There are tentative signs that the US housing market is approaching a bottom but it is premature to declare that recovery is under way. Mortgage rates are low and tax credits to first-time buyers and lower prices are raising interest in home buying.
But as long as home prices keep plummeting, many potential buyers will sit on the sidelines. And homeowners who are underwater, with negative equity, might throw in the towel and default, putting more homes on the market – thus pulling down prices even more. Foreclosures and distressed properties already accounted for more than half of existing home sales in March.
If we want to create a broad-based housing recovery we must stop this downward spiral in prices. A number of government programmes have helped but have not yet stopped the bleeding. We suggest a new approach: give homeowners who owe more than their house is worth a financial incentive to stay in their homes and keep up repayments, by offering them a path to positive equity. Call it the homeowner principal forgiveness vesting plan.
More on this in a minute. But first, let’s look at what’s being done right now. The Obama administration’s homeowner affordability and stability plan is a step in the right direction to slow home-price declines. But it does not go far enough in addressing one of the fundamental problems: millions of homeowners owe more than their homes are worth. We estimate that 16.3m were underwater at least 10 per cent at the end of March; 6.5m more than 20 per cent; and 1.3m more than 30 per cent.
The first part of the administration’s plan allows homeowners to refinance with a loan-to-value ratio of up to 105 per cent through Fannie Mae. If you have negative equity of more than 5 per cent, you don’t qualify and must move to part two of the plan – loan modification. If stringent income and credit guidelines are met, the interest rate can be reduced to as low as 2 per cent. This will lower monthly payments and help many stay in their homes.
The drawback is this plan is unlikely to reduce foreclosures by as much as anticipated. Why? Because more than half of foreclosures are in California, Las Vegas, Phoenix and South Florida, and most homeowners who are severely underwater live in those areas. According to the home-valuation website Zillow.com, 67 per cent of homeowners in Las Vegas would need to bring cash to the table if they wanted to sell their homes and 51 per cent of homeowners in Modesto and Stockton, California find themselves in a similar position.
Let’s say you’re one of these homeowners. Even if you qualify for a loan modification and can afford the new lower monthly mortgage payment, why would you keep paying it if you don’t have any hope of having equity in your home for at least a decade? Only those who are compelled by an old-fashioned sense of obligation might continue making payments.
To fix this conundrum, the Obama administration should add the homeowner principal forgiveness vesting plan to its program. Here’s how it works: After a valuation of the property and proper income and credit verification, two separate loans are made. The first loan, from Fannie Mae, would be for the current value. A second, interest-only loan, from the Treasury Department, would make up the difference between the current home value and the original mortgage.
The Treasury loan would be the ”vesting” element of the program. For each year that the homeowner maintains their payments on the Fannie Mae mortgage and the Treasury loan, one-fifth of the Treasury loan would be forgiven. This gives homeowners the incentive of returning to a positive net-equity position before their hair turns grey – maybe even in time to pay for their children’s college education.
Yes, this plan would be expensive. If 1.5m homeowners were kept from foreclosure, it would cost the Treasury an additional $75bn (€53bn, £46bn) to $100bn. Many Americans might criticise rewarding people who made bad decisions, thereby creating a moral hazard. But it’s not just homeowners with subprime mortgages who are suffering. More than 60 per cent of homes that have been purchased since 2004 are underwater. Sure, the market could correct these problems on its own in time but it would be painful and disruptive. Besides, the moral hazard issue has been thrown out of the window thanks to troubled asset relief programme funds being issued to banks that originated or securitised many of these bad loans.
There would be major economic and financial benefits offsetting most of these costs. For every 100,000 foreclosures avoided, home prices would be 0.5 per cent higher. So, if 1.5m foreclosures were to be avoided, home prices would be 7.5 per cent higher than without the plan.
Assuming the plan were implemented in July, home prices would stabilise by the first quarter of 2010 and begin to recover thereafter. By the end of 2010, household holdings of property and other non-financial assets would be boosted by $1,800bn. Consumption spending and real gross domestic product growth would go up 1.1 and 1.6 percentage points, respectively, by the second quarter of 2010. Most importantly, 1.8m more jobs would be created by the end of 2010 than without the plan.
This is a win-win programme that allows homeowners to keep their homes, raises home values, increases GDP and creates jobs. Even the biggest critic of government bail-outs can forgive those results.