Foreclosures are only a symptom of the real housing problem facing the economy – the deadweight of excessive mortgage debt.
Without the burden of mortgage debt that exceeds present home values, perhaps twelve million households would have more disposable income and more confidence, limiting declines in consumption and employment.
Thus, any housing fix that seeks only to limit the number of foreclosures among the most distressed households will do little to cure what ails the economy. We need a policy that gets at the root of the problem.
There are two ways for policymakers to counteract the deadweight of excessive mortgage debt on our economy. One is to provide a refinancing option for under-water homeowners, as well as the millions of additional households who have insufficient equity and are therefore unable to qualify for today’s low rates. (Refis are generally limited to those who have a mortgage of no more than 90% of the value of their home.)
A second option for dealing with excess mortgage debt is to provide incentives for lenders to forgive principal, or otherwise ease lending terms. (A related possibility of empowering a bankruptcy court to erase debt would only apply to distressed households already on the verge of foreclosure. Thus this reactive policy, which would entail adverse retroactive legal changes that could create a less amicable climate for attracting investment, might do relatively little to moderate a consumer retrenchment.)
These two options for ameliorating the impact of excessive mortgage debt – refinancing and incentivizing principal reduction – can complement one another, but only up to a point. Clearly the more beneficial of the two approaches for household finances and the economy is to simply reduce principal. The refinancing option, while helpful to household cash flows, would still leave the economy carrying a burden of excess debt.
Therefore, the optimal point of government intervention to help mortgage holders is at the point where lenders have the maximum incentive to reduce principal. This is the point at which investors get nothing in a foreclosure and, thus, have every interest in making a loan sustainable.
That is why I am proposing that the government buy out mortgages on homeowner-occupied properties (at least those not eligible for refinancing) only up to the foreclosure value of a home and refinance that fully collateralized portion of the loan at a 3.5% rate, interest-only for five years.
The framework I propose would remove all incentive for foreclosure – since remaining private investors would be wiped out in such a case – while providing an additional incentive of matching principal reductions in the government portion of the loan, thus making reducing principal the default option for modifying mortgages. What’s more, because the government would now be in the driver’s seat in any potential foreclosure, it would be able to facilitate the most constructive outcome (both for lenders and borrowers) for loans that go bad.
Because this approach would benefit all mortgage investors and hurt none, any legal obstacles are surmountable.
I’ll discuss my proposal more fully below, but first I want to discuss an alternative approach that is less than optimal because it effectively rules out the more beneficial option of lenders forgiving principal (except in the most-distressed loans) and settles for a government refinancing of the excess debt load.
This option, recently advocated by Barron’s, would have the government buy out current mortgage investors at par (except for the most-distressed loans that would be covered by government loss-sharing) and refinance the entire loan – even the portion no longer backed by the value of the home – at a 4.5% rate.
This approach would to a large extent paper over today’s excess mortgage debt with a comparable amount of excess debt that is backed by the government and carries a lower interest rate. Households would still have to carry the weight of the full amount of excess debt, investors would be let off the hook and taxpayers would bear the risk of default.
The Barron’s refinance plan would extend to some $1 trillion in high-risk subprime and Alt-A mortgages, another $1 trillion in under-water mortgages, as well as the entire universe of home mortgages. Their plan would have all households with a mortgage benefit from the subsidized 4.5% rate.
For a government that is already going to be incurring deficits of $1 trillion for the next couple of years, this is a potentially risky strategy that would test the limits of just how much cheap financing the U.S. can command from foreign investors.
In my view, our present plight of plunging consumption and the associated plunge in interest rates do cry out for a policy response that provides a refinancing option not currently available to underwater homeowners and those with little or no equity. But that refinancing option shouldn’t come at the exclusion of the more economically beneficial option of principal reduction and it shouldn’t ignore the risk that there is a limit to just how much cheap financing America can count on.
A more conservative, but still-bold approach would be for the government to refinance current mortgages at a 3.5%, but only up to the foreclosure-value of a home. This approach, if extended to all mortgages, might require perhaps about 40% of the debt issuance required by the Barron’s plan. (The foreclosure value might be 30% to 45% of the purchase price, depending on zip code, or more for homes that weren’t bought at the height of the bubble.) Under the framework I propose, for every $1 of principal reduced by the remaining private first-lien holders, the government could match with $1 in reduced principal. On second liens, the government could cut principal by, perhaps, $1 on the first $20,000 of principal reduced by second-lien investors and 50 cents for every additional dollar of reduced principal.
Instead of providing relief to those who are 90 days late, loan mitigation is at the discretion of the private lien-holders, who would now have zero incentive to foreclose and every incentive to maximize the sustainability of the 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.
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%, interest-only 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 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.
I believe this framework is the most efficient way for the government to address the mortgage crisis in a proactive fashion by helping household cash-flow, sharing losses with private investors who reduce principal without creating perverse incentives for borrowers (or investors), and facilitating the most constructive outcome of loans that go bad.
In case you are interested, I made a somewhat more comprehensive case for this proposal in a prior piece for RGE Monitor called Achieving the Seven Essential Goals of a Housing Fix.
Jed Graham writes about economic policy for Investor’s Business Daily, but the views expressed here do not reflect the views of IBD.