U.S. homeowners don’t need another reduction in their mortgage payments. What they need is a break on their debts.
As President Barack Obama prepares to present his job- creation plans to Congress this week, his advisers are studying what some economists have called a “slam-dunk stimulus.” The idea: Push mortgage giants Fannie Mae and Freddie Mac to refinance the loans of millions of homeowners who otherwise wouldn’t qualify because they owe more than their houses are worth.
With mortgage rates at extreme lows, such a move could free up billions of dollars in spending money. Also, by focusing on borrowers who are current on their payments, it would reward people who have acted responsibly -- as opposed to previous mortgage-modification programs, which have been limited mainly to defaulters.
Attractive as it sounds, the slam dunk would in some ways miss the hoop. For one thing, the potential boost would be pretty small in the context of the $15 trillion U.S. economy. Economists at Goldman Sachs estimate that it would provide U.S. consumers with an added $20 billion to $40 billion, enough to increase annual economic growth by only 0.1 to 0.3 percentage point. Beyond that, the sudden demand for new mortgages could actually defeat its own purpose by prompting banks to push rates back up again.
Most importantly, the idea ignores a defining feature of the current economic slump: Responsible people who are still deep in debt don’t go out and spend. If their mortgage obligations exceed the value of their homes and they don’t want to walk away, they’re stuck. They can’t easily sell, they can’t move to take a new job, they can’t borrow money to start or expand a business. Working their way out of the hole takes a long time, which is one reason recoveries after debt crises tend to be so slow.
In an ideal world, the market would sort things out quickly and efficiently. Houses would pass into the hands of those who could afford them at prices the market would bear, lenders would take their losses, and the cycle would start anew. That’s not happening. Mortgage servicing companies are taking years to complete the foreclosure process, providing free housing to defaulters while eroding incentives to maintain homes in good condition. By the time banks get around to selling the houses to new owners, there may not be much left to sell.
A better strategy -- one that would truly be in the best interests of lenders and mortgage investors -- would be to avert foreclosures by writing down the principal on loans. Consider, for example, a $100,000 loan on a house that’s now worth $60,000. A 50 percent writedown, assuming it made the loan affordable to the borrower, would leave the lender with an asset worth $50,000 and a homeowner motivated to invest time and effort in increasing the house’s value.
That’s a lot more than the lender would probably recover by ultimately selling the house after years of foreclosure costs and further depreciation. As of August, recoveries on defaulted loans made in 2006 and 2007 without government guarantees averaged 34 percent of the original balance, and were headed down, according to data compiled by Amherst Securities Group LP.
If done on a grand scale, principal reductions would go a long way toward eliminating the debt burden that is hindering the recovery. To give a sense of magnitude, some 13.3 million U.S. mortgage borrowers owe almost as much as or more than their homes are worth, according to data provider CoreLogic. Writedowns for all of them could cut the country’s ratio of household debt to disposable income from the current 115 percent to a more sustainable 100 percent.
Crucially, the debt relief would come at minimal added cost to the U.S. taxpayer. Banks, including Fannie Mae and Freddie Mac, might require further bailouts right away, but those would probably be more expensive if put off longer. To give taxpayers some benefit and reduce any incentive for borrowers to abuse the program, the government could levy a tax on price gains enjoyed by homeowners who receive principal relief.
With Congress, the Obama administration has the power to make principal reductions happen. New legislation could transfer the responsibility for modifying loans from servicers to new entities with an interest in maximizing value. John Geanakoplos, a Yale economist and a partner at the mortgage-focused hedge fund Ellington Management Group, has estimated that it would cost only $3 billion to $5 billion over three years to hire community bankers to vet loans for principal reductions.
The solution wouldn’t be entirely fair. It wouldn’t help people who were careful not to borrow more than they could afford, and so avoided getting caught up in the housing boom. But those people, too, stand to gain if their neighbors keep up their houses and the economy improves, and will be worse off if millions of their fellow Americans remain in a 21st-century version of debtor’s prison.
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