States Steal Federal Foreclosure Funds at Their Own Peril

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The U.S. housing market is showing tentative signs of life as demand for new homes and housing prices begin to rise in some areas.

Yet pitfalls remain, including about 12 million borrowers who still owe more on their “underwater” mortgages than their homes are worth. To help some of those people, the recent $25 billion national mortgage settlement required five large banks to pay states $2.5 billion for foreclosure prevention and other housing-related efforts.

Here’s the problem: many states -- including some hardest hit by the housing bust -- are diverting more than $1 billion of that settlement money to fill budget gaps, fund public universities and even bankroll litigation against defective Chinese drywall, according to a Bloomberg Government report. In doing so, states are robbing troubled borrowers of assistance and jeopardizing their housing recoveries in the process.

The motivation is understandable: State finances haven’t fully recovered from the recession, which sapped tax receipts and prompted steep cutbacks in personnel and services. States face an estimated $68 billion gap in fiscal 2012, according to the National Association of State Budget Officers, and most of them have to balance their budgets. The housing market’s modest revival raises slender hopes that the foreclosure problem will solve itself. But robbing Peter to pay Paul may further hobble states.

General Funds

Arizona, a state with the highest foreclosure rate in the U.S. and where almost 50 percent of borrowers remain underwater in spite of rising demand for new homes, recently enacted a law that allowed it to move $50 million of its $97.8 million settlement share to the state’s general fund.

In California, where almost 30 percent of borrowers have negative equity in their homes, Governor Jerry Brown has proposed using the $410 million the state received to service its debt, along with other general-fund purposes. Florida has already put 10 percent of its $334 million payment into its general fund. Louisiana is directing almost $1 million of its $21.7 million share for costs associated with the Chinese drywall litigation, and Missouri will use its $40 million to reinstate funding for state universities.

States are able to do this because of loose language in the mortgage settlement, which said funds should be used for foreclosure prevention “to the extent practicable.” U.S. officials say such language is standard in settlement agreements. Housing and Urban Development Secretary Shaun Donovan has asked officials in Arizona and other states to reconsider diverting funds.

States should pay heed. The mortgage settlement provided other housing relief, including payments to certain borrowers who lost their homes, debt forgiveness and refinancing. But the direct payments are a critical piece of the agreement and came at a cost: Attorneys general from 49 states and the District of Columbia released most claims on the banks in exchange for the settlement, meaning there’s no going back to the kitty.

More important, the money can actually help prevent foreclosures, which hurt everyone. Vacant homes languish, driving down the value of neighboring real estate and putting more homeowners at risk of losing their properties. Local finances are also crimped as sales and property taxes suffer. Property taxes, which finance schools and are rarely lowered, are rising much slower than in the past. Such revenue, which increased 19 percent from 2005 to 2008, has climbed just 8 percent since then and declined slightly from 2011 to 2012 if inflation is taken into account, according to Bureau of Economic Analysis data.

Constructive Help

Research shows that the simple types of assistance this money is intended to finance, such as counseling, have a big payback. A recent study by the Department of Housing and Urban Development found that, with a counselor’s help, 69 percent of distressed borrowers were able to modify their mortgages, and 84 percent of those individuals were able to stay in their homes. Most of the 824 homeowners surveyed said they had tried to contact their lender after falling behind in payments but were unsuccessful in negotiating better terms, suggesting that counseling does bear fruit.

The housing crisis has wiped out $7 trillion in household wealth since 2006. It will be a steep climb back for a nation whose past recoveries have been powered by real estate. The mortgage settlement, while not a panacea, offers a chance for states to help repair some of the damage and prevent additional pain. Using the money for anything other than housing-related efforts won’t solve the governors’ fiscal shortfalls. It will set back a sector’s recovery and hurt the states’ economies along the way.

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