Jay Rosengard Commentary: Stepping Back from the Abyss

The US housing financial system is a mess. Large numbers of loans were made that should not have been made. Through false financial alchemy, base assets were sold as golden ones. Creditors are now writing off billions of dollars of assets they thought were of high quality and millions of homeowners face foreclosure.

The worst has yet to come: the amount of subprime adjustable-rate mortgage (ARM) resets will average of $90 billion a quarter in 2008. Other homes in areas with foreclosures will probably also lose value, putting an increasing number of homeowners upside-down – saddled with mortgages worth more than the declining value of their homes. The cumulative negative wealth effect on consumption of a projected 20 percent - for $20 trillion in US housing wealth, a 10 percent would translate to a $400 billion decline in consumption.

These estimates exclude both the direct transaction costs of foreclosure, normally one-third or more of a home’s value, and the impact on the displaced family. They also ignore the credit-tightening impact that bad loans will have on banks and other holders of these mortgages. A severe recession is increasingly likely without a robust policy response aimed directly at the housing meltdown.

What is sensible public policy in such a situation? One answer is to let debtors and creditors work it out. Some creditors will lose money. Some debtors will lose their homes. Too bad, but interfering with the market creates a moral hazard that would encourage even worse problems in the future. However, due to the complexity of secondary mortgage markets, it is often not even clear who “owns” the mortgages or the assets they are financing, and this slows down attempts to take the initiative and voluntarily renegotiate loans before they are unsalvageable.

Another answer is a micro-approach, being tried by some states, to identify problem loans and provide relief on a case-by-case basis. The problem with these programs is their scale and administrative demands. In Massachusetts, a $250 million program designed to help victims of predatory loans will, at most, help 1,500 homeowners or only 1-2% of those in trouble.

With 233,000 foreclosures in January, up 57 percent over the same month one year ago, and the prospect of many more to come in the months ahead, a different approach is needed. As Treasury Secretary Paulson argued recently, a categorical rather than case-by-case approach is needed to deal with a problem of this magnitude.

What would a swift and comprehensive response to the housing finance crisis look like?

To achieve scale quickly, it would be: inclusive rather than exclusive; designated with the authority to supersede existing mortgage contracts; and reliant on loan pricing and home values rather than determination of means and motives to screen participants.

To target effectively, it would be: debtor rather than creditor initiated; restricted to owner-occupied homes; and capped on total home value.

To mitigate the risk of creating moral hazard, it would be: priced to include a penalty interest rate to exclude those with less expensive financing alternatives; designed to impose costs on imprudent creditors; and limited to a specific time period.

Working within these parameters, a potential model might look like the following. Anyone who obtained a subprime ARM in 2005-2007 to finance owner-occupied housing could go to a qualifying commercial bank or non-bank mortgage originator to refinance this loan. The size of the new mortgage would be the nominally owed debt or the current market value of the home, whichever is less. For debts greater than home values, the previous creditor would write off the difference. Very expensive homes would be excluded from this program. The new interest rate would be 100-200 basis points over the 30-year fixed mortgage rate for qualifying mortgages, now about 6 percent. The new mortgage would have a federal guarantee for 75 percent of its value. This feature would allow Fannie Mae and Freddy Mac, with their capital constraints, to buy more mortgages. This program would cease at the end of 2009.

Many who have borrowed will still not be able to afford these new mortgages. In such cases, shared equity or contingent debt upon resale mortgages could be allowed. If states wish to provide temporary assistance to borrowers to avoid foreclosure, these mortgages should make any given amount of rescue money go further.

Consider this proposal from the perspectives of borrowers, lenders, intermediaries, and the public.

Conforming debtors facing unattractive alternatives are better off. They can initiate their refinancing, and might get a write-down of the amount of the mortgage to the current value of their home. They get an interest rate considerably lower than the variable rate resets that many face and a thirty-year term. Many hundreds of thousands will be able to keep their homes that might otherwise have lost them.

Participating lenders avoid the considerable costs of foreclosure, and the collateral damage of lower home values on their other mortgage holdings. They are paid a penalty interest rate on a safer mortgage that will be liquid. While they take a “haircut” where prices have already fallen below the face value of the current mortgage, this is money that would anyway be lost in a foreclosure. With shared-equity mortgages, they might attract buyers for the remaining cases.

Intermediaries are spared the burden of processing potentially millions of individual cases and avoid clogging up the courts.

The public would also benefit . Over three-fifths of families own homes and their home values will not be depressed so much. The economy will not suffer from an extreme decline in consumption, and associated unemployment. The taxpayer will have little to complain about. The 75 percent federal guaranty from current prices gives little exposure to large claims, while the otherwise anticipated decline in the property tax base that might push local real estate tax rates up or local services down would be avoided.

Jay Rosengard is Director of the Financial Sector Program at Harvard Kennedy School.