The Obama housing plan sets out to mitigate the house price crash by helping many, but not all, struggling homeowners stay in their homes and avoid foreclosure.
It hopes to find a way to help over-indebted households manage their debts over a number of years, hopefully with the help of an eventual partial recovery in house prices.
The administration is betting that most people will choose to remain up to date on their loans if monthly payments are more affordable – even if their homes are now worth less than the outstanding mortgage. So the plan revolves almost entirely around bringing down monthly payments, primarily through reducing the interest rate on home loans, and has little to say about writing down the principal of the loans.
This approach was pioneered by the Federal Deposit Insurance Corporation, which says its evidence suggests loans that are aggressively modified tend to have low redefault rates.
But studies by other bank regulators are less encouraging. Many senior Federal Reserve officials think an anti-foreclosure strategy should address principal writedowns as well as rate reductions. If the fundamental premise is wrong, and negative equity rather than unaffordable monthly payment is the main driver of defaults and foreclosures, the plan will fail.
The plan sets out to reduce monthly payments for two distinct groups of borrowers. The first are borrowers with so-called conforming loans – those guaranteed by government mortgage agencies Fannie Mae and Freddie Mac. These borrowers are stuck paying mortgage rates much higher than those available today because they do not have enough equity left in their homes to refinance loans.
The administration is solving that problem at a stroke by allowing Fannie and Freddie to refinance loans they already guarantee up to a loan-to-value limit of 105 per cent. It estimates that this will allow 4m-5m homeowners to refinance at lower rates.
Since the government in effect owns Fannie and Freddie it can change this part of the mortgage market relatively easily. To buttress the policy it is stepping up its financial support for Fannie and Freddie – allowing them to draw on up to $200bn (€159bn, £141bn) in capital each rather than $100bn. This is largely an accounting fiction, however, since the government is essentially on the hook for all Fannie and Freddie liabilities anyway.
The second group are borrowers with unaffordable loans, defined as loans for which the monthly outgoing exceeds 38 per cent of income. The government is creating a $75bn fund to subsidise loan modifications to reduce this rate. While the lender takes all the cost of reducing loans down to the 38 per cent threshold, beyond that it will meet half the cost of reducing the payments down to a floor of 31 per cent. This should be relatively simple to implement for bank lenders.
However, 62 per cent of the most problematic loans are held in securitised pools of mortgages, jointly owned by investors with different claims on the assets and managed by servicers.
The legal arrangements in private mortgage pools, which vary enormously, frustrated earlier efforts to implement standardised home loan modification programmes because of limitations on the number, or type, of changes that can be made to the loans.
The Obama plan tries to overcome this by providing a standardised framework to provide greater legal cover for loan modifications. It is offering the carrot of financial incentives for investors and servicers to modify loans and the stick of bankruptcy reform that would allow judges to write down mortgage debts.
It is also providing partial guarantees against further declines in house prices on modified loans – a potentially large expense, though only $10bn has been allocated for this purpose.
Bill Frey, portfolio manager at Greenwich Financial said: “The problem is that there is not an easy way to present this to investors: the investors are all over the world and the “transaction costs” are high.”
He said the plan did not resolve the complications of modifying securitised mortgages, short of forcing a borrower into bankruptcy where the plan supports judges changing the terms of contracts – a provision which he opposes.