It has been nearly six years since U.S. home prices peaked and then plunged, and still the nation’s mortgage markets remain mired in slump. Despite occasional signs of improvement in some localities, the S&P Case Shiller Index shows home prices down 9 percent from their previous post-bubble high – itself very low in relation to trend. Meanwhile a backlog of some 400,000 homes awaited liquidation at the end of 2011, and an additional 2.86 million mortgages were 12 or more months delinquent. That’s a “shadow inventory” of 3.25 million homes already foreclosed or now facing foreclosure – an inventory that weighs on home prices, families and neighborhoods alike.
It also weighs on our economy, at the city, state and national levels. As a recent Federal Reserve Board white paper and other sources abundantly demonstrate, foreclosure and slump in the housing markets feed back into the broader economy by diminishing wealth and consumer spending. That lowers growth and employment – bad enough in themselves, but also sweeping more mortgages into the wave of defaults. Hence the familiar downward-spiraling “feedback loop” of high foreclosure rates, causing low growth and employment, causing yet more foreclosure, and so on.
Easily the worst source of drag is the large class of “underwater” mortgages – loans on which more is owed than the underlying post-bubble housing collateral is now worth. It isn’t hard to see why. Wrought by the rise in housing prices until 2006, the so-called wealth effect supported consumer spending even when wages and salaries stagnated. But it runs in both directions: Homeowners with “negative equity” cut their spending the most. Even tax cuts, rather than flowing toward employment-supporting consumer expenditures, go toward trimming back overhung mortgage debt. That’s why the 2009 stimulus did so little.
In light of these truths it is now widely appreciated that principal writedowns will be required for a broad swath of underwater mortgages. Even many creditors – the prospective bearers of writedown-wrought losses – understand and embrace this. For they are better than defaults, which underwater mortgages do at high rates. Indeed for most underwater mortgage debt, principal writedowns maximize expected value.
So writedowns will have to be done. The question is how. Unfortunately, a host of what lawyers and economists know as “collective action problems” stand in the way of the win-win solution here. For one thing, the securitization agreements pursuant to which many modern mortgage loans are pooled and then sold often require unanimity or supermajority votes among mortgage-backed securities (MBS) holders before loans can be modified. And today’s fragmented owners of MBS cannot even find one another, much less reach agreement on what’s best for them. For another thing, these same agreements likewise typically prohibit loan servicers, who act on behalf of the loan holders, from modifying as well.