First, let’s start with a general premise: if a borrower has a reasonable ability to service his mortgage (and “reasonable” is in the eye of the beholder, but one has to assume it better be north of 50% of a “fair” rate) it’s better to renegotiate and keep him in place.
Now that we have the specter of large-scale foreclosures, policymakers are fixated with the idea of preventing foreclosures. Under the current fact set, I have a lot of problem with the willingness to go to extremes to salvage underwater homeowners, and some of it is due to a lack of vital information.
1. A fair number bought their homes with little to no equity. The idea that they are homeowners in the traditional sense is spurious; it’s more accurate to view them as renters who bought a home equity option. It would be useful to understand what proportion of stressed homeowners have any skin in the game. For instance, there are reports of borrowers abandoning mortgages even though they can service them because they are now in negative equity territory. Does anyone know what proportion of these voluntary foreclosures had low to no equity from the get-go?
2. Many of the recent borrowers are in trouble even before a rate reset. That means their ability to service even a lowered mortgage may be much weaker than the would-be rescuers assume. As Dean Baker pointed out:
….many of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance….. Either borrowers could not afford even the low teaser rates or they were defaulting because they realized that their homes were worth less than their mortgages…Falling house prices will cause many homeowners to find that they owe more than the value of their mortgage. This provides a temptation to just walk away, which will get larger as the gap between the size of the mortgage debt and the price increases.
And recall that the 2007 vintage subprimes were junkier than 2006.
One of the least publicized, relevant facts is that over half the subprime loans weren’t for purchases; more than half were cash-out refinances. As we discussed in a September post:
Perhaps it’s the lack of a catchy name. “Cash-Out Refinance” doesn’t exactly trip off the tongue. But its role in subprime has been largely overlooked. A June MarketWatch story mentioned it in passing:
More than half of subprime loans are actually cash-out refinance loans. Those loans are used to pay off credit cards or other debts, take trips to Bermuda, buy an unaffordable car or do some speculative investing – in the market, real estate or elsewhere.
“These loans are all about people in a tough spot,” said Matthew Lee, head of Fair Finance Watch, a Bronx, N.Y.-based community group ….
Half the subprimes were cash out refis. This isn’t implausible. Freddie Mac reported that cash-out (meaning the new mortgage was at least 5% larger than the one it replaced) refis for its borrowers were 35% in the second quarter of 2007, and noted that refinancings as a proportion of total mortgages were declining, which is typical in a rising interest rate environment.
Now why is this so significant? It gives a completely different picture of the nature of the problem. It suggests that many of the people who took out subprimes weren’t people who bought more housing than they could afford. It says they were already overstressed and overstretched financially. Using their home as a source of cash was a gamble to keep themselves out of bankruptcy, but in many cases, that bet didn’t work out.
This poses a nasty equity versus efficiency problem. Truth be told, many of these people speculated with what little home equity they had left and lost. They may not have had better options, but consider: the ease of extracting that equity may have kept them from making better choices or exploring less obvious options.
Thus to taxpayers who have been conservative with their finances, bailing out this bunch is going to be an unpopular proposition (and it also has the aura of being as much about saving the bank miscreants who created this mess as the unfortunate borrowers). It thus behooves the powers that be to do a better, more fact-based triage: who is worth saving and why.
But instead we are getting shotgun approaches and grand schemes. First over the weekend, we saw a round of applause among economists for the idea of reconstituting the 1933 Home Owner’s Loan Corporation; today in the Financial Times, Larry Summers gives us “Prevent US foreclosures“:
The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes currently being debated, to bring practice with respect to family homes into conformity with general bankruptcy practice in two areas, could make an important contribution.
First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes…..
Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims.
Obstacles to such mortgages include uncertainties about tax and accounting rules. But at a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.
Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures and, by establishing templates for renegotiation, aid a wider restructuring of mortgage debts. Proper support for voluntary restructurings involving interests in future appreciation should realise still greater benefits. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.
This program muddles a good idea with a bad idea, and bizarrely, Summers seems to have forgotten that a mortgage is a secured credit.
The idea of letting judges reset mortgage terms is one we’ve advocated. Predictably, the mortgage industry has fought it tooth and nail, but if they can’t (or won’t, staffing up entails costs) be bothered to do mods, having courts do it is the next best option. This is hardly unprecedented; judges have this power in commercial bankruptcies, and not one seems particularly bothered that they exercise it there.
Indeed, having the threat of judge-imposed mods might get some banks and servicers off their duffs and put the heat on them to put more resources behind renegotiating mortgages. Since there are costs and stigma attached to a bankruptcy filing, it is unlikely to be used casually.
One item that seldom mentioned in the discussion of the bankruptcy law: the judge can’t change the mortgage willy-nilly, but he can (and usually does) write the principal balance down to the current value of the collateral; the rest of the balance is deemed to be “unsecured” and that is included with the other unsecured debts. Removing the negative equity overhang giver the borrower much more incentive to make payments and take good care of the house.
But no doubt missing this key element, Summers then wants to throw in the OTS negative equity certificate concept, and draws the analogy to corporate bankruptcies. Huh?
A Chapter 11 expert please speak up, but my impression is that secured creditors in a corporate bankruptcy take their collateral and run. Does any know of any examples in bankruptcies where secured creditors of any type get an equity participation (ex post facto, not as part of the initial financing)?
And of course, as many have observed, the negative equity certificates demotivate the borrower. It may sound fair, but it provides bad incentives.
If we are going to have grand schemes, I prefer Dean Baker’s “own to rent” plan:
Gives homeowners facing foreclosure the option of renting their home for as long as they want at the fair market rate. This rate is determined by an independent appraiser in the same way that an appraiser determines the market value of a home when a bank issues a mortgage.
The proposal requires no taxpayer dollars or new bureaucracies. It would be administered by a judge in the same way that foreclosures are already overseen by judges. It simply changes the rules under which foreclosures can be put into effect.
The proposal does not bail out in any way lenders who made predatory mortgages or made risky gambles in the secondary market.
There are no windfalls for homeowners. They will have the right to stay in their house, but will no longer own the home. This means that there is no real incentive to abuse the program. The plan would be capped at the value of the median house price in a metropolitan area, so it will not benefit high income homebuyers.
Rents will be adjusted in later years by the Labor Department’s consumer price index for rents in the area. If either the owner or renter believes that their rent is unfair, they can arrange, at their own expense, to have the court make a second appraisal.
After the foreclosure, the mortgage holder is free to resell the house, but the buyer is still bound by the commitment to accept the former homeowner as a tenant indefinitely.
By allowing homeowners to stay in their house as renters, this plan will help to prevent the sort of blight that often afflicts neighborhoods with large numbers of foreclosures. Homes will remain occupied, and long-term renters will have an incentive to keep up the appearance of the property. This should help to sustain property values for whole neighborhoods.