As we discover the booby traps in the financial system, the need for new bomb-disposal techniques is becoming pressing. Are the solutions that people are proposing likely to help or will they just make the economic fallout worse? We can start with the symptom that first told us the economy was ill: the US mortgage crisis.
Ten per cent of US homes are now worth less than the amount of the mortgages on those houses, according to new research by the reputable Moody’s Economy.com. At eight million underwater loans that is an impressively ugly number. The jingle mail could be deafening. Jingle mail is the term coined by some wit for the phenomenon of homeowners moving out and mailing the house keys to their mortgage lender, walking away from their loan obligations.
It is not supposed to happen with the kind of frequency that a 10 per cent underwater rate would imply. Even this 10 per cent is not expected to be the peak, by the way, with one projection showing 15 per cent of homes underwater by the middle of 2009, before the “waters” recede. If the estimates are right that nationwide house prices need to fall by 25 per cent from peak and are only down a few per cent so far, the damage could presumably go a lot deeper still.
On a moment’s reflection, jingle mail probably will not happen to most of the homes where mortgage values are under water. With 10 or 15 per cent of people playing musical houses, where would they all actually live when the jingling stopped? Many owner-occupiers will have to stay put. Owners who never want to borrow for a house again may decide to cut their losses, but those who ever plan to be in the housing market again will have to grin and bear it. Their credit ratings would be shot if they walked away from their house debts.
Yet what these households do will depend if they can actually afford to hang on. The game for a lot of debt-happy households in America these past few years has been to re-finance whenever their home values rose, and use the extra equity to live large. With that game over, many simply cannot make ends meet. When they cannot pay the monthly mortgage they may have no choice but to mail in the keys.
This is where new solutions are being floated. The half-baked voluntary relief ideas from the Bush administration are not going to work. In the latest one, a consortium of large lenders agreed to a 30-day delay before foreclosing on borrowers who are 90 days late on their payments. The idea is to use the extra month to look for a way to work things out. It does not face the problem fairly and squarely: that somebody is going to have to take a hit. Allowed to fester on its own, the joint housing debt and glut problems will result in a massive wave of foreclosures.
Lenders do not usually benefit from foreclosures and it really is in their interest to avoid this outcome. They may be better off keeping their debtors in these homes, paying some portion of the interest owed. The alternative for the bank is an empty house with no interest coming in at all, and potentially further losses to the value of the house. When foreclosures hit neighbourhoods, they reduce the values of all the other homes on the streets around, and there is also risk of physical damage and decay to unoccupied houses.
So what are the proposals to break the foreclosure cycle? One before Congress now is to allow bankruptcy judges to rewrite mortgage terms, enabling some bankrupt occupiers to stay in their houses and make reduced payments. By forcing lenders to take a hit, write down the loan principal to the reduced market value of the house and accept reduced interest payments, this approach could adjust the market back closer to balancing supply and demand.
Supporters say it would solve the problem for 600,000 sub-prime mortgage holders.
The bankers’ lobbyists are still dead against the idea, which they call a cram-down, and they can probably prevail while the Bush Administration is in office. Practically, it seems both unwieldy and costly for judges to conduct individual hearings and come up with new loan terms on hundreds of thousands of mortgages. Would they have to approve new valuations of the homes and determine what each borrower could truly afford to pay based on their personal circumstances?
What banks want, not surprisingly, is for the government to bail them out. Bank of America is proposing that a federal agency should buy delinquent mortgages from them and convert the borrowers’ debt to a manageable, fixed-rate, government-guaranteed loan. In this case the banks are accepting that they have to take the bad medicine of a reduced value for their loans, but then they would be out from under a risk that could be open-ended.
Two obvious problems are how to negotiate the price at which the government would take any loan and how to avoid the government guaranteeing loans to weak borrowers who will simply default again.
It seems especially rich that Bank of America, which only a couple of months ago scooped up Countrywide, the heaviest perpetrator of the sub-prime lending fiasco, now wants government help. Maybe they already feel that Countrywide’s assets are not the bargain they thought they were getting for the $4 billion (Dh14.6bn) they invested, on top of the horrible $2bn convertible debt deal that they did when Countrywide’s stock was much higher. If Bank of America wants to offload all those bad loans, why should their deal look like a bargain to the taxpayer?
Credit Suisse and JPMorgan are reportedly trying to get the Federal Housing Administration to provide federal guarantees for sub-prime borrowers, turning them in effect into prime credits. The bankers want the Feds to give their blessing to any borrower who has made at least six payments on a loan. It is interesting how the banks’ definition of credit-worthy becomes more lax when the government is going to be the lender. The idea of the taxpayer being stuck with debt of hundreds of thousands of deadbeats must be a non-starter.
The Office of Thrift Supervision is offering a new wrinkle in which bankers would write down their loans sharply to the current market value of the house, but retain the right to recoup some of that loss if the borrower is able to sell the home in future for more than the reduced mortgage. If the bankers who got us into this huge mess retain the risks, it’s reasonable they stand to reap any potential rewards.
A big difficulty with all these plans is the perennial problem with property: it is a lot harder to value than a financial asset, since valuation depends on many local and physical details. This, of course, is why it was always a weak idea to securitise mortgages. Far better for a local banker to make the house loan and remain on the hook for it, so the actor with the best information about the local property market also has the incentive to ensure adequate collateral for the loan.
An initiative that was actually enacted as part of the recent fiscal stimulus extends federal guarantees to higher-value homes than before. These jumbo mortgages, for homes above $417,000, have always carried higher rates, to compensate for their higher risk of default, since the federal agencies that back smaller loans were not allowed to cover them. These days the interest rate on jumbos runs at seven per cent, versus about six per cent for conforming loans.
With the new guarantee bringing down the cost of a mortgage on some expensive houses, demand for these places will rise and that may reverse the price declines in this segment.
So the eventual number of underwater mortgages at the high end should be lower than it would have been without this provision. It particularly applies to regions such as coastal California cities, where scarce land has pushed prices to several times the national average. The provision is temporary, kicking in some time in March and possibly not lasting beyond the end of 2008.
Apparently the maximum loan amount for mortgages that Fannie Mae and Freddie Mac will be allowed to buy from banks will vary from local market to local market and is still being worked out.
Of course, this provision of the stimulus bill does nothing for the sub-prime mess, which is predominantly in low-end homes. If anything it moves money away from the lower-priced housing segment by enabling buyers to get their hands on bigger mortgages for lower payments. Nor is it any use to people who are already delinquent on their loans.
Is it good public policy to make the taxpayer ultimately liable for the mortgages of affluent homeowners, which is what this programme achieves? Generally speaking, no, this is a misuse of public resources. Americans already spend more on housing than they would in an undistorted market, both because they get to deduct mortgage interest on their income tax returns and because loans below $417,000 are federally guaranteed and, therefore, somewhat subsidised. Instead of putting savings into productive businesses that would theoretically promote productivity growth, Americans use them for deposits on a larger home. Homes are more of a consumption good than they are an investment.
Quite apart from an economist’s dislike for encouraging sub-optimal behaviour, there is a serious question of fairness in this government intervention. The risk of the taxpayer having to bail out the guarantee agency is problematic. Given the chaotic nature of the housing market at present, it is all too conceivable that some of these jumbo loans will go into default and that it will turn out that the loans exceed the value of the collateral.
Prices are down by as much as 20 per cent in some California property markets in the last 12 months. Who is to say that they won’t fall further, in view of the fact that they are still unaffordably high relative to incomes? If Fannie Mae is stuck with heavy defaults, average taxpayers in no-growth Ohio for example, who have had no chance to get rich owning a house, will be stuck with the loss for putting a go-go Californian into a fancy home. It hardly seems equitable. It does nothing to avert jingle mail. But as a way to alleviate the economic crisis by getting the housing market moving again in expensive regions it has some appeal.
As usual, a US government solution is hampered by the many competing organisations with responsibility for regulating and funding housing finance. Also there is no clean way to distribute the pain among lenders, borrowers and taxpayers. Jingle mail may have to get very much louder before the players agree on a solution. And it may just be better to allow market forces to work it out: that way, irresponsible bankers and borrowers may remember the lesson for decades to come.
Let market forces work their way to bail the system out