The government’s foreclosure flop

By Christopher Swann
August 12, 2009

The Obama administration has attacked the problem of rising home foreclosures with a humanitarian zeal. Their program — the most ambitious in generations — was intended to save up to four million people from being thrown out of their homes.

A few months on, this $75 billion policy has been a humiliating flop. Only about 270,000 mortgages have been modified since the scheme was announced in February, according to government figures, and if past experience is anything to go by, half of those could be delinquent again within six months.

The root of the failure is that the Administration crafted its policy on a powerful narrative of banks hoodwinking borrowers into taking out exotic and extremely dangerous loans.

Instead, homeowners’ own reckless borrowing and unemployment have been far more important.

The Making Home Affordable plan aimed to help victims of bank sharp practice, offering various incentives to lenders to bring monthly payments back down to around a third of an owner’s income. It was not designed to aid families whose income had disappeared due to unemployment, those who had large debts beyond their primary mortgage, or those suffering from serious negative equity.

If the administration is serious about stemming foreclosures they need to go back to the drawing board and consider some politically perilous alternatives

A study of 4,000 foreclosures from 2006 to 2008 in Southern California by Michael LaCour-Little, a finance professor at California State University at Fullerton, found that many borrowers were not the hapless victims either of machinations by the banks or of an unlucky decision to buy at the top of the market.

Rather, the study suggests that they borrowed excessively against the rising value of their homes using fairly conventional loans. These foreclosed owners took around $2 billion in equity from their homes, or nearly eight times the $262 million they put in, while lenders lost about $1 billion.

About 80 percent of borrowers had attached a second lien to their property and about 20 percent had a third.

Consumers, it seems, were more than capable of getting into trouble using plain vanilla products.

Leaving aside the moral argument against bailing out such borrowers, the presence of so much additional debt makes them harder to help through government modification schemes, because of both the presence of extra liens and the high levels of negative equity.

“We get tranche warfare as holders of junior liens are unwilling to go along with modification for fear of being cut out,” says Lacour-Little.

Meanwhile, the number of homeowners losing their homes due to nefarious lending practices is being dwarfed by unemployment-driven foreclosures.

“Short of requiring a 40 percent down payment there was no way many of these mortgages could have been designed to avert disaster,” Paul Willen, an economist at the Federal Reserve Bank of Boston, said in an interview.

This has important implications for government policy. Firstly it means that a Consumer Financial Protection Agency alone — though very necessary — would not have protected most Americans from the current foreclosure crisis.

(Cynics might suggest that consumer advocates such as Elizabeth Warren and Michael Barr have overstated the role of egregious lending standards in the foreclosure crisis when making the case for the new agency.)

Secondly, it means that the White House anti-foreclosure drive needs to be completely rethought. For those looking to prevent the next bubble, curbs on mortgage equity withdrawal might help. Using derivatives to protect borrowers and lenders against negative equity should become part of high loan-to-value mortgages.

The options for stemming the current crisis are less appealing. Adding a top-up payment to the unemployment benefit of homeowners would be hard to justify on equitable grounds, and would certainly raise howls of protest. However it is one of the few workable alternatives.

Unless the administration is willing to reverse course, the United States will remain on track to hit 9 million foreclosures by 2012.

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