Tuesday, March 5th 2008, marked a quantum jump in the response of U.S. federal authorities to the foreclosure crisis facing America. This was when Fed Chair Ben Bernanke urged bankers in Orlando, Florida to reduce the principal amounts of their mortgage loans to distressed homeowners. This, in simple terms, is debt forgiveness, or partial debt forgiveness. Such an action is normally anathema to lenders anywhere in the world. And U.S. mortgage lenders have not been too pleased to hear this, though some of their organizations have made polite noises showing some accommodation towards this suggestion, as long as it is voluntary for lenders to act upon it, and such action is consistent with the joint interests of lenders, borrowers and investors. But one bond investor minced no words and described the proposal as pouring napalm on the fire.
As of today, the Administration’s response to the foreclosure crisis has taken the form of the “Hope Now” program and other similar programs, endorsed by Treasury Secretary Paulson and President Bush, that seek mortgage servicers to voluntarily reset mortgage rates to lower levels than previously decided, or to freeze the reset for a period of time. But now federal regulators, members of Congress, and advocacy groups are ratcheting up the pressure and talking about a “vigorous response.” According to Sheila Barr, Chair of the Federal Deposit Insurance Corporation (FDIC), current efforts are analogous to “kicking the can down the road.” Bernanke seemed to acknowledge the limitations of current programs when he exhorted: “more can, and should, be done.”Although Tuesday was the first time that the Fed Chair used his bully pulpit to urge lenders to mark down principals of their home loans, federal officials have in the recent past made similar proposals. FDIC Chair Sheila Bair said last month that lenders should be more aggressive about writing down principal; and the Office of Thrift Supervision Director John Reich proposed a plan for principal reductions accompanied with loan servicers getting certificates that can be redeemed if home values rise by the time the property is sold.
What has prompted the quantum jump in proposed policy responses is the fact that a startling number of U.S. homeowners—8.8 million—now have negative equity in their homes—that is, the value of their mortgage loan exceeds the market value of their home. And this number is projected to grow to still more alarming levels, peaking to nearly 14 million in the second quarter of 2009, according to Moody’s Economy.com.Goldman Sachs has estimated that if home prices fall another 15 per cent, about 15 million homeowners (30 per cent of all U.S. households with mortgages) will face negative equity in their homes. The received wisdom about the foreclosure crisis, that is now gaining wide acceptance, is that inflated home appraisals are even more to blame than high mortgage interest rates. A study at the Federal Reserve Bank of Boston (by Kristopher Gerardi, Adam Shapiro and Paul Willen) suggests that falling housing prices that have created negative equity situations are greater contributors to foreclosures than interest rate resets. This could be the basis for Bernanke’s statement on Tuesday that principal reductions “may be a relatively more effective means of avoiding delinquency and foreclosure” than renegotiating interest rates. It is likely that inflated home appraisals were deliberately carried out with the support of mortgage lenders. In many cases, appraisers were related to the lender. It is clear that lenders have an incentive to cater to higher-valued homes because profit margins are higher for higher-valued loans. New York Attorney General Andrew Cuomo, who investigated the home loan industry after several loans ran into problems, said: “We believe the appraisals were often fraudulent because there were conflicts of interest and pressure on the appraisers.” Recently, Fannie Mae and Freddie Mac have entered into an accord with the New York Attorney General to purchase mortgages only from lenders who use independent appraisers that follow proper appraisal standards. Of course, where fraudulent appraisals can be established, the homeowner would have a case for redress in the form of lowered principal amounts through the legal system. But where this cannot be established, the inflated appraisals will just have to be accepted as reflecting the then “market value” of the home, albeit in a bubble market. In such cases, it is hard to make a case that lenders should reduce the principal amounts; indeed, such a course is contrary to elementary business principles.
Costly foreclosures claim about 25 percent to 50 percent of the value of a home loan. Foreclosures also impose high costs on local and state governments. States and local jurisdictions feel the severest impacts of high foreclosure rates. According to a recent report by the U.S. Conference of Mayors, rising foreclosures and falling property values are expected to reduce tax revenue by more than $6.6 billion for ten states, including New York, California and Florida.
There might be an incentive for local and state governments, lenders, and homeowners together to work out an acceptable principal readjustment with shared equity for all the parties involved. For example, if a home was bought with a mortgage loan worth $700,000, with practically no down payment, and now the market value of the home is $550,000, then the homeowner faces negative equity worth $150,000. He may have an incentive to walk out and allow the property to foreclose. In such a situation, local or state governments could step in and work out a plan with the lender to reduce the principal amount to $550,000, with the lender covering for $75,000 and the government covering for $75,000. In return for lowering the principal, the government and the lender each should get a 75/700 or 10.7 percent stake in the sales proceeds from the home whenever the home is sold. In housing markets that are expected to revive to previous peaks and beyond, this would be an attractive proposition for all.
It is better that local and state governments, rather than the federal government, be involved in the deals because they have a better sense of the urgency and costs of the foreclosure crisis within their own jurisdictions. There may be places where it makes more sense to foreclose the property than to avoid or prolong a foreclosure. These might be places where there are buyers ready to buy the foreclosed property and keep the homes occupied and well-maintained. These might be places where a homeowner who has foreclosed can easily find suitable rental or owner-occupied housing at affordable rates; there, homeowners would simply move into more suitable housing that they can sustain in the long-term. Local and state governments are in a better position to make this assessment. There could well be a federal program to provide funding to states to enable them to take part in such programs.
Thus, a shared equity mortgage as proposed above will divide up the risks between the homeowner, lender and local government, and allow homeowners to sustain their homeownership with positive and growing equity as housing markets revive. And see the genius of this: neighborhoods with homes in which the local government has an equity stake will receive good quality municipal services, and this will revitalize communities and boost the local housing market.
