At this time, it's pretty clear that the government's efforts to modify mortgages haven't done enough to prevent foreclosures. In over a year, the HAMP program has resulted in just 435,000 permanent mortgage modifications, which falls far short of its goal of preventing several million foreclosures. Meanwhile, home sales are struggling and foreclosures continue in high numbers. New York Times columnist Gretchen Morgenson argues that new action should be taken by the government to stop the housing market from bleeding out. Her suggestions have made some waves in the blogosphere, as there's some good and some bad in what she suggests.

Short Sale Stigma

First, she notes a problem: struggling borrowers engaging in short sales are often forbidden from obtaining a new mortgage for several years. Considering that banks are having trouble selling their large inventory of homes, it certainly isn't helping to limit the supply of potential buyers. But in noting the problem, she stops short of saying that these standards should be universally loosened. Felix Salmon of Reuters picks up on this, saying:

So, the first, easy thing to do is to get rid of the blunt restrictions on lending to people with a short sale in their recent past: the housing market needs all the potential buyers it can get, right now. Once upon a time, it might have made sense to think that people with recent short sales would be such bad credits that no bank should think about selling them a mortgage. But not now, when the presence of a short sale on your credit report is likely to say much more about the broader housing market in your region than it does about you.

There are two situations to consider here. First, should government enterprises like Fannie, Freddie, and the Federal Housing Authority be allowed to insure new mortgages to short sellers? Second, should banks? Really, the policy solution should only concern the first. Banks can underwrite whatever sorts of loans they please with their own money, and the government shouldn't interfere with their prudent underwriting standards. The problem, of course, is that these days banks don't want to back any mortgages without a government guarantee, which is why the GSEs' willingness to do so matters.

There are two sides to this argument. If you believe that these short sellers really are high quality borrowers who were in an once-in-a-lifetime bad spot that led to their short sale, then you'll agree with Salmon. But if you think that, defying financial logic, these short-sellers would have stuck with their mortgage if they were truly high-quality borrowers, then it's prudent for the strict criteria to remain in place. After all, if the housing market falls again, they might just walk away next time. The answer here is more subjective than objective, and it ultimately depends on whether policymakers are comfortable changing the rules with taxpayer money backing loans to short sellers.

Refinancing Good Subprime Borrowers

But the actual suggestion that Morgenson makes comes from a proposal from way back in 2008. She explains:

As conceived by two Wall Street veterans, Thomas H. Patrick, a co-founder of New Vernon Capital, and Macauley Taylor, principal at Verum Capital, the plan calls for refinancing all the nonprime, performing loans held in privately issued mortgage pools (except for Fannie's and Freddie's) at a lower rate.

Economic consultant and author of the Big Picture blog Barry Ritholtz has already considered this plan, noting a few drawbacks. The first, and most obvious issue is that the borrower will remain underwater -- which is really the big problem here.

He notes that without addressing the size of the loan and lowering the principal to something closer to market value, the defaults won't be prevented. These borrowers will still feel that they're paying a mortgage balance greater than what their home is now worth and will feel encouraged to walk away.

Consequently, he suggests a compromise, where the bank and borrower each take on some of this difference between the mortgage balance and market value of the home. He proposes doing this through a zero-interest balloon loan for the difference, half of which is forgiven by the bank after 10-years of good paying by borrower. The other half gets added to the mortgage balance at that time.

One problem with this plan is that, in ten years, we'll suddenly see banks taking huge write-downs. But this can be remedied. Instead, you could amortize the bank's portion of the difference over the course of those ten years, instead of leaving it as a balloon.

This would accomplish two things. First, it would give the banks a more realistic, conservative accounting treatment of the loss, but still allow it to be gradual. Second, it would further encourage borrowers to continue paying, because they would see the way the bank is rewarding their keeping up with payments by reducing their total obligation each month.

Of course, the big question is whether or not banks would be willing to play ball here. They probably won't be enthusiastic about facing big losses over the next ten years. But the alternative, in many cases, is facing an even bigger loss in the next year or two if these borrowers walk away. So it's plausible that banks would find an alternative like this attractive in many situations.

Finally, such a program shouldn't be limited to subprime borrowers. Indeed, we now see that prime borrowers are also strategically defaulting, because they aren't fools. So if banks want to prevent those loses, then the universe of participants must extend to all underwater homeowners.

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