Better Idea: Principal Reduction/Balloon Payment

Gretchen Morgenson discusses “refinancing all the nonprime, performing loans held in privately issued mortgage pools (except for Fannie’s and Freddie’s) at a lower rate” in today’s Sunday Times.

She notes it was originally proposed in 2008:

“$1.1 trillion are current on interest and principal payments . . . [Patrick and Taylor] propose refinancing all $1.1 trillion of the loans in securitization pools that are still performing but that may soon face punishing interest rate resets. Homeowners whose loans are in these pools would receive newly issued loans with fixed interest rates, currently 6.14 percent, and 30-year terms. Under this plan, Fannie Mae and Freddie Mac would issue debt to pay off the outstanding principal on the loans and then guarantee the new ones.”

There are some issues with this idea that need to be resolved — but my initial reaction is there are 3 problems with it:

1) This proposal addresses the cost of financing — but not the issue of the cost of the houses purchased.

2) Thus, the proposal ignores the underlying problem: People paid too much, and banks lent too much, for homes at the top of an credit/asset bubble. For both banks and homeowners, carrying an over-priced asset at a lower interest rate does not resolve this.

3) For Fannie & Freddie to pay 100% for this simply seems wrong to me. (Think Goldman & AIG). There are typically provisions that would allow FNM/FRE to recoup some losses when loans go bad from whoever they purchased them from.

Will Investors who bought and sold risky assets be made 100% whole? Is Fannie & Freddie taking risk off of the speculators in alt-A and subprime — with no hair cut? Should these specs get to keep all of the gains?

I am not clear about the rules in point #3 of the Patrick and Taylor proposal. More to the point, let’s address points number 1 and 2:

We know that many home buyers paid too much for circa 2004-07 houses. And a big swath of these homes with mortgages — about 24% — are now worth less than their outstanding mortgages. We also know that the banks lent too much against these homes, and that they are defaulting in huge numbers.

We can address both of these issues through a voluntary combination of principal reduction and balloon payments.

Let’s use round numbers to keep this simple:

Someone paid $500k for house with a $400k mortgage. But the house is now worth $300k. This is a house that very well might be a walkaway, or go into foreclosure.

Solution: The bank refinances the home for its appraised value — $300k. It takes the $100k balance of the mortgage, and puts it into a zero interest, 10 year balloon loan. After year 10, if the mortgagee has stayed current on all of his payments, the $100k balloon payment gets reduced by 50%. The bank takes a hit on half of the “overlending.” The homeowner takes a hit on their downpayment. The $50k then gets added into the duration of the mortgage (20 years) at the same rates as the original $300k.

Prices come down the 10% they are overvalued, but not in a wrenching fashion. In theory, the homeowner will be earning more money by then, RE values will have stabilized (or even gone up). The bank doesn’t take a full hit — its a smaller write-down a decade later. And homeowners get to stay in a house at a price they can afford.

There is only a little congressional action required: The interest free loan should be tax exempt (it would otherwise be taxable). The banks should be permitted to put these loans into a special “held to maturity” vehicle, so they don’t have to take the accounting write down today.  The entire process is voluntary, but it is obviously in the banks interest to delay the writedown, and in a fashion that reduces foreclosures.

This is a variation of our original 30/20/10 proposal, and these refinements reflect what we have learned over the ensuing two years.

Thoughts, ideas, comments ?


Fixing Housing & Finance: 30/20/10 Proposal (September 22nd, 2008)

Stopping Counter-Productive Mortgage Mods and Foreclosure Abatements (January 5th, 2010)

Housing Doesn’t Need a Crash. It Needs Bold Ideas.
Gretchen Morgenson
NYT, September 11, 2010

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