Two mortgage plans

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.


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