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The foreclosure crisis has crawled
on for going on four years now with no end in sight. The S&P/Case-Shiller index for August fell 3.8 percent from a year
ago. The index includes home prices for 20 US cities.
"Continued house price
declines could lead to even more defaults, foreclosures and distress sales,
undermining wealth, confidence and spending," William Dudley, president
of the Federal Reserve Bank of New York said.
"Breaking this vicious cycle is one of the most pressing issues facing
policy makers."
Every one of the Republican
presidential candidates is being asked how they would handle the slow-motion
housing wreck. Long shot Newt Gingrich says he would rewrite the rules to
make it profitable for banks to renegotiate loan principal amounts.
"He disagrees with his
Republican colleagues that the free market will find a fair way to let the
banks and homeowners work things out," writes
Karoun Demirjian for the Las
Vegas Sun.
President Obama has jumped in to
adjust Fannie Mae and Freddie Mac rules to allow refinances for loans
exceeding 125 percent loan to value.
The president says this will save
underwater homeowners thousands of dollars a year.
Princeton professor Alan Blinder
penned an op-ed for the Wall Street Journal proposing forced principal
reductions with the cost to be shared by banks and taxpayers — with the
proviso that government be given an equity kicker when housing prices go back
up.
Blinder also thinks the Federal
Reserve and Treasury should provide cheap financing to developers who will
use the money to buy up properties with the intention of renting the
properties out.
Harvard's Martin Feldstein put in
his two cents' worth on the issue for the New York Times. Feldstein
points out that home values have dropped 40 percent. The result, he writes,
is "less consumer spending, leading to less business
production and fewer jobs."
Feldstein claims the government can
stop the fall in house prices by slicing off any mortgage principal amount
owed exceeding 110 percent loan to value. He says this policy would cost $350
billion or less and would modify 11 million of the 15 million
"underwater" homes in America. The banks and the government would
split the cost, and in the case of mortgages held by Fannie and Freddie,
"the government would just be paying itself," he writes, presumably
with a straight face.
In exchange for having their lender
take a haircut over 110 percent, borrowers would accept full recourse on the
modified loan.
"I cannot agree with those who
say we should just let house prices continue to fall until they stop by
themselves," writes Feldstein. "Although some forest fires are
allowed to burn out naturally, no one lets those fires continue to burn when
they threaten residential neighborhoods."
"Recovering the 31 percent
plunge in home prices from their 2006 peak will probably be years in the
making as foreclosures throw more properties on the market and sales
flag," writes
Shobhana Chandra for Bloomberg.
Despite the obvious, policymakers
and wonks think trimming mortgage principal down to just 10 percent
underwater or that lowering borrowers' financing costs for those 25 percent
(or more) underwater will somehow halt the slide in home values and spur
consumer spending.
The belief is that if homeowners
are just kinda, sorta
underwater then they will keep on faithfully paying Fannie, Freddie, BoA, Wells, Morgan, and the rest. Never mind that it will
still take years of steady payments to ever see the faintest ray of equity
light shine through the crack between what's owed and the home's value.
We can see how this works out for a
hypothetical couple created by Brent T. White in his Arizona Legal Studies
discussion paper.[1] The young couple buys a
1,380-square-foot home in Salinas, California, for $585,000 in January 2006.
The couple purchased the home with no money down with a 30-year, fully
amortizing loan at 6.5 percent interest. The payment including insurance and
taxes is $4,300 a month.
Now the home is only worth
$187,000. An Obama refinance of the $560,000 that they still owe on the note
will lower their payment by $900. But the couple will never really own
any of the home.
Under the Martin Feldstein plan,
the note holder and taxpayers would eat $354,300, leaving the young couple
with a mortgage of $205,700. Given the ultralow current mortgage rates of 4.5
percent, a 30-year fully amortizing deal including taxes and insurance would
be a payment in the neighborhood of $1,250.
If we closed the deal this month,
assuming home prices don't fall any further in Salinas,
our young couple will see some equity in December 2016.
Meanwhile the same home can be
rented for $1,000 a month. Instead of paying $1,250 a month to have equity of
$168 in 61 months, saving the extra $250 a month and earning no interest on
it equals $15,250 in the same amount of time.
Of course home prices in central
California might rise 2 percent a year, so after five years the home would be
worth $206,500, but then half of any equity belongs to Uncle Sam under the
Blinder plan.
All of these ideas to save the
housing market and supposedly to increase consumer spending do exactly the
opposite. These plans keep people chained to underwater mortgages, keeping
them from moving to where there are more and better job opportunities.
Unemployed heavy-equipment operator
Charles Mills wanted to leave North Las Vegas for Oklahoma and a job, but he
is $200,000 underwater on a home he bought at the peak of the housing market
in 2006. The plans mentioned by Blinder and Feldstein would relieve Mills of
roughly $190,000 of the debt, but the principal reduction won't put him back
to work. Plus, the odds of a quick turnaround in North Las Vegas home values
are about the same as for the Kansas City Royals to win the 2012 World
Series.
The idea that the too-big-to-fail
banks will cover half the cost of these plans is laughable. The hit to their
capital would be considerable, sending the banks right back to Washington's
door with a tin cup.
And how much bureaucracy would be
required to manage the implementation of these plans and determination of
equity splits when homes are sold?
All of these plans are not really
aid to underwater homeowners as much as another bailout for the banks —
not to mention Fannie and Freddie.
Any business dominated by entities
only in business because of the good graces of the government cannot be
considered part of the free market. The reason the housing market is not
clearing is that the government stands in the way by propping up the large
mortgage holders.
No reasonable person sees Fannie
Mae and sister entity Freddie Mac, which were seized by the government in
September 2008, as the product of spontaneous order. To stay in business, the
two firms together have needed about $169 billion in taxpayer bailout funds,
with no end in sight.
Changes to FASB rules 157, 115, and
124, which allowed banks greater discretion in determining at what price to
carry certain types of securities on their balance sheets and recognition of
other-than-temporary impairments have made the big banks wards of the state
as well.
The real help for underwater
homeowners will only arrive when Fannie, Freddie, and the rest are allowed to
fail. The equivalent of a chapter 7 bankruptcy filing (liquidation) would put
these underwater loans out for bid in the market place. Would our mythical
mortgage in Salinas, secured by a house worth $187,000, trade for $205,700?
Not hardly.
No one can get a loan for a 110
percent of value in this market, let alone 125 percent, or 100 percent for
that matter. Those looking for mortgages should expect to put 20 percent
down. Values in a bankruptcy sale would reflect this reality and then some.
Based on the liquidation prices received by the FDIC and other distressed
debt sellers, this mortgage paper would likely be scooped up for half or a
third of the home's value.
Buyers of the paper would
immediately negotiate with borrowers to create loans that are conforming (80
percent LTV) and performing.
For instance, Selene Residential
Mortgage Opportunity Fund purchased the mortgage secured by the home of Anna
and Charlie Reynolds in St. George, Utah, for a deep discount, the Wall
Street Journal reported in a front-page story. The Reynolds were struggling with a $3,464 monthly payment and the
value of their home had plummeted.
Selene, run by Wall Street legend
Lewis Ranieri,
buys loans to make a profit on
them, not as a public service, but company officials say it is often more
profitable to keep the borrower in the home than to foreclose. If a
delinquent loan can be turned into a "performing" loan, with the
borrower making regular payments, the value of that loan rises, and Selene
can turn around and either refinance it or sell it at a profit.
Home values in St. George had
plummeted in similar fashion to that of Las Vegas, only a two-hour drive
away. Selene slashed the principle balance of the loan due from $421,731 to
$243,182 and lowered the interest rate, reducing the Reynolds' monthly
payment to $1,573.
"Around 90% of Selene's loan
modifications involve reducing the principal," James R. Hagerty wrote
in the WSJ, "compared to less than 2% of the modifications done
by federally regulated banks in the first quarter."
And while many upside-down
borrowers can't even find a human to talk to about their loan, let alone sit down
and renegotiate terms that will benefit both parties, Selene immediately
tries to contact the borrowers on the notes they have purchased,
"sometimes sending a FedEx package with a gift card that can be
activated only if the borrower calls a Selene debt-workout specialist."
It's hard to imagine Fannie and
Freddie being so proactive.
Ludwig von Mises
explained that one government intervention leads to an endless succession of
interventions to deal with the effects of the first and subsequent interventions.
Ultimately, it comes down to two choices. "Either capitalism or
socialism: there exists no middle way," Mises wrote.
Likewise, there is no middle way to
solve the housing crisis. For capitalism to work its magic and set underwater
homeowners free, mortgage holders must be allowed to fail.
Douglas French
Notes
[1] Brent T. White,
"Underwater and Not Walking
Away: Shame, Fear and the Social Management of the Housing Crisis,"
Arizona Legal Studies Discussion Paper No. 09-35.
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