Notes on the Foreclosure Crisis

By Tom Weisskopf | November 7th, 2008

1. The number of home foreclosures across the United States is now approaching 2 million, and economists expect that several million more borrowers may default within another year as job losses rise and housing prices continue to fall. This constitutes a crisis that must be addressed as soon as possible, for multiple reasons.

• (a) Home foreclosures hurt not only individual homeowners but entire neighborhoods and the whole economy;
• (b) housing is at the root of the ongoing financial crisis, which will not be overcome until housing prices stabilize;
• (c) enabling people to remain in their homes is the quickest and most compassionate way to promote home price stabilization.

2. It is estimated that at present roughly 10% of all U.S. home mortgages are “delinquent”—meaning that the homeowner has fallen behind in mortgage payments. A home foreclosure happens when a home “mortgage servicer,” acting on behalf of lenders who put up the money to finance the home loan, determines that a delinquent homeowner is not going to meet mortgage payment obligations in the future. The mortgage servicer then moves to claim what can be salvaged for the lenders by taking possession of the home and attempting (eventually) to sell it.

3. Delinquency in mortgage payments can arise for either of two reasons—and sometimes both. The first reason is homeowners’ inability to make scheduled mortgage payments. This tends to arise because the homeowner has lost an important source of income (e.g., a job) or because the monthly payments due have ballooned upward from enticingly low initial payments. In the latter case, blame often rests on the lender, for having misled the borrower into thinking that the payments would be manageable; but some blame may rest on the borrower, for having been unduly optimistic about how much s/he could afford to pay for a home.

4. The second reason for delinquency is homeowners’ unwillingness to make scheduled mortgage payments. This can arise from a situation of “negative equity,” meaning that—because of unanticipated falling housing prices—a home is worth less than what the homeowner owes on it. In such cases the homeowner has little economic incentive to keep making mortgage payments; s/he could save money by going delinquent on the payments, undergoing foreclosure, and then spending less than the previous monthly mortgage payments on alternative housing. Some estimates suggest that one of every five U.S. home mortgages is now “under water”—meaning that the homeowner has negative equity in the home and may choose to have it foreclosed.

5. The Federal Government has so far done little to address the mushrooming of home foreclosures, even though this is clearly a critical element of the financial crisis. The Bush Administration did introduce a “Hope for Homeowners” program in July 2008, but it is too narrow and complicated to be of widespread help. The $700 billion bailout/rescue bill passed by Congress and signed into law by President Bush in October does allow the U.S. Treasury to use some of the funds in support of home mortgage relief, and it contains some pleas to help homeowners; but it does not require financial institutions to modify home loans in exchange for the infusion of taxpayer dollars. The short time span within which the bailout/rescue package had to be put together, and the difficulty of reaching agreement amid sharply clashing political ideologies in a divided U.S. Government, helps to explain why little progress was made on the home mortgage front.

6. Another major obstacle to progress on this front is the unfortunate fact that devising solutions to stem home foreclosures is inherently a very difficult task, for many reasons:

• (a) a substantial percentage of home mortgages have been sliced and diced into complex securities, with significant restrictions on renegotiation of payment terms, rather than being held by a single lending institution with the authority to renegotiate;
• (b) one doesn’t want to reward unscrupulous lenders by guaranteeing payments on loans that they pushed fraudulently or misleadingly onto unknowing borrowers;
• (c) one doesn’t want to bail out borrowers who could have and should have known better than to take on highly risky mortgage obligations;
• (d) one doesn’t want to encourage borrowers who are actually quite capable of repaying their loans to participate in a bailout of financially stressed borrowers.

7. On the other hand, the crisis is so serious that a plan to avoid massive home foreclosures must not be held hostage to perfection in avoiding rewards to undeserving lenders or borrowers. The price of stemming home foreclosures will surely have to include some unfairness in bailing people out. Moreover, given the wake-up call that the financial crisis as a whole has sounded against risky financial transactions, there is little likelihood that an extensive bailout of homeowners would generate significant “moral hazard”—i.e., that it would encourage in the future the kind of careless lending and borrowing that precipitated the current crisis.

8. A variety of different solutions to the foreclosure problem have been proposed by various interested parties; I will review some of the major ones here. (If you’re bored by the details, just read the italicized subject lines of the next seven paragraphs.)

9. A moratorium on foreclosures (proposed by President-elect Barack Obama, among others). This obviously does not solve the long-term problem, but it may be a good idea to buy some time to develop a comprehensive solution.

10. Reliance on lender-initiated renegotiation of mortgages as an alternative to foreclosure. This is not a completely futile strategy, since lenders typically lose about 50% of the value of mortgage loans when they resort to foreclosure. And, in fact, many banks with delinquent mortgages have begun voluntarily renegotiating the loans with borrowers; most recently JPMorgan Chase pledged to cut monthly payments, by lowering interest rates and at least temporarily reducing loan balances, for as many as 400,000 homeowners. But this approach cannot be applied to the vast majority of residential mortgages that are securitized rather than in the hands of a single lending institution, because contracts for loans packaged into securities are generally quite restrictive.

11. Government mandates or subsidies for mortgage modification. On the basis of a legal settlement that judged mortgage loans by Countrywide Financial to have amounted to predatory lending, 11 states have imposed mandatory loan modification programs that will provide relief to roughly 400,000 borrowers in the form of reduced interest rates and/or loan balances. More lawsuits and more such legal settlements could lead to more such modifications. Moreover, Sheila Bair (Chair of the Federal Deposit Insurance Corporation) is pushing for a plan that would enable the FDIC to guarantee mortgage loans modified according to standardized loan modification practices to lower monthly payments by borrowers—so that lenders would not run the risk of default on the modified loans. But this approach is also very hard to apply to the majority of residential mortgages that are securitized.

12. Government buy-out and refinancing of unaffordable mortgages. This was proposed by John McCain and suggested earlier by Hillary Clinton; it would operate like the Home Owners’ Loan Corporation of the New Deal era. Where there is a threat of foreclosure of a primary residence and the homeowner can prove s/he was creditworthy when the original loan was made, the U.S. Treasury would simply buy unaffordable mortgages at full value directly from mortgage servicers and then provide homeowners with manageable fixed-rate mortgages that keep them in their homes. This approach sounds quite humane, but it wastes taxpayer money by generously rewarding the same financial institutions that in many cases were responsible for generating ill-advised loans. A more promising variation on the above plan has been suggested by James Grosfeld, who proposes that the government buy up pools of mortgages at a discount and refinance them through Fannie Mae and Freddie Mac; if this plan works, there is even the possibility that the government could end up making a profit from the process.

13. Exchange of home ownership for a five-year rental agreement and potential future buy-back. This proposal, labeled the “Freedom Recovery Plan” by its author Daniel Alpert, calls for legislation to allow homeowners facing foreclosure to turn over ownership of their home to their lenders, in exchange for the right to stay in the home for five years while paying prevailing market rents. At the end of the 5-year period, when the former homeowners could expect to be in better financial shape, they would have the opportunity to buy back (and refinance) their homes at prevailing market prices. This approach has the advantage of keeping people in their homes during a financially challenging period, while obviating the need for government expenditures and requiring both lenders and homeowners to absorb some of the inevitable losses without taking a huge hit. On the other hand, it does not guarantee that most homeowners will be able to get their homes back after 5 years; and it is not clear whether and how it would be applied to securitized mortgages with multiple lenders involved.

14. Reform of personal bankruptcy laws to allow individuals in financial distress to renegotiate mortgages on their primary residence. This proposal, supported by the President-elect, would require new legislation to allow bankruptcy judges to modify home mortgages for bankrupt borrowers, since at present bankruptcy laws do not protect homeowners from having to give up their home ownership when they cannot meet monthly mortgage payments. The plan would not necessarily clog up the court system, since most mortgage servicers and the lenders they represent, if faced with the possibility of having mortgage payments greatly reduced in bankruptcy courts, would prefer to take the initiative in modifying loans to make them less onerous for financially stressed borrowers. This proposal has the advantage of helping those homeowners in greatest need, and it could potentially be designed in a way that would be applicable to securitized mortgages. The principal disadvantage is that it would not apply to the substantial proportion of financially stressed homeowners who are not close to bankruptcy.

15. Government take-over of the role of “master servicer” for securitized mortgages. This proposal, from John Geanakoplos and Susan Koniak, is designed specifically to deal with the majority of mortgage loans that are securitized rather than in the hands of a single financial institution. In these cases, a “master servicer” rather than a bank lender has the power to rework the loans, but under restrictions that act as a strong disincentive to do so. G & K propose that the reworking function be transferred (via legislation) to community-based, government-appointed trustees hired from the ranks of community bankers; they would consider, loan by loan, whether a reworking would bring in more money than a foreclosure. G&K argue that their plan would be far more efficient than having judges attempt this role, because the community trustees would have expertise that the judiciary lacks.

16. None of the above approaches can alone resolve the home foreclosure crisis; each of them has some advantages and some disadvantages. To deal adequately with the crisis will therefore require a multi-pronged strategy involving several different approaches. To my mind, however, the last two proposals are the most promising of the ones I have reviewed here—because they are likely to be applicable to a broad range of home foreclosure situations and because they impose the lion’s share of the burden of bailing out financially stressed homeowners on institutional and individual lenders with some responsibility for precipitating the crisis. By the same token, however, they are likely to face the most formidable political opposition; powerful financial institutions do not like to take big hits. To design and implement such proposals will clearly require not just smart economic thinking but also strong public pressure from below and effective political leadership from the new Obama Administration.

Tom Weisskopf is a professor of economics at the University of Michigan.