Pushing down mortgage principals

By Kevin Huffman
Saturday, January 9, 2010

About one-quarter of Americans who have mortgages are underwater, meaning 11 million to 15 million people owe more money than their homes are worth. Let me introduce you to one of them: me.

When the housing crisis started to break in 2007, I felt pretty safe. I was newly separated and had refinanced my home in the Denver suburbs with a run-of-the-mill, 30-year fixed-rate mortgage. I lived in a nice cul-de-sac where adults took pride in their homes and kids and dogs ran in the streets.

Then the bottom started to fall out of the market -- and in Denver, it fell particularly fast. Some houses in my neighborhood went into foreclosure when their adjustable-rate mortgages reset at usurious rates. One couple vandalized their home on the way out. Another family gave its keys to the bank and its beautifully landscaped property fell into ruin.

As banks offloaded the properties at deep discounts, all the neighborhood home values started to drop -- first 10 percent, then 20 to 30 percent from peak value. In a remarkably short time, I owed more money than the house was worth.

When the Obama administration inherited the housing mess, it had a difficult choice: give banks incentives to make voluntary loan modifications or bail out underwater homeowners. Treasury Secretary Tim Geithner testified last month about the administration's approach, saying: "This is a conscious choice we made, not to start with principal reduction. We thought it would be dramatically more expensive for the American taxpayer, harder to justify, create much greater risk of unfairness."

I can't fault this logic. As distasteful as corporate bailouts are, homeowner bailouts reek of unfairness. I bought at the top of the market, putting down 15 percent and hoping for the best. Let's say my neighbor saved for a 30 percent down payment, putting off vacations and other indulgences. Anything the government did to reduce my principal would be fundamentally unfair to my neighbor.

So the administration instead set aside $75 billion to get banks to voluntarily modify loans. I'm sure that in the computer models, the banks and consumers responded efficiently to the incentives. In the real world, however, only about 31,000 permanent loan modifications have been done through the government's foreclosure relief program. While more than 750,000 temporary loan modifications have been done, as of December only about 4 percent of the homeowners who signed up have qualified for permanent federal relief.

It's bad enough that more than half of the homeowners in the first round of modified loans wound up defaulting again, finding their situations so dire that the adjustments to their monthly payments were insufficient. But a growing number of people are looking at what they owe and their home values and finding the option of walking away more attractive.

In other words, the administration's program has been a Band-Aid on a gaping wound. Some 2.4 million Americans are likely to lose their homes this year, Moody's Economy.com estimates -- up from 2 million in 2009 and 1.7 million in 2008.

Meanwhile, millions of homeowners are underwater. Experts such as Laurie Goodman of Amherst Securities Group have told Congress that negative equity is the best predictor of future foreclosures -- bigger even than unemployment.

Brent White, a professor at the University of Arizona who has written on the legal and moral obligations of mortgage contracts, tells me that every job loss, divorce and medical emergency in an underwater home is a recipe for disaster. "The government has to address negative equity or people will continue to default," he said. Moreover, in White's view, more homeowners should consider walking away if their homes have negative equity. It's wrong to suggest there is a moral obligation to pay, he argues. "The option to default is part of the mortgage contract."

If more people default -- out of desperation or through calculated strategy -- this crisis could go on for years, dragging down the chance of real economic recovery. The administration has taken some steps, but they are insufficient.

We need a way, through the courts or government agencies, to force banks to write down mortgage principal balances. The government and banks could share the burden of ensuring that that banks have every incentive to negotiate independently, but the process must be designed to reduce homeowners' negative equity.

Geithner's assessment of the options was right: Bailing out underwater mortgages could be unpopular and unfair. But the administration ultimately faces a choice: Maintain the policy of fairness and failure, or embrace a policy that, while unfair, could help end the crisis.

The writer won The Post's America's Next Great Pundit contest.

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