More Mortgage Meddling: Will it Work This Time?

The Obama administration has just released the details on yet another "major" push to help homeowners who are underwater on their mortgages--a number now estimated at something like 20% of all homeowners.

The last big pushes yielded little in the way of results.  The problem we thought we had a year ago--vulnerable homeowners being rocked by resetting "teaser rates" on their adjustable mortgages--turns out to be much less pressing than we thought.  Instead, we an income problem:  a lot of homeowners whose income has fallen too far to afford any reasonable payment on their homes. This is actually a particularly tragic subset of a larger problem, which is the market rigidities introduced by underwater mortgages.

Until around 2005 or 2006, home equity actually cushioned other income shocks.  If anything bad happened, you could always refinance, or in extremis, sell.  Now people who have had income shocks can do neither.  People who need to move for career or family reasons are also trapped.

That's why many people have suggested principal write-downs.  But this has run into multiple problems.

1. The ownership structure of mortgage securities makes this very complicated.

2. Banks reasonably fear that if you make it easy to demand a principal reduction, everyone will do it, causing them to lose money on loans that would otherwise have paid off

3. This moral hazard problem is particularly pressing for second-lien holders.  Second mortgages became popular, either to tap home equity, or to avoid the need for mortgage insurance on low-downpayment loans.  To do principal reductions, second-lien holders usually have to sign off on taking a total loss on the loan--knowing that they are going to encourage more creditors to stiff them in a similar fashion.

4. In households that have suffered a job loss, there is often not enough money to pay the loan even with a sizeable principal reduction.

5. The above is also true of the worst mortgages, which were given to people who never had any reasonable hope of repaying even at a more realistic market price.

6. Servicers have little incentive to do principal write-downs, which are complicated and don't help them.

The old plan to deal with the problem was to offer modest incentives for modifications, which barely dented most of these issues.  So now the administration is going to give lenders incentives to temporarily reduce payments for homeowners who are unemployed, and to do principal reductions large enough to let homeowners refinance into FHA loans.

This probably has more chance of working than earlier efforts--and by working, I mean reducing foreclosures.  But there are a few things to worry about:

  • The temporary payment reductions only seem to last 3-6 months.  Given the long-term unemployment problems we're now facing, I'm not sure how much this will help--and if it does help, it seems likely to assist only the least needy.  In fairness, however, it at least keeps people with a brief job loss from racking up arrearages that send them into an otherwise unnecessary foreclosure.
  • The easier you make this, the more moral hazard there will be.  You may not care, thinking that this is just about transferring money from banks to needy people--but with the aggressive deployment of FHA loans, that ultimately means the taxpayers are going to be on the hook for a lot of marginal mortgages.  Given how badly the FHA has already been overstretched by the collapse of the private market, this is worrisome.
  • The new plan, like the old plan, will probably provide minimal relief for borrowers in the worst-afflicted areas.  The FHA will not finance anything that results in more than 115% being owed on the home, while places like Las Vegas and parts of Florida have seen price decreases of 50%.