Co-written with Marc Gilmore
The Federal Housing Finance Agency's recent announcement that it would bar Fannie Mae and Freddie Mac from reducing principal for borrowers at risk of foreclosure has brought attention to an almost certain means to fix an economy that over the past few years has taken halting, unsteady steps towards recovery. Distinct signs of progress have been observed in several areas. Manufacturing productivity has increased, hiring has picked up, and the unemployment rate has fallen from more than 10 percent to roughly 8 percent. Despite these signs of progress, though, there is one prominent segment that continues to undermine the economic recovery: the housing market. The problems in the housing market will continue to impose a serious drag on the economic recovery until that market is stabilized.
The failure to prevent the millions of troubled mortgages from becoming delinquent and being foreclosed causes damage not only to individual borrowers who lose their homes, but also to their communities and to the economy as a whole. When borrowers default on their mortgages and are not provided effective modifications, their homes are eventually sold through short sales or foreclosure sales at substantial losses to the lenders and investors who funded the purchase of the home. For the past two years, those distressed property sales have comprised 30 percent of all home sales, on average, and have sold at an average discount of 30 percent less than the contemporary market value of non-distressed properties. Because they sell for so much less than other properties, those distressed properties drive down the values of the other homes in their neighborhoods, across their community, and throughout their metropolitan areas. These are the headwinds that continue to hold the housing market back.
The depressive effect that distressed property sales have on home values extend beyond the housing markets, though, and affects the larger economy. In the first instance, the lenders and investors who enabled borrowers to finance their home purchases lose significant percentages of the monies lent when homes are sold through distressed property sales. The 30 percent distressed sale discount, when combined with the 35 percent decline in the housing market, means that those investors and lenders lose as much as 50 percent of the funds they had lent. Those losses undermine lenders' and investors' ability to make new investments today, such as loans to small businesses or for new home purchases. But the effects of distressed property sales also affect other homeowners directly, through a phenomenon that economists call the negative wealth effect. In short, as the value of homes fall, homeowners feel less financially secure, and as a consequence they spend less than they otherwise would, which means that the economy does not grow and recover as fast as it otherwise would. That lack of robust growth prevents companies from hiring more personnel, keeping unemployment inflated. Thus, the problems in the housing market are holding back the economic recovery overall.
By preventing the massive wave of foreclosures and short sales through effective modifications, the government and banks can help not only struggling homeowners, but can also bolster the economic recovery for the entire country. Moreover, if the modifications are implemented in a carefully balanced manner, it is possible to avoid the moral hazard problems that have undermined other programs, such as giving some borrowers a windfall or arbitrarily excluding other borrowers from receiving assistance. If a balanced solution can be found, then the modification process would be fair to all borrowers, and could also avoid penalizing borrowers who have remained current on their mortgages. It could also avoid using taxpayer money for modifications.
With respect to the idea of finding a proper balance for implementing mortgage modifications, this is really no different from issuing a mortgage in the first place. All mortgages inherently contain some risk that the borrower will default, and provide for a positive return on the investment to the lender to compensate for that risk. The greater the risk of the mortgage defaulting, the greater the interest rate that the lenders charge. Viewed in this perspective, it is apparent that the act of modifying a troubled mortgage should really involve nothing more than re-balancing the structure of the mortgage to reflect the reality that the mortgage was much riskier than was realized when the mortgage was first issued. Had the lenders properly estimated the risk, they would have lent less money and would have charged higher interest. From this perspective, it is evident that the best means of modifying troubled mortgages is by using principal reductions and requiring that borrowers share future equity. Such a principal reduction and equity sharing modification requires that borrowers continue to be responsible for their own mortgages, and that the risks and benefits of the mortgage modifications remain between the banks and borrowers and do not affect other taxpayers.
As an example, consider how such a modification strategy could be used to help a homeowner in a severely depreciated housing market like Phoenix. As a hypothetical, consider a homeowner who bought a home in Phoenix for $400,000 in October, 2006, borrowing the full purchase price at 6 percent interest. Because the home was purchased during the housing bubble, the borrower overpaid for the property, in this case by 64 percent. Nevertheless, assume that the borrower managed to make the mortgage payments for several years, until the end of 2011, when the borrower simply could not make the payments any more. At that time, the Phoenix housing market had fallen 56 percent from its peak values, and 55 percent since the borrower purchased the home. To salvage the loan from foreclosure, the bank could agree to a modification with the borrower where the bank would reduce the principal balance and require that the borrower later share some percentage of the property's value in proportion to the assistance provided. To correct for the overpayment problem, the bank would reduce the principal balance by $144,450.59, enabling the borrower to make much more affordable payments of $1466.16 per month, as opposed to the higher payments of $2398.20 per month based on the inflated purchase price. In exchange for writing down such a large portion of the principal balance, the bank would receive a commitment from the borrower to share 38.86 percent of the property's value when eventually sold. While that might seem excessive, that is precisely the percent by which the borrower's monthly payment was reduced by the modification. By structuring the principal reduction and the equity-sharing components to be proportional, the modification is eminently fair to the parties involved, and does not require any support from taxpayer money.
Not only do such modifications prevent the severe losses and negative effects to the economy, but they also provide several ancillary benefits. First, this type of modification strategy can eliminate much of the bureaucratic red tape currently required to qualify borrowers for modifications. Because borrowers will be required to repay any assistance granted -- and because the amount to be repaid will be safely locked up as equity in the house, guarded by a lien -- there is no need to perform cumbersome manual evaluations of borrower financial positions to determine if borrowers truly deserve a modification. It also eliminates the need to have separate programs for borrowers who are delinquent as opposed to those who are still current but need a modification. In addition to facilitating review and modification processes, though, such a modification strategy will also produce direct benefits to the economy. By reducing borrowers' monthly mortgage payments, such modifications enable borrowers to spend more of their money in other areas of the economy, which helps to spur additional real economic growth, which will result in a faster and more robust recovery for the whole country and which, in the end, is likely also to have a beneficial effect on home prices in the future. Thus, balanced and proportionate modifications represent a win-win situation for everyone.
Mr. Gilmore is an attorney and financial analyst who has advocated the adoption of principal reduction modification strategies since 2008.
Admiral Sestak submitted similar legislation in 2009 as an U.S. congressman and vice-chairman of the Small Business Committee.
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