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.

But if the idea is to package them with hundreds of other liens, then all you really need to know is what they will be worth, on average, after all the houses are finally sold. And before too long, that calculation won't be made by Fannie or Freddie. It will be made by investors who buy and sell the packages of liens on Wall Street's credit markets, just as they do every day with trillions of dollars of options and derivatives contracts, which have many of the same uncertain characteristics.

By now you're probably wondering why the various parties would be interested in getting involved with all this. The answer is pretty simple: They would all come out better off than if they were forced to go through foreclosure.

Borrowers would get a chance to stay in their homes, with an affordable mortgage and the opportunity, albeit reduced, to begin rebuilding some equity in the property and profiting from any appreciation in property values. They would also be able to avoid a big blot on their credit history.

As for the lenders, this kind of workout would be of interest only in cases where the proceeds they would receive from foreclosure would be insufficient to pay back the full amount of the loan. That would be most obvious in the case of a loan that is larger than the value of the house that secures it. But this mechanism would also be worthwhile in cases where the house may be worth a bit more, because of the added cost of going through the foreclosure process, which can often amount to 15 to 20 percent of the value of a loan.

In addition, the whole industry -- to say nothing of the whole economy -- would benefit if house values were not further depressed by a rash of foreclosures that suddenly puts hundreds of thousands of homes back on the market.

This isn't an entirely original idea -- it's a second cousin of the "Brady bonds" used by the first Bush administration in the early 1990s to help solve the Third World debt crisis.

But while this is a market solution, it is not one that the market is likely to serve up without the intervention of Fan and Fred. No other entities have the knowledge or the market influence to set the standards for the new instruments or the resources to create a liquid market for them. It is what they were invented for and what they do better than anyone else.

But the companies probably couldn't launch such an initiative without the approval and encouragement of the Bush administration, which hasn't come up with any better ideas but somehow still can't seem to get past its free-market hangups about government-sponsored enterprises.

So, over this Labor Day weekend, when you hear the president or Treasury secretary or their fellow travelers at the Federal Reserve declare they are doing everything they can to deal with the mortgage crisis, remember the old Gershwin song: It ain't necessarily so.

Steven Pearlstein can be reached atpearlsteins@washpost.com.