How to Fix the Housing Crisis
The foreclosure crisis has crawled on for going on four years now with no end in sight. The S&P/Case-Shiller index for August fell 3.8 percent from a year ago. The index includes home prices for 20 US cities.
"Continued house price declines could lead to even more defaults, foreclosures and distress sales, undermining wealth, confidence and spending," William Dudley, president of the Federal Reserve Bank of New York said. "Breaking this vicious cycle is one of the most pressing issues facing policy makers."
Every one of the Republican presidential candidates is being asked how they would handle the slow-motion housing wreck. Long shot Newt Gingrich says he would rewrite the rules to make it profitable for banks to renegotiate loan principal amounts.
"He disagrees with his Republican colleagues that the free market will find a fair way to let the banks and homeowners work things out," writes Karoun Demirjian for the Las Vegas Sun.
President Obama has jumped in to adjust Fannie Mae and Freddie Mac rules to allow refinances for loans exceeding 125 percent loan to value.
The president says this will save underwater homeowners thousands of dollars a year.
Princeton professor Alan Blinder penned an op-ed for the Wall Street Journal proposing forced principal reductions with the cost to be shared by banks and taxpayers — with the proviso that government be given an equity kicker when housing prices go back up.
Blinder also thinks the Federal Reserve and Treasury should provide cheap financing to developers who will use the money to buy up properties with the intention of renting the properties out.
Harvard's Martin Feldstein put in his two cents' worth on the issue for the New York Times. Feldstein points out that home values have dropped 40 percent. The result, he writes, is "less consumer spending, leading to less business production and fewer jobs."
Feldstein claims the government can stop the fall in house prices by slicing off any mortgage principal amount owed exceeding 110 percent loan to value. He says this policy would cost $350 billion or less and would modify 11 million of the 15 million "underwater" homes in America. The banks and the government would split the cost, and in the case of mortgages held by Fannie and Freddie, "the government would just be paying itself," he writes, presumably with a straight face.
In exchange for having their lender take a haircut over 110 percent, borrowers would accept full recourse on the modified loan.
"I cannot agree with those who say we should just let house prices continue to fall until they stop by themselves," writes Feldstein. "Although some forest fires are allowed to burn out naturally, no one lets those fires continue to burn when they threaten residential neighborhoods."
"Recovering the 31 percent plunge in home prices from their 2006 peak will probably be years in the making as foreclosures throw more properties on the market and sales flag," writes Shobhana Chandra for Bloomberg.
Despite the obvious, policymakers and wonks think trimming mortgage principal down to just 10 percent underwater or that lowering borrowers' financing costs for those 25 percent (or more) underwater will somehow halt the slide in home values and spur consumer spending.
The belief is that if homeowners are just kinda, sorta underwater then they will keep on faithfully paying Fannie, Freddie, BoA, Wells, Morgan, and the rest. Never mind that it will still take years of steady payments to ever see the faintest ray of equity light shine through the crack between what's owed and the home's value.
We can see how this works out for a hypothetical couple created by Brent T. White in his Arizona Legal Studies discussion paper. The young couple buys a 1,380-square-foot home in Salinas, California, for $585,000 in January 2006. The couple purchased the home with no money down with a 30-year, fully amortizing loan at 6.5 percent interest. The payment including insurance and taxes is $4,300 a month.
Now the home is only worth $187,000. An Obama refinance of the $560,000 that they still owe on the note will lower their payment by $900. But the couple will never really own any of the home.
Under the Martin Feldstein plan, the note holder and taxpayers would eat $354,300, leaving the young couple with a mortgage of $205,700. Given the ultralow current mortgage rates of 4.5 percent, a 30-year fully amortizing deal including taxes and insurance would be a payment in the neighborhood of $1,250.
If we closed the deal this month, assuming home prices don't fall any further in Salinas, our young couple will see some equity in December 2016.
Meanwhile the same home can be rented for $1,000 a month. Instead of paying $1,250 a month to have equity of $168 in 61 months, saving the extra $250 a month and earning no interest on it equals $15,250 in the same amount of time.
Of course home prices in central California might rise 2 percent a year, so after five years the home would be worth $206,500, but then half of any equity belongs to Uncle Sam under the Blinder plan.
All of these ideas to save the housing market and supposedly to increase consumer spending do exactly the opposite. These plans keep people chained to underwater mortgages, keeping them from moving to where there are more and better job opportunities.
Unemployed heavy-equipment operator Charles Mills wanted to leave North Las Vegas for Oklahoma and a job, but he is $200,000 underwater on a home he bought at the peak of the housing market in 2006. The plans mentioned by Blinder and Feldstein would relieve Mills of roughly $190,000 of the debt, but the principal reduction won't put him back to work. Plus, the odds of a quick turnaround in North Las Vegas home values are about the same as for the Kansas City Royals to win the 2012 World Series.
The idea that the too-big-to-fail banks will cover half the cost of these plans is laughable. The hit to their capital would be considerable, sending the banks right back to Washington's door with a tin cup.
And how much bureaucracy would be required to manage the implementation of these plans and determination of equity splits when homes are sold?
All of these plans are not really aid to underwater homeowners as much as another bailout for the banks — not to mention Fannie and Freddie.
Any business dominated by entities only in business because of the good graces of the government cannot be considered part of the free market. The reason the housing market is not clearing is that the government stands in the way by propping up the large mortgage holders.
No reasonable person sees Fannie Mae and sister entity Freddie Mac, which were seized by the government in September 2008, as the product of spontaneous order. To stay in business, the two firms together have needed about $169 billion in taxpayer bailout funds, with no end in sight.
Changes to FASB rules 157, 115, and 124, which allowed banks greater discretion in determining at what price to carry certain types of securities on their balance sheets and recognition of other-than-temporary impairments have made the big banks wards of the state as well.
The real help for underwater homeowners will only arrive when Fannie, Freddie, and the rest are allowed to fail. The equivalent of a chapter 7 bankruptcy filing (liquidation) would put these underwater loans out for bid in the market place. Would our mythical mortgage in Salinas, secured by a house worth $187,000, trade for $205,700? Not hardly.
No one can get a loan for a 110 percent of value in this market, let alone 125 percent, or 100 percent for that matter. Those looking for mortgages should expect to put 20 percent down. Values in a bankruptcy sale would reflect this reality and then some. Based on the liquidation prices received by the FDIC and other distressed debt sellers, this mortgage paper would likely be scooped up for half or a third of the home's value.
Buyers of the paper would immediately negotiate with borrowers to create loans that are conforming (80 percent LTV) and performing.
For instance, Selene Residential Mortgage Opportunity Fund purchased the mortgage secured by the home of Anna and Charlie Reynolds in St. George, Utah, for a deep discount, the Wall Street Journal reported in a front-page story. The Reynolds were struggling with a $3,464 monthly payment and the value of their home had plummeted.
Selene, run by Wall Street legend Lewis Ranieri,
buys loans to make a profit on them, not as a public service, but company officials say it is often more profitable to keep the borrower in the home than to foreclose. If a delinquent loan can be turned into a "performing" loan, with the borrower making regular payments, the value of that loan rises, and Selene can turn around and either refinance it or sell it at a profit.
Home values in St. George had plummeted in similar fashion to that of Las Vegas, only a two-hour drive away. Selene slashed the principle balance of the loan due from $421,731 to $243,182 and lowered the interest rate, reducing the Reynolds' monthly payment to $1,573.
"Around 90% of Selene's loan modifications involve reducing the principal," James R. Hagerty wrote in the WSJ, "compared to less than 2% of the modifications done by federally regulated banks in the first quarter."
And while many upside-down borrowers can't even find a human to talk to about their loan, let alone sit down and renegotiate terms that will benefit both parties, Selene immediately tries to contact the borrowers on the notes they have purchased, "sometimes sending a FedEx package with a gift card that can be activated only if the borrower calls a Selene debt-workout specialist."
It's hard to imagine Fannie and Freddie being so proactive.
Ludwig von Mises explained that one government intervention leads to an endless succession of interventions to deal with the effects of the first and subsequent interventions. Ultimately, it comes down to two choices. "Either capitalism or socialism: there exists no middle way," Mises wrote.
Likewise, there is no middle way to solve the housing crisis. For capitalism to work its magic and set underwater homeowners free, mortgage holders must be allowed to fail.
 Brent T. White, "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis," Arizona Legal Studies Discussion Paper No. 09-35.