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For Whom the Bell Tolls: Making the Best Choice for Borrowers in a Bad Situation

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This week, the housing news has been dismal: record low sales, talk of a double dip in values, and growing foreclosures. Meanwhile, the help that many homeowners hoped would come from government programs has not materialized. Instead, ever changing and complicated programs without teeth seem designed to prop up the industry rather than truly assist homeowners. Not surprisingly, many borrowers are coming to the realization that their options are limited. While some savvy borrowers are defaulting for purely 'strategic' motivations (meaning they have reasonable means to continue to pay but choose not to), for many others, the decision is not so clear cut, especially when they face an extended period of owing more than their home is worth with little economic relief in sight. Despite efforts by industry and elected officials to discourage it, more and more borrowers may choose to exercise their option to default. Why?

First of all, defaulting on a mortgage is completely legal. There is an implicit option in all mortgage contracts that allows borrowers to give the house back to lenders in exchange for extinguishing the mortgage obligation. The value of this option is a function of the outstanding debt, the value of the home and the costs associated with default. Lenders price this option when they originate the loan expecting that a small number of borrowers will default. Unfortunately, bad lending decisions leading to and combined with steep drops in house values have made this option rational for many more borrowers. Instead of owning up to their mistake, financial companies and government programs have promoted loan modifications so that borrowers can continue to make payments, even if such action may cause more harm than good to many of them in the long run.

It is not difficult to see why default is the best option for many borrowers. According to the National Association of Realtors, a single-family house typically sold for around $220,000 between 2005 and 2007. Even assuming a very conservative 20% down payment and the ability to refinance at the favorable 5.0% interest rate currently going for conventional, conforming, fixed-rate mortgages, mortgage payments would still come to $945 a month, or 36% higher than the current median asking rent reported by the U.S. Census Bureau. That is, borrowers who continue to make mortgage payments spend about $3,000 more a year than if they chose to rent instead.

Analysts at J.P. Morgan Securities estimate that if house prices remain flat, 13 million borrowers currently have an incentive to walk away from their mortgage. Even if housing prices appreciate by 3% for the next five years, the number would still be 6.5 million borrowers. Meaning that, for several years, millions of homeowners will pay thousands of dollars a year above the cost of housing just to meet their obligation to the bank. All together, this amounts to nearly $100 billion of wealth flowing away from communities to line the pockets of Wall Street. Most rental properties are owned by individuals or partnerships. The Property Owners and Managers Survey found that a quarter of landlords live on the rental premises. Rent payment to them is cash that supports local businesses. Even the mortgage payments made by those landlords typically go to local banks, where they can be recycled into the community. By contrast, residential mortgages are more likely to be held by large financial companies and investors all over the world.

Everyone debates the causes of the crisis. Was it irresponsible borrowers? Deceitful lenders? Greedy financiers? Lenient regulators? Regardless, the financial burden seems to have fallen heavily on borrowers and taxpayers. From day one, Wall Street has made money from these mortgages. The loans were highly profitable during the boom years; then, when they started to default in large numbers, Congress authorized $700 billion under the Temporary Asset Relief Program to purchase the loans, supposedly at market value. But the Congressional Oversight Panel found Treasury paid $254 billion for assets actually worth just $176 billion, a 44% mark-up. Imagine how many underwater homeowners could be put right with that kind of deal.

What has Wall Street done with this heads-I-win-tails-you-lose arrangement? Paid itself handsomely. In 2009, at the depth of the crisis when one in six Americans were out of work, domestic financial industries raked in $242 billion in profits and Wall Street paid $145 billion in bonuses, all benefits and other compensation. The result is an exacerbation of wealth and income inequality. Nearly 34% of new worth is currently held by the top one percent.

Moreover, the explosion of sub-prime lending was an expansion of credit particularly to low-income households, although it was certainly not limited to them. While most subprime loans went to whites and higher-income borrowers, the housing bust has disproportionately affected those least able to weather the storm. In 14 of the 16 metro areas that the S&P Case-Shiller House Price Index breaks out homes by value, the lower tier of homes experienced greater price appreciation than the higher tier between 2002 and 2006; and in 15 of those metro areas, the lower tier experienced greater price declines between 2006 and 2010. For example, the peak-to-trough decline in house price in Los Angeles was 30% for higher-valued homes but 56% for lower-valued ones.

Given that low-income borrowers are more likely to own lower-valued homes and are also more likely to have higher loan-to-value ratios to begin with, these borrowers who already paying the higher interest rates associated with subprime loans are also more likely to be underwater. By some estimates, home equity accounts for 60-80 percent of household wealth among low-income borrowers and/or minority households. In the presence of negative equity and the fact that sustainable appreciation occurs very gradually, these households are likely to feel the aftermath of the crisis especially hard for years to come. Continuing mortgage payments on a loan that has no relationship to the value of the underlying house is likely to deplete even more the precious financial resources of low income/low wealth borrowers.

Unfortunately, this depletion of resources exacerbates an already unfortunate trend. For decades, policy has encouraged consumer spending when most of the gains in economic growth went to those with the highest income among us. According to Robert Reich, America's median wage, adjusted for inflation, has barely changed for decades and between 2000 and 2007 it actually dropped. For most Americans, the only way to consume and keep up with ever higher prices was to acquire debt, mostly by using the homes as ATMs, i.e., taking large amounts of equity out of the property through often lender-promoted refinance or junior lien borrowing.

From a policy perspective, such promotion of consumption was not a savings or asset-building-friendly policy. Neither are federally supported policies leading to modifications of mortgage loans that increase the loan balances when there is little hope of financial gains in any foreseeable future. Longer term, this policy-induced neglect of asset building is likely to worsen the so-called "retirement crisis" at a time when policy makers are trying to figure out what to do about it. Policy makers fear the collapse of the Social Security system when an unprecedented number of baby boomers retire and they encourage Americans to rely on household savings, invested over time, and home equity. Promoting additional mortgage payments when they make no financial sense works against such efforts. Isn't the left hand aware of what the right hand is doing?

We know from our work that the vast majority of mortgage borrowers take their responsibilities seriously, even if underwater. This is especially true of modest-wealth households that will go to extreme sacrifices to continue to make mortgage payments. They will exhaust their savings, max out their credit cards, try to get a second or third job, and tap or deplete children's college and their own retirement funds. For example, we know that in 2009, 18% of Americans 45 years or older, including 22% of Hispanics and 26% of African Americans, withdrew funds prematurely from their retirement accounts, already depleted by the financial crisis, to continue making mortgage payments. Unfortunately, we also know that there is a high probability that despite these sacrifices, borrowers are likely to lose their home anyway, and almost certainly experience long-term financial ruin.

Isn't there a better way to solve the problem? Until 1993, judges were allowed to "cram down" mortgage debt on primary residences as part of Chapter 13 bankruptcy. The mortgage amount could be reduced to the value of the property with the remaining amount treated as unsecured debt. The concept of allowing bankruptcy judges to modify the mortgage debt owed on primary residences as they can on other debt, including properties owned for investment (or speculative) purposes, had been considered by Congress and the Obama administration, but was ultimately rejected due to industry complaints. The Mortgage Bankers Association and others claimed that the uncertainty of the legal process would result in greater lending costs and restricted access to credit. But a recent report by the Cleveland Federal Reserve found a similar process introduced in the wake of the 1980s farm crisis had only a minor effect on the cost and availability of credit to farmers. In fact, the threat of legal proceedings prompted lenders to seek private modification settlements. Such a stick might induce more loan modifications with principal reductions than the carrot of HAMP has been able to accomplish. The latest Office of the Comptroller/Office of Thrift Supervision Mortgage Metrics report reveals that just 0.1% -- that is, one tenth of one percent -- of HAMP loan modifications and 1.9% of all modifications in the first quarter of 2010 involved principal reduction.

Without principal reduction, what options are left for underwater borrowers? Unfortunately, the widely touted solution of improving a borrower's financial literacy is likely to be considered counterproductive by some. That is because many underwater borrowers who become better informed about financial issues will soon realize their best choice is to exercise the default option already written in their mortgage contracts.

Concern about such a realization is probably what is prompting industry and public officials to play the "morality" card. They say that these borrowers have not only a financial obligation but also a moral obligation to repay their mortgage instead of walking away. John Courson, chief executive of the Mortgage Bankers Association, asks "What about the message they will send to their family and their kids and their friends?" I would ask what kind of message borrowers send their children when their own retirement savings and savings for their children's futures are poured down the drain to support a financial crisis that has already added billions, perhaps trillions, of dollars to the tab of the next generation to pay for the excesses of the private mortgage market? With no realistic prospects of gain, many underwater borrowers who continue making payments are really only transferring wealth -- theirs and their children's -- to Wall Street. Now, that is immoral and comes at a terribly high social cost.

In the absence of any real solution to fundamentally address this problem, any policy initiative that continues to put the well being of Wall Street and the lending industry ahead of the ability of many Americans and their children to build wealth should fail in the long run. That failure is a price none of us should be willing to pay.