The long-awaited housing bailout will finally be announced on Wednesday.
In a speech in Phoenix, a signature real estate boomtown gone bust, President Obama will explain his plan to reduce foreclosures. And the key to understanding that plan will be remembering that there are two different groups of homeowners who are at risk of foreclosure.
The first group is made up of people who cannot afford their mortgages and have fallen behind on their monthly payments. Many took out loans they were never going to be able to afford, while others have since lost their jobs. About three million households — and rising — fall into this category. Without help, they will lose their homes.
The second group is far larger. It is made up of the more than 10 million households that can afford their monthly payments but whose houses are worth less than what is owed on their mortgages. In real estate parlance, they are underwater. If they want to stay in their homes, they will have no trouble doing so. But some may choose to walk away voluntarily, rather than continue to make payments on an investment that may never pay off.
Scratch beneath the details of any housing bailout proposal, and the fundamental issue is whether it tries to help the second group or just the first.
Mr. Obama has evidently decided to focus on the first group, based on the previews of his speech that aides have offered. In coming weeks, his administration will begin spending $50 billion to entice banks to reduce the monthly payments of people who otherwise couldn’t afford to stay in their houses. In effect, the government will split the losses on these mortgages with banks.
The $50 billion will come from the money Congress has already allocated for the bailout of the financial system. It is likely to be aimed at people who need a significant, but not an enormous, amount of help to meet their mortgage payments.
There are some big advantages to this approach. Bailing out all underwater homeowners would be tremendously expensive. All told, about $500 billion in mortgage debt is already underwater, and it’s impossible to know in advance who is likely to walk away. So the government would have to spend hundreds of billions of dollars to help millions of people who don’t need help staying in their homes.
But the Obama approach also brings risks. The administration is betting that few of those 10 million underwater homeowners will walk away. (A year from now, the number will about 15 million, Moody’s Economy.com projects.) If they begin to abandon their homes in large numbers, however, they will aggravate the housing bust and the financial crisis — and probably force the administration to come up with a new, much larger housing bailout down the road.
In that case, the speech that Mr. Obama is making in Phoenix could come to look like a rose-colored bit of incrementalism, which happens to be the very criticism that Obama advisers have leveled against the Bush administration’s response to the housing bust.
Underwater homeowners clearly face a difficult choice. By walking away from a house and then renting a similar one in the same town, many could save themselves a lot of money. And those who need to move — to take a new job, for example, or to marry — may have little choice but to default. They may not get enough from a sale to pay off the mortgage.
On the other hand, defaulting will wreck a homeowner’s credit rating. For families that don’t need to move, doing so will also bring other headaches and costs. They will be leaving behind their homes. Many other people may continue to make their payments simply because they think it’s the right thing to do.
The current housing bust doesn’t have a good recent historical analogy. It’s too big. But there have been some serious regional housing slumps that may offer a window into how underwater homeowners will behave this time.
Three economists at the Federal Reserve Bank of Boston recently did an analysis along these lines, looking at the Boston area in the early 1990s. From early 1989 until late 1991, prices in Boston fell 15 percent. They did not return to their 1989 peak until 1997.
Yet only 6.4 percent of homeowners who had been underwater at the end of 1991 were eventually foreclosed on. And the majority of these foreclosed homeowners weren’t merely underwater; they were also unable to make their monthly payments, because of the severe recession hitting New England at the time, as Chris Foote, an economist at the Boston Fed, told me. They are the kind of people the Obama plan is meant to help.
In all, maybe only 1 or 2 percent of underwater homeowners walked away even though they could make their payments. Mr. Foote and his colleagues predict that the nationwide foreclosure rate over the next few years will be higher than it was in Boston, but not radically so.
For most people, the Fed economists write, being underwater “is a necessary but not a sufficient condition for foreclosure.”
Now, not all economists buy this argument. They say that the psychology of the current bust is different from what it was in Boston in the early 1990s. In a handful of metropolitan areas, including Phoenix, prices have fallen almost 50 percent from their 2006 peak.
Homeowners in such places may wonder if their houses will ever be worth more than their mortgages. So fairly small changes in their lives — like a reduction in work hours or the breakdown of a car — may lead them to walk away from their homes.
“I would not minimize that risk at all,” said Frederic Mishkin, a member of the Fed’s board of governors until last year.
If even 10 percent of the underwater homeowners walked away, Mr. Mishkin notes, foreclosures would soar, exacerbating the economy’s many problems.
Other economists who share his view are calling for across-the-board programs that would reduce interest rates or otherwise juice the housing market. They are worried that without bolder government actions, the housing market will continue to spiral downward.
In the end, the choice between the two approaches becomes a matter of cost-benefit analysis. The more aggressive approach would almost certainly do more to reduce foreclosures. But it would also be enormously more expensive.
If the economists from the Boston Fed are right — or even close to right — then the aggressive approach may cost something like $500 billion to prevent 500,000 foreclosures.
That’s $1 million per prevented foreclosure. Is that really worth it? Or could the money be better spent in other ways? (There is also the small matter of whether Congress would be willing to spend another $500 billion anytime soon.)
Mr. Obama is apparently going to try to get more bang for the buck by focusing on those homeowners who would certainly lose their homes without government help.
The plan will also help some underwater homeowners refinance their mortgages, but that won’t be the emphasis.
The administration’s next task is to execute its plan better than the Bush administration executed its various housing plans. That will mean offering subsidies that are big enough to persuade banks, finally, to rewrite mortgage terms.It also might help to suggest that the federal government would look unfavorably on any bank that did not make good use of those subsidies. After all, the government is now a shareholder in many banks.