Homeowner Affordability and Stability Plan: Finding a way forward.

I like the idea behind this plan. (You can find the fact sheet here) The Administration clearly wants to help homeowners and is taking steps to do so. The plan is creeping closer to the foreclosure mitigation plan I put forward in this post. I think the plan is net positive for the housing market and that it will help, on the margin. However, the initiative does not solve the fundamental problem that is leading to foreclosure: A large (and growing) number of homeowners are underwater. That is, the amount owed on the mortgage exceeds the market value of the house net of transaction costs.

Underwater households are by far the most at risk of foreclosure. They are at risk for two main reasons. 1. At some point as the value of the home falls, the homeowner is better off defaulting on the mortgage than continuing to make payments. Households in this category are clearly at risk for imminent default. 2. Underwater households are very sensitive to income shocks. If they lose their income for any reason (health, layoffs, wealth losses), they have to default. Had they not been underwater they would have had the preferable option of selling the house. (Preferable because they lose the house either way and with the sale they may recoup some losses and avoid a default judgment.)

Rewriting mortgages such that the payment is affordable (under the household’s current income) solves neither of these problems. A household that cannot afford their current house should be encouraged to move to a house they can afford. It’s not pleasant, it’s not popular, but it is still true. And, there are very few cases where a 1 or 2 percentage point change in the mortgage interest rate will make a true difference between foreclosure and affordability. (Think of the success rate of mortgage modification to date. See my comment here.)

Here is my comment on the plan point-by-point. (Actually, I just comment on the parts that strike me as particularly good or particularly bad.):

Neighborhoods are struggling, as each foreclosed home reduces nearby property values by as much as 9 percent.

I would really like to know the source for this statement. I believe foreclosed properties have a negative impact on house prices. However, empirical studies have difficulty identifying such large effects. Take a look at this recent study by Calomiris, Longhofer, and Miles. This paper is carefully done and is representative of the literature. They find a statistically significant but small independent effect of foreclosure.

Enabling Up to 4 to 5 Million Responsible Homeowners to Refinance

I have no problem with this provision. The Administration wants to allow homeowners who already hold loans guaranteed by Fannie and Freddie to refinance at today’s rates. They are willing to relax the 80 percent down payment rule to make this happen. The only cost to this program is a potential reduction (and a possible increase) in the profitability to the two GSEs. On paper, the institutions are taking on more risk because they now hold low down payment mortgages, but in reality the risk was already there.

This aspect of the plan should have a modest positive effect. Essentially, we are transferring $2300 (the Admin’s number) from Fannie and Freddie to each of the 4 million homeowners. For the absolutely most marginal borrower, this might make the difference between foreclosure and ongoing payments.

A Shared Effort to Reduce Monthly Payments: … the lender [is] responsible for bringing down interest rates so that the borrower’s monthly mortgage payment is
no more than 38 percent of his or her income. Next, the initiative would match further reductions in interest payments dollar-for-dollar with the lender to
bring that ratio down to 31 percent.

Again, reducing payments does not necessarily lead to a reduction in foreclosures. Plus, I suspect, without having the data in hand, that most foreclosed households have had a bigger shock to their income than can be accommodated by an adjustment in interest. Unemployment insurance is not going to cover a very big mortgage payment.

Lenders will also be able to bring down monthly payments by reducing the
principal owed on the mortgage, with Treasury sharing in the costs.

Here is the one sentence in a 2300 word document on principal reduction. The details of the implementation are critical here. Reducing principal is nothing if it is only done to help make payments affordable. Reducing principal is only effective if it moves households back above water. Again see my comment here.

"Pay for Success” Incentives to Servicers: Servicers will receive an up-front fee of $1,000 for each eligible modification … They will also receive “pay for success” fees … of up to $1,000 each year for three years.

The payment reduction part of the plan is intended to serve 4 million households. $4,000 times 4 million households is $16 billion or 21 percent of the $75 billion allocated.

Incentives to Help Borrowers Stay Current: To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his or her loan, he or she can get up to $1,000 each year for five years.

This is just a transfer and a poorly designed transfer at that. I plan to pay my mortgage (unless my house value falls a lot). I would be glad to get $5000 for doing what I do now. But keep up with the math. This is an additional $20 billion, we are up to 48 percent of the total allocated money in just these two “throw away” lines.

Home Price Decline Reserve Payments: ... The insurance fund – to be created by the Treasury Department at a size of up to $10 billion – will be designed to discourage Lenders from opting to foreclose on mortgages that could be viable now out of fear that home prices will fall even further later on. Holders of mortgages modified under the program would be provided with an additional insurance payment on each modified loan, linked to declines in the home price index.

$10 billion dollars is not even in the right ball park to actually insure these loans.

Supporting Low Mortgage Rates By Strengthening Confidence in Fannie Mae and
Freddie Mac

Here I will simply note that the Administration is spending more than 3 times its total homeowner initiative to work a backdoor support of the housing market.

So, in the end, although I think the plan has many positive aspects. It will not help the mortgage market much.

New Home Sales and Foreclosures

The drum beat of economic bad news continued on Thursday. In addition to record levels of continuing claims and further falls in new manufacturing orders, new home sales fell 14.7 percent in December, with large declines in every census region. The drop in sales pushed month’s supply up to a record 12.9. And, the median time for sale since completion rose to 9.3 months: over half of the new homes for sale in December were completed in March or earlier.

The report did not, however, contain only bad news; the number of homes for sale dropped a record ten percent. Inventories are continuing to adjust in the housing sector and apparently the rate of adjustment is accelerating (see my post on the topic here). As I noted previously, but for the record number of foreclosures, I would have expected the housing market to begin its recovery in early summer.

I have been wondering about how to measure the impact of foreclosures on the housing market. Very well done academic studies have failed to find a substantial effect of foreclosures on starts, new home sales, or house prices. (See for instance the recent study by Calomiris et al.) Although these studies control for many variables, by necessity they study foreclosures during relatively good times, times when the economic outlook is fairly benign and when the number of foreclosures is relatively low.

My intuition has always been that foreclosures are an independent negative factor for housing markets. In my view, foreclosures act as inventory in ways that are very similar to new housing: the houses are empty and need to sell. Proving this empirically is difficult as foreclosures do not happen in a vacuum; think of the housing market in a mill town when the mill shuts down, falling prices and high foreclosures.

With this release of new home sales this month, it occurred to me that the differences in behavior between new home sales and existing home sales might give us an indication of the magnitude of the effect of foreclosures. Foreclosure sales appear in the data as an existing home sale. Since both new homes and existing homes are affected by the same macro factors (employment, interest rates, financing availability) a change in the relative sales rate should be informative. An increase in the sales rate of new homes would indicate a relative oversupply of new housing and vice versa.

Take a look at the following picture. In the graph, I plot the ratio of existing home sales to new home sales from 1967 through December 2008. Amazingly, the ratio is relatively constant from the early 1970s through January 2006. This period is not one of stability. There are at least four recessions and as many housing market swings over this interval. Yet, the ratio remained solidly between 4 and 6 for more than 35 years.


It was not until 2006, when the first large wave of subprime foreclosures hit the market, that the ratio began to move upward, that the number of existing home sales began to outpace the number of new home sales. As foreclosures became a more acute problem, the ratio swung rapidly upward, reaching almost 13 in December.

If this increase owes to foreclosures rather than some other factor, I would expect that regions hardest hit by the foreclosure crisis would experience the greatest change in the ratio. The graph below compares the ratio for the West census region to the total shown above. While the ratio for the country has less than tripled, the ratio for the West, which includes the hard-hit states of California and Nevada, has more than quadrupled.

The sudden movement in the ratio is strong evidence that foreclosures themselves are having a large impact on the housing market over and above what would be expected from the downturn alone. However, I cannot use this data to give a numerical estimate of the impact. With essentially only one observation, I cannot map this swing into changes in house prices. I know that foreclosures are an important contributing factor in California and I know that house prices in California are falling. I cannot separately identify the shift in demand from the shift in supply. I can only say that the supply effect (foreclosures) is larger than at any time since 1967.

Bad News for the Foreclosure Crisis

Take a look at this chart released by John Duggan from the OCC today. (Here is Duggan's speech.)

Let me explain, the OCC asked lenders what percentage of borrowers re-defaulted on their mortgages after modification was complete, and how quickly did they do so? The chart shows the results. Each point of the line represents the number of borrowers who were thirty or more days delinquent following loan modification.

The results are stunning and unambiguously bad news for all of the loan modification plans out there. One-fifth to one-quarter of all modifications slip immediately back into default; that is, thirty days after modification they are thirty days behind. By six months, 50 percent of the borrowers are delinquent. The upward sloping line indicates that, at least on average, they are never returning to good status. No wonder the loan industry has not been enthusiastic about working out mortgages: Loan modification does not work.

Importantly, we do not know why the modifications are failing. The OCC is following up with lenders now trying to answer this question. In his speech, John Duggan offerred the following thoughts:

Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?

So, we need more data to distinguish between the different possibilities, but let me offer a speculation of my own: many of the borrowers remained underwater after the modification. Even the best modification plan, the Hope for Homeowners, the most the principal is ever reduced is to the value of the home. This means the borrower who would rather sell than default must come up with 6 percent or so of the value of his home, in cash. For the rest, what difference does it make if the lender lowers the interest rate a few percentage points if the mortgage is still worth way more than the house. There is no monetary incentive to make payments.

There is no easy, free solution to the crisis. Home values have fallen and they are likely to fall a lot further. Falling prices mean more foreclosures and more foreclosures mean falling prices. I am still on the fence as to whether we should bail out banks and homeowners by stopping the foreclosures, but if we are going to do it then get it right. It takes a fiscal transfer from good, reliable, safe households to households that recklessly over borrowed. The transfer has to be sufficiently large that the household is above water after the modification.

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.