Bailing Out Underwater Mortgages
Ronald Reagan's chief economist has a radical plan for solving the housing crisis.
Martin Feldstein, a Harvard ecoomics professor who chaired Ronald Reagan’s Council of Economic Advisors, calls for a radical write-down of underwater mortgages.
HOMES are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.
But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America. The resistance is understandable. Voters don’t want their tax dollars used to help some homeowners who could afford to pay their mortgages but choose not to because they can default instead, and simply walk away. And voters don’t want to provide any more help to the banks that made loans that have gone sour.
[…]
Most residential mortgages are effectively nonrecourse loans, meaning creditors can eventually take the house if the homeowner defaults, but cannot take other assets or earnings. Individuals with substantial excess mortgage debt therefore have a strong incentive to stop paying; they can often stay in their homes for a year or more before the property is foreclosed and they are forced to move.
The overhang of mortgage debt prevents homeowners from moving to areas where there are better job prospects and from using home equity to finance small business start-ups and expansions. And because their current mortgages exceed the value of their homes, they cannot free up cash by refinancing at low interest rates.
[…]
To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion. Here’s how such a policy might work:
If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half. For the millions of underwater mortgages that are held by Fannie Mae and Freddie Mac, the government would just be paying itself. And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse — in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.
The notion of write-downs has been out there for some time but this is the first time I’ve seen the “full recourse” twist. Then again, I don’t read the economics literature all that closely.
This proposal makes a lot of sense, in that being trapped in an underwater mortgage has all manner of cascading effects, as Feldstein alludes to. Politically, though, it’s a non-starter because it once again rewards those who made bad choices at the expense of those who didn’t.
The DC area housing market, like our economy generally, was hit less severely than most of the country. Still, our house is worth less than it was when we bought it five years ago. But we’d also benefited from the previous bubble, having sold my house before we got married and then hers a few months later. We rolled that money into the financing of this one, putting down a much larger than necessary down payment. The net result is that, while we no longer have the 20 percent equity needed to refinance, we’re not underwater either.
So, we’re talking about 11 million homes where either values have gone down way more than the national average, the owners put down little or no down payment, or both. It’s going to be really hard to convince their neighbors, who deferred gratification until they could put down substantial down payments, to pony up the money to bail them out.
Fairness aside, it may well be the right thing to do to get us out from under this mess. And this is yet another data point in the story of the changing definition of conservative in America. Again, Feldstein was Ronald Reagan’s chief economist. Can you imagine a Tea Party conservative coming out with this plan?
I have no idea why he thinks this would be ideal; there’s certainly no economic case for such a specific number. Having said that, this plan will provide some acceleration in consumer delveraging and push the balance sheet recession to an earlier end.
Re. the “full recourse” condition, it has been a pattern in the last 4 years that any government mortgage plan has a poison pill, to make sure not too many people take it. This seems typical.
Re this:
I can’t help but see that as a huge cash impulse to banks, at taxpayer cost. You know, old conservative theory would be that these things be self-funding, and be paid for by users. Hence if the government is going to pay mortgages, it needs to tax mortgages going forward to pay for the operation.
What, we should “transfer wealth” from general income tax (and renters) to mortgage banks?
BTW, related:
So … TARP, riskier loans, and then mortgage reductions. That’s a vicious little cycle of moral hazard, isn’t it?
You needn’t worry, as this proposal will go nowhere…Wall St. got theirs, but you aren’t going to get yours…
Moral hazard isn’t the reason the proposal is a non-starter, James. It’s a non-starter because it would force banks to acknowledge that they’re insolvent. This week Nouriel Roubini and associates made a similar proposal, even more precisely targeted at ending the “balance sheet recession”. Their proposal has the same problem.
“Can you imagine a Tea Party conservative coming out with this plan?”
I can’t imagine a Tea Party conservative getting all the way through the article. Seriously, though, I don’t think this is as much about shifting ideologies of conservatism as much as the deteriorating intellectual underpinning of the movement. The fact that a torches-and-pitchforks mob is being asked how they feel about mortgage modification in the first place, when they’re still hung up on how Teh Soshulism is going to raise their taxes somehow, shows how far the GOP has fallen.
On the merits though I don’t see how this plan helps unless you’re of the opinion that lots of people would move to more affordable houses if they weren’t underwater. What would be nice is a plan that simultaneously reduced the principle of the mortgage and refinanced the payment schedule so that monthly premiums went down. And you’re still left with the fact that 9.1% of us can afford basically zero. Sigh.
@Dave Schuler:
It seems the general public bought the “paid back TARP, things are fine” story line.
@Andyman:
I think the way bad debt works is that the creditor may know that some debt will never be fully paid, but prefers to receive high payments as long as possible before being forced into recourse. Imagine 10 houses underwater. Maybe 7 will make payments right on through, and the remaining 3 will fail at various times. Well, hopefully later rather than sooner, right?
It is hard for me to see this plan, to convert all 10 at once, as anything other than a bank subsidy. See also “OWS”
Given there are states that specifically forbid full recourse mortgages, does the federal government have the power to enforce such a clause?
@john personna:
On the flip side, why should we transfer wealth from people who are paying their mortgages to those that aren’t.
I’m willing to listen to anything that will actually work…but you have a Teapublican caucus that votes no on things it likes…so it ain’t going to happen. So while were sucking on the crack pipe:
Assuming they are going to write down principal that is at 110% of value to 100%….then I want my principal written down 10% too. Think of it as a one-time mortgage pay-down grant. It would be massively stimulative.
@Stormy Dragon:
Because they are all potential users of the program.
It is directly analogous to banks paying for FDIC protection on deposits. We do not pay those from the general account.
Since this is explicitly a “voluntary plan”, which is subject to the lender and and borrower agreeing, there is nothing to stop it from happening now. Oh, except for that the lenders aren’t willing to take the loss from the write-down of the loan on their books. I strongly doubt that the difference between the bank taking 50% of the loss and the bank taking the whole loss is going to make the bank willing to accept this.
@Moosebreath: Exactly, as you and Dave Schuler have noted, the problem with this and any other plan, including cramdown in bankruptcy proceedings is that it would force the banks to mark their assets to market and reality instead of fantasy. Right now, the banks are in decent shape as long as they can pretend their toxic assets are not toxic — reality would be an ass-kicker.
@Moosebreath, @Dave:
Well the half-contribution to the write-down from the federal government is not in place.
As I understand it, the banks would take a write-down for their half and then get a check from the fed for the other half. Given that large cash infusion (compared to normal loan cash flow), I’d think that would be a pretty sweet deal for the bank. Reserves spike. New loans can be made. Etc.
@Stormy Dragon:
The government could make it a requirement that states change their laws to be able to participate in the program. That is how the feds always get the states to go along.
The biggest losers would be the people who made big down payments and paid their bills on time. Their less responsible neighbors get a huge financial windfall and the respnsible people lose value of their houses.
Once gain, the government would be rewarding bad behavior and punishing good behavior.
“Politically, though, it’s a non-starter because it once again rewards those who made bad choices at the expense of those who didn’t.”
I don’t know about that one. Speaking from personal experience, I just found out I was massively underwater on my house. The reason? Several of my neighbors have foreclosed or sold their homes for a major loss because the market is crap.
I wish I was living in my own private real estate paradise, but the value of my home isn’t determined by my home alone. And my “good” choices don’t insulate me from the “bad” choices of others.
I also tried to refinance recently. My interest rate is low, but it could go lower. The bank said NO. (With a credit score of 723????) And I get it. Why volunteer to make less money?
After all, my only way out is to pay it off or default. Either way, the bank is covered and I’m pretty much screwed.
Indeed not. Didn’t Rick Santelli explain quite clearly that this kind of thing is Commie through and through?
Who on earth would agree to switch a non-recourse loan into a recourse loan while still being underwater (albeit less so) from the get go? This plan is a non-starter for that reason alone: nobody actually would do this. Plus as previously stated in the thread if banks suddenly had to mark to market on mortgage debt the negative fallout there greatly would exceed any positive fallout from writing down the consumer side. It’s a non-starter on both sides of the loan coin.
(Incidentally, the author of the piece presumably engaged in a Freudian slip when it was said that with Fannie Mae and Freddie Mac the government would be “paying itself.” Really? Wow. Fannie and Freddie are not government agencies. They’re private companies, albeit ones who’ve been bailed out with public dollars and ones where there has been an implicit guarantee of public backing, which ironically fueled the housing bubble in the first instance. I guess taxpayers now are presumed to be on the hook in toto for the Fannie and Freddie debacles.)
The way in which to deal with the housing and home loan crises is to spur job creation. You can write down mortgage principal until the cows come home but it won’t mean squat if Joe and Sally Homeowner don’t have jobs. The way to spur job creation is to engage in fundamental regulatory reforms. If for example Congress enabled the private sector to maximize our domestic shale, oil and natural gas production it automatically would create several million net high-paying jobs across the country.
@Tsar Nicholas II:
We mostly agree, obviously, but I think you are missing the huge short term-transfer that would take place if such a plan were implemented and acceptable. The banks don’t take a “loss,” they take a “write down.”
Before the adjustment say they are getting $3K payments per month. After the adjustment they get $2.4K per month, a lump sum of $100K, and a tax loss of $100K. [making up semi-reasonable numbers]
That is complicated, and it would take an accountant to work out the future-value of the deal, but it still looks pretty sweet to me. On a cash flow basis … definitely
It’s a non-starter because it would force banks to acknowledge that they’re insolvent.
That’s my reaction too. But how long can they/we hide from the fact that (some of them) are insolvent?
If for example Congress enabled the private sector to maximize our domestic shale, oil and natural gas production it automatically would create several million net high-paying jobs across the country.
This sounds like wishful thinking to me. Even leaving aside the negative environmental impact, I don’t see how it would create several million high-paying jobs.
@john personna:
Your observation that half a loaf is better than none is, of course, correct. However, there’s a big difference between a bank with a trillion dollars in assets and one with $500 billion. What I think that the bank top management fears is a drop in their own incomes and shareholder revolt.
That’s what I think all of this is about: top management income and shareholders. The problem is that the loss has already happened. Now we’re just extending and pretending, hoping that things will get back to normal.
Unfortunately, normal is a lot lower housing prices than are the case even now in some areas and a lot less financial activity with much smaller, less well-compensated financial sectors.
@Herb: Oh, I don’t mean to imply that everyone underwater is there through their own fault. The housing market is not under any individual’s control.
But compare two neighbors, living in essentially identical homes. One paid 25 percent down, has his home values go down to eat every bit of that equity, and now owes pretty much what the loan is worth. The other paid nothing down in is now 25 percent underwater. The second would get forgiveness for that 15 percent–a hell of a lot of money, especially amortized over the cost of a 30 year mortgage–and the second would get zip. Indeed, the first would get doubly hosed since he’s now on the hook for his portion of the part that the taxpayers paid for.
@Dave Schuler:
Right. This would be a mechanism to convert loan assets into reserves. How the board would respond to that might depend on how much they desire reserves 😉
And of course the projected value for loan X under the plan would depend on things like odds of default and before/after interest rates.
@ Herb and James…
Tripley hosed because his homes value is probably going to take a hit when his neighbors value is lowered.
Again with the Fannie and Freddie Fairy Tales.
Can’t you guys get over that thoughourly debunked talking point?
“I can’t imagine a Tea Party conservative getting all the way through the article.”
Well, there’s that problem, too,
“Most residential mortgages are effectively nonrecourse loans, meaning creditors can eventually take the house if the homeowner defaults, but cannot take other assets or earnings.”
True in CA. False in most of the other states. The WSJ ran a story about banks selling the debt left after foreclosure to third parties. It claims the debt is still valid for twenty years. Feldstein is wrong on the basic facts. The WSJ article was titled “House is Gone but the Debt Remains” try here for a link:
http://online.wsj.com/article/SB10001424053111904060604576572532029526792.html
Big picture…I think it’s terrific that a conservative is thinking outside the box and not reverting to talking points. Yesterday the Senate Republicans offered up their Jobs Plan and it was nothing but the same old crap. Also yesterday Boehner got in Obama’s face that the House republicans had offered up a Jobs Plan some time ago…but again that plan was the same old crap…tax cuts for the wealthy and de-regulation…two things proven not to do a damn thing to stimulate job growth. And of course you have Paul Ryan…the Republicans go-to guy on economics supporting Cain’s 999 plan…which everyone agrees is a stupid idea. I wish Republicans would begin to listen to people like Feldstein…who at least are testing out new ideas…instead of just going back to the same old ideas that didn’t work and had a big hand in putting us in this hole to begin with.
Subsidies (a variety of ways) definitely fueled house appreciation. The key question is whether it would have been possible to exit the appreciation cycle, say 1993 – 2005, without the bubble at the end?
And of course, everyone wants “appreciation” back again.
So … Freddie and Fannie were there all through the appreciation, lost share to the sub-prime packagers as the bubble spiked … what do we want now?
No subsidies and less appreciation? Maybe that would be healthy for the economy as a whole, but most voters are in “house as primary asset” territory.
Really? Maybe. I don’t know. They might think they are. I guess if they ever pay them off…but what is their real equity position today? I know my 401K and my various IRA’s and Roth IRA’s are about 2.5x the current equity I have in my house…especially with current real estate values.
@Hey Norm:
I was really calling out the first line from Feldstein above:
“HOMES are the primary form of wealth for most Americans …”
I think it IS a risky strategy.
Gotcha.
Yeah…it’s a non-starter…but nice to see the so-called right thinking for a change.
Would home equity loans count towards determining whether a homeowner is underwater or not?
The dichotomy presented in this plan is expressed well by James. It would directly address the financial misery of huge underwater loans, making them more palatable by those homeowners to shoulder. However, it would also be yet another reminder to mortgage holders, who used financial pragmatism in their borrowing, that there are few up sides for coloring within the lines, when ‘poor decisions’ are so often quickly whited out by such government programs.
Actually yes–no subsidies and less appreciation. I see helping out those people who are underwater in their mortgages at the expense of those who aren’t and those who rent as a bad deal all around. In “hot” areas of the country, housing prices practically doubled during the bubble years. The trend was clearly unsustainable though, at the time, a lot of folks seemed to think the party would go on forever.
We lived in the Hell-A area during the peak years of the boom, when little piece-o-crap houses in areas where you couldn’t send your kid to public high school without an AK-47, were selling for half-a-million plus. Having sold our condo in the Chicago area when we made the decision to move to LA, we decided to forgo home ownership, even though we could have easily gotten some kind of Alt-A loan, because it was pretty clear the insanity couldn’t last. I think that somewhere near 75 percent of all mortgages issued in California were less than prime during those boom years.
TARP was bad enough, creating an illusion that a lot of the now even bigger banks are relatively solvent when they aren’t. I have no desire to see the government throw good money after bad trying to prop up inflated home values.
@James Joyner:
I think if it’s done then the people choosing to do so apply their mortgage (or other, for that matter) deduction(s) that they would get. It would to the government each year till the balance is covered.
In other words, the IRS keeps the deductions of those in the plan.
For example, my deduction is 20k year, if I were underwater, I’d take a steep reduction on my monthly nut and lose any deductions. I would beg to break even, and happily not get the refund.
That way on the moral hazard aspect at least, the people getting helped out do have skin in the game.
Lots of reasons that can’t work, I’m sure, but…
@Herb:
I’m probably underwater on my house too, but since my purchase was no based on the assumption that I must be able to sell it at a profit in the near term, that’s really of only academic interest too me.
When I bought it, I only bought a house I could afford, rather than buying a house I could not afford an counting on future capital gains to allow me to refinance it on terms I would be able to afford.
@Stormy Dragon:
Two things:
1) I bought that way too, so thankfully I’m not in trouble; but…
2) the drop in prices is of more than academic interest, though.
If Zillow is reasonably accurate, my house has lost ~19% of its value since we bought it (June, 2007). That means that the amount we had to borrow was greater than it would have been absent the bubble.
This is partly mitigated by the fact that we sold a house at the same time. Only partly, though, since the house we sold was a smaller/less expensive one. My back-of-the-napkin math suggests that if both houses (sold/bought) were at present-day post-bubble prices (well, not quite, IIRC prices are actually still above-trend), we would have ~$45,000 less debt. The bubble cost us ~$45k. I can only imagine the frustration of a renter who finally gave in and bought a house at the peak of the bubble (like, say, the folks we sold our house to in 2007).
Anyway, $45k isn’t academic. It isn’t going to break me or anything, but ouch.
edit: one can certainly argue that the $45k loss is further mitigated by low mortgage rates – I refinanced in 2009 to 4.99% and am pondering doing it again (my general rule of thumb is if I can shave off a full percentage point, it’s probably worth it, and rates are right around 4% for 30-yr fixed now). That’s of some comfort.
@Fiona:
I well remember that time. There were tons of conversations about “How can this last?” too. But, people just kept getting in line, competing for overpriced real estate with multiple offers. It was a frenzy to establish yourself as a homeowner, whether one could afford the label or not. The rationale was, if the property was a little over priced, it would soon average itself out when comparable housing sold for even more. This is how people saw themselves creating equity in their investments — gambling that the pricing excesses in housing would have no end.
One major psychological factor that needs to be dealt with in clearing the market is convincing people that the top-of-the-bubble valuation of their house is not the “correct” price for their house.
Which reminds me, I need to watch Raising Arizona again. God bless Leonard Smalls.
@de stijl:
No doubt.
Thankfully I’m not trying to sell. As rational as I tend to be and try to be, it would seriously suck to actually put my house on the market for 80% of what I paid for it.
Of course, if you try and recoup what you paid, it just sits there, not selling.
Compare this to 2007, when I got asking price for out old house within 7 days.
@Rob in CT:
But, you also have to add in points etc., to any of your loan modifications, to reason the cost factor involved. Another aspect, to at least consider and pencil out, is taking a 15 year amortized mortgage vs the standard 30 years. You could save a lot of interest payments/money if such a loan could figure within your budget.
My husband and I took that amortized period down to 10 years the last time we refinanced, and now only have two years remaining on a free-and-clear status, with most of our payment currently going towards paying down the principle.
I think the plan is politically unfeasable. Half of the debt run up in the housing bubble was by households in the top quintile of income. Bail outs for McMansions anybody?
To the extent the debtors are still in the top quintile, you are basically taking an income stream from from the banks, possibly at the risk of their insolvency, to give wealth to the upper class.
@jan:
Requirement #1 is no points, Jan. Obviously, paying points changes the equation.
I’m also considering 15 (and 20, if offered) year mortgages. 15-year rates are around 3.25% apparently.
The question is what payment that locks you into. We overpay every month now, effectively transforming our 30-year loan into a 16-year one, but if something bad happened we could drop back to just the required payment and be ok. If we lock in at a higher level, we have less wiggle room. It all depends on the details.
The other factor is Loan-to-value. I think we’re over 80% (unless our house is magically worth much more than Zillow thinks it is), which would mean mortgage insurance. I *hate* that, since I consider it just pissing money away. It’s somewhat irrational, but it’s there. So then I have to consider plunking down more money to get back to 80% LTV.
@de stijl:
I’d like to rebut my own comment.
The much bigger problem in clearing the market is to have financial services firms actually value the real estate they own at current-day market value.
PD Shaw, above, has beaten me to the punch on pointing out the other problem: the mortgages held by the top quintile constitute the major of mortgages. Even in the case of subprime mortgages many were held by those in the top quintile, odd as that sounds. Redistributing to the top quintile will probably be pretty hard to sell.
I don’t like the plan, having had time to think. It has virtually no chance of getting through Congress, and requires creditors to agree to the plan unless one’s mortgage came through Fannie or Freddie.
A far better option would be for the Fed to simply buy those mortages at their marked-to-market value and then funnel them through the Consumer Financial Protection Bureau for modifications. No monetary expansion, no cost to the taxpayer.
@Stormy Dragon: “When I bought it, I only bought a house I could afford, rather than buying a house I could not afford an counting on future capital gains to allow me to refinance it on terms I would be able to afford. ”
When I bought my house, I too bought a house I could afford. It’s even more affordable now! Wanna buy it?
Seriously though…I know the bank wants to keep their 1 point for the next twenty years. I don’t mind. That’s why I pay extra principal every month, cuz screw them. You see, the refinance scheme was me trying to pay them faster. It seems they muttered, “This guy wants to pay us off,” panicked, then fled.
@Ben Wolf: “I don’t like the plan”
PS. I don’t like the plan either. I really don’t want help from the government. Side bennie of being underwater: Though I may have lost 50K in equity, I also lost 50K in tax liability.