Resolving the Foreclosure Crisis: What Can We Do?

Almost two years have elapsed since the beginning of the recession, but the foreclosure crisis continues.  At the end of the second quarter, residential mortgages held by commercial banks reached a new record default rate of nearly 9 percent, and according to recent news reports, this number continued to rise through the third quarter.  The high default rates do not owe to subprime borrowers alone.  The majority of delinquencies are no longer subprime mortgages.  That honor now belongs to prime and near-prime mortgages. 

The crisis has continued despite innumerable programs, at both the state and federal level, to alleviate the crisis.  The FHA has introduced a string of programs to help homeowners refinance into more affordable loans.  Together, various supervisory authorities have put pressure on banks and lending companies to modify the terms of residential mortgages—more than 1.5 million mortgages have been modified in the last year.  Several states have tried temporary foreclosure moratoriums.  In two indirect efforts to reduce foreclosures, the Federal Reserve purchased close to $800 billion in mortgage-backed securities and Congress passed an $8,000 new home-buyer tax credit. 

None of these programs has worked because none attack the source of the problem.  Households owe more on their mortgage than their home is worth.  They have economic incentives to default. 

Background

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 borrowing bubble not a housing bubble.  While subprime mortgages are the poster children of the borrowing bubble, prime mortgages also flowed freely.

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 under way. 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.

Falling prices are the root cause of mortgage foreclosures.  The more prices fall, the more households are under water (the value of the mortgage exceeds the value of the home).  Under water households are more likely than any other class of borrower to default.  They may continue making payments for a time, but the 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.  From the household’s perspective, this default can be optimal. 

The relationship between being under water and defaulting is simple and direct.  Think of a household that has lost its income.  Households that have sufficient equity in their homes will always, under this circumstance, choose to sell the home (even at a loss) rather than undergoing foreclosure.  By selling, these households profit financially and socially—they go forward with their credit unblemished.  Without sufficient equity, they do not have this option.  Without income they cannot make payments.  But, they also cannot sell because they owe more than the home is worth.  Default is the only option.

The Plan

Any successful foreclosure-reduction plan must address under-water households first.  Reducing a household’s monthly mortgage payment reduces the probability of default but only slightly (see this post).  For most under-water households, a lower interest rate or an extended term does not change the default incentives. 

My plan is simple:  a voluntary program to purchase all mortgages with a loan-to-value ratio greater than 90 percent and issue a new mortgage with a 90 percent LTV to the household.  To reduce moral hazard and capricious program take up, issue an equity claim with the new mortgage.  Optimally, this claim amounts to 30 percent of the difference between the ultimate selling price and the origination value of the mortgage. 

The devil is in the details, but this plan would solve the foreclosure crisis. 

A Few Details

Why 90 percent?  This ratio gives homeowners an immediate financial stake in their property. A household with 10 percent equity does not have a financial incentive to default.  Even after paying closing costs and paying the equity claim (see below), selling is more profitable than defaulting.  A few households will still default, households make mistakes, but a few defaults are not a problem.

Why issue an equity claim?  The equity claim reduces the redistributive aspects of the program and reduces moral hazard.  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.  The program 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 distortions.

Why 30 percent?  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.  That is, even at origination, the household has an incentive not to re-default.  If the claim were larger, households would remain under water, and the program would not meet with success.  Moreover, with a 70 percent stake in their property, homeowners have incentives to maintain their house.  

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.  No one who does not need this program will voluntarily forfeit 3 percent of their home’s value.  

How do we determine home values?  The most difficult part of this plan is determining the house value.  But this is a macro program—macroeconomic policy is designed to care for the health of the economy not individuals—the program only has 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 metropolitan area as measured by any good house price index.  The program should permit the household to increase but not decrease the current declared value.

Because no price index is perfect, especially when volumes are low, the government should reevaluate home values periodically, say quarterly.  If homeowners cannot sell their houses at the declared value, the declared value is too high and must be lowered.  If take up rates are high and homes are selling easily, the value may be too low.

Who would own the mortgage?  The mortgages would be held, initially, by the government.  But these notes do not have to be held.  Since the mortgages are now above water and since the government is committed to repeating the plan if values should fall, the mortgages could be sold to private investors.  If the plan is followed in its entirety, the mortgages would not even need a government guarantee. 

How much would the plan cost?  The cost of the program depends on take up rates, but it need not be expensive.  Outstanding mortgage debt increased almost $4 trillion between 2005Q1 and 2008Q2.  The average LTV for these mortgages was far less than 80 percent.  Most of these households remain above water; indeed, the best guess is that 3 out of 4 of these households remain above water.  With a 100 percent take-up rate amongst under-water households, the cost of the program would be roughly $100 billion.  Most likely, the final bill would fall between $50 and $100 billion.

Takeaways

This is the simplest plan for resolving the foreclosure crisis.  It requires little private information, and the government does not need to make an affordability determination.  The household’s income does not matter.  If the household can afford their payments, they will make them.  If not, they will sell, making a small profit. 

The plan 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.  Labor market adjustment can also proceed.  An under-water manufacturing worker in Michigan is no longer forced to look for work in his local labor market alone.  He is free to sell his house and conduct a national search. 

My plan is scalable and can easily incorporate the good elements of other plans.  For example, with ongoing rising job losses, in some areas, too many houses could flood the market, hindering adjustment.  In this case, a temporary payment holiday for high LTV households or even an outright foreclosure moratorium could be combined with the mortgage purchase plan, effectively metering the flow of houses onto the market.  

No matter the bells and whistles, a successful program must ensure that households remain above water.

Households must have a stake in their property or they will default—at some point.