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:
- Cost of renegotiation
- Difficulty of figuring out how much Henry can pay
- Difficulty of figuring out who can pay a reduced amount and who can’t pay any amount
- Fear that people who can pay their mortgages will start pretending they can’t to renegotiate their mortgages
- 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
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.