“Bailing Out” Homeowners Through Mortgage Restructuring

On Capitol Hill today, attention turned back to where this all started – delinquent mortgages. Sheila Bair of the FDIC is working on a program to encourage lenders and servicers to restructure mortgages by partially guaranteeing post-modification mortgages that meet certain criteria. Christopher Dodd is also considering new legislation in November to help homeowners. Here at the blog, we made intervention into the housing market one the four proposals in our first Baseline Scenario way back when in September, and we are planning to publish something more detailed in the next several days. But first, I wanted to lay out the nature of the problem.

Remember the wave of indignation that accompanied the “bailout of Wall Street” last month? Judging by some emails and comments I’ve seen, it could be even worse when it comes time to “bail out” delinquent mortgage holders. Much as people hate the idea of bailing out Wall Street “fat cats,” for some the idea of bailing out their neighbors – especially the neighbors in the new McMansion – is even worse. I think for some people it’s the idea that someone else is getting away with something that they could have done but chose not to (buying too big a house, in this case); by contrast, most people recognize they had little chance of becoming the CEO of an investment bank. OK, now that I’ve opened myself up to a flood of nasty comments, on to the substance.

I think that indignation is misplaced. Let’s take a simple example. Henry the Homebuyer buys a house for $200,000. He puts down $20,000 and borrows $180,000 from Lisa the Lender. The interest rate resets one year later and now Henry can no longer afford the monthly payments; at the current interest rate he can only cover a $150,000 mortgage. Unfortunately, the house has lost 30% of its value and is now worth only $140,000. Assume Henry wants to stay in the house.

At this point, Henry has zero equity. Lisa has a mortgage asset with a face value of $180,000 but that is really only worth about $100,000. Her only recourse is to foreclose, in which case she will gross $140,000, but after all the fees she will probably net something like $100,000. So what should they do? They should renegotiate the mortgage on some terms that Henry can afford and that are worth more than $100,000 to Lisa. This isn’t a bailout; this is good business. And, frankly, apart from Henry and Lisa, it’s none of anyone else’s business.

So why isn’t this happening? Transaction costs, broadly speaking:

  1. Cost of renegotiation
  2. Difficulty of figuring out how much Henry can pay
  3. Difficulty of figuring out who can pay a reduced amount and who can’t pay any amount
  4. Fear that people who can pay their mortgages will start pretending they can’t to renegotiate their mortgages
  5. Securitization, which results in the loan being managed by a servicer who may not have the legal right to renegotiate the mortgage in a way that affects the rights of the investors, who may even be hard to identify
  6. Etc.

Some of these challenges are bigger than others. #2 and #3, for example, are what lenders are supposed to be good at in their ordinary business. #5 may be one of the trickiest, because the way mortgages were pooled and then divided, the interests of different members of the pool may differ. (Michael Barr and James Feldman have an idea of how to get around that problem, appended to a proposal they made in April.)

Getting around these problems may require government intervention; given how few mortgages have been modified, it’s probably safe to say that it requires government intervention. Some will call this a bailout, and yes, whatever program is implemented may result in a few extra dollars going into one pocket or another. But think about what’s happening here. A house lost $60,000 in value. Henry and Lisa both made bad decisions. The point of mortgage restructuring is to agree on a way to split that loss. The overriding policy goal is to avoid foreclosure if at all possible, which creates an additional loss to all parties on the order of $75,000. That is an eminently reasonable goal of government action.

10 thoughts on ““Bailing Out” Homeowners Through Mortgage Restructuring

  1. With FHA-backed mortgages, how much of the loss taken by the lender is repaid by FHA, and at what point in the process? Does the lender have to foreclose and sell the property; if so, this would be a huge incentive to NOT renegotiate.

    My question: you say “given how few mortgages have been modified…”, but what are the stats? How many troubled mortgages have been renegotiated, and have the reworked mortgages been successful (in other words, not simply delaying an inevitable foreclosure).

  2. There is no deficit-based solution that works IMHO.

    We should instead rethink Equity through a new approach to REIT’s within a partnership framework.

    Step One: Transfer the freeholds of distressed housing into the hands of a Custodian – eg State Street, Northern Trust.

    Step Two: agree reasonable and affordable rentals, and then link these rentals to an agreed measure of inflation or to a %age of market rental levels (same thing).

    Step Three: divide the pool of rentals into proportional Units or “nth’s”.

    Step Four: sell the Units to risk averse investors, particularly those interested in ethical or Islamically sound investment (this model is entirely consistent with Islamic investment as it should be, rather than the current Islamic veneer on an UnIslamic reality…).

    Anything the Occupier pays more than his rental automatically acquires Units at the market price, until eventually he has enough Units to be in economic terms at least the “owner”.

    For investors there is a reasonable (2 or 3%?) index-linked income. In risk terms, there is a virtuous circle: because the rental is affordable, it is more certain that it will be paid, and hence a lower rate is justified…

    In summary, the solution to the crisis is a “Debt/Equity swap” on a massive scale.

    But not Equity as we know it, Jim…..

  3. The price was originated determined by the buyer’s cash flow according to the interest rate it was locked. So a fair split in damage can be determined by the difference in PV of the house based on the 30 years fixed mortgage and previous mortgage rate. Government can subside the fixed rate to reduce the damage (buying down the points). If the subsidy exceed a limit, then it make sense to foreclose.

  4. “So why isn’t this happening?”

    It is happening, to some extent. Here are examples of entrepreneurs in Northern NJ and Southern California buying distressed mortgages and modifying them. Instead of buying opaque securities derived from mortgages, the Treasury Department could use a couple hundred billion dollars of the $450 billion it has left in its rescue fund to buy distressed mortgages themselves, at significant discounts, and then modify the terms. If Treasury offered to buy first mortgages for 50% of the current appraised value of the property, or 50% of the face value of the mortgage, whichever was lower, it might set a floor under the value of mortgages, and, presumably, under the the complex securities derived from them. It could also reduce foreclosures, help stabilize home prices, and free up capital for new mortgage loans.

  5. Thanks for the link. The Northern New Jersey example shows that lenders are willing to part with their distressed mortgages at a discount, and at least sometimes a deal can be worked out that is helps the homeowner as well. (They do end up foreclosing, sometimes.) However, it isn’t happening at scale. Biltmore (the hedge fund in that article) is mainly buying whole mortgages from small regional banks. Buying securitized mortgages is much trickier for legal reasons, and cutting that knot may require government intervention.

  6. I think the bail out program ,they should help the home
    owners who are in behind payments and lower the payments for those who has high payments no,Equity on the house.

  7. I need the government bail out program to help me to lower my payments. I can’t get the loan, because my house no,Equity on it.
    So do i have any hope of that and when is the bail out program is ready?

  8. No plan has been finalized, so no one knows. Probably there will be some kind of income-based threshold. For example, at IndyMac they are restructuring loans so your mortgage is no more than 38% of your income. In that case, if 38% of your income can support a mortgage that your lender finds acceptable (is worth more than foreclosing), then you may get a modification. However, your lender may prefer foreclosure to a mortgage based on 38% of your income.

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