The Best and Surest Way to End Foreclosures

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.

12 Responses to "The Best and Surest Way to End Foreclosures"

  1. Guest   January 15, 2009 at 9:06 am for a do it yourself loan modification ebook

    • Mitty   January 20, 2009 at 10:07 am

      Thank you! Thank you! Thank you, for saying it like it is. Why prop up artificial prices when nobody (except those who use their houses as ATM machines) benefits? And high prices substantially harm first-time home buyers.Which would a first-time home buyer rather have?(1) Low interest rates & a liar loan so they can buy a house they can’t afford; or(2) Higher interest rates (that reduce their tax bill) & tight lending standards so they can buy a house that they can actually afford. Which scenario would better suite a modest income family: a $600,000 house, with a no down payment 5% loan, or the same home costing only $200,000, with a 10% down payment, 7% loan?High prices only benefit realtors, lenders, insurers, speculators, property tax collectors, etc.

  2. Anonymous   January 16, 2009 at 4:18 am

    You are suggesting that the government should invest trillions of dollars in non-performing assets (houses) at a time when the economy is in serious need of stimulation. The banks are the root cause of the problem and in a perfect world the banks would be accountable for their fiendish activities. Unfortunately though it is not a perfect world and the banks will never be converted into charitable organizations. Home “owners” will continue to be forced out of their homes and they will unfortunately have to settle for something more modest. Even if by some miracle the $50-$100 billion of TARP funds (to be set aside to reduce the number of foreclosures) was enough to radically reduce the natural attrition, the opportunistic behavior of homeowners would ensure that it was never enough. People will dream up ever more inventive schemes to abuse such a system, such as spending their way into a position where they then qualify for some generous handout.The current economic crisis stems purely and simply from borrowing. Greedy borrowers have been accommodated by greedy lenders and the whole process has been supported by greedy governments. Real estate assets that should be worth $100,000 are, by what some individuals see as a blessing, priced at $300,000 or more instead. The truth is that everyone loses. Even the modest individuals who are forcibly sucked into the system that is driven by the greedy. We are now in a situation where there is no quick fix. As prices continue to fall the less effective these band aid measures (and suggestions) will be.

    • Brett Barry   January 17, 2009 at 9:09 am

      Incorrect on most counts. The current crisis does NOT stem from borrowing and “greedy borrowers.” In case you’ve been sleeping for the last 8 years, the crisis began when banks were thoroughly deregulated and allowed to leverage at 40+ times. That money sought higher returns, and thus numerous exotic mortgage products were developed by the greedy banks/brokerage houses/etc.Consumers were the target, and lenders found their mark with deadly precision. The #1 issues now are massively falling prices (here in Phoenix at 3% a month) and growing foreclosures, which is them feeding lower prices in a vicious cycle.The only way out at this point is for the government to *force* banks (and their investors of the highly securitized assets) into accepting reduced principal at todays market prices. This would be the “mar to market” that has been sorely missing from the last use of TARP funds. The government will also have to find a method to legally protect the loan servicers who will be responsible for making these modifications. This must be done on a vast scale…and soon…Other top/down approaches will surely fall flat.

      • Anonymous   January 18, 2009 at 5:59 am

        Many borrowers are in fact greedy. They want to live beyond their means and they want to own a bigger and better house than their rivals, enemies, colleagues, acquaintances or even relatives. I’m surprised that this comes as a surprise to you??!! To say that the crisis stems from borrowing is, by definition, the same as saying that the crisis stems from lending. If it makes you feel happier you can change the word “borrowing” to “lending”. The deleveraging that we are now seeing is the borrowing/lending activity being reversed on a massive scale.You should know that you can’t force the financial institutions to do anything without shareholders paying close attention. If the thing that you’re trying to force upon them seems financially damaging they will run like the wind. Citigroup is a perfect example. You should take the time to familiarize yourself with how and why they are suffering. Then you can come back and tell us more about your vicious cycles.

  3. Guest   January 16, 2009 at 10:04 am

    How does the lifelong renter, waiting for homes to become affordable, lose? He loses only if the deadbeats get bailed out, artificially inflating home prices. How does the borrower, paying faithfully on their mortgage, and not upside down because they weren’t greedy, lose? They lose, because the greedy ones get help, while the solvent borrowers (and the renters) get robbed to pay them.

    • Brett Barry   January 17, 2009 at 9:17 am

      Many folks losing their homes today are not “deadbeats.” They are people like you who put 20% or more down, and have lost a job or had a health emergency.We can all sit around and make accusations, but the question is what can be done to stabilize this market?I’m not worried about the renters and future buyers – I am VERY worried about a collapse of our banking systems on a scale not yet seen before. Fairness has not been a mainstay of the past use of the TARP funds, and the solution to this mess (forcing lenders to accepting and modifying reductions in principal) will be considered as unfair by many. In the end, however, all will benefit when the market stem their bleeding.Until the government stabilizes from the bottom (the consumer) then the vicious cycle continues and banks will continue to need billions if not trillions more to feed their widening hole of losses.

  4. Anonymous   January 16, 2009 at 3:18 pm

    The lifelong renter waiting for homes to become affordable needs to factor in all these government rescues when tendering an offer. We prospective buyers need to keep saying “NO” to overpriced housing markets until median prices drop back to at least 2000 price levels.

  5. Anonymous   January 16, 2009 at 6:20 pm

    The lifelong renter will continue to be find it difficult to break out of the rental trap for a number of reasons. Firstly, rents will not fall in the same proportion as the fall in property values. Secondly, banks are much more cautious about lending money than before and will only deal with prospective customers with a large deposit (loan to value ratio). Nearly all renters don’t have that luxury, particularly while they are paying high rents. Finally, as mentioned by someone before, with government assistance via the TARP funds, borrowers are provided with an advantage over renters.There is mounting evidence that many world economies are heading towards, or already in, a deflationary spiral. This is a particularly nasty formula for job losses and, with with the consequent decrease in people’s ability to make mortgage repayments, further falls in property values and foreclosures. Even more scary is the prospect of the stagflation that lies ahead. If the US government can’t find foreign investors to bail it out of its mounting debts then interest rates will rise as a natural consequence, putting even more pressure on borrowers to stay afloat. The modest economic recovery that we have seen since November ’08 has been driven primarily by central banks lowering interest rates. The opposite of that is a sobering thought indeed. As I said earlier, everyone loses.

  6. G. Crooks   January 16, 2009 at 11:45 pm

    Wow! Jed shows the flaws in the current proposals. And they seem serious. But as a renter that stayed out of the this housing bubble all the way back to 2002, when it seemed silly to the flippers to stay out or even serious hometowns, it frankly sucks.I know I am showing perhaps my selfish position, but I doubt I standalone on this one. I can not imagine renters, holders of clear titles, or solvent borrowers accepting this plan either.It just does not seem fair.

  7. GueLynn Robb   January 20, 2009 at 7:37 am

    No one ever said economics was fair. What it is is relentlessly impartial. No matter what the Government or banks do or not do, housing prices will fall until they become affordable for an individual or family with an average paycheck in the community. Real estate was a a very profitable investment in the 90’s before the bubble started floating upwards, and it will be again after the dust settles.One of the things I learned as a Century 21 Realtor in the 90’s was that it is not location, it is price which sells a house. When properties get to the “right” price–whatever that may be–sales will pick up. My take is that prices still have a good way to fall before housing actually becomes affordable again.