By Rebel A. Cole
The financial crisis has thrown the US economy into a deep and lingering recession. Most analysts agree that delinquent mortgages are at the heart of the crisis, and that opaque mortgage-related securities have spread their toxicity to other sectors of the credit markets.
What is needed is a programme that strikes at the heart of the problem of delinquent residential mortgages. One such scheme would attack this problem by using the second half of the US government’s $700bn Troubled Asset Relief Programme funding to subsidise the write-down and refinancing of these mortgages.
The programme would require all financial institutions that issue residential mortgages and receive TARP funding to refinance delinquent mortgages owed by borrowers who meet specified financial criteria based upon standard Federal Housing Authority debt ratios. These indicate whether borrowers have enough monthly income to pay their debts, including mortgages.
The new mortgages would be based upon a reduced principal, where the reduction is sufficient to bring the borrower down to a specified debt-to-income ratio. This principal reduction would help to ensure that the borrower could meet his new mortgage obligation; previous programmes that relied upon longer maturities and reduced interest rates without principal reduction have largely failed.
The difference in the principal values of the new and old mortgages would be reimbursed to the lender issuing the new mortgage from TARP funds; this reimbursement is necessary to provide the new lender with sufficient funds to prepay the existing mortgage.
To address moral hazard, mortgage holders who meet existing FHA debt-to-income guidelines and have sufficient income to pay their current mortgages would be ineligible for this programme, regardless of the market value of the home. To address the concerns about allowing borrowers who overextended themselves to purchase homes they could not afford, those borrowers would be required to split with the government any gains on eventual sale of their homes in excess of the new mortgage balance.
Currently, there are about five million delinquent mortgages with average outstanding balances of less than $200,000. If each of these is refinanced with an average principal write-down of 25 per cent, or $50,000, per mortgage, then the outlay for this programme would be $250bn. While this is a very large amount, it appears modest when compared with the $700bn TARP, the $900bn stimulus proposal and the more than $1tn expansion of the Federal Reserve’s balance sheet since September 2008.
What does this programme accomplish? First, it stems the tide of foreclosures, which puts a floor on the housing market, and enables almost five million families to avoid eviction. It also is important to note that the programme provides relief very quickly-the scheme could be fully implemented within the current fiscal year, if not sooner, providing a huge stimulus to economy this year and reducing the need for the proposed $900bn stimulus package.
Second, to the extent that these delinquent mortgages are held in the portfolios of depository institutions, this programme provides a direct injection of capital by removing these delinquent assets from their balance sheets. This benefits the financial health of these institutions and frees scarce equity capital that can then support new lending.
Assuming that only half of the proposed funding goes to depository institutions, $125bn in equity capital would be unencumbered, which could then support up to $1.25tn in new lending by these depository institutions.
Third, and, perhaps more importantly, the programme “cleanses” the mortgage-related securities of these delinquent mortgages with face value of approximately $1tn. This aspect of the programme deals with what are, perhaps, the two most vexing problem facing policymakers.
The first problem is how to “price” toxic assets: while pricing thousands of tranches of mortgage-related securities is incredibly difficult, pricing millions of individual residential mortgages is incredibly easy.
The second problem is how to identify and entice the investors who hold these securities to allow mortgage servicers to renegotiate delinquent mortgages on their behalf. Because of their fear of investor lawsuits, loan servicers have refused to make wholesale modifications to existing delinquent mortgages, effectively eliminating this policy option from the table. This programme eliminates this problem by prepaying delinquent mortgages-prepayments simply flow through to the mortgage-backed securities, requiring no action on the behalf of investors or servicers.
Rebel A. Cole is a former staff economist for the Federal Reserve Board of Governors and the Federal Home Loan Bank Board, and currently teaches real estate and finance at DePaul University in Chicago. He is the author of articles published in top academic journals covering banking, finance and real estate.
For a more detailed version of Prof Cole’s housing plan, click here:
