Opinion

Felix Salmon

Two mortgage plans

By Felix Salmon
October 14, 2011

With the enormity of the jobs crisis looming over the 2012 presidential election, it’s worth being reminded every so often that there’s a huge housing crisis in this country as well. And so it’s worth keeping an eye on new ideas there.

Martin Feldstein has one, which I don’t much like. He gets one thing right: we need massive principal reductions. But the way he’d like to do them is very flawed.

For one thing, he’s very keen on converting non-recourse mortgages to recourse mortgages: “in exchange for 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”.

In theory, I’m a fan of recourse mortgages, if they’re taken out voluntarily in a healthy housing market, and so long as they can be written down in bankruptcy proceedings. But I don’t like Feldstein’s idea here. It’s a bit like the Brady Plan: in exchange for a reduction of debts, the debtor is forced to switch from an easy-to-default-on instrument (a bank loan, or a non-recourse mortgage) to a harder-to-default-on instrument (a sovereign bond, or a recourse mortgage). That’s the kind of thing which should be done only when (a) the debtor has a seat at the negotiating table; and (b) when the debt reduction is a one-and-done deal which undoubtedly reduces the debt burden to a manageable, sustainable level.

In this case, however, the homeowner is just being given a take-it-or-leave-it choice; and the principal reduction only reduces the value of the mortgage to 110% of the value of the home, even as house prices continue to decline. The homeowner is still underwater — and, of course, is living in a very tough economy. Here’s Dean Baker:

There will be more questionable loans that will go into the program. Some of these people may be able to make their payments after the principle write-down. They will then get to live in their home until they move and in all probability never accumulate a dime in equity (but the bank got half of its loss picked up by the government).

Others will take the deal and then find themselves still unable to pay their mortgage — remember we still have 9.1 percent unemployment and most people in Washington don’t seem to give a damn. Under the Feldstein plan the debt will now become a recourse loan, which means that the bank can hound foreclosed homeowners until the day they die for any portion of the mortgage that is not repaid by the sale of the house.

The other big problem with the Feldstein plan is that if it works, it will involve the government writing hundreds of billions of dollars in checks to the banks. This is dreadful politics, and it’s not much better as policy. If there’s going to be a huge subsidy being paid into the housing market, better it go to homeowners — who can then use the money to pay down their mortgage — than that it go to the banks.

How about this, then: if the bank does a principal reduction so as to increase its chances of being repaid, the government will pay the homeowner 25% of that principal reduction, on condition that the money is used to pay down the new mortgage.

That would be cheaper for the government (depending on how transfers to Frannie are counted), and would also bring a significant number of homeowners back into positive-equity territory, which has to be a good thing.

Meanwhile, Alan Zibel has a trial balloon from the Obama administration which is reasonably smart but which is unlikely to make much substantive difference. Basically, Frannie should sell off an equity tranche of its mortgages, which is explicitly and credibly not guaranteed by the government.

Investors in this “first loss” position would take on an additional risk of absorbing losses, but would receive a higher interest rate. While investors would be taking on some risks because home prices are still falling in many areas, mortgage lenders have significantly tightened their standards in the aftermath of the housing bust.

Andrew Davidson, a mortgage-industry consultant in New York, said there is likely to be enough interest from investors to buy around $10 billion in securities issued as part of a pilot program.

The idea here is to bring private money back into the MBS market slowly — by having Frannie sell off more and more of its bonds in the form of these first-loss bonds. They would reduce the amount that the government is on the hook for housing-market losses, and they would also insulate the government from some of those losses.

But the market in these new securities would only evolve slowly, and it would have very little effect on the housing market.

If Feldstein’s plan is too generous to banks, then, the Obama administration’s plan is just too ineffective. But maybe something small and ineffective is the best we can hope for right now, given political realities. Certainly Feldstein’s plan, even if it were any good, is a political non-starter.

Housing debt is going to come down, somehow, over time. That can happen with government help, or it can happen messily, through continued foreclosures for years to come. The former would be better. But the latter is what we’re going to get.

Comments
62 comments so far | RSS Comments RSS

Haven’t run through the numbers, but we are at liquidity trap with somewhere between 9% and 16% unemployment due to slack demand.

Fed balance sheet is south of $2 trillion, I believe. But according to americanprogress.org:

“American families lost a total of $19.4 trillion (in 2010 dollars) in household wealth from June 2007 to March 2009, when the stimulus started to take hold. First it was the housing market, and then it was the housing and the stock market together that tanked. American families lost $6.4 trillion in home value during this period.”

There wasn’t runaway inflation before that wealth got flushed down the toilet, I’m not sure how 500% inflation will magically appear as it is worked out again.

Posted by mere_mortal | Report as abusive
 

he idea here is to bring private money back into the MBS market slowly — by having Frannie sell off more and more of its bonds in the form of these first-loss bonds. They would reduce the amount that the government is on the hook for housing-market losses, and they would also insulate the government from some of those
losses.

Posted by coln | Report as abusive
 

“There wasn’t runaway inflation before that wealth got flushed down the toilet, I’m not sure how 500% inflation will magically appear as it is worked out again.”

If the Fed holds the mortgages, purchased with new money, then you are increasing the MONEY SUPPLY. Not merely household wealth.

It isn’t the household that ends up with the cash, anyways. Under your proposal, the Fed pays the banks a lump sum and the household stops paying the banks their monthly payments.

What happens when you suddenly redeem $15T of loans with new money? What do the banks do with the money? Why would this not be inflationary? We may be in a liquidity trap, but that is an awfully large shock for even a liquidity trap to absorb.

Posted by TFF | Report as abusive
 

Yes, a large shock. But if you Google money supply and look at what has been done so far to little effect, I’m less afraid.

You can also limit the program to the areas worst hit by the bubble, to people who came in at the worst time, to those who fell prey to the most abusive mortgage vehicles, you can even roll out slowly and look around for problems.

You can increase capital requirements for banks so that safe money replacing risky mortgages doesn’t flood the economy if that is a real fear.

What you shouldn’t do is despair that nothing can be done, and thereby do nothing and lose this first decade of the 21st century, and accept whatever national and global instability comes along for the ride.

Posted by mere_mortal | Report as abusive
 

mere_mortal, if you limit the program to a few hundred billion dollars, then you don’t even come close to repairing the debt overhang. If you don’t limit the program, then the cost is exorbitant.

Since June 2007, the M1 has increased 56% while the M2 has increased 32%. It is a stretch to assume that an increase twice as large on top of what we’ve already seen ($1.5T) would have no appreciable impact. Anything less would be just a drop in the bucket, if spent according to your proposal.

Rather than making a massive gift to a small number of households, wouldn’t it be more effective to make a smaller gift to a large number of households? Are you concerned because you feel that there are only a small number of households that NEED help? You seem to be tightly focused on saving the upper middle class, ignoring those below-median households that wouldn’t benefit from your proposal at all. (Most rent, most of the rest didn’t buy during the period in question, and most of THOSE have already washed out.)

I’m also puzzled why you are so reluctant to put any of this cost on the banks. You are placing it squarely on the shoulders of the 99%, to the profit of the 1%.

Any proposal which involves the banks receiving full repayment on underwater loans (at the expense of the government) ought to be a non-starter.

“What you shouldn’t do is despair that nothing can be done”

I’ve offered some ideas of my own. They are less expensive, more equitable, would help more people, and they are designed to put as much of the cost as possible on the banks.

Posted by TFF | Report as abusive
 

Re: money supply shock

Given the present situation, I suspect the economy could absorb a large amount of money without inflation budging. Perhaps another $1T?

But once you knock it off the block, I think you’ll find that it builds up steam very rapidly. Corporations and banks are sitting on cash hoards right now because they have nothing better to do with it. But if they are staring at high-single-digit inflation, they’ll find something to spend it on quickly.

Ever pull on something harder and harder with no effect, then suddenly have it slam open? I’m afraid inflation might be a little like that.

Posted by TFF | Report as abusive
 

“I suspect the economy could absorb a large amount of money without inflation budging. Perhaps another $1T?”

Nope, over $3 trillion in new debt in the last two years, interest rates didn’t budge (ask Paulson or Gross). If $3T in excess government demand won’t budge them, that gives some confidence to be bold.

“if you limit the program to a few hundred billion dollars, then you don’t even come close to repairing the debt overhang. If you don’t limit the program, then the cost is exorbitant.”

This is either blatantly dishonest or just too cute by half. If it is limited, somehow it must only be “a few hundred billion” but if it is not limited then “exorbitant.”

Very disappointing, either an incredibly dishonest position or you are a person who so lacks imagination that there is no room between $200 billion and $15 trillion.

Posted by mere_mortal | Report as abusive
 

Mere_mortal, you could perhaps stand to be a little less insulting? Would that hurt you? This is hardly the first time that you’ve stooped to that level…

There is plenty of room between $350B (the stated cost to the government of Feldstein’s plan) and $15T. The lower end of that scale is affordable. The upper end of the scale is the magnitude of the problem. Do you have reason to believe there is a sweet spot in between that addresses the problem at an affordable cost?

I will have to disagree with your claim, “that gives some confidence to be bold.” Put simply, I have very little confidence in the stability of the current house of cards that we call an economy. It is under pressure on several fronts — and once things start cracking, they can get very bad very rapidly.

Perhaps that is at the root of our disagreement? If I felt that the government (Fed or Congress) could freely afford to borrow/spend another $3T (on top of the current deficit spending) without destabilizing the system, then I might be inclined to agree with you on some points.

But I would still target my program towards the young (student loans) and the poor (jobs creation) rather than towards the middle aged (homeowners) and the upper middle class (those most significantly underwater).

Posted by TFF | Report as abusive
 

“If I felt that the government (Fed or Congress) could freely afford to borrow/spend another $3T (on top of the current deficit spending) without destabilizing the system, then I might be inclined to agree with you on some points.”

Well, Fed went from about $1T to about $3T on its balance sheet and we haven’t budged from the trap. $3T in new treasuries have been issued in two years and interest rates have fallen. Fortunes have been lost by people who decided that Krugman was a hack and the end of QE2 would depress bond prices.

My only targets for any program to get us unstuck is a mechanism to unwind that program. That’s why I prefer ideas such as allowing home owners to trade equity for elimination of debt (because the money comes back out of the economy once the asset is sold), or trading future earnings (in terms of higher marginal rates once the degree starts to pay off) for student debt forgiveness.

These are the sorts of ideas that can reel themselves back when better times return, so that overheat or excess demand or inflation or whichever term you prefer can be managed without magnifying shocks in the other direction.

About the other, I do my best to try not to stoop, but it seemed to me that you were being intentionally obtuse, as most programs can be limited or expanded such that they help the most needy, unlucky or desperate and exclude those who would cause harmful costs with less beneficial effect.

We know this is a slow recovery due to debt overhang. If we can’t address that debt, we won’t have a decent recovery.

Posted by mere_mortal | Report as abusive
 

“My only targets for any program to get us unstuck is a mechanism to unwind that program.”

I fear that is a serious problem with your proposal. Consider the near-zero turnover in rent-control apartments in NYC. When somebody has a below-market deal on their current residence, they have a very strong incentive to stay put.

You are proposing giving “homeowners” with zero equity free rent — as long as they don’t move. I can only assume that they will respond to this by being highly reluctant to ever move. Thus this program would take many decades to unwind, and would greatly inhibit economic mobility.

“I do my best to try not to stoop, but it seemed to me that you were being intentionally obtuse”

I have done my best to point out what I see as flaws in your proposal. If I am obtuse, it is my natural state.

“We know this is a slow recovery due to debt overhang. If we can’t address that debt, we won’t have a decent recovery.”

Once again, I agree wholly with you on this point. I would simply argue in favor of debt-reduction programs with a broader impact and more reasonable cost. I see greater impact in giving many households a small windfall (perhaps worth $1000-$10000 each) than in giving a few households a large windfall (literally worth $100,000 or more each), albeit recognized slowly over decades.

Posted by TFF | Report as abusive
 

“Thus this program would take many decades to unwind, and would greatly inhibit economic mobility.”

How would you describe the current situation where workers who otherwise would be mobile as well as homeowners cannot relocate, regardless of their economic situation, just because their mortgage has more debt than the equity of their home? That’s a five to ten year anchor in quite a few cases right now, unless the homeowner wants a multi year sentence as a bad credit risk.

People who own their homes outright sell them often, as do those who have a positive equity stake, a reasonable mortgage rate, or any number of positive situations regarding their housing situation.

I am as concerned as many of my conservative counterparts regarding putting money into the economy in a slowdown that would cause pain to remove after recovery. Helicopter drops of cash are not among my preferred ideas. But allowing homeowners to give up an equity stake in housing is not the same as holding a right to rent control in an apartment, not by a long shot.

Posted by mere_mortal | Report as abusive
 

“How would you describe the current situation”

Also with inhibited economic mobility, but at least that will repair itself within 10-25 years. I expect that most of the loans will have either defaulted or will be above water a decade from now. In 25 years, they will ALL have either defaulted or been paid off. Under your proposal, the mobility would be inhibited indefinitely.

“People who own their homes outright sell them often”

There is a huge difference you are failing to recognize. If you own the equity in your home, then you get a large check when you sell. This check can be used to purchase another home of comparable value. You can afford to move. If the Fed owns the equity in your home, then you get NO check when you sell. You either have to rent (in which case your expenses go up) or take out a mortgage on a new home (in which case your expenses go up). You are granting people the right to use the Fed’s capital — interest free — as long as they stay put.

You are right that it isn’t exactly rent control, but it is a very strong incentive to stay put, worth easily a thousand dollars a month on an average home.

“allowing homeowners to give up an equity stake in housing”

It isn’t truly an “equity stake” if they have negative equity in the home. And that is the rub.

Run the calculations some time (I presume you are familiar with the discounting of cash flows)? A homeowner with 20% equity in their home might gladly trade that for the right to stay in the home mortgage-free for as long as they wish. It would be the difference between paying that monthly mortgage and not. Sure, they “lose” that 20% equity, but that only represents ~2 years of fair rent anyways. They might then stay in the home for decades. A homeowner with negative equity would be getting an even greater gift.

Seriously, try running the numbers. Or give me specifics and I’ll do it for you. I’m not opposed to a solution, I simply don’t think you’ve hit on the right one.

(1) Mobility would be inhibited for decades, not merely 5-10 years. If it doesn’t cost you anything to “own” the property, there is no reason to ever sell. Even if you move out, you would rent rather than giving up that free capital.

(2) There would be no possibility of reversing the money-drop until people tire of using the Fed’s free capital. (Unless you permit the Fed to dictate when the house is sold?)

(3) Assuming it costs you $300,000 per mortgage, the $3T of new money that you seem to be talking would cover just 10 million households. Nice for them, but what about the other 90% of the country? The solution to existing inequities is not to perpetuate new ones.

One of the basic principles of capitalism is that capital has value. If you give people the free use of capital, it is a perpetual gift. Why would anybody ever give that up?

Posted by TFF | Report as abusive
 

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