Rescue Net Is Too Small To Catch Many Borrowers

Most of the small print about the Obama administration's plan to help beleaguered mortgage borrowers is now available. In my view, it is coherent and well thought out, but disappointing in its limited scope.

The program is designed to provide benefits to owners who deserve to be helped, rather than to reduce foreclosures and stabilize home prices.

The limited scope of the program is why its cost is estimated at only $75 billion, or less than the amount required to bail out AIG. The impact will be correspondingly small.

The major limitation of the program is that it does not attack the problem of negative equity -- mortgage balances larger than the value of the homes securing the mortgages. Large and growing negative equity underlies the sharply reduced values of mortgages and mortgage-related assets on the books of the financial institutions holding them. These reductions in asset values have eroded the capital of these institutions, which the government has had to replenish to prevent failures.

The new program is focused on the capacity of borrowers to make their monthly payments. Indeed, this is evident from the program name, Making Home Affordable. The major tool for reducing the payment is rate reduction, with balance reductions only a last resort in cases in which rate reduction and term extension can't get the payment low enough to be affordable.

This approach flies in the face of evidence that balance reductions are critically important in avoiding re-defaults. A recent study by the University of North Carolina's Center for Community Capital found that modifications that reduced the balance owed had the lowest re-default rate. "We believe that this is because it addresses both the short-term issue of mortgage payment affordability and the longer-term problem of negative equity. . . . The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment," the authors wrote.

The administration's plan has two parts. The first is directed toward increasing refinance opportunities for borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac and who don't have more than 5 percent negative equity on their first mortgage. Borrowers with negative equity greater than 5 percent don't qualify.

The second part of the program encourages payment-reducing contract modifications of mortgages when a borrower faces trouble such as a job loss or a pending rate increase.

Both parts leave negative equity to take care of itself. In my view, this reflects the different mind-set that is applied to helping borrowers as opposed to helping financial firms. Firms are helped in order to avoid the systemic consequences of their failure. Whether or not the firm "deserves" help is irrelevant. Indeed, it could be argued that the largest bailouts have been directed to the least-deserving firms. This is unfortunate but unavoidable because it is the system that is at stake.

When it comes to assisting mortgage borrowers, however, the mind-set is that assistance should be limited to those who have some moral claim to government help. Eligibility is based on whether someone deserves a hand, with the systemic implications swept aside.

In the minds of the program's designers, having negative equity is not an indicator of whether help is deserved. True, most negative equity has arisen from broad price declines affecting entire markets, but borrowers are not altogether blameless. They could have made larger down payments when they bought the house, and they certainly did not have to take out that second mortgage that allowed them to live (temporarily) beyond their means.

This same mind-set is evident in the rule, incorporated in both programs, that only owner-occupants are eligible. Investors -- those who rent their properties rather than live there -- are not eligible. In this mind-set, investors don't deserve help because they were implicated in the bubble that preceded the crash: They bought houses in the hope of turning a quick profit, and government should allow them to take their lumps without interference.

I happen to agree with that sentiment, but in a financial crisis, it's an indulgence we can't afford. The foreclosure of an investor-owned property puts the same downward pressure on home prices as the foreclosure of an owner-occupied property. Making investors ineligible because they aren't deserving weakens the systemic impact of the program, which should be its major focus.

Meanwhile, those borrowers who can take advantage of the program should. To see if you qualify, go to MakingHomeAffordable.gov.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag; Distributed by Inman News Features