for five years.
(With the second lien effectively wiped out as far as the borrower is concerned, the homeowner would receive a single bill.)
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 the FDIC plan, by contrast, second-lien holders are guaranteed a return in the event of foreclosure. Among the potential negative consequences of the FDIC plan is that second-lien holders would have much more to gain from foreclosure than from a short-sale, which might be the most constructive outcome.
Also unlike the FDIC plan, my proposal does not say that if you’re 90 days late on your payment, then you’re eligible for help.
The help is at the discretion of the private lien-holders, who have everything to lose from foreclosure and everything to gain from maximizing the sustainability of loans.
They will have to judge the extent to which it is in their interest to reduce principal, in order to trigger matching reductions by government and to hedge against downside economic risk.
This ability to hedge by reducing principal will be critically important to the areas that have been hardest hit by falling home prices and job losses. In these regions, under-water homeowners who are still current on their mortgages will be at the greatest risk of losing their jobs and defaulting. Thus, the incentive of government loss-sharing will give private lien-holders reason to be proactive in reducing principal in these areas, thus limiting the economic fallout of the mortgage crisis and directing the most help where it is most needed.
In return for reduced principal, the government and private lien-holders also would receive tradable warrants to benefit from future home-price appreciation enjoyed by the universe of homeowners bailed out through principal reduction. To be fair, this share in future appreciation should cover any home purchased in the next twenty years, so that those who sell right away are more likely to contribute their fair share.
While fairness is in the eye of the beholder, I think this proposal comes closest.
All homeowners with mortgages could benefit from the refinancing option provided by the government up to the foreclosure value of a home. Additional help is directed to those who most need it, but they have to give up a share of future home-price appreciation.
The final piece of a fair and comprehensive solution is to provide tax credits for home purchases to sop up excess supply, thus rewarding renters who have made sound economic decisions. These should be designed to incentivize risk-taking without artificially inflating home prices.
With home prices expected to fall another 10% or so, a sensible approach would be to start with a 6% tax credit (up to $30,000) on home purchases. (To ensure the credit isn’t wasted, half could be provided up front and half (with interest) after several years of timely mortgage payments.) This tax credit could steadily phase out over 18 months, helping to rebalance supply and demand while cushioning the landing in home prices.
Jed Graham writes about economic policy for Investor’s Business Daily. This column reflects his own views, not those of IBD.