Change We Could Believe In?

January 05, 2010

As the New Year gets underway, the housing market’s continuing weakness and the Obama Administration’s loan modification plan’s poor performance have refocused attention on what better ways there might be to prevent foreclosures and keep people in their homes.  

The urgent need for change is clear:

• The Making Home Affordable mortgage modification program has produced close to 700,000 trial modifications, but to date only about 30,000 of those have been finalized.  We won’t know until well into 2010 whether the Administration’s initiative in the 3rd quarter of 2009 significantly accelerated these conversions or not.
• Meanwhile foreclosures in 2009 likely will reach 2 million.  There is no indication that 2010 will be significantly better, as loan performance, particularly among prime borrowers, continued to weaken through 3Q09.
• The Comptroller of the Currency’s last report on the performance of modified loans documents that an alarming 61 percent of all borrowers that had received any kind of modification—through the Obama plan or directly from the lender—were seriously delinquent 12 months after the modification.   Loans modified in the third quarter of 2008, when actual reductions in interest rate and principal were more common, show a significantly lower early redefault rate, suggesting that their long-term performance will be better, but still suffer from significant redefaults as currently structured.  Too few Making Home Affordable loan modifications have been finalized to know how they will perform.
• Significant numbers of borrowers across the credit spectrum owe more than the current market value of their homes.  These “underwater” mortgages make it difficult for families to move for employment or other reasons, or to refinance for a lower rate.  
• A study by the New York Federal Reserve concluded that modifications that reduced payments by reducing prinicipal performed better than those that reduced payments through interest rate reductions.  

Shifting the focus of the Making Home Affordable program to principal reductions, rather than interest rate reductions, offers an immediate step that could improve the program’s success rate, give borrowers a more attractive long-term stake in their homes, and reduce the long-term handicap assisted borrowers face when their loans remain underwater.  

Principal reductions, however, face some potent obstacles.

• Moral Hazard  Principal reductions, this argument goes,  encourage borrowers to renege on their obligations.  Ultimately, it continues,  this will increase borrowing costs for everyone, as lenders charge for the risk of nonpayment of principal.  Borrowers who can still make the scheduled payments on their mortgages will stop doing so in order to qualify to have their total obligation reduced.  Neighbors who don’t receive help will resent those that do, and like-situated households will receive differential treatment of their obligations simply because one chooses to make their payments and the other doesn’t. Moral hazard is a serious problem that needs to be addressed.  But it can be managed and contained by using the same criteria that have been applied to the current interest rate writedowns, limiting it to a owner occupants in homes below a ceiling value, that were originated before the start of the modification program, for instance.  The current program poses similar issues—some borrowers get their interest rates reduced, others do not.  It’s not fair.  Public policy is full of “borderline” issues where only a small difference separates those who receive support and those who do not.  Helping borrowers stay in their homes creates broader social benefit by reducing foreclosures, vacancies and blight.  Stabilizing neighborhoods and home prices benefits every owner in the neighborhood.   Moreover, many of the loans made at the height of the housing bubble were inflated to begin with, sometimes with extraneous charges and bogus fees, and yield spread premiums to brokers paid for by borrowers.  They were made possible only by qualifying borrowers with artificially low rates while lenders knew they would be unable to make payments on the ultimate, higher rates.  And so on.  In this case, where is the moral hazard:  on the borrower that has been victimized by crappy underwriting and dangerous products, or on the lenders who should have known better?  
• Write downs  Forgiving principal on the loan means that the investor holding the mortgage has to take a write down on its value.  Lenders and investors hate this.  But in the current modification program lenders and investors already are accepting a real loss of anticipated return on their loan by accepting a lower interest rate.  What they are avoiding is having to recognize a loss today on a loan they are still holding on their books.  But if the net present value of a principal write down to the borrower is greater than a foreclosure is likely to net, then it is no different than the costs lenders already are willing to bear in reducing their note rates.  If the government used its Making Home Affordable funds to match write downs of principal, it surely would reduce lenders’ asset value.  But it could provide a far greater return through stabilization of the housing, increased likelihood of a successful modification, and restoration of equity potential for the borrower. Write downs could force lenders to increase their capital again, as the value of the assets they hold are reduced by the principal reductions.  But if the assets they hold are being artificially propped up through modifications that ultimately won’t succeed, or that leave the borrower in a long-term negative equity position that keeps them locked in their homes, isn’t it better to take the pain now and deal with it, rather than allow zombie portfolios to stumble along while hoping that time will wipe out the problem? 
• Participation  Lenders are voluntary participants in the Making Home Affordable program.  Requiring principal reductions could drive them out of the program.  But the banking sector continues to benefit from the wide array of liquidity efforts that support the system.  These could be used to “encourage” lenders to participate.  Also, as the crisis has dragged on and more borrowers seem to be willing to walk away from their underwater mortgages,  lenders’ attitudes about principal reduction ought to be changing.  Taking a calculated hit now surely is a better choice for shareholders and the nation than gambling on a much greater loss down the road. In point of fact, lenders are already making principal reduction modifications.  In the New York Fed study sample, 7 percent received principal reductions, averaging 20 percent. The OCC report states that 13.2 percent of the modifications in 3Q09 received them.  This is an increase over 10 percent in 2Q09 and 3 percent in 1Q09.   By far the largest share of these—37 percent of all modifications they made—were offered by lenders holding the loans in portfolio.  A negligible number—rounded to 0.0 percent—were made for loans held by investors.  This suggests where the pressure needs to be applied most heavily—on the securities portfolios and on Fannie Mae and Freddie Mac, who together did only 134 compared to 17,259 by portfolio lenders.  Why are portfolio lenders so much more willing to offer principal reductions in their own modification programs?  

The drumbeat for some kind of change is growing.  The New York Times’ January 5 editorial concluded that “To avert the worst, the White House should alter its loan-modification effort to emphasize principal reduction.”

Sounds like change we could believe in.