Help the homeowners

The Obama mortgage plan looks set to help one in nine homeowners.  The Wall Street Journal says "Administration officials made a point of noting that the loan-modification program will not aid people who bought homes merely as investments; the program is designed for those who live in their homes."  Of course, most of them were taking a flyer on a leveraged investment in housing too.

There are a lot of arguments that this won't help--that only principal reductions work.  I'm not sure whether this is so.  Many of the mortgage modifications have failed haven't succeeded in reducing payments--they reduce the interest rate, but pile penalties and arrearages onto the principal, so that payments don't drop much.  As far as I can tell, the Obama plan will result in actual payment reductions, which should reduce the pressure to default.

How successful you think it will be depends on your view of human nature--do you think people are basically good, and will pay if they can; or do you think that once arrears on their mortgages have already trashed their credit, they'll rationally walk away from any house that doesn't have substantial equity in it?  I suppose I take a middling view.  Some people will default, live rent free until the bailiffs come, and meanwhile trash the house, because they think they're entitled not to make payments on a house that has fallen in value.  On the other hand, people are very attached to their homes.  They will often do irrational things to keep them.  And at least a few of them actually believe that they ought to repay money they've borrowed, even if it might be to their advantage to default.

The bigger difficulty, I think, is that with interest rates currently pretty low, there's just not all that much room to modify them down to affordability.  Very few people default because there's a gap of, say, $50 a month.  The gaps are in the hundreds of dollars.  If people were paying interest rates of 10%, there'd be a lot of room to adjust interest rates to make their payments affordable.  Most people in trouble have fairly new mortgages; a couple of years in, the payment on a 10% 30-year fixed-rate mortgage is nearly all interest, no principal.  But as the interest rate falls, the percentage of the payment that's principal goes up, making it harder and harder to eke out enough savings on the interest rate to keep the borrower in the house.

If you can't make enough on the interest rate to keep people in their houses who are really in danger of foreclosure, then all this ends up as is a transfer to people who would rather spend the money for their mortgage payment on something else.