How to help underwater homeowners

By Felix Salmon
July 25, 2012
Jeff Merkley's new plan to help out the 8 million American homeowners who are current on their mortgages but underwater and therefore unable to refinance.

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I’m a huge fan of Senator Jeff Merkley’s new plan to help out the 8 million American homeowners who are current on their mortgages but underwater and therefore unable to refinance. If you like to see such things in video form, the YouTube announcement is here; for the nerds among us, the full 31-page proposal is here.

I’ve been bellyaching for a while about one of the biggest and most obvious market failures out there: the fact that huge numbers of mortgages are trading well above par — at roughly 106 cents on the dollar, on average — just because the homeowners are locked in to high interest rates because they’re underwater. When investors made these loans, they made them in the knowledge and expectation that if rates fell sharply, the loans would be refinanced and prepaid. But that never happened, and now they’re reaping an undeserved windfall.

Merkley’s plan addresses that problem straight on, and because it only concerns homeowners who are current on their mortgages — and not the 3 million homeowners who are underwater — it doesn’t come with any moral hazard problems attached: indeed, at the margin, it encourages homeowners to stay current on their loans, rather than defaulting on them.

The basic idea’s very simple: the government will buy, at par, any new underwater mortgage written on certain terms. So if you currently have a $240,000 mortgage on which you’re paying 8% interest, but your house is only worth $200,000 and you can’t refinance, then suddenly now you can refinance. In fact, you have three options. You can get a $240,000 15-year mortgage at 4%, which keeps your payments roughly the same, but which gets you paying down principal quickly, so that you should be above water in about three years. You can get a $240,000 30-year mortgage at 5%, which cuts your monthly payments substantially. And there’s a third option I don’t fully understand, which includes a $190,000 first mortgage at 5% and a $50,000 second mortgage with a five-year grace period; on that one, monthly payments, at least for the first five years, drop even further.

In many ways, if you don’t sell your house, this is functionally equivalent to a principal reduction. That $240,000 15-year mortgage at 4%, for instance, has exactly the same cashflow characteristics as a $198,000 15-year mortgage at 7%. And the $240,000 30-year mortgage at 5%, similarly, asks homeowners to pay exactly the same as they would if they had a $193,00 30-year mortgage at 7%.

Problems arise, of course, if and when you want to move, or sell your house. In that event, Merkley told me, “we have to be very aggressive in not accepting short sales that dump losses onto the taxpayer. They’re on the hook for the amount”. He suggested that instead of selling, homeowners simply rent out their home until they’re no longer underwater. That works for some people; it doesn’t work for others. But in any case, his proposal is clear: “the program would not entertain short sales during the first four years of a loan,” it says.

And bigger problems might well arise with banks and investors, who are not going to be happy to see the loans they’re carrying on their books at 106 cents on the dollar suddenly reduced to par. On top of that, the banks are going to be asked to pay a “risk transfer fee”: 15% of the first 20% that the loan is underwater, and 30% of the second 20% that the loan is underwater. Beyond a loan-to-value ratio of more than 140%, banks are going to be asked to write off everything.

For Merkley’s typical family in a $200,000 home with a $240,000 mortgage, the result is that the bank would have to pay the government $6,000 in risk transfer fees, on top of any losses it might take if it had been holding the loan on its balance sheet at more than par. In total, the bank losses could reach $20,000 — a substantial sum, and one which might well result in the banks dragging their feet quite a lot.

On the other hand, there’s upside for the banks, too. For one thing, all their default risk — which is non-negligible, on underwater mortgages — goes away. And for another thing, they get paid off on second mortgages as well as firsts: the Merkley plan will refinance everything, up to 140% of the value of the home. And the opportunity to exit an underwater second mortgage at or near par is one that few investors would pass up.

The Merkley scheme has been very carefully assembled, so that it should make money for the taxpayer even at higher-than-expected default rates. Nothing’s guaranteed, of course. But after all the bailouts of banks, if there’s a plan which will credibly make money while saving homeowners enormous amounts of money at the same time, the government really should adopt it — especially since the funding will come from the private sector.

If you’re not persuaded, maybe these numbers will help. If you have a 30-year $240,000 mortgage at a blended interest rate of 8% (between your first and your second), your monthly payment is $1,761, and over the course of those 30 years you’ll make a total of $633,967 in mortgage payments. On the other hand, if you have a 15-year $240,000 mortgage at 4%, your monthly payment is $1,775 — basically exactly the same — while your total mortgage payments, over the life of the loan, plunge to just $319,544. (For all these calculations I am as ever indebted to this wonderful mortgage calculator.) Your monthly payments stay the same; your aggregate payments fall by 50%. And your total interest payments fall by a whopping 80%.

If we can save homeowners 80% on their mortgage-interest bill, while still making a profit and while helping to stabilize the housing market at the same time, well, that’s a no-brainer. I don’t know whether this plan is going to get any traction. But it should.

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