Solutions for the housing problem
We have discussed the main factors determining the state of the housing market. Some of these factors can't be changed anytime soon. For instance, clearly the economy and household size can't be fixed, or at least not instantly. The main problems that policy could address are the enormous overhang of foreclosed housing and the $700 billion in negative equity that 11 million, nearly a quarter of home owners, experience.
As it happens, these are important points of leverage, not only for the housing market but also for improving household balance sheets and thereby the economy at large.
Some general principles
Since banks were part of the problem (by virtue of having far too lose mortgage standards), banks should bare part of the cost of the solution, we feel.
Negative equity is the main problem. Since houses are the main assets of households and the deterioration of household balance sheets was the main driver of the recession, it's clearly the point of greatest leverage. Negative equity is what's impairing household balance sheets and keeps them from refinancing at greatly reduced rates.
Negative equity also keeps the market from clearing. Mortgages are due on sale, if buyer and seller agree on a price that's below the value of the mortgage (not at all an unlikely situation), the transaction is unlikely to materialize. One could argue that even banks themselves might benefit from addressing this problem, even if they have to pay substantial amounts.
The removal of uncertainty (an expression of which is the difference between market and book value suggest that investors do not think that bank assets are worth what banks are claiming, or they suspect a large amount of unrecognized liabilities, or both) could do wonders for bank shares, so banks themselves have an interest in clearing up the housing mess.
Reducing the principal
Reducing the number of mortgages that are under water would be the easiest (but not necessarily the cheapest) way to unlock the housing market, repair household balance sheets, and help the economy at large. At present, the way to deal with this is the foreclosure procedure, but that is very wasteful, cumbersome, and not necessarily much cheaper for banks.
The most prominent idea has come from Martin Feldstein, former top economic adviser of President Reagan. He argues for cutting underwater mortgages to 110% of home value (still underwater), sharing the cost of that between banks and the government, and changing mortgages into full recourse contracts.
The latter would make it impossible for home owners to simply walk away from their mortgaged property without consequences (rescinding both the house and the mortgage), a somewhat curious practice. With full recourse, the banks could go after the borrower's other assets if he defaulted on the mortgage.
According to Feldstein:
House prices are falling because millions of homeowners are defaulting on their mortgages, and the sale of their foreclosed properties is driving down the prices of all homes. Nearly 15 million homeowners owe more than their homes are worth.
Making defaults more difficult, both by changing the status of the mortgage to full recourse, and by educing the principle will reduce defaults, thereby reduce the amount of properties in foreclosure which exerts a downward pressure on house prices, and it keeps more people in their homes. What's not to like?
Well, the plan would still leave many with under water mortgages (and much more dire consequences in default), even if less so. If house prices fall further, then what? Rinse and repeat? Also, it doesn't do much for unlocking the housing market as these houses still can't be bought or sold unless the 10% extra needed to pay off the mortgage comes from somewhere.
There have been studies to assess the effects of negative equity on default. Stripping out the effects of negative income shocks (unemployment and the like), a study from Neil Bhutta, Jane Dokko and Hui Shan finds that:
the median borrower does not strategically default until equity falls to -62 percent of their home's value. This result suggests that borrowers face high default and transaction costs.
Although some have argued that this study is a negative for the Feldstein plan, we think it's more likely the other way around. After all, the plan involves to cut the deepest negative equity situation and bring them back to 110% of house prices.
It would involve large payments from the government to the banks as well, which not everybody will applaud. And before we forget, if everyone eligible participates, the cost would be $350 billion. Not to mention the fact that it rewards bad behavior.
Another problem is that commercial banks hold about 20% of the mortgages in the US by principal, most of the rest have been securitized and/or are on the books of Fanny or Freddy. Changing the contracts of the latter involves a host of legal problems. Here is Alan Blinder:
When a mortgage owned by Fannie (OTCQB:FNMA) or Freddie (OTCQB:FMCC) is proposed for refinancing, it has the legal right to "put" the original mortgage back to the originating bank if there was even the slightest irregularity in the original documents. That right can make the originating bank afraid of refinancing, even if the homeowner is at risk of default.
Reviving the Home Owners Loan Corporation
Another proposal comes from Alan Blinder and involves reviving the old Depression-era Home Owners Loan Corporation, which "refinanced about a tenth of all the mortgages in America and closed its books with a small profit."
He argues that the massive underbuilding of houses now far exceeds the overbuilding during the housing boom, but the market cannot find equilibrium because of the overhang of foreclosures. He mentions three barriers:
- Financial, huge sums involved
- Legal complications as property rights are being altered and there are all kinds of problems related to the securitization of most mortgages
- Political, the famous Santelli rant on CNBC that gave birth to the Tea Party movement in reaction to what was really a very modest (relative to the scale of the problems) proposal from the Obama administration. However, others have noticed that the right of the political spectrum is more receptive to measures to limit foreclosures now
Another useful suggestion from Blinder is in exchange for principal reduction and refinancing, provide those who help (banks, government agencies) with some of the upside (rather than changing the nature of the contract to full recourse, as Feldstein suggests).
Fanny Mae and Freddie Mac could function as a late day Home Owners Loan Corporation. If they're too busy watching the mortgage backed securities on their books, perhaps the Fed could help there, buying some more of these.
The foreclosure procedure and the overhang of foreclosed properties, together with the quarter of mortgages that are underwater, is a large drag on the housing market and, via the wealth effect, on the economy at large. House prices in the US are now back to normal levels but these problems haven't gone away. While not cheap, measures to reduce the principal are a better way to deal with this problem than the foreclosure route.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.