The Mortgage Professor
U.S. Must Attack Foreclosure Rates
The government's efforts to combat the worst financial crisis since the 1930s can be divided into three phases.
Phase one, executed in good part in catch-as-catch-can fashion, was directed toward shoring up financial firms that were undercapitalized and had lost the confidence of their creditors. The goal was to prevent their failure, which would have made the crisis worse -- far worse.
The first phase is still far from over. New flare-ups continue to arise, and new approaches for recapitalizing banks are being considered. But the threat of major failures that would further destabilize the system has largely receded.
Phase two, executed in much more deliberate fashion, was to reduce interest rates to mortgage borrowers. Where phase one had the highest priority, phase two is low priority, adopted largely because it is easy to implement and helps some homeowners, even if not those who most need it.
Lower rates have generated a refinancing boom in the midst of a growing recession, like an oasis in the desert. The impact is limited because access is restricted to homeowners who qualify for loans that can be purchased by Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration. To lower their rates, borrowers must have equity in their property and good credit -- the thirstiest homeowners can't drink at this oasis.
Phase three has yet to be defined, but the focus has to be on shrinking the foreclosure rate. The financial crisis started in the housing market and will not end until home prices stop declining and foreclosed homes stop flooding the market.
None of the existing programs, including loan programs (Hope for Homeowners and FHA Secure), counseling programs (Hope Hotline) and foreclosure moratoriums, have made a significant dent in the foreclosure rate. The same will be the case if bankruptcy laws are amended to allow judges to modify mortgages, a proposal now under discussion.
To make major inroads into the foreclosure rate, we need a marked increase in contract modifications of mortgages that are on the path to foreclosure, returning these loans to good standing and keeping them there. The private sector has made efforts in this direction, but the loans they have modified are too few and the modifications too small to make a substantial difference. In particular, very few modifications reduce the loan balance, which is why so many of these borrowers go into default again.
Another important objective of phase three is to begin the process of restoring confidence in the quality of financial assets, which the crisis has undermined. With the loss of confidence has come the loss of ascertainable values and marketability. This is the major reason why borrowers today who need loans larger than those that can be sold to Fannie Mae or Freddie Mac have to pay a rate premium of about 2 percentage points, which is about eight times larger than it was before the crisis.
I think there's a solution possible. The following are the main features of a plan directed to these objectives that a colleague and I have proposed. We have submitted it to the U.S. Treasury. I've left out a lot of the details here for space reasons. A complete version is on my Web site; see "Breaking the Back of the Financial Crisis."
The government should encourage servicers and investors to mark down loan balances to 90 percent of current market value by contributing to the markdowns, and by guaranteeing timely payment of principal and interest on modified loans. Eliminating negative equity on modified loans will lower payments and give borrowers an incentive to remain in their homes, which will reduce the incidence of redefaults.
The government outlays required to support balance write-downs would be large but would be secured by second liens, which borrowers would be obliged to repay in the future. In this way, the government would be able to recover some (if not all) of the outlays.