The foreclosure crisis is at the heart of the more general economic crisis. Protecting homeowners at risk of foreclosure is therefore an obvious priority. Here I outline a plan to ameliorate the foreclosure crisis, using the FHA’s mortgage authority to force lenders to recognize the actual values of homes and thus to restructure loans accordingly. The plan has four basic elements.
1) All those who purchased homes after a specified date are eligible, period. There is no distinction between those in arrears and those current in payment. There is neither time nor reason for a fight about moral hazard.
2) Participating homeowners will pay a small amount to register and receive an appraisal of current house value from the Federal Government.
3) If the household is able to make payments on a new first mortgage with a 40 year term for this appraised value, using standard underwriting criteria, then the household will be offered a new FHA mortgage. This new mortgage will be structured as interest-only for an initial period of years. This mortgage will be guaranteed, and premiums will be paid into the existing Mutual Insurance Fund administered by FHA.
The mortgage under these new terms will be reported to the master servicer, who will replace the existing contract with the new contract. Servicers will inform the owners of securities in any pool containing parts of the previous mortgage, and servicers will continue to pass on payments made by homeowners under the new contract to owners of existing mortgage pools or other securities.
4) In addition, when the new contracts mature or are terminated, any capital gain, net of costs, will be divided, with a small fraction accruing to the homeowner. The residual gain, net of costs, will be transmitted to the servicer who will distribute it to the owners of securities or pools in which the mortgage is bundled.
The Big Picture:
The most important thing is that the government force these revised mortgage contracts to be marked to market quickly, to reflect the actual value of the underlying housing.
There also doesn’t need to be a fight over securing the agreement of lenders or owners of securities. Some financial gurus claim that the sanctity of contracts requires agreement. This is nonsense. Terms of contracts are changed all the time by legislation. All this legislation does is to recognize the current market value of the contract. Finally, the biggest contractual change ever in American financial history, the abrogation of the gold standard, was made unilaterally by FDR. If this plan were adopted tomorrow, it would still take a lot of time to gear up a Home-Owners-Loan-Corporation (HOLC)-like appraisal process for hundreds of thousands of appraisals. And time is of the essence. So we need a simple program that can be implemented as soon as you are able to move.
And the cost? With 12M households currently holding underwater mortgages, we can safely assume that the average writedown would be less than $100,000. With a 1 percent default rate on new loans, and a loss on default of $100,000, this might add up to $12B. I used to think this was a lot of money. If the average write down were $100K, and housing prices did not increase at all before the new contracts were terminated or matured, the total private write down would be $1.2T.
This figure does not represent a new loss to the lenders, but rather is a recognition that the underlying asset is less valuable. Each lender or servicer will be given a coupon entitling him to some percentage (perhaps even 100%?) of the gain in value between the date of the new contract and the date of contract termination or maturation.
In effect, we force holders of this paper to mark these assets to market today, and preserve their right to any capital gain on the assets which have been marked to their current value. (But don’t let the bastards securitize these coupons.)
1) Eligibility is not based on delinquency in payments, and those who have struggled to make payments are not disadvantaged relative to those who are in arrears. The “right” –utterly arbitrary — date of eligibility might be January 1, 2004. (Subprime mortgages increased from about 9 percent of originations in January 2003 to 18 percent a year later, and to almost 22 percent in January 2005.)
2) Participation costs are meant to be small, a hundred or two hundred dollars. The appraisal will be some average of estimates of replacement cost, rental value, and current selling price. This is the same procedure used by the HOLC, and it will not underestimate the current value of the house.
3) The “standard underwriting criteria” could involve the 38 percent payment-to-income ratio of the New Hope Alliance, or Sheila Bair’s number. (I prefer Bair, but I also like vanilla.)
4) The interest-only aspect of the mortgage is not essential, but we are in a recession. That period could be limited to two years.
5) The new mortgage will be structured just like “regular” FHA mortgages with a payment by the household into the FHA’s mutual insurance pool.
6) The owners of the existing mortgages will share in any capital gains realized during the term of the new contract, perhaps in proportion to the writedown in asset value under the new contract. As a result, this is not a constitutional “taking,” and claims to the contrary are incorrect.
My two quibbles:
(1) John is a terrific, admirable economist (there is a difference between the two adjectives) and has long been an intellectual hero of mine. That said, he is not a lawyer, and so I am not sure we can be so sanguine about mass contract modification. Then again, I am not a lawyer either...
(2) I think cap gains should be split at something like 50-50 between homeowners and lenders. If nearly all the cap gains go to lenders, owners will have less incentive to maintain, to expend effort when selling, etc.