One year ago the collapse of the I-35W Bridge in Minnesota sparked a national debate about shoring up our deteriorating infrastructure. Today, the continuing financial collapse has sparked an international debate about shoring up our deteriorating economy.
When the bridge collapsed, repairs were being made to the concrete deck, but not to the disintegrating supporting struts that were causing the bridge's surface to crumble. Similarly, we are pouring capital into rapidly deteriorating banks to shore them up, but neglecting the underlying cause of the deterioration -- declining home prices.
The mess that we're now in derives almost entirely from financial institution losses caused by market value declines of securities backed by residential mortgages (rmbs). The accounting treatment of these declines (marking them down to their market values) has depleted bank capital, precluded banks from raising capital in the private markets, and limited bank lending. As long as there is no visible bottom to rmbs values, the credit pipes will remain clogged. And rmbs values will continue to decline until the values of the homes backing them stabilize.
Home values will not stabilize until we stem foreclosures, which drive housing values down because they increase the inventory of homes on the market. Moreover, mortgage servicers allow foreclosed homes to be sold at fire-sale prices because high default rates have all but wiped out their excess servicing fees and residual interests in the mortgages, so they have little incentive to manage foreclosures effectively.
A proposed change in bankruptcy law would allow judges to modify troubled mortgages by reducing rates and lowering the principal amount of underwater mortgages to the current value of the home. But this requires a bankruptcy proceeding in each case -- an impractical solution for the millions of mortgages that need modification.
Treasury's plan to buy rmbs from the banks would stem capital depletion from rmbs markdowns provided the government buys enough of them to convince the markets that future markdowns will be minimal. Although this could be a positive step, it has its drawbacks. It transfers future losses on rmbs to the taxpayers and, if we stabilize home prices, the increase in rmbs values won't benefit the banks as they will no longer own them.
Therefore, it would be better for the government to guarantee the rmbs rather than buy them. That would put a bottom under rmbs markdowns and allow the banks to replenish capital as rmbs values rise. But even here, we need to stabilize home prices to improve the performance of rmbs so the government won't have to pay on its guaranty.
So how do we stem foreclosures? Government sponored enterprises (GSEs) Fannie Mae and Freddie Mac own or guaranty about $5.5 trillion of the approximately $7 trillion of rmbs outstanding. These rmbs are not nearly as vulnerable to market value declines as other rmbs, but they account for nearly 80% of all residential mortgages. Foreclosing on the mortgages underlying these rmbs would flood housing markets with inventory and push down values of homes and of rmbs that are not guarantied.
The GSEs could prevent that by modifying the mortgages in cases where homeowners could afford reduced payments. Principal amounts of underwater mortgages would have to be reduced enough to give the homeowners hope that the value of the home would exceed the amount of the mortgage before it comes due. The homeowner would then have the incentive to meet the new mortgage payments.
Although default recidivism rates on modified mortgages have been high, the data is not based on modifications where the principal amounts of the mortgages were reduced. As a result, homeowners with underwater mortgages had little incentive to meet their new payment schedules.
Modification should actually save money as the GSEs are almost certain to realize more through modification than they would through foreclosure, given the fire-sale prices in foreclosure sales.
If we succeed in stemming the tide of foreclosures, the inventory of homes for sale would shrink, home values would stabilize, rmbs values would increase, bank capital would be replenished, banks could raise private capital, mortgage financing would become more available and home buying would increase. Perhaps most importantly, this would start an economic recovery, since home purchases spur consumer spending, which is 70% of our economy. In other words, we'd finally fix the bridge's struts and not have to continually repair its concrete surface.