Felix Salmon

John Kemp might just have delivered the perfect John Kemp column yesterday: 1,700 words on an obscure commodity you probably didn’t even realize was a commodity. In this case, it’s a noble gas: the Federal Helium Reserve (yes, there’s a Federal Helium Reserve) is at risk of imminent shutdown, which in turn threatens everything from the semiconductor industry to MRI scanners. Already, at least one particle accelerator had to delay operations “because of problems obtaining fresh supplies of helium.”

Kemp’s column is based in large part on a 17-page GAO report which includes this chart, showing the seemingly inexorable rise in the price of refined helium. (Another thing you didn’t know: helium comes in both “crude” and “grade A refined” versions.)

As you can see from the chart, the problem here isn’t finding crude helium, so much as it is refining the stuff into something usable. Reports Kemp:

Problems at helium refineries in Texas, Oklahoma and Kansas, as well as start up delays with new refining facilities in Qatar in 2006, led to shortages and rationing, as well as price spikes for some customers.

Reliable and affordable supplies are essential. But around half of the helium used in the United States, and roughly a third of the gas consumed worldwide, is sourced from a stockpile in northern Texas left over from the Cold War.

At the moment, the only way that helium can be sold from that stockpile is in order to pay down the debt which was run up in 1960 building the Texas facility. But thanks in large part to the soaring helium price, there’s virtually none of that debt left — and when it’s all gone, the government can’t sell any helium any more. As a result, it’s pretty urgent that Congress put in place some kind of mechanism to keep the sales going. The alternative would be devastating to many industries including the medical profession.

It also turns out that the US government’s role in the helium market is not dissimilar, in some ways, from its role in the mortgage market. Here’s Kemp:

The cost-recovery pricing formula ensured BLM was originally charging much more for its helium than other suppliers, minimizing the market impact.

But BLM has become such an enormous seller, in a market with few other competitors and substantial barriers to entry, that other suppliers have taken it as a benchmark, and moved their own prices higher to match it.

Essentially, when you’re the US government and you’re a major participant in a market, you can’t help but become the marginal price-setter. Whatever Frannie pays for mortgages becomes the market price for mortgages; whatever the government asks for helium becomes the market price for helium.

In both markets, the government wants out and wants the private sector to take over. But in both markets, the process of disentangling the government from the market is extremely difficult, because it can’t just shut down its operations and leave the market to its own devices.

Because Congress has left the helium problem to the last possible minute, it’s unlikely they’re going to be able to come up with an elegant solution here. Instead, they’ll just kick the can down the road by allowing the stockpile to continue to sell helium for another year or so. But over that time, someone is going to have to work out how to extricate the US government from the global helium market. If and when that happens, I hope that mortgage-minded legislators are paying attention. Because it’s long past time that the government stopped underwriting the vast majority of home loans in this country, and they could use all the ideas they can find.

This chart comes from a new paper by Karl Case and Robert Shiller, looking at the results of a survey they’ve been handing out to homebuyers annually since 2003. The idea is a very smart one: if you want to get an idea of the behavioral economics of homebuyers, the best way to understand what they’re thinking is to simply ask them.

And this chart, in particular, is both very elegant and very informative. It’s elegant because you have a very close maturity match: the average duration of a US mortgage, before it’s refinanced or the house is sold, is about 7.5 years, which is close to the ten-year horizon in this question, which Case and Shiller ask every year:

On average over the next 10 years, how much do you expect the value of your property to change each year?

Now the number of homebuyers in America vastly exceeds the number of people who understand the mechanics of compound interest. If you asked instead “how much do you think your home will be worth in ten years”, and then presented that answer as an annualized percentage increase, I suspect that the answers — especially in the peak years of 2004 and 2005 — would be substantially lower. (Put it this way: if you bought a $260,000 home in 2004 and expected its value to rise at 12% a year for 10 years, then by 2014, you’re saying, it would be worth more than $1 million. I suspect the number of people answering 12% or more is going to be greater than the number of people who think the value of their home will quadruple in ten years.)

Still, that’s not particularly important, especially since the question has remained the same for the past decade: the trend here is real. And what’s fascinating is that the big fall in expected long-term home-price appreciation happened before the financial crisis, and that the crisis is actually completely invisible in this chart: expectations continued to deteriorate long after it was over.

And even given the fact that homeowners tend to overestimate annualized percentage returns over 10-year horizons, we’re now at the point at which the expected rise in home values barely exceeds today’s record-low mortgage rates. Over the long term, homebuyers still think it’s a good idea to buy a house. And they might be right about that. But they’re not buying because they think they’ll make a handy profit in ten years’ time.

Which brings me to one of the central themes of the Case-Shiller paper: the idea of a “speculative bubble”. If you look at the situation in the chart circa 2004-5, there was a huge gap between the cost of funds and the long-term expected return. And if people really believed house prices were going to rise that much in future, it made all the sense in the world to lever up, get the biggest mortgage they could find, and buy lots and lots of house. After all, the more levered you are, and the more house you buy, the more money you make.

Case and Shiller have a handy definition of a speculative bubble, in this paper: it’s a bubble with “prices driven up by greed and excessive speculation”. But here’s the thing: people don’t speculate on a ten-year time horizon, and the producers of “Flip This House” weren’t waiting around to see what properties would end up being worth once the kids had gone off to college. A truly speculative bubble, it seems to me, is a function much more of short-term house-price expectations than it is of long-term expectations. If you think you can buy a house today, sell it in a few months’ time, and make tens of thousands of dollars doing so, and if you intend to do precisely that, then you’re clearly part of a speculative bubble. But it turns out that home buyers were actually surprisingly modest in their expectations of one-year price increases — they expected prices to rise less than they ended up rising in reality.

On the other hand, if you buy a house now in the expectation that it’s going to increase in value substantially over the next decade, you might be a buy-and-hold investor, but it’s hard to characterize what you’re doing as speculation.

I’ve been disagreeing with Shiller on the subject of speculative bubbles for five years now, but I think this is important: just because you have a bubble, doesn’t mean you have a speculative bubble. The dot-com bubble was speculative; the rise in house prices in 2000 was not. There was a speculative bubble in Miami condos; there was not a speculative bubble in Manhattan co-ops. If you buy because prices are rising, that might be because you want to flip your property and make money — or it might equally be because you worry that if you don’t buy now, prices are going to run away from you, and you’ll be forced to move out of the neighborhood you love because you can’t afford it any more. It’s still a bubble, but it’s more of a fear bubble than a greed bubble.

Still, bubbles are bad things, and they’re liable to burst either way. And so I take solace in this chart, because it shows me that people are buying, these days, for the right reason — which has nothing to do with expectations of future house prices, and everything to do with simply paying a fair price for the shelter they’re consuming. House prices might not rise much over the next decade. But if they fail to rise, today’s house buyers aren’t going to be disappointed: they will still have lived in their homes while paying a perfectly reasonable sum to do so. Which is a much better state of affairs than bubble-and-bust.

In 2007, it became clear to Congress that there was a serious mortgage crisis, with lots of underwater borrowers. And it was also obvious that an important part of working through the mess would comprise some combination of short sales and principal reductions. Thus was the Mortgage Forgiveness Debt Relief Act of 2007 born. Until the act was passed, any lender offering a short sale or a principal reduction would in doing so leave the homeowner with a massive tax bill, since the written-off debt would count as simple income for income-tax purposes.

In 2007, however, no one had a clue how long the mortgage crisis would drag on for, or how slow lenders would be to offer principal reduction. The original act expired at the end of 2009; it was then extended, through the end of 2012. But here we are, in August 2012, and principal reductions are only just beginning in earnest.

David Dayen has a good piece on the expiry of the tax break, including the interesting nugget that the CBO has put the cost of extending it for two more years at $2.7 billion. If the average underwater homeowner pays a marginal tax rate of 20%, then that means the CBO expects write-downs from principal reductions and short sales of somewhere in the $10 billion to $15 billion range during 2013 and 2014. And this, remember, is six years after the housing bubble burst.

My guess is that the tax break will be extended, somehow, somewhere in the horribly complex mess of legislative give-and-take that will arrive with the fiscal cliff. But it’s instructive to realize that if Ed DeMarco had actually agreed to Fannie and Freddie doing principal reductions, they would realistically only get started, in earnest, in 2013. As it is, thanks to his obstructionism, they’ll probably only happen even later than that.

The housing recession is dragging on for longer than anybody anticipated, and there’s no end in sight. Principal reductions are a good way of bringing it to an end; they should of course not incur a massive tax bill. I hope that we’ll see most of them done by 2015, eight years after the housing bubble burst. But in my heart of hearts, I don’t actually believe that. This housing crisis, I think, is going to last a decade. Or more.

It’s Ed DeMarco vs Tim Geithner today, on the subject of principal reductions, and the fight is getting ugly.

DeMarco, in a letter to Congress, explains that the Treasury has put a lot of effort, and is willing to put very large sums of money, into something with the rather unwieldy name of HAMP PRA, where PRA stands for Principal Reduction Alternative. But here’s the thing: PRA is going to get nowhere unless Fannie and Freddie sign up for it. And they can’t sign up for it until DeMarco signs off on it. And DeMarco is refusing to sign off on it.

DeMarco has released a 15-page paper explaining his decision, although in reality his letter, and the reasoning in it, is much clearer. He basically says that principal reductions would be costly to implement, and he doesn’t have a lot of time for Treasury’s offer to pick up the tab: “although principal forgiveness may provide some financial benefit to Fannie Mae and Freddie Mac,” he writes, “it presents operational challenges for them and their servicers as well as a risk of loss to the taxpayer”. It’s not his job to worry about costs to Treasury or taxpayers generally — but he’s making it his job.

But the main thrust of DeMarco’s argument is less financial than it is moral. Any kind of principal-reduction strategy risks encouraging strategic default, and DeMarco hates the very idea of strategic default. And even if there’s no strategic default at all — and the letter from Geithner makes a very strong case that strategic defaults as a result of this plan would be de minimis — DeMarco still hates principal reductions on, well, principle:

Perhaps the greatest risk of the Enterprises’ allowing principal forgiveness is one with far more significant long-term consequences for mortgage credit availability. Fundamentally, principal forgiveness rewrites a contract in a way that other loan modification programs do not. Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before. Longer-term, this view could lead to higher mortgage rates, a constriction in mortgage credit lending or both, outcomes that would be inconsistent with FHFA’s mandate to promote stability and liquidity in mortgage markets and access to mortgage credit.

This is a classic “parade of horribles” argument, and it’s not a particularly strong one, either. As Jared Bernstein says, “in unusual times, like the aftermath of the worst housing bubble implosion in decades with 30+% price declines, guess what? Write downs happen.”

But the weirdest thing about this argument is that the horribles aren’t particularly horrible. Higher mortgage rates? Um, fine: no one is exactly complaining that mortgage rates are too high right now. A constriction in mortgage credit lending? That’s fine too: it was too-lax credit lending that caused this whole problem in the first place. Both together? Even that’s fine: it would help bring homeownership rates down from their current too-high levels, and encourage more people to rent rather than own, creating a more flexible national labor force.

The fact is that while it’s imperative that we fix the problem of broken mortgages issued at the height of the credit bubble, the last thing we want to do is return to those days and tell anybody who wants a house that they can just go out and buy one, whatever their creditworthiness or cash position. If you want to make mortgages safer, you should ensure that homeowners have large amounts of positive equity in their homes. That means significant down-payment requirements for people buying houses. And it also means significant principal reductions for those who are currently underwater.

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.

Brad Miller, arguably the most sophisticated and well-informed member of the House when it comes to housing finance issues, has an op-ed in American Banker today about the eminent-domain plan being mooted in San Bernadino (which just voted to file for bankruptcy, by the way). Miller’s excited about the plan, because he thinks that it will force banks to take losses on all-but-worthless second liens. But, sadly, he’s wrong about that.

Miller actually makes two mistakes in his piece. The first comes when he explains how the price of the mortgages would be determined:

Deciding a fair price would not be hard. There are frequent auctions of mortgages with a sufficient number of informed, sophisticated buyers. The auctions are an almost perfect pricing mechanism. There would be comparable sales to determine almost any mortgage’s fair market value.

Miller’s right that mortgages do get auctioned relatively frequently, if not frequently enough that the market can even be considered highly liquid, let alone “an almost perfect pricing mechanism”. But here’s the thing: the private-label mortgages which tend to get sold off are precisely the mortgages that Mortgage Resolution Partners does not want to buy — the ones in default. Banks which own performing mortgages have almost no incentive to ever auction them off. And MRP has said that performing mortgages are the only mortgages it’s interested in.

What’s more, when performing underwater mortgages are traded, they’re often sold above par, since the homeowner is locked in to higher-than-prevailing mortgage rates. MRP, by contrast, is determined that it will only buy mortgages well below par: indeed, they’re saying that they’ll demand a discount not only to the face value of the mortgage, but even to the market value of the property. As a result, deciding a fair price might well be completely impossible: the owners of the mortgage would value it as a performing loan at a high rate of interest, while MRP would essentially ignore the fact that it’s performing, and value it on the basis that it cannot be worth more than the value of the collateral.

A free market copes quite easily with huge valuation discrepancies like that: there’s simply no trade, and the owner of the mortgage holds onto it, while companies like MRP find themselves unable to offer a price at which anybody is willing to sell. That’s why MRP’s whole idea is contingent on doing an end-run around the free market, and forcing the owners of the mortgage to sell. The point here is that if there really was a low market-determined fair price for the mortgages, then MRP wouldn’t need eminent domain at all: it could simply buy up those mortgages on the free market, directly from banks. Maybe, eventually, once it ran out of free-market mortgages to buy, MRP could try to use the eminent-domain method to buy mortgages from CDOs and MBSs. But at that point they’d have real-world market-based proof of how much such mortgages were worth.

MRP isn’t going down that road, however, because it knows that no one will voluntarily sell them mortgages at the kind of discounts it’s looking for. Which is prima facie evidence that the amount it’s willing to pay is not a fair price after all.

Miller then moves on to the thorny issue of second liens. While first liens are often owned by special-purpose investment vehicles, second liens are generally owned by banks. Miller writes:

So the real losers from the program would be the biggest banks, the holders of second liens, not investors in first mortgages. And even for the biggest banks, eminent domain would not cause losses but reveal losses.

But this isn’t true. If anything, the holders of the second liens would make money from this scheme, rather than losing money. Remember that MRP is not planning to buy houses using eminent domain, which would make much more sense. Instead, it’s only planning to buy mortgages — and it’s refusing to buy any mortgages held directly by banks. Instead, it’s only buying mortgages held by special-purpose investment vehicles, which tend not to have expensive lawyers willing and able to contest any and every valuation.

“Involuntary sales of seconds at fair market value would end fictitious valuations and require an immediate accounting loss,” writes Miller — and he’s right about that. Sadly, there’s nothing in the MRP plan which suggests that MRP has any interest at all in buying up second liens from banks. If MRP were buying houses rather than mortgages, then the banks holding the second liens would be forced to take an immediate loss. But it’s not. Instead, it’s just buying up performing first liens, and leaving everything else intact, including all second liens. At the margin, then, by reducing the amount of money that homeowners owe on their first liens, the MRP plan will increase, rather than decrease, the value of the second liens.

Why won’t MRP buy up second liens at what it considers to be a fair market value? For the same reason that it won’t buy up first liens directly from banks, either — the two sides will never be able to agree on a price. By MRP’s calculation, if the first lien is worth much less than par, then the second lien has to be worth something very close to zero. By the bank’s calculation, on the other hand, a performing second lien is a valuable revenue stream, worth a significant amount of money. And because MRP will be willing to pay very, very little for that second lien, it will not be willing to spend a substantial amount of money defending that near-zero valuation in court: its legal fees would almost certainly be greater than the amount it was willing to pay for the second lien in the first place.

If Brad Miller can point me to a plan where eminent domain is used to buy underwater houses rather than underwater mortgages, or if he can point me to a plan where eminent domain is used to by delinquent mortgages rather than performing ones, including seconds — then he’ll have me persuaded. But sadly the plan on the table is not the plan that Miller thinks it is. Which is why it’s a bad plan.

Back on June 21, I looked at the plan from Mortgage Resolution Partners to use eminent domain to buy up underwater mortgages. I wasn’t very impressed, and now that the dust has settled a bit, it increasingly looks as though the scheme — at least as currently designed — is going to end up going nowhere.

San Bernadino, which seemed to be very interested in the idea originally, is now backpedalling:

“We see it as intriguing, but it’s definitely not something we’ve decided to do,” says San Bernardino spokesman David Wert. “We just wanted to get all the information and see if it might actually work.”

And most importantly, a grand coalition of powerful interest groups has released a strong broadside saying that MRP’s plan is a really bad one. Check out some of the names here: The American Bankers Association, the American Securitization Forum, the Association of Mortgage Investors, the California Bankers Association, the Community Mortgage Banking Project, the Mortgage Bankers Association, Sifma, the Financial Services Roundtable — it’s an impressive list, and at this point it’s pretty much impossible to find any institution which supports the idea, other than those directly involved.

The letter from the various interest groups does not, in truth, make particularly compelling arguments. For instance:

If eminent domain were used to seize loans, investors in these loans through mortgage-backed securities or their investment portfolio would suffer immediate losses and likely be reluctant to provide future funding to borrowers in these areas.

This is pretty silly stuff: the fact is that nearly all new mortgages in San Bernadino and across the country are being financed by the government, and insofar as there is a little bit of private-sector financing, it’s probably not coming from people who bought subprime CDOs at the height of the bubble.

But really the point of the letter isn’t to make an argument: it’s to make a point. Two points, really. Firstly, there’s the word “unconstitutional”, which appears very high up. That’s code for “we’re going to appeal this thing all the way to the Supreme Court, so you’d better be willing and able to spend an enormous amount on legal fees.”

And secondly, the letter sends a very clear message that CDO investors are not on board with this scheme. And that’s the thing which ultimately will result in its death.

In principle, a plan like this could be put together in a way that investors could get behind. But it wasn’t, and MRP got greedy, and as a result it’s not gaining traction: just this morning, for instance, the LA Times came out against it.

The problem, at heart, is that MRP is looking to buy up only seasoned, performing mortgages: precisely the ones which are worth the most money, and which don’t present much of a systemic danger to the San Bernadino housing market. We’re talking here about loans which were made during the height of the bubble, on homes which have since plunged in value — and yet the homeowners have diligently made all of their payments on time. If I’m a mortgage investor holding a portfolio of mortgage loans, these are the ones I love — they’re the ones which help to offset the fact that so many of my other loans are in default. Yes, it’s true that I will have written down the value of my holdings on the grounds that my mortgages aren’t worth as much, in aggregate, as they were during the bubble. But that doesn’t mean that I’m valuing the performing loans at deeply-discounted rates. Quite the opposite, in fact: many of them are worth more than par, trading at about 106 cents on the dollar, just because the interest rates are high and the underwater status of the loan means that it can’t be refinanced.

MRP, by contrast, wants to pay vastly less than par for these loans. To use Kathleen Pender’s example, where a homeowner owes $300,000 on a house now worth $200,000, MRP might pay $170,000 for the loan. Which works out at just 57 cents on the dollar. That’s a highly-distressed price for a performing asset, and I can definitely see that MRP would have a huge amount of difficulty persuading the court that it was a fair price. After all, the only way you get to such a price is by assuming that there’s an extremely high probability of future default — despite the fact that the homeowner has remained current through the largest financial and housing crisis in living memory.

There’s a very big collective action problem in the distressed-mortgage world, and in principle the use of eminent domain is just what the doctor ordered to sort it all out. But I fear that MRP has done everybody a disservice here by putting forward the worst possible use of eminent domain: basically buying up precisely the mortgages which no one is particularly worried about. What’s desperately needed here is a plan which CDO investors can get behind. Right now, they own many mortgages they’d love to get out of, but instead they’re holding on to them because the way that the CDOs are structured, they basically can’t be sold and have to be serviced instead, at significant expense, even when they’re deeply in default.

So let’s see an eminent-domain plan which is designed to buy up defaulted properties, rather than ones which are current on their mortgages. Let’s see a plan which buys properties themselves, rather than just the liens on those properties. And most importantly, let’s see a plan which is constructed by the owners of CDOs, rather than by a bunch of outside financiers looking for a huge profit opportunity. In principle, there’s a way to do this right. It just isn’t the MRP way.

A couple of weeks ago, Matt Goldstein and Jenn Ablan had an intriguing story: Mortgage Resolution Partners, a politically well-connected firm in San Francisco, was shopping to municipalities the idea of using eminent domain to restructure mortgages. Then, on Tuesday, Cornell University’s Robert Hockett weighed in, saying that the idea was a compelling one. “To solve a collective action problem, we need a collective agent,” he wrote. “That’s what governments are.”

According to Imran Ghori of the Press-Enterprise in San Bernadino, where the idea seems to be furthest along, Hockett “has been working with Mortgage Resolution Partners” but “said he has no financial interest in the proposal”. I don’t really know what that means, but I think it’s fair to assume that if this happens, Hockett is very well placed to make a lot of money from it. So it’s worth approaching the idea with a skeptical eye.

In principle, I think I can like this idea. On Monday I met with Jorge Newbery of American Homeowner Preservation, whom I’ve written about a few times in the past; his company buys pools of defaulted underwater mortgages from banks, often for just $1 each, and then, having bought the mortgages at massive discounts to par value, can come up with any number of ways to successfully modify the mortgage, nearly all of which involve principal reduction. This is a very successful outcome for nearly everybody involved, but there’s a problem: while Newbery can buy pools of bank-owned mortgages, he can’t buy mortgages which have been securitized. And those mortgages represent the vast majority of defaulted subprime debt.

Newbery started buying pools of mortgages when his original idea didn’t work. That idea was elegant: investors would buy a house in a short sale at the market price, and then lease the home back to the homeowner until the homeowner had the ability to get a mortgage and buy it back at a pre-set price. The idea might have been elegant, but it didn’t work in practice, because the banks wouldn’t play ball: they (and Freddie Mac) simply hated the idea of a homeowner being able to stay in their house after a short sale, and often asked for an affidavit from the buyer saying that the former owner would certainly be kicked out.

The idea from Mortgage Resolution Partners and Robert Hockett basically does an end-run around the banks’ objections: they can’t object to the short sale, because they’re being forced to do the short sale. Clever.

But then things become extremely murky. Here’s Hockett:

Using their traditional eminent domain authority, municipalities can “take” – it’s a constitutional term of art – underwater mortgages from holders for fair market value. They can then write down the loans to just under the values of underlying homes, bringing these back above water. They can finance these takings with moneys supplied by investors, who then are repaid on the refinanced mortgages.

Got that? Me neither. Here’s Goldstein and Ablan, trying to explain the same idea:

Mortgage Resolution Partners would work with local governments to find institutional investors willing to provide tens of billions of dollars to finance the condemnation process to avoid using taxpayer dollars to acquire millions of distressed mortgages.

A local government entity takes title to the loans and pays the original mortgage owner the fair value with the money provided by institutional investors.

Mortgage Resolution Partners works to restructure the loans, enabling stressed homeowners to reduce their monthly mortgage payments. The restructured loans could then be sold to hedge funds, pension funds and other institutional investors with the proceeds paying back the outside financiers.

The key here — which is spelled out in much more detail in Hockett’s 56-page paper on the idea — is that the eminent domain powers are not being used to buy the actual houses in a short sale, as would have been the case under the original AHP scheme. Instead, they’re being used to buy the mortgage. Hockett doesn’t spend any time in his paper or his op-ed explaining why eminent domain should be used to buy mortgages rather than houses, and it’s here, I think, that his plan moves from something which could be a very good idea, to being something which is actually a pretty bad idea.

Here’s how a scheme like this should work. MRP, or a company like it, borrows short-dated money for a term of say three months at very low interest rates. Meanwhile, underwater homeowners in San Bernadino are invited to volunteer for the scheme. Once the money has been raised, it is used to buy those homeowners’ houses at the market rate. The homeowners then buy their houses back from MRP at say a 2% premium to the price paid, using a mortgage given to them either by MRP itself or by some other lender. MRP then repays the short-term loan. MRP’s profits come from that 2% premium, and from its separate mortgage-lending arm; if it wants, it can restrict the houses it buys to only the ones owned by people it would be willing to lend money to.

Under this scheme, the banks or investors who hold the mortgage would receive in return the fair market value of the home in question, just as they would in a short sale. That’s a very reasonable amount to receive for an underwater mortgage, so the banks can’t really complain. MRP would make a modest amount as a middleman and facilitator, and the homeowner would end up with a house mortgaged at its fair market value, rather than at some inflated old purchase price.

But that’s not what Hockett is proposing. Instead, Hockett wants MRP to be able to buy the mortgage, rather than the house. That’s very weird: while it might be legal under eminent-domain law (I have no idea about that), the spirit of the law is very much that the government can buy property, rather than liens. But after talking to Newbery, I understand what MRP is thinking here. His company, AHP, is buying up underwater mortgages for much less than the value of the underlying property — sometimes only 10% or so, and never more than about 25%. Admittedly, all of those mortgages have been in default for some time. But MRP clearly wants to be able to buy mortgages at a deep discount to the value of the home, and then “restructure” the mortgage so that the principal amount is very close to the value of the home. The result could be massive profits for MRP.

In both cases, the homeowner essentially ends up refinancing into a new mortgage with a principal amount just below the value of the home. But in the first case that money is essentially used to pay off the old mortgage holder, while in the second case — the one MRP is proposing — the money goes largely to MRP, the middleman, doing a job only really worth a percentage point or two of the deal.

What’s more, the market for liens is much more opaque than the market for houses, and as such MRP could probably make a colorable case that fair value for the mortgages it wanted to buy was extremely low. Since MRP would have all the important political relationships, the owners of the mortgage — especially if they’re just distant bondholders somewhere — would have very little ability to contest the valuation, and might end up getting paid much less than a genuinely reasonable price for it.

It seems to me that MRP is not adding a huge amount of value here — certainly nothing commensurate with the amount of money it’s likely to make. The real value is added by the use of eminent domain to buy the liens, and it’s the municipal government, rather than MRP, which has that power. So if anybody makes money from using eminent domain, it should be taxpayers: not some private-sector middleman.

If I represented the municipality of San Bernadino, I would respond to MRP’s proposal by giving them two choices. Either cut the city in to a very large proportion of MRP’s profits on these deals, or else force MRP to buy houses rather than liens. Both of those options seem fair to me. Hockett’s scheme, as it stands, doesn’t.

Update: I just had a long conversation with Steven Gluckstern, the chairman of Mortgage Resolution Partners. He explained that they were only interested in buying mortgages held by private-label securitizations, and not mortgages held by banks or by Frannie. Banks would put up too much of a fight in front of the judge, saying that their liens are worth more than the value of the house, even as MRP will never pay more for a mortgage than the house is worth. And Frannie-backed mortgages, of course, are worth par, because of that government guarantee. That alone seemed to me to be an excellent reason to buy homes rather than mortgages — but Gluckstern was adamant that transferring title was far too much work. He also admitted that it might be hard to make this scheme work at all in recourse states: it definitely works best in non-recourse states like California.

The financing for the scheme will come from investors putting up relatively short-term funds: the idea is very much that the homeowner will refinance their mortgage once they’re told they can do so at a much lower face value. MRP is only interested in buying underwater houses where the owner is current on their mortgage, partly because those owners shouldn’t find it too difficult to find a new mortgage for a lower amount. But still, owners in default, or owners whose mortgages are owned by the wrong kinds of institutions, won’t be eligible at all.

As for Hockett, he was paid an honorarium by MRP to write his paper; Gluckstern described him as a consultant to MRP, but definitely not one of MRP’s lawyers. MRP did not see the paper before Hockett published it, but seeing as how Hockett wrote “The Way Forward” with Dan Alpert, one of the key principals behind MRP’s scheme, there was surely no doubt about what his conclusions would be. The disclaimer in Hockett’s paper says only that “Readers should also be advised that the author is disinterested in what he is here recommending, but may subsequently undertake more legal, financial or expository work in connection with the proposals offered and advocated herein.”

Yesterday, I published the chart on the right, showing that in the nation as a whole, houses look like they’re a pretty good value, relative to rents, for the first time in many years. The chart elicited an email from one New Yorker, asking whether the same thing was true here in Manhattan.

It’s a good question, so I asked Jonathan Miller, of Miller Samuel, to provide some New York data which I could overlay on the US chart. And here’s the result:

The most striking thing, of course, is how expensive New York is relative to the country as a whole: that huge spike in the original chart now just looks like more of a foothill.

But it’s also clear that even with record-low interest rates, Manhattan prices are still a lot higher than Manhattan rents.

It wasn’t always that way. Rents were higher than prices from the fourth quarter of 1994 through the fourth quarter of 1999 — a full five years, during which prices rose from $227,500 to $320,000. Which in hindsight was a great time to buy, seeing as how prices now are at $775,000.

Obviously the Manhattan data series, with fewer transactions, are much noisier than the national series. But broadly speaking, it costs you the same amount to buy a house today, in terms of your monthly mortgage payment, as it did at the end of 2004, when the median sales price was just over $600,000. By the standards of recent history, then, Manhattan real estate is a lot more affordable than it was during the bubble. But look back a couple of decades, and it still looks expensive. And compare it to rents, and it still looks like you’d be better off renting than buying.

This is an important milestone, even if it’s too little, too late:

Bank of America Home Loans has begun reaching out to customers who may be eligible for forgiveness of a portion of the principal balance on their mortgage under terms of a recent settlement…

The bank estimates average monthly savings of 30 percent on mortgage payments of customers who qualify for this program…

Bank of America actually began making principal reduction offers under the program guidelines in March, initially concentrating on homeowners who were already in the modification review process. So far under this early initiative, about 5,000 trial modification offers have been mailed, providing a potential total of more than $700 million in forgiven principal. Homeowners are required to make at least three timely payments before the modification can become permanent.

On average, the principal reduction being offered is substantial: it’s on the order of $150,000. And this offer is being extended to some 200,000 homeowners, which means we’re talking a lot of mortgage principal here: some $30 billion.

In reality, however, the actual amount of principal forgiven by BofA is likely to be much smaller than that. As we’ve seen with HAMP, banks are incredibly good at putting people into three month trials, and then managing to determine that for whatever reason they don’t qualify for conversion to permanent modification. What’s more, ironically, many homeowners might not be able to afford to accept this principal reduction, since after the end of this year, forgiven principal will count as income, for income-tax purposes, and the income tax on $150,000 of windfall income is substantial.

Still, principal reduction is exactly what the country needs right now, and I’m glad that it’s finally beginning to happen. I wrote about the subject in The Occupy Handbook, and this seems as good a time as any to put my chapter up online. So here goes.

There’s a lot of blame to go around when it comes to the causes of the financial crisis, but at heart, it was about debt — or, as the the financial markets like to call it, leverage. Investment banks created highly leveraged mortgage-backed securities that blew up; commercial banks backed up their holdings of super-senior debt instruments with little or no capital; homeowners bought houses with no money down, paying for them by borrowing amounts they could never afford to repay.

In many ways, the debt-fueled housing bubble was the financialization of America carried to its logical conclusion. From the early 1980s onward, economic growth was increasingly a function of leverage: small improvements amplified by being turbocharged with debt. A little debt can do wonders for growth — but like a drug addict, the economy eventually needs that much debt just to stand still, and ends up having to take on more and more leverage to sustain the growth it’s used to.

With leverage, of course, comes danger — what finance types call “systemic risk.” If the debt stops getting rolled over, as happened in 2007, then the entire economy can come to a screeching halt, with the loss of trillions of dollars in wealth, not to mention millions of jobs across the country. When the party stops, as happened in 2008, a new word enters the lexicon: deleveraging. It’s a central paradox of finance: while the economy needs credit in order to grow and to create jobs, it also needs to reduce the total amount of debt outstanding, in order to reduce not only individual and corporate debt burdens but also the risk of another massive crunch.

Deleveraging is always a painful process. When done on a nationwide scale, it often takes the form of inflation, which tends to hurt the poorest members of society in a particularly invidious way. When done on a case-by-case basis, it involves the loss of a lot of wealth. After all, your liability is my asset. (The money in your checking account, for instance, is counted toward your bank’s total liabilities. If your bank repudiated your claim to that money, then it would be richer, but you would be poorer.) Nevertheless, deleveraging is necessary. And every so often, it’s possible to find a positive-sum way of making it happen: a plan that makes everybody better off.

How can writing down debts ever benefit a creditor, the person to whom those debts are owed? The answer lies in the fact that if a debt is not going to get paid off in full anyway, the creditor’s best interest lies in simply maximizing the value of what he does end up receiving. Let’s say you owe me $1,000 — but then you come and tell me that you can’t afford to pay me back. You’re faced with a choice. Either you empty out your checking account and I take everything in it, which is $250, or you can find some money elsewhere and give me $450 in settlement of the debt. If I’m sensible, I’ll take the $450 — and I’ll leave you with a working checking account.

Compared to the $1,000 I had in the first place, I’m worse off, but that’s a sunk cost at this point, and there’s no point crying over spilled milk. I have to face the situation as I find it today, and make the best of it.

You’d think that banks, in particular, would be alive to the sunk-cost fallacy — partly because denial is a pretty bad business strategy at the best of times and partly because they all worship at the altar of something called “mark to market.” That is, they check to see what their loans are worth every day (or at least every quarter) and then value the loans at what they’re worth in the real world rather than how much was borrowed in the first place. Yet banks — and this probably comes as little surprise, at this point — can and do behave in surprisingly irrational and childish ways. A lot of the time, especially when it comes to dealing with homeowners, they seem more interested in inflicting misery than in maximizing their own financial returns.

All of this comes into starkest focus with respect to mortgages. America has millions of underwater homeowners, many of whom are behind on their payments and all of whom are significantly less likely to pay off their mortgage in full than they would be if they actually had equity in their houses.

It’s simple logic, used by every company and commercial real estate operation in the land. If you owe more than your property is worth, and you can walk away from that property and discharge your debt in full, then you should absolutely do so: indeed, the Mortgage Bankers Association did exactly that in 2010. It had a $75 million mortgage on its Washington, D.C., headquarters but sold the building for $41 million, moved out, and is renting elsewhere, relieved of the burden of $75 million in debt.

Banks hate it when people walk away from their homes. (The act is often called “jingle mail,” because you’re essentially mailing in your keys to the bank.) At the same time, they’re often enormously reluctant to do the one thing that is completely effective at preventing people from doing that, which is to reduce the principal due on the mortgage so that the amount of the mortgage is lower than the value of the home. The US government, too, has been reluctant to push this as a solution: its attempts to encourage banks to refinance mortgages have all been centered on reducing monthly mortgage payments rather than the total amount owed. In fact, many government-backed mortgage modifications actually increase the total principal amount because of various fees tacked on during the modification process.

Even if your mortgage payments go down, it can still make all the financial sense in the world to stop paying them, especially if you run into trouble. If you can rent a nice place for less than your mortgage payments, and if you have no real prospect of owning any positive equity in your home for the foreseeable future, it makes sense to free up a lot of cash flow by just stopping payments on your house. This is especially true when banks can take well over a year even to start foreclosure proceedings.

The result is a huge “shadow inventory” of homes overhanging the market. These homes aren’t yet for sale but will at some point get sold in a foreclosure sale, depressing values across the neighborhood. As a result, in 2011, no one wanted to buy — and house prices continued to fall, despite record low mortgage rates of less than 4 percent.

So what should happen when people get into trouble making their mortgage payments on a house that is underwater? After 2008, banks tended to do one of two things. They waited for an interminable amount of time, then initiated foreclosure proceedings and kicked the family out of their home. Alternatively, they worked out a mortgage modification that didn’t reduce the amount owed by a single dollar, thereby maximizing the probability of a redefault and of the homeowner’s having to go through the same painful process all over again.

There are multiple ways of doing this better. The simplest is just for the banks to unilaterally reduce the principal amount owed on a mortgage. It’s much more effective, always, for a bank to reduce principal and keep the interest rate constant than it is to do what they tended to do after 2008, which was to keep the principal constant and reduce the interest rate. Why don’t they reduce principal? They don’t because doing so involves writing down the value of the mortgage on their books — something they’re bound to do sooner or later, but which they’d much rather do later than sooner.

As the depressed stock prices of every bank in America in 2011 attested, however, no one really believed the values that the banks put on their mortgages — they weren’t kidding anyone. Coming clean on the true value of their mortgage portfolio might hurt banks’ quarterly earnings, but it wouldn’t necessarily hurt their share price. Once the mortgages are marked down to a reasonable level, banks can be much more sensible about how they’re going to deal with homeowners in difficulty.

There are circumstances in which banks have shown themselves willing to take losses on the mortgages they own. One is when they sell a big portfolio of mortgages to some third-party investor: such portfolios are often sold at just 10 percent or 20 percent of the face value of the mortgages if a lot of those mortgages are in default. Another scenario, and it happens pretty frequently, is the short sale, in which a homeowner sells a house and hands over all the proceeds to the bank, and in turn the bank writes off the mortgage, even though it isn’t fully paid off. Then, of course, there’s the worst scenario of all: you fall behind on your mortgage, and the bank forecloses on your property, taking over the deed to the house. At that point, the bank will turn around and sell the property, almost certainly for less money than it was owed on the mortgage, and take a loss.

All of these mechanisms open up possibilities for keeping homeowners in their homes, even after they’ve fallen behind on their mortgage payments: you just need a little imagination. For instance, let’s say you’re a bank that has foreclosed on a home. Standard operating procedure in such a situation is normally to kick the occupants out, put the house up for auction, and take whatever you can get for it. But there’s no rule saying you have to do that; indeed, there’s no rule saying that you have to evict the home’s occupants at all. Instead, why not rent the house back to them at the market rate? The market rent will almost certainly be lower than what they used to have to pay in mortgage payments, and at the same time you get to avoid kicking the family out of their home. Everybody wins in this case. The family gets to stay where they are, the neighborhood isn’t blighted by a boarded-up home being sold at auction by an owner who doesn’t care about it, and the bank gets a healthy income stream rather than a modest sale price.

And if the bank prefers to get cash rather than be a landlord? No problem: it can simply sell the property to someone happy to rent it out to the current occupants. Many such organizations and individuals exist: in days of record low interest rates, people with money often jump at the opportunity to make a decent rental yield on their investment, especially if they’re helping out a family in straitened circumstances at the same time. Often, such a rental contract will include a clause allowing the former owners to buy the house back at a pre-set price: the new owner might ask for a 10 percent profit after one year, a 15 percent profit after two years, and so on. If the family members manage to qualify for a mortgage to buy their house back, then the new owner will sell it to them — for less than the occupants originally paid but more than the new owner/landlord paid. Again, everybody wins.

Similarly, if a bank sells a defaulted mortgage for a fraction of its face value, then there are lots of ways in which the new owner can keep the former homeowners in their house and still make money. The principal amount can be reduced, of course, as can interest payments — and you probably wouldn’t be surprised to learn how much simple and sympathetic human contact can help.

Most of the time, homeowners have no ability to get through to a sensible human being at their mortgage company who can understand what they’re saying and make empowered decisions with regard to any possible mortgage modification. Instead, they get the standard run-around: they’re constantly being asked to fax in documents that always seem to then go missing. By contrast, if you buy a mortgage and approach the homeowner with good will and a genuine desire to find a reasonable solution, it’s amazing how often something mutually beneficial can be worked out. Indeed, a company called American Homeowner Preservation (AHP) is doing just that: it’s set up a hedge fund devoted to buying pools of defaulted mortgages and keeping the homeowners in their homes, and it is making good money doing so. All it takes, really, is a little bit of compassion and an ability to be inventive — rather than following exactly the same script every time.

AHP started with a simpler, nonprofit model: it would act as a broker, putting together willing buyers with underwater homeowners. The homeowners would do a short sale to the buyers at the home’s market value, and the buyers would lease the house back with an option to repurchase. That model didn’t work, because the banks refused to cooperate. While they were okay with short sales in general, they were emphatically not okay with any short sale that involved sellers remaining in their home. Tired of fighting and losing endless battles with the banks, AHP decided it would be a lot easier to buy the mortgages themselves. That way, AHP didn’t have to deal with impenetrable and illogical bureaucracies all day.

The banks have a reason for making it hard for people to sell their homes and stay in them regardless: they’re worried that lots of other homeowners will attempt the same stunt. However, it only makes sense to sell your house if you’re significantly underwater on your mortgage. And if you’re significantly underwater on your mortgage, then it probably makes sense to sell your house whether you get to stay in it or not.

Indeed, one of the more evil tricks of America’s banks is that the very people who need the most help with their mortgages — people who are far underwater — are also the people least likely to be able to get it. If you bought your home at the top of the market and it’s now worth a lot less than you borrowed to buy it, you’ll probably be rejected for the kind of mortgage refinance that everybody else can get with no difficulty. As a result, if you’re current on your underwater mortgage, banks and investors reckon that mortgage is worth not less than par (because it’s underwater) but, rather, more than par — about 106 cents on the dollar, on average. On a $200,000 mortgage, investors will pay a $12,000 premium just to be able to collect your high-interest mortgage payments, which you can’t reduce because you’re not allowed to refinance.

It’s a little bit crazy: if these homeowners were rational, especially if they live in a nonrecourse state like California, they would just mail their keys in to their bank and be done. That’s certainly what the bank would do, in the same situation. (In 2009, for instance, Morgan Stanley mailed back the keys to five San Francisco office buildings worth $1.5 billion rather than pay the mortgage on those buildings out of its record profits that year.)

Instead of reacting with gratitude to the fact that these underwater homeowners are paying their mortgages in full, though, banks punish those homeowners by forcing them to continue paying the high interest rates they locked in at when they bought at the top of the market. Mortgage rates had never been lower than they were in 2011, which meant that mortgages that couldn’t be refinanced to a lower rate were particularly valuable to banks.

If you’re current on your mortgage, the banks won’t let you refinance, and if you’re behind on your mortgage, they won’t let you stay in your home, even if you have a willing buyer waiting with the cash to buy the house and let you do just that. There’s only one exception to this rule, and it’s a fascinating one. If a bank bought its mortgages below par rather than lending the money out itself, then it’s quite likely to be open to the idea of principal reductions. For instance, when Wells Fargo bought Wachovia and when JP Morgan Chase bought Washington Mutual, they bought those banks’ mortgage portfolios at a large discount to par. It turns out that those mortgages — the ones bought from Wachovia and WaMu — have been getting modified with principal reductions.

The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans by writing down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, which is what Wells and Chase can do if they manage to put some smart principal-reduction plans in place. (Some principal reductions, indeed, have even been done for homeowners current on their mortgages.)

Economically speaking, of course, what the banks are doing here makes no sense at all. Either writing down option-ARM (adjustable-rate mortgage) loans makes sense, from a profit-and-loss perspective, or it doesn’t. If it does — and, yes, of course it does — then the banks should do so on all their toxic loans, not just the ones they bought at a discount.

The solution, then, is clear. We need to encourage banks — and servicers — to mark their mortgages to market, and to do whatever makes sense if they’re being realistic about how much those mortgages are worth. And while it’s okay to assume that homeowners will develop an emotional attachment to their homes and pay more than necessary to stay in them, it’s not okay to take advantage of that fact to extract thousands of dollars a year in extra mortgage payments from those homeowners.

More generally, principal reduction in mortgage modifications has to become the rule rather than the exception. The reason the government’s efforts to fix the mortgage market have failed so miserably is that those efforts have centered on interest payments, not the total amount owed. A sluggish housing market will act as an economic drag for as long as millions of homeowners owe vastly more than their house is worth.

If done right, these policies can be implemented in a positive-sum way, making everybody — including the banks doing the write-downs — better off. For instance, the government could impose higher capital standards on banks that insist on marking underwater defaulted mortgages at par, and give the banks an incentive to write down principal that way, while making the whole banking system safer at the same time.

Not all deleveraging can be done this efficiently or painlessly, but that’s a great reason to grab this low-hanging fruit while we can. If we don’t want the United States to continue to suffocate under the weight of far too much debt, we have to start making serious efforts to bring our debt burden down. This one’s a no-brainer. Let’s do it.

Many thanks to Ben Walsh for putting this chart together for me. The source is this data at the Census bureau, inspired by page two of the first-quarter 2012 Census bureau report on rental vacancies and homeownership.

The first thing to look at here is the blue line, which shows that the median asking rent for vacant rent units tends to rise pretty steadily. It doesn’t spike during housing bubbles, and it doesn’t plunge when those bubbles burst. Which is one reason why if you can, it’s always a good idea, when you’re buying a home, to take a look at what rents are like in the area. That’ll help you work out whether prices are too high.

David Leonhardt performed this exercise two years ago, and came to the conclusion that in some parts of the country, including South Florida, Phoenix and Las Vegas, buy-to-rent ratios were making houses look attractive again. I wasn’t completely convinced, but over the past two years, prices have continued to fall, while rents have continued to rise — sometimes painfully so.

In the chart, the red line shows the mortgage payment you’d have to make if you took out a standard 30-year mortgage for the median asking sales price for vacant sale units. In reality, your mortgage payment would be lower, since this doesn’t take into account any downpayment. But in any case, thanks to ludicrously low mortgage rates below 9% 4%, that number is now lower than the median national rental price. This is the first time that’s happened since 1988, and probably for quite some time before that, too.

Remember that houses for sale tend to be bigger and more valuable than houses for rent, too — which only goes to underscore how good a deal buying is versus renting right now.

Of course, not all markets work this way: around New York, there are lots of places where it’s still a lot cheaper to rent than to buy. But if rental prices are a good gauge of the value of housing — and I think they are — then I think we might finally have reached the point at which most Americans are getting good value when they buy a house.

To put it another way, we can now take advantage of long-term fixed financing (thanks, Uncle Sam!) to own a home for a monthly payment less than the cost of renting. Which doesn’t mean that prices won’t fall further, of course. But at least there’s a good chance that if you do buy a house right now, with a fixed-rate mortgage, then if push comes to shove you’ll probably be able to rent it out and more than cover your mortgage payments.

After Ben Walsh covered Ed DeMarco’s speech in the Counterparties round-up yesterday, I got a very smart note from the undisputed kind of the housing blogosphere, Calculated Risk:

I think DeMarco made a key point about “strategic modifiers” as opposed to what people have been calling “strategic defaulters”.

In the 2nd case, these are people who can afford their mortgage, but walk away because they are so far underwater that continue to pay makes no sense.

DeMarco is talking about people who will want to keep their home, but default for the purpose of receiving a principal reduction.

I think this is more likely than the classic strategic defaulter (something I’ve played down for years).

The reason is Fannie and Freddie will have to make the program guidelines clear and public. People are very good at figuring out how to game the rules. So, unless the rules are very tight, there will be more “strategic modifiers”.

Certainly this is something that DeMarco is worried about: in his speech, he defines a “strategic modifier” as “a borrower that either claims a financial hardship or misses two consecutive mortgage payments in order to attempt to qualify for HAMP and a principal forgiveness modification.” If there are enough of these borrowers, he says, then the financial benefits of principal reduction could go away quite quickly.

DeMarco’s worries are not entirely unfounded, given, as he says, that three quarters of the Enterprises’ deeply underwater borrowers are current. But the distinction between a strategic defaulter and a strategic modifier is a very subtle one, given that their actions — defaulting on their mortgage while being capable of making payments in full — are indistinguishable.

The difference is not in what they do, but rather in their motivation: the strategic defaulter expects to lose the house at some point, while the strategic modifier expects to retain the house, and the mortgage, but get a principal reduction along the way.

Personally, I don’t believe that the problem of strategic modifiers (over and above the problem of strategic defaulters) is likely to be huge. One reason is that I’ve been writing about the upside of strategic default for a long time, and it really hasn’t caught on, outside a few second homes and the like. Strategic default is not something that Americans like to do, and one of the main reasons is that they really care about their credit rating. Even if a strategic modifier keeps her house, she’ll suffer the same hit to her credit rating as a strategic defaulter would. And people don’t like that at all.

On top of that, the strategic modifier will still be running the risk of getting far behind on her mortgage payments, being unable to make them up, and then for some reason not qualifying for a principal reduction or indeed any other kind of modification. DeMarco is right that the principal-reduction program would be broadly publicized. But it will be publicized to people who are having real difficulty making their mortgage payments. If you can’t make those payments, then applying for a principal reduction is a no-brainer: it’s all upside and no downside. But if you can make those payments, the calculus is a lot more complex.

Even if principal reduction were made available to people who hadn’t missed a single mortgage payment — and I doubt that it would be — it would still constitute a write-off of a large chunk of debt, and would likely be considered a default as far as FICO was concerned. And if you do have to be in default to apply for a principal reduction, then not only do you suffer the hit to your credit rating, but you also run the risk of falling into a major mortgage-related nightmare which might well end up with you losing your home.

CR is right that people like to game rules. But he misses a crucial point here, which is that any principal-reduction program would be run by mortgage servicers. And the one thing that everybody knows about mortgage servicers is that they’re incompetent. No one will trust the servicers to play the game perfectly by the rules.

I, for one, would be petrified of playing this game, because I would have no faith at all that my mortgage servicer would do the right thing and give me that principal reduction, rather than having its left hand lose lots of paperwork while its right hand started foreclosure proceedings.

So let’s try principal reductions in the real world, and see what happens. If they turn out to be incredibly expensive, then we can revisit the issue. But my guess for the most likely outcome is not a wave of strategic modifiers. Rather, it’s that the program turns out to be much like all other government attempts to deal with underwater borrowers: a damp squib where very little happens at all.

If you haven’t read it, I can highly recommend Paul Kiel’s magnum opus on the US foreclosure crisis, available online or as a Kindle Single. Kiel tells the national story using synecdoche: the story of Shelia Ramos is representative of millions of others. And Kiel makes it very clear just how typical her tale is, zooming back out to a big-picture view on a regular and welcome basis.

What Kiel doesn’t do is look forward, and give his informed opinion on whether the new rules being outlined by the Consumer Financial Protection Bureau are likely to work to prevent such events from happening again. The question isn’t whether the new rules are good ones; the much more important and salient question is whether they will be followed and enforced. I’ll believe it when I see it: as Kiel shows, servicers are really bad at this kind of thing, and there’s a strong case to be made that they’re simply not capable of following the rules that the CFPB is laying out.

Meanwhile, the weird cognitive disconnect in the housing market seems greater than ever. If you look at Fannie Mae’s latest monthly survey, it shows lots of new highs being set: the percentage of people thinking that house prices are going up, the percentage of people thinking it’s a good time to buy, and, especially, the amount that people think they’re going to have to pay for housing if they don’t buy.

And yet, the facts on the ground don’t support any of this. Check out the latest quarterly home price report from LPS, for instance. Not only are prices still falling, they’re actually falling at a faster rate than they were a couple of years ago:

The rate of relatively slow price declines, from January 2009 to May 2010, was the time when there were tax incentives for first-time homeowners. When those tax incentives went away, so did the artificial support for the housing market; in hindsight, most of those first-time buyers would probably have been better off just waiting, and buying a house now without the tax incentive instead.

What’s more, this index, unlike other indices, excludes short sales. If you include short sales, then the numbers are far worse. And as the mortgage industry moves from foreclosures to short sales (since short sales don’t require the lender having to prove title to the home), the discount on short sales is growing alarmingly, and approaching the discount on foreclosure sales.

In Kiel’s story, Ramos abandoned her house to the mercy of her lender, rather than suffering through a foreclosure: in that sense, when it was finally sold it was more of a short sale than a foreclosure sale. But the distinction is less and less important these days — and there’s still a shadow inventory of millions of homes being lived in by delinquent borrowers, which are going to come on the market sooner or later at discounts of more than 20% to their peers. So long as that’s the case, it’s hard to see how house prices are going to stop going down and start going up.

So what explains Americans’ optimism surrounding house prices, especially when they think mortgage rates are going to rise? My guess is that it’s the fact that the recovery is proving itself to be real, combined with a natural bullishness when it comes to housing, which somehow wasn’t eradicated by the 2008 crisis.

But color me contrarian: if house prices can’t rise even with mortgage rates at all-time lows and the government desperately underwriting nearly all the mortgages in the land, I can’t imagine how they’re going to go up in future when rates go up and the government manages to extricate itself from the market. And if house prices don’t go up, of course, then the number of underwater borrowers will stay high, and the foreclosure crisis is going to remain a big problem for the foreseeable future. That’s the real horror of Kiel’s story. Not that it happened in the past — but that it’s likely to be repeated into the future, as well, for many years to come.

Ed DeMarco, the regulator in charge of Fannie Mae and Freddie Mac, has many critics, myself included, who would love him to allow Frannie to do principal reductions where it makes sense. But now he’s managed to find a defender. In Gretchen Morgenson, of all people.

Morgenson’s column today is utterly bizarre. She starts off by painting DeMarco as a “career public servant”, “under fire” in a “thankless job”. This is a phrase she seems to reserve for DeMarco alone: she made sure to describe him as a “career public servant” in 2010, as well as in her book. And as far as I can tell, she’s described no one else that way. And there are many career public servants, up to and including Tim Geithner, who can’t stand DeMarco* and who think he is being deliberately obstructionist here.

Morgenson then defends DeMarco from critics like Barney Frank and Elijah Cummings:

What the proponents of principal reductions at Fannie and Freddie don’t talk about is what a transfer of wealth from taxpayers (again) to large banks such a program would represent.

Morgenson is actually serious about this: the headline on her column is “A Bailout by Another Name”. And when she says bailout, she doesn’t mean a bailout of deadbeat homeowners, who would see their net worth jump overnight as a bunch of their obligations were written off at a stroke. No, she means a bailout of banks.

On the face of it, this makes no sense. How can reducing homeowners’ principal end up as a bailout of banks? And not just any bailout, either: Morgenson goes on to tell us that such a program “would constitute a direct and sizable gift from taxpayers to the largest banks”, “another backdoor bailout for the banks that brought you the mortgage crisis”, and “another stealth bank bailout, courtesy of taxpayers”.

Don’t worry, Morgenson does actually spell out her thesis here. In her 1,170-word column, she spends a full 65 words explaining exactly how principal writedowns are in fact a “direct and sizable gift” to banks. So I may as well quote those words in full:

Many banks hold second liens on the same properties for which Fannie and Freddie either own the first mortgage or have guaranteed. If principal amounts on these first mortgages are reduced while leaving the second liens intact, those seconds become much more likely to be paid off over time. With no principal reduction, the banks would have to write off many of those second liens.

That’s it. I don’t know what your idea of a “direct gift” is, but I’m pretty sure it’s not this. Even if Morgenson’s argument here made sense, which it doesn’t, the gift would at best be indirect. And there’s nothing here at all indicating that it’s sizable.

More to the point, Morgenson’s whole argument, such as it is, is based on a classic straw man — that the holder of the first lien would be perfectly happy to write down a large chunk of what they were owed without any kind of write-down whatsoever on the part of second-lien holders. As far as I know, nobody advocating principal reductions is proposing this.*

It’s worth remembering here, that the whole point of principal reductions is that when people are underwater on their homes, they’re much more likely to default than when they have equity in their homes. If you reduce principal to the point at which the homeowner has positive equity again, then you’re more likely to get repaid, and you can end up with a more valuable loan than one with a higher face value.

But if there’s a second lien on the house in question, then even if the first lien is reduced to less than the value of the property, the homeowner would still be underwater, thanks to that second lien. Which would quite literally defeat the purpose of reducing the principal on the first lien.

Banks holding first mortgages negotiate with banks holding second mortgages all the time. If the homeowner is in default, then the owner of the first lien is in a strong negotiating position: they can foreclose on the home, sell it, and take all the proceeds, leaving nothing at all for the holder of the second lien. And because the second-lien holder is well aware that the first-lien holder has that nuclear option, they’re normally well disposed to negotiate: they’ll accept $5,000, say, to write off their debt.

Why does Morgenson think that wouldn’t happen here? She doesn’t say — after all, her entire argument is just 65 words. But she does go on at some length about the loan modifications which we are seeing from Frannie — more than 1.1 million, to date, with an impressively low redefault rate. She writes:

This suggests that the types of loan modifications provided by Fannie and Freddie — reducing borrowers’ monthly payments — are working fairly well. Addressing borrowers’ ability to repay loans has been the focus, Mr. DeMarco said. At the same time, these changes in loan terms do not encourage people to default in spite of being able to pay.

What Morgenson doesn’t seem to realize, here, is that exactly the same argument that she’s marshaling against principal reductions could be used against loan modifications as well. If you reduce borrowers’ monthly payments, and increase their ability to repay their loans, then quite obviously you’re also increasing their ability to repay second liens as well. And if you do a loan modification rather than foreclose on the delinquent borrower, then the second lien holder isn’t wiped out and the homeowner can continue to pay off their second lien over time.

So how is it that principal reductions are a giveaway to banks, but loan modifications aren’t? Morgenson even says that loan modifications don’t encourage people to default on their original loans, which would seem to be an argument for principal reduction: the moral-hazard argument, that such things only serve to give people an incentive to default, seems already to have been disproven with the loan-modification program.

Remember, too, that Morgenson said in her 65-word argument that “with no principal reduction, the banks would have to write off many of those second liens”. Something doesn’t add up here. After all, banks will never voluntarily write off a second lien if the homeowner gets a loan modification which increases their ability to repay their debts. So if Frannie is great at loan mods, then they must also be great at forcing second-lien holders to write off their loans at the same time. But if they can do that with a loan mod, they should be able to do it with a principal reduction, too. And if they don’t do that with loan mods, then the banks wouldn’t otherwise be forced to write off those second liens.

And we haven’t even touched, yet, on the most obvious and silliest part of Morgenson’s case — which is that most of Frannie’s delinquent mortgages don’t have second liens attached. DeMarco doesn’t like the idea of doing principal reductions on homes with second liens? Fine, don’t do it, then. But that’s no reason not to do principal reductions on loans without second liens.

More generally, DeMarco is just the regulator, here — he’s not actually running Fannie and Freddie. If he lifted his injunction on principal reductions, then we wouldn’t suddenly see a huge influx of the things overnight. These agencies move slowly and deliberately, and they’d almost certainly start small, and only on homes where there weren’t second liens. If that program worked, then they’d expand it, taking just as much care in doing so.

Morgenson’s argument implies that were it not for DeMarco holding back the floodgates, Fannie and Freddie would be doing principal reductions on a massive and reckless scale, without even trying to involve banks holding second liens. She has no reason to believe this, because it isn’t true. The agencies might be philosophically inclined — for good reason — to do principal reductions, but only when and because they make financial sense. DeMarco, on the other hand, seems to have some kind of quasi-religious belief that principal reductions never make financial sense. And his arguments to that effect are extremely weak.

But not as weak, it must be said, as Morgenson’s effort today. If principal reductions really would be “a direct and sizable gift from taxpayers to the largest banks”, then the largest banks would surely be pushing loudly for their implementation. But they’re not. Because the principle beneficiaries of principal reductions are not banks, but rather homeowners — the people whom Gretchen Morgenson wants to see continuing to suffer under the weight of mortgages worth far more than their homes. And all because of some inchoate and irrational animus she has towards Fannie and Freddie.

*Update: Anthony Coley at Treasury emails to say that Geithner “has tremendous respect for Mr. DeMarco”, even as he thinks “there’s a pretty strong economic case for principal reduction as part of a strategy to limit the future losses of the GSEs. What Treasury is trying to do is encourage Mr. DeMarco, who is fully independent, to take another look at the evidence because we think there’s a place to do more in a way that is consistent with the mandate that Congress gave him.”

And Shahien Nasiripour, who’s been getting the same line from DeMarco, points out that there is at least one person who thinks that principal reductions should be done absent write-downs on second liens: NY Fed president William Dudley.

It’s principal-writedown day today! Jesse Eisinger has uncovered a huge story: that internal analyses at both Fannie Mae and Freddie Mac show that reducing principal on troubled mortgages has a “positive net present value”. That of course directly contradicts the testimony of Frannie’s regulator, Ed DeMarco — but it’s now going to be much harder for DeMarco to maintain his position that principal reductions would never help Frannie’s finances.

Meanwhile, Bank of America has launched a pilot scheme which is a variation on the theme of principal reduction. Remember that by far the most common form of principal reduction is the short sale — and it’s also the most damaging form of principal reduction, since homeowners invariably have to leave their homes when they do one. Under BofA’s new scheme, however, that’s not the case: the bank would buy the property from the homeowner, but would then immediately turn around and rent it back at a market rate.

This idea is hardly a new one. It’s known under many names, including Right to Rent, and dates back at least as far as August 2007, when it was proposed by Dean Baker. I’ve been bashing away at it for years myself, but I’d pretty much resigned myself to the idea that it wasn’t going to gain traction.

So what changed? The markets did. The WSJ’s charts show how home prices have been falling even as rents have been rising:

The left hand chart, here, shows why banks don’t want to foreclose: prices are still very depressed, making homes extremely hard to sell. The right hand chart, on the other hand, shows why banks might find the rental market rather attractive. Banks have no particular interest in being landlords, but if they can do right-to-rent deals with a large number of homeowners, they can bundle those deals up into a big package, and sell it off to investors searching desperately for yield. And that could make the banks much more money than trying to sell the houses off one by one.

The WSJ explains how the BofA scheme works:

Borrowers would agree to a what is known as a “deed-in-lieu” of foreclosure, where they essentially sign over ownership of the property to the lender. This is less costly to the bank and also does less damage to a borrower’s credit than a foreclosure.

In exchange, former owners would be offered one-year leases with options to renew the leases in each of the following two years at rents that the bank determines are at or below the current market price. Borrowers would have to demonstrate an ability to pay the market rent.

For example, based on a sampling of home values and rental rates in Phoenix recently, a consumer with a $250,000 mortgage and monthly payments of $1,600 could swap the house for a lease, renting the home for $900, depending on the condition of the property and the neighborhood…

Borrowers selected for the program must be at least two months past due on their mortgage and face considerable risk of foreclosure. Bank of America is reaching out to borrowers who have exhausted other alternatives to foreclosure or who haven’t responded to earlier solicitations. Homeowners with second mortgages or other liens won’t be selected.

This is a far cry from a right to rent a home that has been foreclosed, of course. All of these self-imposed rules seem silly to me: I would much rather see a scheme where BofA simply declares that anybody facing foreclosure will have the right to rent back their home from the bank at a market rate once the home is owned by the bank. If they fail to make their rent payments, then they can be evicted just like any other delinquent renter.

I’d also love to see BofA extend this scheme to include renters in houses being foreclosed. Rental homes are homes too, and people shouldn’t get kicked out, especially not if they’ve been making all their rent payments on time, just because their landlord had mortgage problems.

The real reason for this pilot scheme, I suspect, is just that BofA is very worried about its legal ability to foreclose on houses. The difference between a foreclosure and a deed-in-lieu operation like this one is that a foreclosure is involuntary on the part of the homeowner, who retains lots of legal rights. A deed-in-lieu, by contrast, is something the homeowner must agree to, and therefore doesn’t present nearly as many legal obstacles.

In any case, let’s hope that the pilot works, and is copied by other banks around the country. It’s about time.