Treating debt wounds with Band-Aids
James Saft is a Reuters columnist. The opinions expressed are his own.
A new U.S. plan to aid underwater homeowners once again tries to treat a debt-inflicted wound with a cash flow Band-Aid.
Under changes to the Home Affordable Refinance Program (HARP) the Obama administration will shortly allow current borrowers whose home loans are backed by Fannie Mae or Freddie Mac to refinance to lower rates, even if they owe more than 125 percent of what their house is worth.
HARP covers borrowers who are not behind in their payments but who would otherwise be unable to refinance into a lower mortgage interest rate.
The program might possibly help the housing market and economy, and definitely will help banks, but it will very likely do so at the expense of the poor saps who decide to stick with their impossibly underwater loans and the houses that go with them.
Seeing as how many of these borrowers could walk away from the loans without putting their other assets at risk, HARP really is an unforgivable instance of using people as a means to accomplishing other goals rather than as ends unto themselves.
Let’s put this in corporate terms and pretend that a company had bought a widget factory with a loan only to see the market for widgets crash, leaving it owing 25 percent more on the facility than it was worth. Now, in part because the lender has no recourse to the company’s other assets, the bank comes along and offers a new lower interest rate. Sounds good on its face, but a corporate board which approved such a deal would be liable to be sued, and with good reason. That board has a fiduciary duty to act in shareholders’ best interests, and if the company has a chance to walk away from a bum deal it very likely should.
People who owe that much more than their houses are worth — and 25 percent of U.S. borrowers are underwater to some extent — are usually better off defaulting on the loan, handing the keys to the bank, taking the hit to their credit rating and getting on with the rest of their lives. Even if real estate prices rise, the first four or five years’ gains might essentially only benefit Fannie Mae and Freddie Mac.
This has been the problem with so much of the approach to the debt bubble; no one wants to admit that the assets aren’t worth that much any more and make the painful decisions that admission implies. The only way to help these borrowers was to give them a large break on the value of the loan, despite the damage that would do to banks, investors and mortgage servicers.
FROM MAIN STREET TO ATHENS
That’s exactly what has happened in the euro zone, where an early unwillingness to deal with the damage that a Greek default will do to banks has been hugely destructive. Almost two years have been lost, and terms imposed on Greece which made it less and less able to ever pay back the money. Now we are looking at a 60 percent Greek debt write-down, which may not be deep enough. And still euro zone efforts concentrate more on giving weak borrowers like Italy low rates than on delivering credible long-term fiscal plans.
This is, of course, because recognizing losses is painful, and if you do it you sometimes discover you are broke, which can be inconvenient. Think of the billions in bank dividends and bonuses which would not have been paid out over the past two years if banks had been forced to come clean. Think too of the campaign contributions that never would have been made, and the lobbying money never spent.
This brings us back to HARP, which should be greeted with joy by banks. One of the aspects of the plan is that a loan that gets refinanced under the program releases the institution that services or originally sold it to Fannie Mae or Freddie Mac from their representations and warrants. Reps and warrants give Fannie and Freddie the ability to make a lender take back a loan that’s fraudulent or faulty under certain circumstances. That’s quite a gift to the banks, and as Fannie and Freddie are wards of the state potentially puts taxpayers on the hook for greater losses.
To be sure, the lower interest rate means fewer borrowers will default, and some of the cash saved will be recirculated into the economy. Many will still default, especially those owing so much more than their house will bring, and even worse they will have done themselves an injury by accepting a Band-Aid where radical surgery was needed.
Somehow that doesn’t seem quite right.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)