U.S. Housing Gridlock Can Be Solved By Reducing Principal

by: Martin Lowy

One of the current economic problems America faces is the housing gridlock that results from about a quarter of American homeowners having no or negative equity. Homeowners that have negative equity cannot sell and buy another house because they will not cover their loan when they sell, and they will have no money for a down payment on the new house. The problem does not seem to be getting solved. There are about 2 million homes in foreclosure and just this week, home prices continue to decline, as renewed signs appear that the delinquency situation may be deteriorating further.

When you combine the level of foreclosures and foreclosure sales with the negative equity problem, the impact becomes quite serious. Significantly ameliorating both problems would be worthwhile.

The negative consequences for the economy cannot be fixed by lowering interest rates on either the old loan or a new loan in the same amount. The Fed’s attempts to lower long-term rates and the Administration’s programs to renegotiate loans at lower rates may be beneficial to homeowners, but they will not fix the real problems.

Here are a few of the negative consequences of the gridlock:

  • Mobility of Americans has been restricted. Therefore many people cannot take new jobs even if they want them because they cannot move.
  • It does not make sense to build new houses when so many people are shut out of the market to buy them.
  • People do not remodel houses that are underwater; they barely maintain them. They do not buy new carpets or appliances or furniture, since they may lose them at any time.

The overhang of foreclosures and the likelihood of additional foreclosures clearly are a drag on house prices and on mobility.

What Can We Do?

There are two ways out of this box: One is to raise house prices; or two, forgive some portion of the debt.

The Administration has done all it can to raise house prices, and it has not been successful. I do not think that any governmental policy can change the market that way. Significant economic growth and greater employment probably would raise house prices, but that seems a long way off.

Therefore we have to think about whether there might be a sensible way to forgive debt that would have beneficial consequences for the economy as a whole.

We should not approach this question as a morality play; it is about the future of the American economy. We are four years on, and the problem is not getting better.

(I know you cannot stand to think about debt forgiveness. It goes against all your principles—and mine. But let’s face facts, and think about it. Suppose the cost to the Government-- half of which the Government would pay to itself-- were under $100 billion and the cost to mortgage holders was basically zero. And suppose the program really would reduce the level of foreclosures, enable people to move, and stimulate the economy. Would you not be willing to think about it?)

What a Program Might Look Like

Our goal in forgiving debt is to create equity for the homeowner. If homeowners had equity, fewer would lose their homes, they would spend money on maintaining and improving their homes, and they could move, if desirable to do so.

The necessity for homeowners to have equity tells us that whatever the formula is, it has to be based on current values, not whatever the value was when the last mortgage loan was originated. Whether the resulting equity should be 1% or 20%, we could argue about. For discussion purposes, I will advocate 5% equity after the debt forgiveness.

Who will take the losses that result from the forgiveness? There are two logical parties: The Government and the mortgage holder. Let us put constitutional legality to one side: If we were a wise Congress, unimpeded by the Constitution, what would we do?

We could reason that the holder of a mortgage that is underwater is at significant risk of losing principal, and that if such a risk comes to pass through the foreclosure process, the loss is likely to be in the 50% range. We could reason that it would be better for the mortgage holder to forfeit 25% of the principal in exchange for a Government guarantee of the remaining mortgage than it is to take the continuing risk of a 50% loss. Therefore we would have the Government cushion the economic blow of the mortgage holder writing down the principal by up to 25%.

Thus, we might decree that the mortgage holder must forgive up to 25% of the principal in order for the borrower to have the targeted 5% level of equity. In exchange, the Government will guarantee the remaining principal amount. If the forgiveness has to be more than 25% of the outstanding principal in order to reach the 5% equity target, then, in addition, the Government will pay the mortgage holder the excess forgiveness.

No financial information would be sought from the homeowner, which would streamline the process. The only requirement would be an appraisal of the property so that the formula for forgiveness could be applied to a current value.

Although this is not a morality play, my wise Congress will require that any homeowner that is delinquent or in foreclosure that wants to participate in the program and reap the debt forgiveness must get current (with penalties forgiven, whether or not previously paid) and must waive all defenses to any future foreclosure action on that mortgage. (Mortgage holders actually might forgive some of the outstanding payments on mortgages in foreclosure, since with the government’s help-- even with the forgiveness-- they might come out ahead of where they would be if they completed the foreclosure.)

My wise Congress also would make the debt forgiveness a non taxable event. The homeowners would benefit not only from the reduced principal amount but also from the reduced payments that result in most cases. This would be a significant ongoing economic stimulus.

In order to qualify for the reduction in principal amount, the borrower also would have to agree to an interest rate for 6% for five years (which is lower than the interest rate on most of the outstanding underwater mortgages). This rate would apply to the new principal balance. The homeowner would also be required to agree not to refinance the loan for the five-year period. This set of terms would give the mortgage holder a 6% coupon on a five-year government-guaranteed instrument at a time when five-year government debt pays about 2%. The difference at the end of five years is $110 of value versus $130 of value, decreased by whatever assumptions one makes about the likely sales of the mortgaged properties. Let us assume fairly robust sales, so that the average loan will be repaid in 2 ½ years. In that event, the market value should be about 110% of the remaining principal balances.

What Is the Impact on the Mortgage Holders?

With this kind of formula, what happens to the value of the mortgage? The interest rate remains a higher rate than the rate on a U.S. government-guaranteed loan. Thus, depending on assumptions about prepayments, it might be that a substantial part of the 25% forgiveness would be recouped. Moreover, if the value of the property was only 75% of the outstanding principal before the forgiveness, the original loan certainly was not worth 100 cents on the dollar before our decree. Depending on the amount by which the loan was underwater and the general level of losses in foreclosures in the area where the property is located, the loan in fact might have been worth a good deal less than 75% of its face value. If this is true— or even nearly true— then the only loss that we are imposing on the mortgage holder is an accounting loss that, at least arguably, should have been realized long ago. (That loss will be net of a tax deduction, as well. Forgetting about the accounting, many holders would come out ahead.)

What about mortgages that have been put into securities and effectively chopped up so that our law is declaring winners and losers among those parties? The answer is that is the risk that investors take when they invest in a complex instrument. The cashflows are uncertain. In very tough times, difficult measures must be taken. My wise and unified Congress says it must deal with the loan as a whole. The deals that private parties made to chop it up are not our affair.

What about second mortgages? These are not so easy to deal with. In many cases, homeowners are current with their second mortgages even though their houses are significantly underwater. My Congress would cut them down to 25% of their outstanding principal amount and promise to pay the holders the change in market value for their loss, based on market value at some date before the law was introduced. (Please note that the data that I am working with does not disaggregate first and second liens. Therefore, the assumed levels of forgiveness that are described below include, in many cases, the entire second lien. More work will be needed to disaggregate the two.)

Some Estimates

I have done some estimates of losses that would be taken by mortgage holders and by the Government based on data from CoreLogic dated September 13, 2011 that is available here. My biggest assumption is that the CoreLogic proprietary estimates of home values are correct. I have made a further assumption that, based on the heavy concentrations of negative equity mortgages in California, Nevada and Florida, the average negative equity mortgage is 20% larger than the national average. Such numbers are approximate, but they are useful.

Regarding mortgage holders, my initial conclusion is that they would take a hit of about $155 billion. However, they might come out ahead after the debt forgiveness and Government guarantees. The $155 billion hit would be offset by two factors: (1) The increase in market value of the remaining principal amounts by reason of the new terms, which is about $98 billion. That leaves a net loss of about $57 billion. And (2) the already-reduced carrying values of homes that are in foreclosure or 90-days-plus delinquent -- a total of about 4 million mortgages, or $880 billion of debt outstanding. Of that total, about half-- per LPS (see this data), with outstanding principal balances that I estimate at $440 billion-- are in foreclosure. Looking only at the loans now in foreclosure, if they already have been written down, as they should have been, there may be no net detriment to the mortgage holders. If the loans in foreclosure already have been written down by 25%, which should be a minimal write-off level for mortgages in foreclosure, then they already have been written down by $110 billion. If that is the case, the mortgage holders would get a windfall gain of something like $50 billion rather than a loss ($57 billion minus $110 billion).

At least half of the benefit or detriment to mortgage holders would accrue to Fannie, Freddie and the FHA, with private parties exposed only for the remainder.

I have asked a friend who is the chairman of a bank that is a portfolio lender (not in CA-NV-FL-AZ) to evaluate this proposed structure. He tells me that it would be good for his bank. He would not expect the bank to incur net losses. He also thinks that it would be very good for the economy of his area.

The Government’s Exposure

In addition to whatever gain or loss Fannie, Freddie and the FHA would show, the Government would take a hit of about $72 billion on the mortgages that are over 20% negative equity, perhaps half of which would be payments to itself in the form of Fannie, Freddie and FHA. Unlike the mortgage holders, the Government would not get a direct benefit by reducing the frequency of future foreclosures. The government also would be on the hook for future losses on the guaranteed portion of the formerly underwater loans, which I estimate at $823 billion. Losses on these loans could be in the neighborhood of 5%, or $41 billion, although Fannie and Freddie’s historical loss rate on seemingly similar loans was far lower. The Government also could, impliedly, arbitrage the 6% rate on the mortgages for five years against its own cost of funds of similar duration, yielding significant savings.

Thus the Government would risk about $100 billion, perhaps half of which it would pay to itself.

Suppose my data is bad. If CoreLogic’s estimates of home values are high by, on average, 500 basis points, then the overall forgiveness would increase by about $120 billion, to be shared about equally between the Government and the mortgage holders.

I am shocked that these numbers are not worse, but they are the best estimates that I can make based on the CoreLogic data. In fact, the cost seems nominal for such a great benefit. It seems like we have been afraid of our shadows.

The U.S. Constitution

Oh, you want to come back to the U.S. Constitution? I was afraid of that.

Let us suppose that this program is, at least vis-avis private mortgage holders, a “taking” under the Fifth Amendment. As I recall, the private party from whom something is taken has to prove in court the value of the thing that was taken versus the value it received for that thing. My Congress will want to deal with that— after receiving more competent con law advice than mine. Perhaps my wise Congress will establish a mechanism for aggrieved parties to go before the U.S. Court of Claims to demonstrate the amount that they lost. My wise Congress would, however, prescribe the procedure to be followed in the Court of Claims: A party would have to show an overall loss from the program, including all of its interests in mortgages and including the market value amounts that its interests in mortgages increased as a consequence of the program. And if the court found that the party actually had benefitted from the program, the litigant would be required to repay the government for its windfall.

Impact on the Economy

With this legislation, the U.S. economy will almost immediately get back on track. Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW) would get business, everyone involved in real estate— people who have struggled for four years— would get busy again: Painters, plumbers, electricians, agents, lumber companies, etc. Many companies that have nothing to do with the real estate business but are looking for competent employees also would benefit from workers’ renewed mobility. It is likely that consumers and investors would gain confidence. It may not be a stretch to suggest that the program would more than pay for itself in increased tax revenue and reduced expenses for unemployment payments and other safety net expenses.

The real estate sector has led the country out of numerous recessions. It has been missing since 2007 because of the gridlock. This program would allow it to join the recovery and become an important source of growth.

Will some banks or other highly leveraged financial businesses suffer severe accounting losses from this program? Perhaps, but I do not think so. If so, maybe they should get some TARP-like equity to tide them over. Although I am less afraid of bank failures than most people, it would not be fair for a government program to cause the failures.

There are hundreds of details that would have to be worked out, nevertheless, this kind of program would be worth implementing.

We have other serious long-term economic issues, but the housing gridlock is a very important medium-term issue, and one we must deal with. If we do, the long-term issues will become easier because growth will reduce the size of the long-term issues. Please forget about the morality play. People who have been struggling for four years to stay in houses where they no longer have any equity ownership already have suffered. The health of the economy is too important to hold them hostage.

You probably would like to know where I got my wise Congress. I imagined it, of course.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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