The Good and Bad in Obama's Housing Plan

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Obama announced his proposal to prop up the collapsing housing market today in Phoenix (one of the country's foreclosure capitals). Having obviously learned from the debacle of Geithner's banking plan roll-out, today's proposal was both larger ($75 billion rather than $50 billion) and more detailed than many expected. The proposal has its faults -- it is more costly than necessary and includes cram down provisions -- but I expect it to be effective, and I'm glad to see the focus on servicer and homeowner incentives. The White House has published an executive summary of the plan (PDF) and an online Q&A. Here are a few of the plan's strengths and weaknesses:

The good:

  1. More homeowners in good standing can refinance. Currently one generally has to have a loan-to-property-value ratio (LTV) of 80% or less in order to refinance. Since interest rates are at historic lows, nearly all mortgage holders would benefit from refinancing, but because property values have fallen sharply in the last year and a half, many homeowners (even those who put up substantial down payments on their homes) have seen their LTV rise over that time, even as they made regular payments on their mortgages. Obama's proposal would raise the maximum LTV limit to 105% for homeowners whose mortgages are already owned by Fannie or Freddie, which would allow up to 5 million households to refinance into the current lower rates.
  2. Motivating mortgage servicers to modify at-risk mortgages. The plan would pay servicers $1,000 for each modified mortgage (and an additional $500 for mortgages modified before the borrower misses a payment). Additionally, the "pay for success" provision of the plan would pay servicers up to $3,000 over the next three years if the borrower successfully makes payments on the modified loan during that time. These provisions are crucial to providing servicers the incentive to modify loans, rather than foreclose. Since servicers receive fees when homes go through foreclosure, without such payments servicers might have an incentive to foreclose on securitized mortgages even if foreclosure is not in either the borrower's or lender's interests. (I have written about the relationship between servicer and investor incentives here.) This component of the plan would stem foreclosures, thereby keeping more families in their homes while also preventing additional house price declines in neighborhoods with many underwater mortgages.
  3. Clear guidelines for efficient loan modification. Uniform guidelines will both make loan modification faster and cheaper for servicers (who are normally in the business of processing payments, not modifying contracts) and will also prevent homeowners from ending up back in complex mortgages with terms and fees they do not understand.
  4. Support for Fannie and Freddie. The plan would expand federal support for Fannie and Freddie and increase the size of the GSEs' mortgage portfolios in an effort to shore up confidence in the agencies and keep mortgage rates low.

The bad:

  1. Bankruptcy court cram downs. As I argued earlier, allowing judges to write down mortgage principal in bankruptcy proceedings will likely increase future mortgage rates - exactly what the market does not need right now. Hopefully the rest of the proposal will make the incentives to modify mortgages strong enough that these cram downs will be uncommon.
  2. Costliness. As my colleagues Chris Mayer, Tomasz Piskorski, and Ed Morrison at Columbia University have argued, giving servicers the incentive to modify mortgages is likely sufficient to bring about widespread modification. Yet Obama's plan will also partially compensate investors when mortgages are modified. This seems unnecessary, since the "pay for success" provision should already motivate servicers to alter loans where modification is in the investor's interests, so there is no need to additionally compensate those investors. Of course, it is possible that this component of the plan is simply a politically palatable way for the administration to pump capital into the troubled banking sector. But if the goal of the plan is to save the housing market at the least cost to taxpayers, this measure falls short.
  3. No safe harbor provision. One worry is that even if servicers would like to modify mortgages, they may be unable to because securitization contract (the pooling and servicing agreement, or PSA) explicitly prohibits loan modification. In other cases, the PSA may be vague enough that the servicer risks an investor lawsuit if they modify mortgages. But (at least in the information I've seen so far about the Obama plan) there is no provision to protect servicers from such investor lawsuits, which could reduce the effectiveness of the modification incentives. This may turn out to be an unfounded worry - investors might worry that Congress would hit back hard if they pursued such a lawsuit, and the cram down provision may motivate investors to allow loan modification to avoid principal write downs in bankruptcy court - but I am troubled to see no mention of safe harbor provisions in the proposal so far.

On balance, the Obama plan will likely bring a much needed boost to the housing industry, and it's about time that housing is recognized as a crucial component of reviving the economy. Let's just hope the proposal's faults don't slow the path to recovery too much.
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Benjamin Lockwood

Benjamin Lockwood is a researcher at Columbia University Business School.
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