The Risk from Underwater Homeowners

The Obama Administration's $75 billion homeowner-rescue plan offers a lot of help to people in imminent danger of losing their homes. It does far less for those who are deep underwater on their mortgages but have the wherewithal to keep making their monthly payments. And that could be a problem—not only for those homeowners themselves, but for the banking system and the economy in general.

Here's the dilemma: Many homeowners owe more on their mortgages than their homes are worth, and—rightly or wrongly—increasing numbers of them may decide to give up and mail in the keys. The taboo against reneging on debts already shows signs of fading in hard-hit markets like Phoenix and Las Vegas. More abandonments would increase losses for lenders while damaging the vitality of neighborhoods.

There's not much in the Homeowner Affordability and Stability Plan announced on Feb. 18 to deal with this looming problem. Provisions to reduce monthly loan payments for homeowners who are struggling don't prevent these so-called "voluntary foreclosures," since in many cases the payments already are affordable. The most effective way to keep underwater homeowners from walking away en masse would be a big writedown of the principal they owe. That would give them positive equity in their homes—or at least the hope for it once prices begin creeping upward again—and with it, a reason to stay put. Although the Obama plan permits principal writedowns—and even pays off up to $5,000 of principal for homeowners who remain current on their payments—they aren't required, or even central to the proposal.

Temptation to Walk Away

Writing down mortgage debt on houses that are underwater could total $1 trillion or more. The value of underwater homes could be as much as $700 billion below the mortgage values, according to financial analysts and informal government estimates. Keep in mind, though, that this is not an actual expense because no dollars would change hands: The debt holders would simply be bringing their valuations in line with the reality that many of the loans are destined to be defaulted on. And banks would recoup even less if the homes are allowed to go into foreclosure unnecessarily than they would have in a writedown, because the owners will stop paying entirely. What's more, vacant houses are subject to vandalism that further erodes their value, and foreclosures drag down the value of neighboring properties.

For some of the roughly 10 million underwater homeowners, especially those with spotty credit records, the temptation is great to walk away. "It's just common sense," says Yale University economist John Geanakoplos. He takes pains to say he's not defending the behavior, but adds, "If your house is worth much less than the loan, you're pretty sure you'll never really own it. You'll just go rent somewhere. The only bad thing is the mark on your credit rating, which for these people wasn't too good in the first place."

Even for those who want to keep their homes at the moment, reducing monthly payments without addressing negative equity may just postpone the inevitable. "The reality is, people lose jobs, especially in a recession. People get transferred, people have to move at some point," says Sean O'Toole, founder and CEO of, which tracks California foreclosures. "By lowering payments and not principal balance, you're guaranteeing the extension of this crisis for years to come."

Why Default Rates Skyrocket

How big is the risk that many more Americans will give up and walk away from their homes, figuring that paying the mortgage every month is throwing good money after bad? A widely cited study by the Federal Reserve Bank of Boston found, seemingly reassuringly, that only about 6% of people who were underwater on their mortgages in the 1991 regional housing slump eventually faced foreclosure.

But Yale's Geanakoplos says the danger is much greater this time. Housing prices have fallen more, and many more of the loans were made to people with bad credit. His research using more recent data finds that default rates skyrocket when subprime or option adjustable-rate mortgage borrowers owe more than their houses are worth. The default rate is about nine times as high for people who are way underwater as for people with substantial equity in their homes, all else equal, Geanakoplos found.

Lowering the amount that people owe on their homes would obviously help the homeowners. What's surprising is that it might even benefit the people who bought their loans, bundled into mortgage-backed securities. How could that be? Because the values of those securities have already plunged—in some cases to as little as 25¢ per dollar of face value—in the expectation of massive foreclosures. If big writedowns managed to keep more people in their homes, it could actually enhance the value of those mortgage-backed securities.

Lawsuits Are an Obstacle

There is one potential obstacle to big principal adjustments that the Obama plan doesn't address: litigation over writedowns by investors who bought stakes in the vast number of mortgages that have been securitized. A minority of the "pooling and servicing" agreements governing securitized loans explicitly restrict modifications. Even in cases where modifications aren't banned, servicers say they worry about getting sued anyway for abrogating unwritten responsibilities to investors.

Indeed, on Dec. 1, William Frey, a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court alleging that the proposed modification of some 400,000 home loans originally underwritten by the defunct lender Countrywide Financial is illegal.

Many in the industry expected the Administration's proposal to include a "safe harbor" protecting servicers against lawsuits where loan modifications benefit investors as a whole more than foreclosure would. But while Congress is contemplating such protections, the Obama plan doesn't—and one Democratic Senate aide says Administration officials have been distinctly cool to the idea.

A Missed Opportunity

Is there an argument against massive writedowns of principal for underwater homeowners? Sure: It rewards the person who put no money down, and it does nothing for the next-door neighbor who put 20% or 30% down and still has equity. "I don't think you're going to find any sympathy for that," says Guy Cecala, publisher of Inside Mortgage Finance, an industry newsletter. Trouble is, trying to treat those two neighbors equally could have unintended harmful consequences for the neighborhood if the family that's underwater simply walks away.

Ultimately, strong resistance to principal writedowns in the industry—whether from legal concerns, because banks can’t absorb the paper losses, or because it sets a worrisome precedent for other borrowers—means implementing such a program would involve "a major time delay," a senior Administration official says. "If you’re going to try to prevent the foreclosures now, you can’t go that way."

The Obama Administration missed another opportunity to help underwater homeowners when it limited the assistance it is offering homeowners who are current on their mortgage payments. In a step in the right direction, the Obama plan allows Fannie Mae (FNM) and Freddie Mac (FRE) to finance new, more affordable mortgages even if homeowners owe more than the current standard of 75% to 80% of their home's current value. But for unexplained reasons, there's a cap on eligibility. Fannie and Freddie still won't be allowed to help with refinancings if the loan-to-value ratio exceeds 105% (e.g., the loan is $210,000 and the house is worth $200,000).

Putting a cap on eligibility for refis cuts out many of the people who most need a break and doesn't appear to make any sense from the government's viewpoint either, says Christopher Mayer, a Columbia University economist who has helped devise homeowner-rescue plans. Throwing open eligibility for cheaper loans to anyone who currently has a loan owned or guaranteed by Fannie and Freddie would lower default rates and thus the ultimate cost to the agencies and taxpayers, says Mayer. He adds, "I don't understand why they did this."

Coasts Hit the Worst

Moreover, "private-label" mortgages that lack Fannie or Freddie's backing—particularly in California and the Northeast, where home prices are higher and subprime mortgages more common—aren't eligible for Fannie and Freddie refis at all. "Where the markets have been hardest hit on the coasts, where private mortgages are the biggest, this program won't really help," says a fixed-income portfolio manager for a major mutual-fund management firm.

The senior Administration official said the 105% cap seemed advisable in part because re-default rates tend to rise with high loan-to-value ratios. And the government excluded private-label loans from the refinancing program because it little or no authority to dictate rate changes where government-affiliated entities don’t provide guarantees.

Obama's plan is broader and stronger than Hope for Homeowners, the unwieldy, mostly voluntary program passed by Congress last summer. On the other hand, that's not saying a lot. Hope for Homeowners has refinanced a microscopic 25 mortgage loans so far. Even a thousandfold improvement over that would still constitute failure for the Obama Administration. That's why this plan may require some changes in the months ahead.

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