Two months after the collapse of Lehman Brothers, there has still been no broad-based action to help restructure delinquent mortgages and slow down the flood of foreclosures; the Fannie/Freddie plan announced earlier this week is a very small first step, because it is limited to a small portion of the mortgages outstanding – those controlled by Fannie and Freddie, which tend to have relatively low default rates anyway.
Sheila Bair, head of the FDIC, said that that plan “falls short of what is needed to achieve wide-scale modifications of distressed mortgages.” Apparently frustrated by the failure of negotiations with the Treasury Department, yesterday the FDIC posted its mortgage modification proposal to its web site (Washington Post summary), basically breaking with the rest of the administration and hoping the Congressional Democrats can make it happen.
This plan (which we’ve heard about in some form or another for weeks) would apply to all owner-occupied homes that are at least 60 days past due; mortgages would be reduced so monthly payments are no more than 31% of the borrower’s income. Based on FDIC experience at IndyMac, most of those reductions would be made by reducing the interest rate as low as 3% and extending the term; principal would only be reduced in a small number of cases. (From a net present value perspective, of course, lowering the interest rate and lowering the principal are two ways to get at the same thing.)
Because the government does not have the power to force loan servicers to modify loans, the incentives would be a $1,000 fee per restructured mortgage and, more importantly, a government guarantee for up to 50% of the loan value in the case of a re-default. Participating servicers would also have to systematically review their entire portfolios for loans eligible for modifications, to prevent them from picking and choosing. The FDIC’s high-level estimates are that 4.4 million loans will become sufficiently past due by the end of 2009, 2.2 million could be modified, and 1/3 of those will re-default; the total cost to the taxpayer would be $24 billion, mainly for paying off the guarantee on defaults.
The basic principle of the plan is sound: providing a government incentive to get servicers to do something that will help borrowers and the communities they live in. However, I don’t see anything in it that will get around the securitization problem – servicers are legally bound only to act in the interests of the investors who own the bits and pieces of the loan, and some of them may sue if loans are modified in ways they don’t like. Solving that problem will almost certainly take new legislation.
By the way, this is Treasury’s response, according to the AP:
[FDIC] officials want to use part of the $700 billion bailout of the financial industry to pay for it. But the Treasury Department is opposed to that idea.
Testifying on Capitol Hill Friday, Neel Kashkari, the Treasury Department’s assistant secretary for financial stability, said the intent of the $700 billion plan was to make investments with the hope of getting the money back. That, he said, was “fundamentally different from just having a government spending program” that would disburse money with no chance of ever seeing any returns.
Is there really a fundamental difference between (a) making investments that theoretically could get a positive return but are really bad investments you are consciously making to shore up the financial system and (b) extending loan guarantees that you know will cost you some money, but will help stabilize the housing market, increase state and local tax revenues, and keep people in their homes?