Averting the Foreclosure Crisis

Many plans for resolving the foreclosure crisis are circulating at the moment. Both the Federal Reserve (MBS purchase plan)and the Treasury (Paulson speech) are working to boost the housing market, indirectly reducing foreclosures, by lowering mortgage interest rates. Sheila Bair, Chairman of the FDIC, wants to restructure housing debt so distressed households can afford their mortgages (read her plan here). The congress has its own set of initiatives.

None of these plans are going to work to resolve the foreclosure crisis let alone bring the economy out of recession.

The mortgage crisis started because too many households borrowed too much and bought houses they could not afford. Real money flowed into the housing market and residential investment increased. Because we couldn’t build enough, especially in urban areas, the price of houses rose. In this sense, we had not a housing bubble but a borrowing bubble (remember American households borrowed for much more than just houses: cars, big screen TVs, groceries …).

The borrowing bubble has burst. The money that flowed into the housing market is gone. There are now too many houses and house prices have to fall. This adjustment process is well underway. Housing starts have fallen off a cliff and house prices are falling. Prices are anywhere between 5 and 40 percent below their peak depending on where you live and which measure you believe. They are going to be lower.

The more prices fall the more households are underwater—they owe more on their home than their home is worth. These are the households who are most likely to default. These households may continue making payments for a period of time but their incentive to make payments is diminished. If their house price falls more or if they lose even a little bit of income, they are likely to default.

Any successful mortgage plan must address this issue first. The following plan would resolve the foreclosure crisis and eliminate one source of extra downward pressure on house prices (although it would be unlikely to end the recession).

• Voluntary program to purchase all mortgages with a loan-to-value (LTV) ratio greater than 90 percent and issue a new mortgage with a 90 percent LTV to the household: This ratio gives homeowners an immediate financial stake in their property. A household with 10 percent equity in their home does not have a financial incentive to default. Even after closing costs and paying off the equity claim (see below), they are better off selling than walking away. A few households will still default but a few defaults are not a problem.
  
  With this plan, the government does not need to make an affordability determination. The household’s income does not matter. If they can afford their payments, they will make them. If not, they can sell their house for a small profit. This has the added advantage of minimizing forward-looking housing market distortions. Households can freely sell their house and housing market adjustment is not hindered by negative equity households.

• Determining House Value: The most difficult part of this plan is determining the house value. But, this is a macro program—we care about the health of the economy not individuals—so, we only have to be correct on average. The current value of the home can be estimated by using the price of the home when it was last sold combined with the average change in house prices for the MSA as measured by the OFHEO house price index. Allow the household to increase but not decrease the current declared value.
  
  Because none of the house prices indexes is perfect, especially at the MSA level when there is very little volume in the housing market, the government should evaluate the average home value periodically. If homeowners in the plan cannot sell their houses at the declared value then the average declared value is too high and must be reset.

• Issue an equity claim: As with any government intervention in markets, this plan is a transfer between households. Responsible households are subsidizing the houses of those who over borrowed. It also encourages future households to borrow more in the hope they will receive a bailout if things go bad. Issuing an equity claim reduces both of these distortions.
  
  The equity claim recovers 30 percent of the difference between the origination value of the new mortgage and the eventual selling price of the home. With this percentage, the household stands to gain about 1 percent of the value of his home after closing costs at the time of origination.
  
  The equity claim, which is worth 3 percent of the home’s value at origination, also reduces take up of the program and provides an incentive for households in the program to increase the declared value of their property, thereby taking on a larger mortgage.

• Program Cost: Of course, the cost depends on take up rates but the plan should not be expensive (compared to other initiatives currently underway). Outstanding mortgage debt increased almost $4 trillion between 2005Q1 and 2008Q2. (If a house was purchased before 2005 chances are it is above water.) Even assuming that every one of these households had a 100 percent LTV at purchase and that house prices are now 10 percent below the peak, the cost would only be at most $400 billion and it is likely to be much lower.

This is the simplest plan that would resolve the foreclosure crisis. It requires very little private information (mostly the mortgage value). There are good elements to the other plans and those elements can be combined with this plan. For example, with rising job losses one may fear that too many houses would flood the market at one time even under this plan to allow an accurate picture of local house prices. In this case, the above plan could be combined with a temporary payment holiday for high LTV households or even an outright foreclosure moratorium. Either would help meter the houses onto the market.

But, no matter what bells and whistles one adds to the program, a successful program must ensure that households remain above water. They must have an equity stake in their property or they will (on average) default at some point.