March 3, 2008
Foreclosures: How to save America’s family equity
By Michael S Barr and Laura D Tyson
The US economy is caught in a vicious downward spiral of declining home prices, escalating foreclosures, rising losses on mortgage-backed securities, and disappearing liquidity. The liquidity crisis has spread rapidly from the mortgage market to engulf other forms of consumer credit, commercial real estate, and municipal and corporate debt.
Alarmed by the spectre of a prolonged economic slowdown, both the Federal Reserve and the US Congress have acted aggressively to stimulate demand through monetary and fiscal levers. The US Treasury has pressed mortgage holders to restructure mortgages and suspend foreclosures on a voluntary basis. But the continuing turmoil in financial markets confirms that these actions are not enough. Restoring confidence and liquidity in credit markets requires bold action to restructure the overhang of distressed assets and contain the losses in the US housing and mortgage markets.
The scale of the challenge is sobering. Foreclosures in the US are 65 per cent higher than a year earlier. Up to two million foreclosures are anticipated within the next two years. Sharply falling home prices have put a growing number of homeowners underwater, with debt levels that exceed the value of their homes. Goldman Sachs estimates that if home prices fall another 15 per cent, about 15 million homeowners - 30 per cent of all US households with mortgages - will face negative equity in their homes.
Declining property values and escalating foreclosures wipe out family equity, the fuel behind strong consumer demand. Foreclosures drive down the values of surrounding homes. And foreclosures are bad news for investors and financial institutions holding mortgages and mortgage-backed securities.
The inability of the investor community to agree on meaningful voluntary actions to stem foreclosures attests to both the scale of the problem and to the crisis of confidence and lack of transparency impairing capital markets rife with divided ownership and conflicts of interest. The voluntary plan pushed valiantly by FDIC Chair Sheila Bair and the US Treasury has been met with foot dragging by the market.
Rather than a measured market correction warranted by the underlying quality of assets, we are on the verge of a panicked freefall in US home prices and mortgage-related assets. The time for loan-by-loan restructuring of threatened mortgages has passed. The government must create a process for the rapid and transparent re-pricing and restructuring of existing mortgages.
With colleagues at the Center for American Progress, we’ve developed the Saving America’s Family Equity (SAFE) loan plan to achieve these two objectives. SAFE is inspired by the successful Home Owner’s Loan Corporation introduced in 1933 to deal with an unprecedented wave of foreclosures in the Great Depression.
Under the SAFE loan plan, Treasury and the Federal Reserve would run auctions, in which Fannie Mae, Freddie Mac and Federal Housing Administration originators would purchase mortgages from current investors at discounts determined by the auction process. Investors would take a hit, trading a reduction in asset value and yield in exchange for liquidity and certainty. The Federal Housing Administration, Fannie Mae, and Freddie Mac would work with responsible originators to restructure the loans they acquire to stem defaults, foreclosures, and liquidations. Only loans on owner-occupied homes would be eligible for restructuring and speculators would be excluded.
Most of the refinanced loans would take the form of new fixed-rate 30-year mortgages underwritten to 80% of current home value. Backstop credit enhancements would be provided by FHA, Ginnie Mae and Treasury in return for a fee. SAFE loans would be pooled into securities and sold to private investors. Once normal conditions were restored to credit markets, the SAFE plan would automatically cease operation.
But there is nothing normal about conditions in our housing or credit markets today. That’s why we need SAFE to stem the downward spiral of foreclosures and plummeting housing prices that has undermined liquidity and confidence in global capital markets and that threatens a long, painful recession in the US and a global growth slowdown.
If the government fails to take strong action now to facilitate private sector resolution of the crisis, more aggressive government intervention will be required later. By that time, the bill for resolving the US Savings and Loan crisis of the 1980s is likely to look modest by comparison.
Michael S Barr is a professor of law at the University of Michigan Law School. Laura D Tyson is a professor at the Haas School of Business, University of California-Berkeley. Both are senior fellows at the Center for American Progress in Washington DC.
[…] In today’s Financial Times Economists’ Forum, Michael S. Barr and Laura D. Tyson present proposal to deal with the problems of the American residential housing market and the housing finance market: “Foreclosures: How to save America’s family equity”. […]
Posted by: FT.com | Willem Buiter’s Maverecon | Barr and Tyson’s SAFE loan plan: unsafe at any speed | March 3rd, 2008 at 11:12 pm | Report this commentEdward J. Dodson (guest): Reading the above proposal, I have very mixed feelings about the equity of measures that will potentially protect individuals from the risks they knowingly undertook by maximizing leverage of their household income in order to acquire the most expensive property possible - with the expectation of reselling that property within a short period at a huge gain.
My reaction is much different in those instances where homeowners or homebuyers were clearly taken advantage of by unscrupulous mortgage brokers or others involved in predatory lending practices.
The mortgage servicing industry (including the Government Sponsored Enterprises) has very sophisticated and reliable loss mitigation models that forecast which delinquent loans will be brought current and which will not. Thus, if a lender is facing insolvency because of rising nonperforming loans, the portfolio will find a buyer at some discounted price. We created the Resolution Trust Corp. back in the early 1990s to sell off the mortgage loan portfolios of failed institutions that went into receivorship. Are the authors proposing that a new RTC be created?
In the US we have yet to learn to what extent the new National Housing Trust Fund is to operate. This fund has the potential to assist homeowners who are in danger of losing their homes through no direct fault of their own (i.e., for reasons such as family illness, loss of employment due to broader economic issues, or because they fell prey to a predatory lender and/or outright fraud).
The authors of this plan join others in their concern over falling ‘housing’ values. For the overwhelming majority of homeowners, they continue to enjoy a net gain in value over what they paid for their property. For those who found themselves in need of additional funds for home improvements, college expenses for their children, or other reasons and took out second mortgage loans, the lender (and investor) set the terms and priced for the risk involved. Some portion of these borrowers are affected by rising interest rates on indexed loans. If the borrower defaults on the second mortgage loan, the first mortgagee will in most cases be paid off in the event the property goes to foreclosure. Thus, I am perplexed as to how the SAFE program would work with a maximum loan-to-value ratio of 80%. The reductions in land value that have occurred leave second mortgages effectively without collateral. The market need has been and continues to be an investor willing to refinance second mortgages (or combine existing first and second mortgages) at an affordable fixed rate of interest that permit current effective loan-to-value ratios above 100%. Current regulation and law does not permit the GSEs to do so (nor would they be likely to do so even if the regulators lifted the restrictions against doing so).
Mr Dodson retired in 2005 from Fannie Mae, where he was a senior business manager in the Housing & Community Development group based in Philadelphia, Pa. He is a graduate of Shippensburg and Temple Universities in Pennsylvania.
Posted by: Edward J. Dodson | March 4th, 2008 at 5:02 am | Report this commentMartin Wolf: I agree strongly with the concerns expressed by Willem Buiter and Mr Dodson. Is not the whole problem in the US that the government has intervened too heavily to subsidise owner-occupation, via both interest deductions from tax and government-supported, fixed-interest-rate lending? Anybody who purchases a house with debt s/he cannot service in normal times and conditions is a speculator. So the distinction the authors make between owner-occupiers and speculators is, in this case, particularly absurd.
What is really astonishing about all this is that Americans were the people who went across the world preaching the virtues of the free market - and not just preaching, imposing. And now comes a US crisis and the almost universal reaction seems to be “whatever happens, we must not let markets work their way through”. This is hypocrisy, quite apart from anything else.
Let markets clear; help make the process of clearing more efficient; preserve liquidity in financial markets; and keep aggregate demand up. This is surely what the authorities should now try to do.
Posted by: Martin Wolf | March 4th, 2008 at 11:45 am | Report this comment