Marty Feldstein, the former head of the National Bureau of Economic Research and a fearsomely brilliant economist, has a modest proposal for solving the housing market problems:
Optimists note that homeowners with negative equity have generally been reluctant to default in past years. That was sensible when house prices were rising. But with house prices falling, defaulting on the mortgage is the rational thing to do.Limiting the number of such defaults, and preventing the overshooting of price declines, requires a public policy to reduce the number of homeowners who will slide into negative equity. Since house prices still have further to fall, this can only be done by a reduction in the value of mortgages.
None of the current mortgage-reduction proposals are satisfactory. Although bankers sometimes have the incentive to reduce mortgage-loan balances voluntarily in order to avoid a foreclosure, this is usually not possible because the syndication of mortgage loans means that there is generally not a single lender who can agree to the mortgage writedown.
Proposals to force creditors to accept write-downs of interest or principal violate their contractual rights, reducing the future availability of mortgage credit and raising the relative interest rate on future mortgages. Reviving the depression-era Home Owners' Loan Corporation would have the government use taxpayer money to pay off existing loans and become the largest mortgage lender in the country. This would require an enormous federal bureaucracy of appraisers and loan agents.
If the government is to reduce significantly the number of future defaults, something fundamentally different is needed. Although there is no perfect plan, a program of federal mortgage-paydown loans to individuals, secured by future income rather than by a formal mortgage, could reduce the number of mortgages with high LTV ratios and cut future defaults.
Here's one way that such a program might work:
The federal government would lend each participant 20% of that individual's current mortgage, with a 15-year payback period and an adjustable interest rate based on what the government pays on two-year Treasury debt (now just 1.6%). The loan proceeds would immediately reduce the borrower's primary mortgage, cutting interest and principal payments by 20%. Participation in the program would be voluntary and participants could prepay the government loan at any time.
The legislation creating these loans would stipulate that the interest payments would be, like mortgage interest, tax deductible. Individuals who accept the government loan would be precluded from increasing the value of their existing mortgage debt. The legislation would also provide that the government must be repaid before any creditor other than the mortgage lenders.
Although individuals who accept the loan would not be lowering their total debt, they would pay less in total interest. In exchange for that reduction in interest, they would decrease the amount of the debt that they can escape by defaulting on their mortgage. The debt to the government would still have to be paid, even if they default on their mortgage.
Participation will therefore not be attractive to those whose mortgages that already exceed the value of their homes. But for the vast majority of other homeowners, the loan-substitution program would provide an attractive opportunity.
I tremble to disagree with Feldstein, who is about a zillion times smarter than me. But I think he overestimates the problem of people walking away from homes where the loan-to-value (LTV) ratio is above 100%--i.e. where homeowners have "negative equity". Letting a bank foreclose is a traumatic action that will scar your credit report for almost a decade; most people do this, not when a decline in the value of their house reduces their equity, but when they can't make the payments. I see the problem of foreclosures largely as one of people who took out loans they couldn't afford, not owners behaving strategically about a depreciating asset. And preventing some foreclosures will not, I think, stop prices from declining.
The main problem in most housing markets seems to be, not foreclosures, but the simple fact that people are no longer under the delusion that house prices will go up 5-10% per annum. In 2005, people were pricing that into their housing purchase: "Well, it's worth maybe $300,000 to me, but of course, in three years, the house will be worth $450,000, so I could pay $375,000 and have a nice nest egg." Now that the expectations of asset-price inflation are gone, prices have to fall back to the "real" value of the house: what it is worth to someone to have a warm, dry abode of their very own to live in. Actually, a little farther, because the credit contraction means that there's a large mismatch between supply and demand.
Foreclosures might cause the price collapse to overshoot on the downside, but I don't see them as the primary driver, even in depressed markets.
That said, this is not a bad idea. It would give some breathing space to people who can't make their interest payments right now--particularly if the money is used to pay off the first, more expensive loan. I'd think that even people who were upside-down on their mortgages would want to take advantage of this, and assuming a relatively low rate of default, it's not particularly expensive--the government is loaning out money at the rate it borrows. I don't think it would halt the price declines, but it would prevent some foreclosures, and help other people get their finances together without letting them escape the consequences of borrowing money they can't afford.
This probably means, of course, that it has actually no hope of ever making it into law.
There are a number of potential problems with this. First, would this program be limited to primary homes only, or are we also talking about speculative properties? Second, would it be available for those with more than one mortgage on the home? Third, it's not clear to me that a 20% reduction in the underlying mortgages will enable many of those who are currently in trouble to suddenly start affording their payments. It's my sense that those who are in serious difficulties can't afford their mortgages basically at all. Fourth, would the federal government essentially become a lienholder on the properties, or would these be uncollateralized loans? Finally, how exactly do the feds propose to recoup the money loaned to those who still ended up defaulting?
Finally, how exactly do the feds propose to recoup the money loaned to those who still ended up defaulting?
Tax liens.
Fourth, would the federal government essentially become a lienholder on the properties, or would these be uncollateralized loans? Finally, how exactly do the feds propose to recoup the money loaned to those who still ended up defaulting?
I'm not sure that would be a problem when the government is a claimholder. Tax refunds confiscated, Social Security withheld, federal agents tracking you down and breaking your legs...
I may be slow today... but what's the downside for a non-struggling homeowner (say, me) who's not anywhere close to upside-down to use this opportunity to reduce the cost of his mortgage and the monthly payments? As far as I can tell, this program would let me exchange 20% percent of my (let's say 30 yr fixed @ 6% APR) mortgage for a very cheap (Treasury + 0!) 15-year ARM with immediate reduction in payments. Wouldn't that lead to a massive over-use of the program?
The program seems too attractive to those who are othersise unaffected by the crisis and insufficient (as noted) for those who are.
Say this program is available to all primary homes. I (with a $1m 5.5% 30yr fixed at ~65% LTV) would be very happy to cut my costs by taking on one of these. Would even buy a cap with the savings to hedge out the floating rate risk. But note that I'm assuming that I am not at risk on the house or of other financial distress, and am willing to accept the rule that I not otherwise lever myself up.
Since this is a pure bailout of the creditors, I assume they would be even more happy with this, and would be doing everything in their power to get their underwater notes paid down and off risk.
So it looks like this will be taken up en masse, requiring a very quick buildout of a federal bureaucracy to administer, fund and service the program. And a material bump in Treasury issuance to fund this all.
But I am increasing my risk in this program. If I do go bust for any unforeseen reason, I've just taken on $200k of nondischargeable debt. While I've lowered my interest bill, I'm still servicing $1m of debt, so my odds of distress weren't improved much. So, the cost of the program will be borne by the government and defaulting borrowers, while the mortgage lenders walk away laughing.
An unvarnished lender bailout like this only helps if the root cause of the price decline was withdrawal of liquidity by mortgage lenders. I don't think that's the first order problem here.
As Arnold Kling writes about this here:
http://econlog.econlib.org/archives/2008/03/feldsteins_lend.html
"the main effect is to take risk off the table for lenders." The assumption being that if lenders don't feel the negative consequences of risky behavior, their behavior will be even riskier next time.
But then, I have the same negative opinion about the LTCM bailout (http://en.wikipedia.org/wiki/Long-Term_Capital_Management#1998_Bailout).
So, what do I know.
The other problem is that currently your payments don't adjust when you pay down a chunk of the principal on your mortgage. The interest percentage gets recalculated, so effectively you're skipping forward a few years in the amortization table, but you continue to pay the same amount of P&I. My husband and I have been paying down our mortgage for years, and our 30-year note will be paid off in less than 15 years because of it, but our payment will still be the same unless we refinance.
I assume, although I do not know for sure, that banks do this for some good reason, such as being able to count on a guaranteed income of $X per month per borrower. Perhaps re-evaluating the monthly income might have some other unpleasant consequences for the banking industry. I don't know for sure, but it seems a plausible concern to address.
I tremble too Megan, but I have to agree with you that most people won't default no matter what the "value" of the residence is, as long as they can afford the monthly poayments.
I got nailed in the NYC co-op collapse in the early '90's. $135,000 mortgage on an apt valued at $75,000.
I "knew" the value would return to what I had in it ($200,00), if I could afford to pay the mortgage. Unfortunately, I couldn't and had to walk away in a bankruptcy proceeding. The apt is now (17 years later)valued at over $300,000 and it has taken me almost this amount of time to get my credit back near normal.
Well, since I have taken the trouble to pay off my mortgage already (deferring spending the money on other things), there is only one course open to me. I must immediately go out and get a large mortgage (with no pre-payment penalty). Then I get 20% of that refinanced at 1.6% by the government.
At which point, I immediately pay off the remaining original mortgage, and invest the 20% that remains at some nice interest rate (I know at least one bank that is paying 4%). Presto! I've got free money earning me the differece in the interest rates. How cool is that?
"The main problem in most housing markets seems to be, not foreclosures, but the simple fact that people are no longer under the delusion that house prices will go up 5-10% per annum."
Absolutely. In the San Francisco Bay area, it has been true for decades that you could rent a house and pay the owner less than the interest on the purchase price plus real-estate taxes. Why would the owner rent that house instead of selling and putting the proceeds into T-bills? For exactly the reason that people buy stocks on margin -- "they are going up".
The only long term solution is to quit selling houses to people that cannot afford them.
Congress and several political actions organizations caused this by threatening the lenders with discrimination lawsuits and restrictive legislation.
No one explained to the borrowers that a house is a liability and not an asset. They also did not explain that if you are paying $1000. for rent on an apartment that a house of equivalent size would cost you twice as much with taxes, insurance, and repairs.
Politicians and media should keep their noses out of things they don't understand... business and the real world.
I cringe everytime the government wants to do me a favor. I can not afford many more favors.
The only long term solution is to quit selling houses to people that cannot afford them.
Congress and several political actions organizations caused this by threatening the lenders with discrimination lawsuits and restrictive legislation.
No one explained to the borrowers that a house is a liability and not an asset. They also did not explain that if you are paying $1000. for rent on an apartment that a house of equivalent size would cost you twice as much with taxes, insurance, and repairs.
Politicians and media should keep their noses out of things they don't understand... business and the real world.
I cringe everytime the government wants to do me a favor. I can not afford many more favors.
I am concerned about the provision in the legislation that would prohibit excess pay down of any other creditor. This would eliminate the value of the Federal programme for any homeowner who has tried to keep things going for a few extra months by letting the credit card bill mounts up. The improved interest rate on the government loan could end up being more than offset by the high interest rate on the credit card (and, in fact, there would be no incentive for a credit card company not to raise you to the universal default rate if it knew that you were in the Federal programme - after all, at that point you would legally not be able to transfer the balance away or pay more than the mandated minimum).
On the other hand, presumably this programme doesn't work if you fail to restrict the homeowner from differently prioritising their creditors. What's the solution here?
Tanta does the math behind this proposal and shows why it is teh stupid.
Walker:
I am glad you posted that. I was just going to do the same thing.
We did all of this before in 1990, and now we're doing it again. Why is it th US Government's concern if people enter into contracts they can't fulfill? Answer: Because the banking system is becoming unstable. The instability is due to loans with insufficient down payments, and loans with variable rates and high escalator rates. Prepayment penalties are blocking solutions to the problem. What can the government do? Some things. But private banks can do a lot if they have profitable opportunities. That means opening the FED's discount window long term. The loans can be refinanced to fifty years fixed or some such thing so that the impacted cash flow of the owner can handle the offset. That will clear the loan from the books of the CDO holder with payment of the principle as the new loan activates. It will also clear the obligation of the monoline insurer. The government should make null, void and unenforcible all prepayment penalties. We should make the origination of variable rate loans illegal unless the recipient is a qualified investor. The general public can't handle them, and don't understand interest rates well enough to be allowed to transact. Variable rate loans are the property equivalent of buying securities on margin. Not everyone should have, nor should they be permitted to have, a margin account. Regulators should require say, a 20% down from all originations. That will cut the rate of new loan originations. Good!
No one has mentioned the prime reason why housing prices stopped rising and have actually fallen. 20,000,000 home owners/renters are suddenly leaving the market. Given that the market only has 150,000,000 owner/renters, a twenty million loss represents a 13% decline in demand for housing which historically has INCREASED at an annual rate of 3-5%.
Driving 20,000,000 illegal aliens out of their homes has seriously injured our credit markets. They don't give you a moving van when they deport you, so twenty million credit card holders have stopped paying for the stuff they were forced to leave behind. And 20,000,000 hasty sales of houses or broken leases.
Of course there are 20,000,000 jobs that are now empty - but there are 20,000,000 fewer consumers -so on balance unemployment is rising.
There is no progress in reaching any of the goals that justified deporting 20,000,000 aliens and we are suffering massive damage to our economy as an unintended consequence.
There is no possible solution to these problems except to find a scape goat, such as subprime loans.
Re: Driving 20,000,000 illegal aliens out of their homes has seriously injured our credit markets.
???
are you posting from some alternate reality? In this time-line there has been no vast deportation of illegal immigrants, nor is any such planned, much as the nativist Right demands it.
I can see a tweaked version of this making a big difference. My adds:
- The loan is repaid when the home is sold, using any net proceeds after the original mortgage is paid off at the rate of 50cents from each available dollar. This gives the seller an incentive to get a good price.
- Before the loan is approved, the house has to be appraised at a value below the existing mortgage amount and above the reduced mortgage amount. I.e., the reduction has to put the homeowner back in the black. This prevents those who are already in the black or who just can't make the payments on their appropriately sized mortgage from sleazing into the program.
- Make the lender make the actual loan and have the feds cover only half the amount. That way the lender takes part of the hit if there is one down the road.
- Limit the program to those whose mortgages are below the median home price for the area.
The net is to separate those hit by falling prices from those hit by falling incomes. Bailing out the first group will help the market clear and resume normal functioning.