A Spurious Solution to the Housing Crisis

I read an article in the Financial Times yesterday that just has me scratching my head, it's a proposal for a mortgage replacement program that would "protect" homeowners from going into a negative equity situation and potentially defaulting on their loans.

From the Financial Times:

I have proposed a programme of “mortgage replacement loans” that I believe would stop the downward spiral of house prices. The basic idea is to provide an incentive to stop defaults among those who now have positive equity but are vulnerable to a further price decline. The federal government would offer every homeowner with a mortgage the opportunity to replace 20 per cent of that mortgage with a low interest government loan – up to a loan limit of $80,000 (€55,000, £44,000) – that reflects the government’s lower borrowing rate. Creditors would be required to accept this partial mortgage pay-down and to reduce the monthly interest and principal by the same 20 per cent. That mortgage replacement loan would not be collateralised by the house but would be a loan that the government could enforce by lodging a claim on an individual who does not pay.

With the mortgage replacement loan, people who now have a mortgage equal to 90 per cent of their house value would see that mortgage fall to just 72 per cent of the house value, implying that it would take a very unlikely price fall of more than 28 per cent to push those individuals into negative equity.

By stopping the downward overshooting of house prices, the mortgage replacement programme would help all homeowners, including those who now have negative equity. Limiting the destruction of homeowners’ wealth would help to maintain consumer spending, boosting production and employment. Renters as well as homeowners would benefit. And stabilising the values of mortgage-backed securities would strengthen financial institutions, increasing credit flows that would further stimulate the economy.

So first off I've always felt that the reason people with negative equity tend to have higher default rates is more due to them being more likely to have shaky finances, rather than there being some sort of psychological trigger that causes people to abandon their responsibilities once they're in a negative equity situation. Just think about it: who is more likely to be in a negative equity situation: someone who bought his or her home with a 30% down payment or someone who bought his or her home with no money down? The fact that the default rates for prime fixed rate mortgages have barely budged during the current crisis seems to suggest that the answer is clearly the latter and not the former, and as a result I've never quite bought in to the negative equity = default argument.

In other words the defaults are more of a function of the kinds of people who typically end up in negative equity situations than they are a function of negative equity in of itself.

Digging into the mortgage replacement program...

I read the article twice in order to make sure I didn't miss something and found myself sticking with my original conclusion: it's mathematically spurious and would only influence the financial decisions of a fool (I suppose one could argue that the current crisis is a product of fools making financial decisions, but that's a discussion for another day) . It's the functional equivalent of someone paying down $20k of his or her mortgage principle with a credit card, and then claiming to be $20k richer due to the increase in home equity instead of recognizing that the aggregate debt load hasn't changed.

The mortgage replacement program is no different because the amount of debt the individual has related to his or her home wouldn't change, the only difference would be that 20% of the previous mortgage balance is now in the form of an unsecured Government sponsored loan. Aside from the possible savings from a lower interest rate, the only thing about the home equity situation of an individual participating in this program that will have changed is the appearance of it, not the reality of it.

Anyone who would interpret that situation as an improvement or allow it to influence his or her decisions would be a fool. 

Let's also not forget that the aggregate payments between the loans will be similar to the cost of the original mortgage, meaning the replacement program is of little help to those who are having difficulties paying their mortgages each month.

While I understand the need for housing crisis solutions, something that effectively tricks people into thinking their situation has improved isn't the way to go in my opinion. After all, aren't we in this mess because people misinterpreted the nature of their financial situations, made potentially ruinous financial decisions with exotic loans in the name of building wealth, etc, etc?

We need solutions that not only help people get through the present, but enable them to better understand their finances and make smarter decisions in the future, and this solution fails on all counts.

Any truly viable solution needs to include incentives for people to stay in their homes long-term, the easing of pain from high payments (perhaps by deferring principle until sale, and refinancing based on the temporary lower mortgage balance), and financial education, especially if Tax Payer dollars are involved.

You can read the original article in full here.

Sources:

The Financial Times: "How to shore up America's crumbling housing market" -- Martin Feldstein, August 26,  2008.

Comments

[David Martin:]

Here in the UK mortgages have full recourse - in other words you owe the money short of bankruptcy and having all your goods confiscated.
This to some degree makes the idea of handing your keys back short of absolute inability to pay a non-starter, and means that people will continue to pay their mortgages regardless of negative equity.
In the American legal context though perhaps a system where the lender had to renegotiate the value of the loan to reflect current market realities before any government money was available on the balance on a basis of recourse might help, as it would make an actual reduction to monthly outgoings, thus improving the probability of repayment and improving the book quality of the loans remaining from the lender, whilst still keeping people in their houses.
The losses incurred to the lender should still be less than that in a repossession.

2008 Aug 27 08:26 AM

[rm:]

[I've always felt that the reason people with negative equity tend to have higher default rates is more due to them being more likely to have shaky finances, rather than there being some sort of psychological trigger that causes people to abandon their responsibilities once they're in a negative equity situation.]

You are correct. First the financial difficulties, then the focus on how far underwater they are. Negative equity is the proverbial "last straw."

"I'm struggling to make payments (or, I'm behind already), the treatment I'm getting from my mortgage company ranges from neglect to abuse, and this house isn't worth anything close to what I owe."

"Screw it... I'm outta here."

The conversation doesn't begin with, "Gee, I owe more than this house is worth... maybe I should quit making payments."

2008 Aug 27 08:33 AM

[ksmithdc:]

Interesting read.

2008 Aug 27 09:44 AM

[Econ 101:]

I didnt see the original article, but it seems to me this isnt about helping the "homowner". It is about saving the banks, paying off some of the mortgage to improve their capital position and (again) shifting the risk to the public and the profit to the bank. Bend over and smile...

2008 Aug 27 10:37 AM

[300mph:]

The most dangerous words ever uttered: "Somebody has got to do something."

2008 Aug 27 10:42 AM

[DCM:]

In an ideal/perfect world people would not make poor decisions, let alone life changing disastrous decisions. If borrowers knew that home prices were going to decline 20-50%; if investors knew that lenders were making bad loans knowing they could sell the loans to Wall Street, Fannie Mae and Freddie Mac; if we all understood that the government was keeping interest rates low to artificially stimulate economic growth, I believe most people would have made far different decisions with their finances and investments. The point is, bad decisions were made all around and those bad decisions need to be minimized now before Americans pay too heavy a price, especially those who can least afford it. I suggest it could be a big mistake if people underestimate the possibility of our financial markets collapsing. If that happens, the country and probably the world could not avoid a prolonged depression. Hope I am wrong here but I would not bet against it happening.

The solution should not be forcing taxpayers to bail out the wealthy and prosperous people and their institutions that knowingly corrupted the secondary mortgage markets and inflated the bubble. The solution should have been to immediately contain and stabilize the housing market at the expense of those who benefited the most over the previous 8 years. I ask you, how is it possible to ever reach a “bottom” when each month more homes become available for sale while there are fewer and fewer qualified buyers. The last thing banks should be doing is foreclosing on homes and selling them at fire sale prices. Homebuilders also need to be stopped from building more homes.

The way to turn this around is to require lenders to renegotiate existing mortgages at lower interest rates and eliminate the acceleration clause (allow mortgages to be assumable.) The mortgage payment at 2% is about 30% less versus a 6% interest rate. (For example, a $100,000 mortgage, the payment decreases from $745 to $515.) If lenders need to increase yield to investors, they can slightly discount the principal. Remember, lender’s generate the largest share of revenue up front in closing costs and discount points. Servicing fees are revenue producing but not profitable. Looking ahead, how bright is the future for mortgage lending in this country over the next 10 to 20 years anyway? I suggest that the aforementioned approach is potentially better than the current one of banks taking write downs; and/or, the government bailing out lenders and investment banks, or backstopping Fannie Mae, Freddy Mac and the FDIC.

2008 Aug 27 10:59 AM

[Tom Lindmark:]

Think of the possibilities. Once you get your government loan and pay down the mortgage you will be eligible for a HELOC so you can lever back up. Use the HELOC for discretionary purchases and give the economy a shot in the arm.

2008 Aug 27 12:04 PM

[OldLimey:]

And if it were to work for real estate loans, how about extending the programme to over-margined equity portfolios??

2008 Aug 27 02:01 PM

[8 Alpha-Zulu:]

You're right Markham, the "programme" would merely be borrowing from Peter to pay Paul (unless the debt sponsor/the government were to forgive the obligation or commit to forgiving same at some time in the future). Ridiculous actually.
What we may need to do (or at least think about) is create a Government Sponsored 40 Year Amortization Guaranty so that GSE's and Lenders on the mortgaging side could manage their way through this valuation issue by re-casting/re-financin... the existing o/s balance of any loan on these under-water mortgages into a 40yr amortization schedule that is guaranteed by the GSE (backed by the govt). This would, overnight, decrease the monthly payments for the homeowners, keep them in their homes and give the markets time to heal. As these mortgages are paid off in due time and/or are refinanced when the markets are more liquid it just be a faded blip on the screen of history.

2008 Aug 27 03:42 PM

[8 Alpha-Zulu:]

You're right Markham, the "programme" would merely be borrowing from Peter to pay Paul (unless the debt sponsor/the government were to forgive the obligation or commit to forgiving same at some time in the future). Ridiculous actually.
What we may need to do (or at least think about) is create a Government Sponsored 40 Year Amortization Guaranty so that GSE's and Lenders on the mortgaging side could manage their way through this valuation issue by re-casting/re-financin... the existing o/s balance of any loan on these under-water mortgages into a 40yr amortization schedule that is guaranteed by the GSE (backed by the govt). This would, overnight, decrease the monthly payments for the homeowners, keep them in their homes and give the markets time to heal. As these mortgages are paid off in due time and/or are refinanced when the markets are more liquid it just be a faded blip on the screen of history.

2008 Aug 27 03:42 PM

[8 Alpha-Zulu:]

You're right Markham, the "programme" would merely be borrowing from Peter to pay Paul (unless the debt sponsor/the government were to forgive the obligation or commit to forgiving same at some time in the future). Ridiculous actually.
What we may need to do (or at least think about) is create a Government Sponsored 40 Year Amortization Guaranty so that GSE's and Lenders on the mortgaging side could manage their way through this valuation issue by re-casting/re-financin... the existing o/s balance of any loan on these under-water mortgages into a 40yr amortization schedule that is guaranteed by the GSE (backed by the govt). This would, overnight, decrease the monthly payments for the homeowners, keep them in their homes and give the markets time to heal. As these mortgages are paid off in due time and/or are refinanced when the markets are more liquid it just be a faded blip on the screen of history.

2008 Aug 27 03:43 PM

[8 Alpha-Zulu:]

sorry for the 3 posts of the same thing (operator error)

2008 Aug 27 03:44 PM

[Markham Lee_:]

First: thanks for reading.

Second: Tom I dearly hope you were being sarcastic. People using this program and then taking out HELOCs based on their new found "equity" is a nightmare scenario, as it would just increase their debt, payments and greatly increase their risk of default.

Third: The program would really be a stealth bailout of lenders by the government IMO.

Fourth: refinancing mortgages to a 40-yr amortization schedule isn't the worst idea in the world, although it would greatly slow the rate that people paid down their mortgages. Either way a solution needs to reduce month over month payments, and this program would have no real impact on payment amounts.

-M

2008 Aug 27 04:55 PM

[2houndz:]

40 year mortgages are great. They allow people to buy bigger homes and spend less on monthly mortgages so they can in turn fill up the home with junk they don't need and lease more luxury vehicles to impress people on the highway who they don't know. It's the new American way.

2008 Aug 27 09:14 PM