Forestalling Foreclosures

By Steven Pearlstein
Friday, August 31, 2007

Considering the projections for the number of home foreclosures in the next couple of years -- estimates now start at 1 million annually and go up from there -- you'd have thought there might be more ideas floating around for dealing with this economic, social and political calamity.

We've had lots of brave talk from regulators and politicians about taking steps to make sure this doesn't happen again.

And there seems to be a consensus that nobody wants a bailout of lenders and investors, speculators, or homeowners who ought to have known better.

Beyond that, the initiatives, including the plan to be announced today by the Bush administration, have been pretty much limited to modest expansion of existing state and federal programs to help the easiest cases -- those in a position to refinance loans on a sustainable basis.

But even if the majority of problem loans can be refinanced or renegotiated, which is what some officials now believe, that would still mean that hundreds of thousands of families will be forced from their homes and hundreds of thousands of properties will be dumped on an already glutted real estate market.

So I offer here a market-based proposal to deal with the hardest cases -- those in which homeowners find themselves with no equity in the house and incomes so low they cannot possibly sustain their current level of mortgage debt.

The Pearlstein workout process starts where things should have started in the first place -- with the household income of the borrower. Using standard formulas, figure out how much they can afford to pay each month toward interest and principal on a fixed-rate, 40-year mortgage. Then, adjusting for credit score, calculate how large of a mortgage those payments can support.

The size of this new mortgage will be smaller than the old one (otherwise, a simple refinancing would have been possible). The difference between the old amount and the new would define the extent of the problem, the financial gap that now needs to be closed.

But how?

After swapping the old mortgage for the new, the lender would then place a lien, or IOU, on the property, for an amount equal to the gap. The lender couldn't collect on the lien until the house was sold or refinanced. When that occurs, the lien holder would get 90 percent of whatever is left after the first mortgage is paid. (The reason for 90 percent rather than 100 percent is to ensure that the homeowner always has a financial stake in the property.)

In theory, the lender could hold on to these two debt instruments, collect the monthly payments and wait to see how much the lien is worth. But in practice, few would. Rather, the idea is that they would sell both to Fannie Mae or Freddie Mac, the government-sponsored housing finance giants. They would then package the first mortgage loans with other first mortgages, and the liens with other liens, and sell them to investors.

Fan and Fred are old hands at insuring and packaging loans. But the trickier part would be dealing with the new lien instruments, and, in particular, figuring out how much to pay for them initially. Nobody knows when the house will be sold or how much it will sell for, so it is impossible to say in advance how much a $25,000 lien will be worth. All you could say is that the value is greater than zero and less than $25,000.

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