How Should We Help Underwater Home Owers ?

Martin Feldstein has another plan to fix housing. It is a variation of the 30/20/10 plan I proposed earlier in the year, in that it pulls a portion of the original mortgage aside from the corpus of the existing loan.

Feldstein’s solution? Replace part of the non-recourse mortgages with a new, immediately due, recourse loan:

“More than 12 million homeowners now have mortgage debt that exceeds the value of their homes. These negative-equity homeowners have an incentive to default because mortgages are generally “no recourse” loans. That means creditors can take the property if the individual defaults, but cannot take other assets or income to make up the difference between the unpaid loan balance and the lower value of the house. As a result, mortgage default rates are now rising rapidly and are expected to go much higher.

The no-recourse mortgage is virtually unique to the United States. That’s why falling house prices in Europe do not trigger defaults. The creditors’ ability to go beyond the house to other assets or even future salary is a deterrent.”

This is a partial solution, one that fails to address several key issues — mostly price.

But as currently described, it is doomed to failure.

First, because most home owners — even the ones that signed on for really bad mortgages — are simply not that stupid. I cannot imagine many attorneys saying: “Sure, replace your non-recourse mortgage that you can easily walk away from with this one that will follow you for years and years, garnish your paycheck, and be non-dischargeable in bankruptcy! Sign here, here and here, and initial here and here. Congratulations! You are a moron!”

Aside from that one fatal flaw, there are several other issues with Feldstein’s proposal.

The big one is it preventing houses from dropping to their natural price level. It fails to write down enough of the overpriced housing market. Current prices, as measured by price to income ratios, or rent/buy costs, are still significantly elevated relative to their historic means.From a 40,000 foot view, defaults and foreclosures leading to distressed sales are what allows prices to normalize again.  Until entry level homes are affordable to young families, the entire Housing chain will remain partially frozen.

Note: This isn’t a call for affordable housing projects — rather, it is a demand to allow market prices to revert to their historic means. Anything DC does to thwart that mean reversion is ultimately destined to failure. The sooner the powers that be figure out that, the sooner Housing will normalize.

The third issue with these mortgages is that many have been sold and resold, securitized and tranched. Even if a few million people are foolish enough to accept this bad deal offered by Feldstein, how are you going to get the locate the mortgages’ owners to revamp the deal? *

The Feldstein proposal doesn’t resolve the issue, is unworkable for many securitized mortgages, but mostly and is against the interests of the homeowners. It is, in short, a non-starter.

My alternative suggestion is to develop a plan that recognizes this simple truism: People paid too much for houses, and banks lent too much against value that simply isn’t there. The LTV needs to be adjusted to reflect this simple reality.

That’s why carving out a new realistic mortgage relative to home values, plus a 10 year balloon payment for some of the balance, can work.

•It shares the pain of bad decision making of both the buyer and the lender;
• It create an incentive for home owers (not a typo) to stay in their homes;
• It gives the banks an immediate write down of the balloon, and a possible recovery down the road;

• It drops the price of homes back towards something realistic

Consider a $500k mortgage on a home purchased for $550k that is now worth $400k.  I would have the parties negotiate something like the following: A new mortgage for $350k plus a $50k 10 year balloon. The $350k mortgage is affordable, the $50k balloon is interest free, tax free and can be folded into the main mortgage 10 years hence.

You can play with the numbers, for example, doing a $375k and a $50k balloon. The bottom line is both parties have to have an incentive to take some o the hit, and prevent an even worse  outcome.

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*Further, as detailed in our proposal, we can enact notice provisions to turn securitized mortgages into an opt out plan, one where the owner of the mortgages must actively refuse to participate int he new plan.

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Previously:
Fixing Housing & Finance: 30/20/10 Proposal (September 22nd, 2008)
http://www.ritholtz.com/blog/2008/09/fixing-housing-finance-302010-proposal/

Source:
How to Help People Whose Home Values Are Underwater
MARTIN FELDSTEIN
WSJ, NOVEMBER 18, 2008
http://online.wsj.com/article/SB122697004441035727.html