The two mortgage fixes being embraced by Democrats would draw out the necessary mortgage restructuring and might only moderately reduce the coming wave of foreclosures.
There are much more forceful policy options that can end the foreclosure crisis now, while doing more to boost household cash flow and confidence.
Government policy moves should have two goals: First, they should provide the government with maximum leverage to avert foreclosures and arrive at the most constructive outcome, including a potential of renting to the current resident. Second, they should promote an immediate and proactive reduction of principal to reflect current housing values.
Neither the bankruptcy cram-down proposal nor the FDIC’s loan modification plan is well-designed to achieve either goal.
The idea of empowering a bankruptcy court to rewrite mortgage contracts – an adverse retroactive legal change that could create a less amicable climate for attracting investment and raise the future cost of borrowing – would only apply to households as they become distressed and file for bankruptcy.
By spurring an even-bigger wave of bankruptcies, it would clog up the courts and delay relief. And under Chapter 13, individuals would still have to devote all of their discretionary income to paying off negative equity over the next several years. Finally, borrowers who can’t cover the reduced loan would still face foreclosure.
The other approach favored by Democrats is the FDIC’s plan, which would have the government bear up to 50% of the losses on loans that end up in foreclosure even after lenders modify them by cutting monthly payments to about 31% of household income.
By definition, a plan that pays mortgage investors for loans that result in failure is one that makes foreclosure more rewarding than it would be without such payments.
Consider how this might backfire. Normally, second-lien holders would be wiped out in a foreclosure. But under the FDIC plan, second-lien holders might find foreclosure to be much more rewarding than a short-sale.
The problem with this kind of incentive is that it makes foreclosure a more-acceptable outcome and encourages lenders to do as little as possible to keep a loan temporarily afloat, and the specifics of the FDIC plan would further encourage this response.
The FDIC plan, which would apply to mortgage loans at least 60 days past due, bows to the mortgage industry’s reluctance to reduce principal by prioritizing interest-rate relief and extension of loan terms to 40 years.
Now, as my opposition to the bankruptcy provisions suggests, I think it reasonable to leave principal reduction to the discretion of mortgage investors. However, it doesn’t seem a good use of federal tax dollars to reward mortgage investors for doing less than they might to keep distressed loans from failing.
While the FDIC’s target of 31% of income is constructive, there are several problems with prioritizing rate reductions and loan extensions. As long as homeowners are stuck with a mortgage far in excess of a home’s underlying value, they will be unable to sell, limiting job possibilities and leaving them at risk foreclosure. The excess debt, even if its effects are ameliorated with lower interest payments, will depress confidence.
Finally, both the FDIC and cram-down plans share the worst feature of last year’s federal bailouts: they encourage market participants to sell short in expectation of a government intervention. In this case, the market participants are homeowners and the equivalent of shorting would be halting mortgage payments.
A more constructive model than either the FDIC or cram-down plans is Hope For Homeowners (H4H), but this program created last summer needs to be revolutionized.
The concept behind H4H is that lenders voluntarily write-down the full amount of negative equity, and then the government takes over the loan, thus shielding investors from additional risk. But because lenders – especially second-lien holders – have been unwilling to take the necessary write-downs in loan principal, very few loans have been modified under this program.
Here’s how to make this program the answer to our mortgage crisis:
First, the government should buy up a portion of mortgages up to roughly the foreclosure value of a home (say 40% of the purchase price) and provide homeowners with an ultra-low rate on this fully collateralized loan portion of 3% to 3.5%, interest-only for five years. I also favor applying this program not just to distressed loans but to the estimated 50% of mortgages that are unable to refinance because of insufficient equity.
For this outlay, the government can provide an immediate boost to household cash-flow, while gaining maximum leverage as senior debt holder to bring about the most constructive outcome when loans go bad. Unlike the FDIC plan, which would reward foreclosure, this framework would remove all incentive for foreclosure, since the remaining private investors would be wiped out in such a case.
The goal of H4H would still be to erase negative equity, which would allow for the transfer of the balance of the loan to the government. And toward that end, the government would provide an incentive of matching principal reduction. But, importantly, the incentives would only apply for a short time, and they would be less generous for loans that are already in default. No other approach will do as much to bring about proactive principal reduction, while spreading the cost between private investors and the government.
For loans in default, the government could offer to match dollar-for-dollar all first-lien principal reduced and the first $20,000 of second-lien principal. For every $2 reduction in second-lien principal beyond $20,000, the government could match with $1.
For loans that are current, the government could cover two-thirds of principal reduction on first liens and the first $20,000 of second liens, and 50% of additional second-lien principal. (Because investors are unlikely to take significant losses on viable loans, this is a more efficient way of targeting government aid than the bailing out all homeowners with negative equity.)
After perhaps two months, the government matching incentive would expire, or at least fall sharply. Essentially, this would give mortgage investors a narrow window of opportunity to hedge their bets and cut future losses on loans that may well be unsustainable in this economic climate. And the government would reward this proactive approach by taking on a sizable portion of losses.
Further, both private investors and the government would be rewarded with 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.
This framework would have the government act in the interests of both investor and homeowner to maximize both the value and the sustainability of mortgage loans. In cases where a loan goes bad despite mortgage relief, the government would be in a position to avert a foreclosure and potentially rent to the current resident; but as long as a share of the loan remains in private hands, the government would be obligated to make all efforts to bring in a market-level rent.
The government’s ability to gain the leverage to end foreclosures by taking over home loans up to their foreclosure value would require mortgage investors to subordinate the remaining private portion of the first-investment to the government portion. But this is a legal change that all mortgage investors should be willing to accept because it will offer a low interest rate and no principal payments for five years to help make a loan sustainable, an opportunity for matching government principal reductions, and a legislated commitment by the government to act as advocate not just for the homeowner but also the investor.
Clearly, legislation would have to free mortgage servicers from legal liability for making loan modifications consistent with investor interests. And it would have to provide servicers with the financial incentive to make such modifications.
Some are calling for the government to refinance all up-to-date mortgages at par value, even those deeply underwater. But before the government decides whether to take such a step, it makes sense to have private investors make a contribution to lowering the risk of poorly written loans. Investors could decide to hold out for the hope of a universal refinancing, but if the loans they hold default in the interim, they would be out of luck.
The longer it takes for our foreclosure crisis to end, and the longer it takes for homeowners to work off excess debt, the longer it will take for our economy to find a floor and begin to recover. This proposal, unlike either the FDIC or cram-down plans, offers a way of stepping on the gas and gives the government maximum leverage to avert foreclosures.
Jed Graham writes about economic policy for Investor’s Business Daily, but the views expressed here don’t reflect the position of IBD.