Fixing the foreclosure crisis

Photo: Philip Brewer

Because homeowners are also voters, and because the subprime lending crisis threatens the whole economy, the federal government is trying to come up with ways to head off a massive foreclosure crisis. Last week the treasury secretary was meeting with lenders, trying to negotiate a change in the rules.

As I described yesterday, structured loan products have changed the incentives for banks, so that it is often more profitable for them to foreclose on a loan than to workout an alternative payment schedule--even when rescheduling the loan would bring in more money than a foreclosure--because people who got the loan payments were anonymous investors, while the bank got the same fee whether it did a cheap by-the-book foreclosure or put time and effort into arranging restructurings one by one.

The best solution would be to restore those incentives: change the rules so that trusts can renegotiate loans, change the rules so that the banks have an incentive to get the best return, change the rules so that the people who do the work of renegotiating get paid for that work. Some of those things may happen, but some of the changes are not popular, and all of them are hard to arrange after the fact.

Because the nature of piecemeal fixes make them hard to mandate, the government is trying to come up with some sort of "big fix" to make the problem go away. One thing they're thinking about doing is extending low teaser rates.

Treasury Secretary Henry Paulson has been trying to negotiate an agreement to not have adjustable mortgages reset to higher rates. There are many different proposals regarding how long the resets would be held off (three years and seven years have both been mentioned) and no clear rules yet on who would qualify for the freeze.

This is a pretty bad solution.

The details are still being worked out, but it seems to be targeted at people who kept their loan up-to-date until the rates reset, and then started having trouble.

This sort of strategy creates problems of fairness--does the family where the parents took their kids out of private school and both got second jobs so they could stay current on their mortgage get no relief, because they've managed to scrape together each payment so far? How about a family that refinanced their mortgage to pay off credit cards, then maxed out their credit cards again? Does it make a difference if they maxed out the credit cards to pay for medical treatments after an accident?

It also creates problems of free riders--if missing a mortgage payment could cut your rate in half for five years, it'd be awfully tempting to find a way to miss that payment.

It's also bad for lenders whose profits depend on the rates adjusting. Even though it's tempting to stick it to companies stupid enough to use low teaser rates to trick people into taking out loans they can't afford to pay back, it's still bad public policy to change the rules like this. And, of course, the people who lose are the shareholders of those lenders--which includes ordinary people and their pension funds.

Finally, it's not at all clear that any of this would be legal. As I mentioned yesterday, the trust documents that created these packages of loans often don't allow the managers to change the terms. As far as I can tell, the treasury secretary isn't making any effort to get congress to write a law that allows for teaser rates to be frozen, and I don't know of any power inherent in the treasury to allow the secretary to do so. It seems like they're talking about just doing it, and hoping that if everyone does it, nobody will sue. It's a nice theory, but in my experience, things don't work like that in the United States.

At the same time, the Federal Reserve has been signaling (in speeches by both Vice Chairman Kohn and Chairman Bernanke) that a further rate cut can be expected in December. That may help around the edges. Lower rates would reduce the amount that adjustable mortgages would adjust. It also makes it cheaper for lenders to raise funds, which means less of a profit squeeze if they do end up freezing low teaser rates.

Of course, the Fed being too aggressive in lowering rates and too timid in raising them again was the biggest single factor in getting us into this mess, so it's hard to feel all warm and fuzzy about them doing it again.

If you've actually got a mortgage that's in danger of foreclosure, the real news here is that the federal government is leaning on lenders to do what they can to keep you in your house. If you're living in a house that you can't afford, it's probably a mistake the keep throwing money into house that you'll eventually lose anyway. On the other hand, if you like your house, and if you could afford it if the rate weren't so high, keeping it may be more of an option now than it was a few months ago. The treasury is pushing a program called HOPE NOW that's trying to educate people to try to workout the loan problems. If you're in danger of foreclosure, check it out.

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Guest's picture

How about letting persons who are in danger of foreclosure take money out of their 401k's or other retirement plans without penalty and tax consequences and apply this to their mortgage?

Guest's picture

This solution would erase any vestiges of moral hazard. I've been scrimping, saving, and doing without so I can someday afford a home, and a bailout isn't fair to people like me who resisted the urge to get in on the housing frenzy and financially cripple ourselves. I find it hard to believe that everyone who signed an ARM did so because of predatory lending practices. Most did so out of pure greed, thinking that the loan terms wouldn't matter since the home would be sold for twice the purchase price once the rate reset came. Now that home prices are dropping, the people who paid ridiculous prices using creative mortgages are crying foul. Giving in to their demands removes the consequences from stupid actions, and to not punish greed when it backfires only makes it more likely that stupid behavior will continue.

Guest's picture

For those who shed tears for the poor homeowners, remember there are two (2) sides to this equation. The mortgages were bundled up and sliced and diced then sold as securities. Who bought all these wonderful securities (laughable called Structured Interest Vehicles)? Your pension fund, your local bank, your credit union, your insurance company, your granny & grandpa, and so on. So allowing people to renege on their pledge to pay will hurt others.

Not to mention those smart enough to wait on buying a home.

Philip Brewer's picture

As an apartment dweller myself--and one who would like to own a house--I'm totally down with the fairness issue of having everyone else subsidize people who bought houses they couldn't afford.

I'd support changes that removed roadblocks to renegotiating mortgages, as I described in my previous article, They used to call it "loan workout". I'm much more dubious about the sort of big-gesture quick fix that the treasury is trying to arrange.

Guest's picture
Steve W

Those who gambled that they could flip or refinance their mortgages and that market/credit conditions wouldn't drop, have just learned a painful lesson -- don't gamble what you can't afford to lose.

Why don't we just subsidize all failed gamblers -- From the horse track to Vegas to the Lotto?

Guest's picture

The prospect of the government undermining contract law and changing it after the fact should be horrifying to anyone who understands how commerce works. The borrowers and lenders both aught to have been aware of the bankruptcy and foreclosure laws.

The people who foolishly moved into houses they could not afford should put the keys in the mail box and walk away. If they instead restructure their loans to an amount that takes every free penny they will make for twenty or thirty years, they become slaves to the bankers. If the government is to get involved, it should change the personal bankruptcy laws back to what they were a few years ago.

I have remained a renter precisely because the house too expensive. I have no desire to see tax payer money used to bail out either the borrowers or the lenders who could not see the obvious. They made their deals, and that's that.

Philip Brewer's picture

Related to this topic, people might want to read my Interview with AFFIL executive director Jim Campen. Americans for Fairness in Lending is a non-profit organization that works to raise awareness of abusive lending practice.

Our discussion covered exactly the topics raised in the comments here.

Guest's picture

The Fed rate cuts aren't really going to do a single thing for the rate resets. It does keep the credit markets from locking down to the point it becomes a drag on credit worthy individuals and businesses and that is why the cuts are needed.

I am firmly in the camp of those who would like to see very little done to bail out homeowners who entered into these high risk deals. Plenty of people who knew exactly what they were getting into but took a risk that housing prices would continue to escalate at ridiculous rates and that they would be able to refinance down the road. Housing prices turned around, credit markets seized up, banks aren't willing to renegotiate anything and the risk takers got caught.

When I place my bets in the stock market and it has a losing year I don't go crying to the government about my lost money. I knew the risks and accepted them. Same for these home buyers. The only difference being there was no surprise about what was coming in terms of when and how much their monthly mortgage payments were going to increase.

I have no idea what makes them so special. The homeowners should get burned and the banks/mortgage firms that generated and are now holding these loans should feel the pain of their poor business practices as well.

Free markets correct. Free markets work out problems just fine on their own. Just say no to a bail out.

Guest's picture

The Fed cuts to date have had minimal impact so far and there is no reason to expect the upcoming cut to be any different. There may be other benefits to the cut (as Guest in #8 stated) but lower reset rates are probably not one of them.

Philip Brewer's picture

The interactions between the short-term Fed funds rate (the rate that the Fed controls most directly) and the longer term rates that influence mortgages are complex.

Inflationary expectations feed into the market rate for long-term money, and excessive Fed rate cuts can feed fears of inflation and actually push rates up. In the same way, a Fed rate hike might well bring long-term rates down, if that reduces the expected future inflation.

On the other hand, the cost of money drives the cost of all lending rates, and a Fed rate cut reduces the cost of borrowing. Unless the cut produces a change in the market psychology, the result is often lower rates across the board.

It's very hard to foresee what effect Fed action on short-term rates will have on long-term rates. The Fed pretty much just has to take action and then see what happens.

Guest's picture
Steve W

Free, but may require login.


NARVIK, Norway, Nov. 30 — At this time of year, the sun does not rise at all this far north of the Arctic Circle. But Karen Margrethe Kuvaas says she has not been able to sleep well for days.

What is keeping her awake are the far-reaching ripple effects of the troubled housing market in sunny Florida, California and other parts of the United States.

Ms. Kuvaas is the mayor of Narvik, a remote seaport where the season’s perpetual gloom deepened even further in recent days after news that the town — along with three other Norwegian municipalities — had lost about $64 million, and potentially much more, in complex securities investments that went sour.

Guest's picture

These kinds of problems all have stop-gap solutions, all of which are debatable, but the real source of the problem is a finance-driven economy. Millions of people are investing money into things, hoping to get a payoff, but what it all amounts to is people hoping to get something for nothing. Value in economies is created by people who work for a living, doing something productive or useful. Those who simply want to make money from having money have become so numerous that the weight of their burden is causing the economic system to collapse.

"There are a thousand hacking at the branches of evil for one who strikes at the root." - Henry David Thoreau

The ultimate root of all this trouble is a simple concept called "interest". When a person can make money from having money, there is no incentive to work. (Though some may argue that guessing where to invest is work in itself, it actually produces nothing of value for the community) This is a system instituted by banks, the most egregious of which is the Federal Reserve. This "bank" is neither federal nor does it hold any reserves. It creates money out of thin air (not backed by gold) and "loans" it to the country at interest. Since they are the only source of legitimate money in the country, where does the interest come from to pay them back? Only from another loan. In this way they have indebted an entire nation, and forced an economic system of parisitism on the masses.

People who do not work make more money loaning than those who do the labor building the thing the company took the loan out for. This system is a disease on the economy, and the root cause of all the trouble.

Money should BE what people THINK it is. Instead, it is a system whereby the people who control how it is issued, who control credit, and control interest rates are secretly confiscating the wealth of the world.

If you see Google Video: "Money as Debt" you may be as surprised as I was to learn these things. Almost impossible to believe, yet it is true...

Our "Federal" "Reserve" is a privately owned corporation (not part of government) which runs its affairs in secret for one purpose: profit off of the American people.

Americans must have their eyes open to this fact or we will soon be running around mad, hungry, and scared searching for something to save us when we could have solved the problem ourselves all along: Abolish the Fed!