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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28 comments so far

Uh, Senator Merkley, if you refinance undersecured mortgages at par, you are now an undersecured creditor. You are going to have more losses than a lender who insists on full equity, or a cushion. Some of your borrowers are going to need, or choose, to move on while still under water. If you are going to be a hard-ass about short sales in those situations, you are just going to get more bankruptcies or uncollectble walk-aways. This plan would indeed be better than anything currently available for some homeowners, bu there is still much fuzzy thinking here.

Posted by KenWis | Report as abusive

Felix, a white swan is not a windfall.

Posted by maynardGkeynes | Report as abusive

“The program would not entertain short sales during the first four years of a loan”

Is that legally possible in a non-recourse state? Both California and Arizona are non-recourse states, by the way.

Posted by realist50 | Report as abusive

@realist, I don’t think that whether or not you’re in a non-recourse state makes much difference as to whether or not the lender is willing to agree to a short sale. It makes it more likely that you’ll simply walk away, of course, but that’s a different matter, and is basically just a default.

Posted by FelixSalmon | Report as abusive

Seconding maynardgkeynes, the term “market failure” encompasses some pretty well-defined sets of circumstances, and this one doesn’t fit.

Borrowing money secured by collateral, and being unable to refinance in a lower-rate environment because the value of the collateral has declined, is hardly unique to this situation. That’s the nature of secured borrowing, and nobody who borrows on that basis should believe that there’s some God-given right to refinance regardless of collateral value.

Doesn’t essentially this same thing happen to large numbers of commercial property owners every business cycle? Amongst the things that generally happen during a recession are (i) the Fed cuts short-term interest rates, which in turn causes some decline in long-term interest rates, (ii) asset values fall, and (iii) seeing asset values fall, banks lower the loan-to-value ratio that they’ll finance and grow more skeptical of appraised values. So if I own an office building that I bought at a (likely inflated) price during the boom, the odds are that my vacancy rate is up so my cash flow from the property is down, my property value is down, and I can’t refinance my debt at a lower rate unless I kick in more equity.

I understand the political difference with homeowners – they are more numerous and sympathetic than owners of commercial property – but I don’t see any philosophical reason why one outcome is “life” and one is a “market failure”.

Posted by realist50 | Report as abusive

@Felix – thanks for the commentary on short sales, and I was confusing the legalities and economics of the situation.

I think that, non-recourse mortgage or not, the threat of being tagged with a default if they walk away does mean something to the vast majority of these homeowners, since they are already staying current on underwater mortgages.

Posted by realist50 | Report as abusive

Printing money, distributing it equally to everyone, but requiring it to be first used for debt paydown just seems more fair than subsidizing people who made bad investment decisions in the past, but not rewarding the people who decided not to invest in property…

Posted by JustinCormack | Report as abusive

“just seems more fair than subsidizing people who made bad investment decisions in the past, but not rewarding the people who decided not to invest in property”

It’s not only the people who decided not to invest in property who aren’t rewarded. That group also includes anyone who bought a house with cash, or made substantial extra payments to reduce the principal balance on a mortgage that would otherwise be underwater.

Posted by realist50 | Report as abusive

Sometimes you just have to realise a problem may not have a fair solution. Sometimes any solution is better than none at all. The key should include whether or not the plan would stimulate demand, because that’s why the world economy is slowly strangling itself to… well, the longer the lack of demand lasts for, the bigger will be the long term damage. The longer demand is subdued, the more problems such as indebted governments, companies, and individuals will grow.

Posted by FifthDecade | Report as abusive

Agreed with Fifth. This may be the first plan I’ve seen suggested that addresses the problem reasonably (no huge winners) and with an affordable price tag (conceivably might turn a profit).

Borrowers who are still current are not likely to walk away at this point, especially if their carrying cost is reduced.

Banks are being asked to chip in a reasonable amount. Those percentages ought to bother them much less than the thought of widespread jingle-mail.

An underwater borrower remains underwater. No free pass just because they levered up to buy. Don’t think that does enough for your situation? Then give up the house (or continue paying the original loan).

A fair solution is one in which nobody is fully happy, yet all agree that progress has been made. I think this fits.

Posted by TFF | Report as abusive

Good for all this, but is there help for a home buyer who has paid on thieir mortgage for over 15 years, lost their job, is running out of unemployment and can no longer afford to pay on their mortgage? Any suggestions?

Posted by Anonymous | Report as abusive

@Anonymous, sell the home (surely at a profit if you bought 15 years ago) and downsize? Otherwise the only help I know of for your situation is the extended unemployment benefits, and even that has its limits. Sorry.

Posted by TFF | Report as abusive

I’m holding out a little while longer for a principal reduction. TFF is wrong about thinking that people who are currently underwater and still making timely payments will never walk away. The FHFA’s DeMarco subscribes to the same errant reasoning.

Most people, like me, didn’t buy their homes expecting to remain in them for 30 years.

At some point, most of us deeply underwater homeowners will have no choice. We have already lost our down payments and we can’t get enough money by selling to pay off the mortgage… not even close.

If principal reductions are not provided, the current downward pressure on American home values and the American economy due to mortgage defaults will continue for a very long time.

I like the eminent domain idea put forth by the law professor from Cornell University. Senator Merkley’s idea doesn’t appear to address the principal problem.

Posted by breezinthru | Report as abusive

Addendum: If I get a principal reduction to fair market value, I will stay in this house for perhaps 10 to 15 years. If not… I’ll stay no more than 4 years.

Posted by breezinthru | Report as abusive

@breezinthru, why haven’t you already walked?

The biggest problem I have with principal reduction is that it is grossly unfair to those homeowners who made a larger downpayment and thus aren’t underwater. I realize that any policy will have winners and losers, but creating a $100,000 windfall for one set of financially devastated homeowners and not for another set of financially devastated homeowners isn’t even remotely fair.

I have no problem if the banks want to negotiate principal reduction plans with some borrowers, I just don’t feel that taxpayer money should be used to fund programs whose benefits flow to a small percentage of the population.

And a continuing downward pressure on housing costs is a GOOD thing.

Posted by TFF | Report as abusive


Windfall? If I got a principal reduction to fair market value today, I’m still out my 50K down payment and 15K in improvements to the property and 6 years of timely payments has left me with exactly $0 in accumulated principal.

I don’t like taxpayer money being used to set things right for other taxpayers either. That’s why I like Professor Hockett’s eminent domain idea. How is it that banks and investors figure they should have zero risk in this situation? Everyone else has a risk of losing, but them… never?

I have taken a large personal financial loss in the years immediately preceding my retirement. I’m not asking anyone to write me a check for that loss and no one is going to do that. I just want a fresh start, a loan for what the house is worth now in the aftermath of the Wall Street-engineered con. I would just like to be able to sell at some point and break even, excellent credit intact. I would just like a few bucks out of my next payment to actually go to principal.

I recognize that there is a certain amount of risk in purchasing real estate. I get that. It’s up to me to replace my losses. That’s why I’m still working. There is also a certain amount of risk in investing in CDO’s.

Since you’re wondering… I haven’t walked yet because:

* I would have to pay rent somewhere else while I continue to work (I could cut my monthly cost a little but not that much),
* My two old dogs like this house as much as I do, but they won’t be around much longer.
* moving is a pain in the rump. I don’t want to move now and again after I retire,
* I think I have a moderately good chance of getting a principal reduction within the next couple years if I’m patient because principal reductions need to happen in order for our economy and employment situation to improve and in order to mitigate losses to the taxpayers,
* my wife had a stroke last winter and she loves the small deck I built for her in the shade of our beautiful maple tree. We have a group of “cute” flying squirrels that come to the bird feeders at night (year round) and variety of beautiful birds that she enjoys watching as she sips her morning coffee.

If I get a principal reduction to fair market value, I might just pay off the balance rather than take out a mortgage. But I won’t give those bastards on Wall Street $170K cash for my house. Thanks to them, it’s now worth much less than that. I’ve been making my payments but I’m not going to give them an additional cash reward for screwing me over.

I most assuredly will walk away if I must, but I’ll do it when it suits me. And so will most people who continue to make payments on homes they bought in the new millennium. DeMarco is dead wrong about that, but he is just a civil servant with a clerk mentality. It’s hard for him to see the big picture.

Posted by breezinthru | Report as abusive

Breezinthru, it sounds like you have plenty of good reasons to stay put, at least for now. The property is affordable and you enjoy living there. So how does a principal reduction change the equation?

* It would keep your credit score intact.

* It would allow you to rebuild equity from the present price, leaving with something in your pocket when you do eventually sell.

* It would keep you in the property longer than you would otherwise choose to stay.

I can see how this would benefit you personally, since you could save up a little equity and continue living in a home you enjoy. Might even make sense for the bank, as foreclosure is expensive and they won’t recover more than FMV on your property regardless.

But I’m not sure I see the broader societal benefit, a rationale to involve public policy in the situation. I don’t see how a principal reduction would stimulate the economy or employment? You aren’t arguing that it would allow you to sell and buy a more expensive property, activities that generate economic activity. You would choose to stay put.

Moreover, while the banks will eventually recognize a loss on your property (if they haven’t booked it already), widespread principal reductions would push that loss forward instead of spreading it out over a decade. That isn’t going to help the economy either.

To me, the biggest argument for a principal reduction plan is that the securitization process has made it devilishly difficult to negotiate them individually. There ought to be the potential for a win-win solution in there, but I’m not sure the present FMV is the right target.

Posted by TFF | Report as abusive

If I was going to stay here and if every nickel I put into improvements didn’t tumble into a black hole that will only benefit the bank when they repossess the house, I have several projects I would like to do:

Take out some walls to make more modern interior, repair the sagging footing in one corner of my garage that has cracked the stucco in the wall above it, repair the stucco, remodel the downstairs bathroom, replace the beat up sheetrock in the garage, remodel the basement into a sound studio, remodel the entrance to the backyard, install new rain gutters, put in a rain garden, resurface the aggregate patio in the backyard… the list goes on.

This will all cost a fair amount of money… that I have… and I would enjoy spending it in this way. Multiply my “not sinking a lot more of my money into what could soon be the bank’s property” times 11 million underwater homeowners who are still willing and able to make timely payments.

That is the kind of stimulus that the government can’t generate.

Consider at all the family breadwinners who used to do that kind of work who have used up their unemployment and are not buying anything they can’t eat and no longer paying taxes because they don’t have jobs.

Posted by breezinthru | Report as abusive

Corporate landlords who are snatching up gobs of foreclosed properties at 30% of FMV from the banks are probably not going to be good citizens with at least a modest sense of community.

I’d bet they are going to make as much profit as they can while investing as little as possible into the properties. When they have squeezed as much as they can from the properties and have depreciated them out, they will sell the dilapidated properties (probably to HUD because no one else will want them).

I’m willing to give the bank 100% of FMV and I’m willing to maintain the property to a very high standard. I’d call that a no-brainer.

Posted by breezinthru | Report as abusive

Corporate landlords buying properties at 30% of FMV? Seriously? Would love to see some data points to support that claim. Stats I’ve seen suggest that the recovery rate on prime loans is around 40% of the original purchase price, which is probably closer to 75% of FMV. My numbers might be way off, but THAT far off?

I do hope you can negotiate a principal reduction, just don’t want to pay for it out of my own pocket. We’ve lost $100k+ on our house as well, just hard to be “underwater” when there is no mortgage.

Posted by TFF | Report as abusive


You will not see those data points because the billionaire investors have to sign a confidentiality agreement in order to participate in the FHFA fire sale. I just discovered that this morning while researching. Why the secrecy if the deal is so good for taxpayers that DeMarco would be proud of it? We should advocate for Glasnost here in America; maybe the secrecy and losses surrounding this program will eventually bring DeMarco down. Those homes are certainly being sold for less than FMV… so much less that it attracted the enthusiastic attention of billionaire investors.

Homes that could be sold at FMV (and by definition, any property could be sold at the price it could be sold for) should not be sold for less.

I wasn’t just making up the 30% figure. I was sure that I came upon it somewhere from a source I was willing to mostly believe, but I can’t find it now.

Here is a link that conveys what’s going on and how well it is being received in California. -say-gses-reo-rental-initiative-isnt-for -california-2012-04-10

Sorry to hear of your properties loss of value. We’ve actually lost approximately the same amount of amount of money when I add in the principal portion of my payments that tumbled into a black hole for the past 6 years.

The biggest difference is that you can hire a realtor and sell whenever you choose to do so and I cannot… thus my point that most of the underwater properties will eventually go into default in the absence of principal reductions.

A principal reduction to FMV doesn’t change how much I have lost. It only makes it possible for me to sell after my property increases in value enough to cover the cost of a realtor… that could be several years, but it least it could happen in my lifetime.

Posted by breezinthru | Report as abusive

“Why the secrecy if the deal is so good for taxpayers that DeMarco would be proud of it?”

Definitely sounds sleazy to me. Honest men have little to hide.

“Sorry to hear of your properties loss of value.”

Not a big deal for us, as we enjoy living here and have no intention of selling in the near future. Don’t know how much of a gain we’ll have when we do sell (perhaps in 20 years?), but over that kind of time frame it doesn’t much matter. Isn’t an overwhelming piece of our lifetime financial picture.

“The biggest difference is that you can hire a realtor and sell whenever you choose to do so and I cannot…”

So I can pay a realtor $20k to recognize my loss, just so I can get my cash back out? Why, thanks! I feel privileged! You have a much easier way out, and you don’t have to pay $20k to accomplish it. Jingle mail.

Will try to address it from the bank’s POV in a separate post, if I can figure out how to articulate my thoughts clearly.

Posted by TFF | Report as abusive

When a house is seriously underwater, there are three ways out:

(1) Homeowner defaults, leading to foreclosure. Bank recovers what it can, typically a fraction of FMV. Homeowner’s credit rating is dinged for 7(?) years, but (because the foreclosure process takes months) gets to live rent free for a while.

(2) Short sale. Bank receives FMV for the property, without the legal costs. Homeowner’s credit isn’t quite as badly dinged.

(3) Principal reduction. Bank receives a promise of FMV on the property in the future (bird in bush, not in hand). Homeowner retains the property (and any future gains) with no damage to credit score.

(4) Homeowner stays in the home, continues paying the mortgage, and eventually is above water again. For a property that has lost 50%, that might take a decade.

The worst outcome for the banks, by far, is #1. Their recovery, after costs, is a fraction of FMV. But this is frequently also the worst outcome for homeowners. Most cannot buy again without a new mortgage — and qualifying for a new mortgage in the wake of a default is surely difficult! So they rent for several years, repair their credit, and hope that prices/borrowing costs haven’t risen too much by the time they are ready to buy again.

The banks don’t see a heck of a lot of difference between #2 and #3. They get FMV in both cases, and they don’t REALLY want to keep that reduced mortgage. But they are very afraid of the “moral hazard” implied by #3. If they offer widespread principal reductions, then everybody with an underwater loan will want one. Right? There’s really no downside to the homeowner, if it is a free choice between #3 and #4. So the banks are doing everything they can to make principal reductions available ONLY to those who would otherwise end up in foreclosure. (Including telling homeowners that they can’t even apply for a reduction unless they are already in default.)

Does the game theory aspect make sense? Option #3 is best for homeowners, with (depending on your situation) #2 and #4 coming in second best. Option #4 is best for banks, with #2 and #3 coming in a distant second.

So banks threaten #1 (worst or second worst for everybody) to keep as many borrowers as they can in #4 (best for the banks). Homeowners largely cooperate, because they really don’t want to default and because (given rents these days) they aren’t THAT much worse off in #4 than in #1. At least not if they have the income to manage it.

The more people who willingly default, the more likely the banks are to accept #3 as a viable alternative. When they eventually come around, we’ll see a final wave of writedowns with willing participation from the banks.

But from what I’ve seen, calls for principal reduction typically do not adequately address the “game theory” aspects described above. Until they do so, they are doomed to failure.

Posted by TFF | Report as abusive

The game theory aspect makes sense to me but theory doesn’t always translate into the real world. I know some people who have walked away, including the neighbors on both sides of me. In both cases, the bank didn’t make any effort at option 2 or 3. The banks repossessed the home, put a roof on one house and a new furnace in the other, hired a company to maintain the property and hired a realtor. It appears that option 2 is significantly more expensive to the bank than option 3.

Both cases next door went option 1, foreclosure, so the banks did a poor job of looking out for their own best interest.

Posted by breezinthru | Report as abusive

@breezinthru, the game theory is most significant on a larger level. The banks very much want to maintain the “hazard” of default, by punishing the borrowers.

And that strategy appears to be working for them. Defaults are presently at a level they can sustain indefinitely (at least as long as their borrowing costs remain low). Banks have even started releasing loan loss reserves, as the anticipated heavy defaults haven’t wholly materialized.

They won’t abandon this strategy unless non-performing loans rise significantly from their present level. Then they might be more motivated to try something new.

As noted on the other thread, Fannie/Freddie guarantee the bulk of the first mortgages. The banks hold the second mortgages, which get creamed just as badly in a short sale as they do in a foreclosure. Further reason for the banks to drag their feet — and conflicting interests when it comes to loan modifications.

It is a royal mess, one we’ve all dealt with. But underwater homeowners have an option that minimizes their losses. They can walk away and dump the remainder of the loss on the bank. In that, they are better off than homeowners who are not underwater.

Posted by TFF | Report as abusive

It occurs to me that the POTUS, the Treasury Secretary and several well-known economists would like me to win the game I’m playing against the banks because it will advance their goal of returning the US to economic health and advance their goal of maintaining or increasing political power.

Banks have a different objective of minimizing losses and maximizing profits, but it seems to me that banks would have more opportunities to make money in an economy that is thriving and growing.

Are the banks being short-sighted or do they not believe the POTUS’s plan will work or do they not want the POTUS’s plan to work because they like the other guy better?

Posted by breezinthru | Report as abusive

@breezinthru, the POTUS isn’t the one footing the bill. I think the answer depends on the magnitude of writedowns and the degree to which that impacts the economy?

But it also depends on all working together. If one bank writes down their mortgages, the rest profit from the economic activity while the one which acted responsibly bears the losses (and needs years to rebuild its equity capital).

Too many different parties in play, with very different interests in the game. Those holding second mortgages want to drag it out as long as possible even if it ends in default. Those guaranteeing the first mortgages want to avoid default. The POTUS simply wants the issue resolved so we can move forward.

One resolution is to have the Treasury foot the bill (giving the banks a fat windfall as a reward for their misdeeds), but I prefer trying to put pressure on the banks to act for the greater good.

Posted by TFF | Report as abusive

Revisiting this article as I am looking to buy another home. Its interesting to see the way the market has turned a corner and interest rates are climbing. I know many that hunkered down in their ‘underwater’ dwellings, choosing instead to ride out the waves and remodel! Personally I chose to rework my garage, inspired by sites like, com/index.html?layout=desktop,

Of course, my garage doesn’t resemble Tony Stark’s but I was able to remodel and get more use from the space. It provided a modest value increase and proved cathartic.

Posted by McLeo | Report as abusive
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