Saturday, April 4, 2009

The Plan to Assist Mortgage Borrowers: A Limited Scope

From the Mortgage Professor (Jack Guttentag):

Most of the small print about the administration's plan to help beleaguered mortgage borrowers is now available. In my view, it is coherent and well-thought-out but disappointing in its limited scope. The program is designed to provide benefits to owners who deserve to be helped, rather than to reduce foreclosures and stabilize home prices.

The limited scope of the program is why its cost is estimated at only $75 billion, or less than the amount required to bail out AIG. The systemic impact will be correspondingly small.

The major limitation of the program is that it does not attack the problem of negative equity -- mortgage balances larger than the value of the homes securing the mortgages. The new program is focused entirely on the capacity of borrowers to make their monthly payments. Indeed, this is evident from the program name "Making Home Affordable", henceforth MHA. The major tool for reducing the payment is rate reduction, with balance reductions only a last resort in cases where rate reduction and term extension can't get the payment low enough to be affordable.

Flying in the Face of Evidence

This approach flies in the face of evidence that balance reductions are critically important in avoiding subsequent redefaults. A recent study by Roberto G. Quercia, Lei Ding, and Janneke Ratcliffe found that "among the different types of modifications, the principal forgiveness modification [i.e., balance reductions] has the lowest redefault rate. We believe that this is because it addresses both the short-term issue of mortgage payment affordability and the longer-term problem of negative equity...The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment." [Loan Modifications and Redefault Risk, Center For Community Capital Working Paper, March 2009].

MHA has two parts. Part one is directed toward increasing refinance opportunities for borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac, and who don't have more than 5 percent negative equity on their first mortgage. Borrowers with negative equity greater than 5 percent don't qualify.

The second part of the program encourages payment-reducing contract modifications of mortgages that are endangered by adverse events affecting the borrower, such as a job loss or a pending rate increase. As noted, the major tool for reducing the payment is rate reduction, with balance reductions only a last resort.

A Moral Claim

Both parts of MHA leave negative equity to take care of itself. In my view, this reflects the different mindset that is applied to helping borrowers as opposed to financial firms. Firms are helped in order to avoid the systemic consequences of the firm's failure. Whether or not the firm "deserves" to be helped is wholly irrelevant. Indeed, it could be argued that the largest bailouts have been directed to the least-deserving firms. This is unfortunate but unavoidable because it is the system that is at stake.

When it comes to assisting mortgage borrowers, however, the mindset is that assistance should be limited to those who have some moral claim to government assistance. Eligibility is based on deservedness, with the systemic implications swept aside.

In the minds of the program's designers, having negative equity is not an indicator of deservedness. True, most negative equity has arisen from broad price declines affecting entire markets, but borrowers are not altogether blameless. They could have made larger down payments when they bought the house, and they certainly did not have to take out that second mortgage that allowed them to live (temporarily) beyond their means.

A Faulty Mindset

This same mindset is evident in the rule, incorporated in both programs, that only occupants are eligible. Investors -- those who rent their properties rather than occupy them -- are not eligible. In this mindset, investors don't deserve help because they were implicated in the bubble that preceded the crash, they bought houses in the hope of turning a quick profit, and government should allow them to take their well-deserved lumps without interference.

I happen to agree with that sentiment, but in a financial crisis, deservedness considerations are an indulgence we can't afford. The foreclosure of an investor-owned property puts the same downward pressure on home prices as the foreclosure of an owner-occupied property. Making investors ineligible because they aren't deserving weakens the systemic impact of the program, which should be its major focus.

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