Achieving the Seven Essential Goals of a Housing Fix

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.


7 Responses to "Achieving the Seven Essential Goals of a Housing Fix"

  1. Steve   December 2, 2008 at 8:32 am

    In your example of the $320K mortgage, you indicate the govt remaining $120K portion carrying a rate of roughly 3.5% with no interest for 5 years…I believe you mean no principal for 5 years (interest only)….I know, picky, picky, picky

    • Jed Graham   December 2, 2008 at 9:11 am

      Thanks for reading closely, you are correct. Interest-only, no principal.

  2. Retired military   December 2, 2008 at 12:51 pm

    I’ve been getting Google alerts, and your proposal is the first to make sense. Everyone is covered.I fall into the category of “hanging in there”, using credit card borrowing to keep from falling behind in my mortgage payments, but the cc limits are running out. I am about to run into a brick wall. I have never missed a mortgage payment in my 82 years, but now I am facing reality, called survival.I mailed the mortgage holder six months ago outlining my plight. No reply. A few weeks ago, I found the phone number for the lender’s “Loss Mitigation Department”. I was greeted by a border-line rude live person who said I would be contacted within 72 working hours. No, he didn’t have my letter. He gave me their fax number so I faxed the same letter with additional info that I had just returned from serious surgery and was now considered unemployable. That was two weeks ago, and still no reply.I thought you might be interested in my scenerio as an example of just one mortgage holder who has made every effort to meet his financial obligations. I forgot to mention: after many years in this home, out of financial necessity, I put the property on the market about two years ago just when the real estate market went south and haven’t had one offer. In the meanwhile, there is now no equity, but who knows the present value. Having been in the real estate business over 30 years, I don’t. There is no such thing as “comps” anymore. In my view, I am upside down, and no where to go. My reality now is to make a financial decision I never dreamed would ever be necessary; hanging on to my 800 FICO all these years appears to be for naught.

    • Anonymous   December 6, 2008 at 8:44 pm

      Not everyone is covered! What about the millions of homeowners that made prudent purchases with cash or avoided purchasing without financing during the bubble years, or have simply paid off their mortagages? They are being penalized and are helping to subsidize the your proposed bail out. Should’nt they be given a tax credit of some sort? How are they compensated?

  3. Anonymous   December 2, 2008 at 12:55 pm

    Another completely idiotic comment. Thanks for more top down remedies. YOU and yours keep the power over housing. Remedies come as gifts from YOU.Clown. Try reading about the lack of individually enforceable rights in housing. Obviously, being a fathead, you know nothing about the law. Try reading Lindsey v. Normet, which gives housing policy only minimum scrutiny.Raise the level of scrutiny for housing, thereby increasing individually enforceable rights in housing.Enough of your fascist, statist remedies. They’re complete garbage.Just read my book, John Ryskamp, The Eminent Domain Revolt.

  4. Runningdoglackey   December 3, 2008 at 7:41 am

    There must be a reason why so few folks I’ve read, or those making speeches and holding hearings, are talking about the core reason for the credit freeze, which is transparency, but I’ll be damned if I can figure it out, so would appreciate help on this. My understanding, Credit Default Swaps liabilities stand around $50 TRILLION. Idiots at AIG, the investment banks, Citi, et al, took advantage of the (Republican Administration) SEC ruling in 2004, first, to accept this type of insurance as not really being insurance to avoid regulation, and, second, to allow issuers to keep CDS off the books. Then, CDS were open to investment not just by true hedgers, but anyone, e.g. the hedge fund manager not holding any MBS was able to make a simple bet on CDS and suck $3 BILLION for his own account ($15 Billion for his investors?). And the uncertainty of true CDS holdings currently still freezes the banking system because there is no transparency. What would happen if the USG opened these off the book accounts and started to cull out the bettors, letting them take it in the teeth, and making a deal with the hedgers to share the loss? If this were all brought on to the books, would it crash the economy? Is that why no one is talking about this? (Surely craven venal cronyism has nothing to do with it, right?)

  5. Guest   December 18, 2008 at 6:49 am

    And who says we actually need the federal government to solve the problem?No one is accountable anymore for the mess they make. Let the housing industry clean up its own mess. Let the finance industry clean up after itself, too. Why aren’t you demanding that they fix this and if they don’t you will penalize them?