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Housing problems: what could have been done better.

August 26, 2011 1 comment

First of all, some history of what has already been done. Consider the following example : suppose you borrow 100$ from a bank for 2 years to buy a house. The APR is 10%. If it is a mortgage then if you don’t pay, the bank gets your house (this is what is called foreclosure). Suppose you make a payment of 50$ in the end of the first year and the rest of the debt in the end of the second year. Then evolution of payments looks like that:

Time period House price Debt before the payment Payment  Debt outstanding Equity
Year 0  100  100  0 100  0
Year 1  150  110  50 60  90
Year 2  150  66  66  0  150

If house price evolves in the way it is described in the table, you end up  with equity equal to $150.” Shareholder’s equity” is the difference between your assets (the house) and liabilities (the mortgage).

Now suppose things don’t go that well and the evolution of house’ s price is different

Time period House price Debt before the payment Payment Debt outstanding Equity
Year 0 100 100 0 100 0
Year 1 50 110 50 60 -10
Year 2 50 66 ? ? ?

Now suppose that things don’t go that well and the house’s price decreased, instead of increased, say to 50$. Well, in this case your  equity in the end of the year 1 is negative. This is called being underwater. Would you be willing to pay the bank even 60$ if you had these 60$ in the end of year 1? Maybe, but you would probably think twice. As soon as you equity becomes negative, having mortgage is like paying expensive rent for the house.

What can the bank or government do in this situation and what was actually done?

  • Decrease the interest on the loan? Would it work? No, just because your equity is already negative in the end of the first year. If the bank says that the APR is now 5% it wont make any difference because it still not worth it paying the mortgage in the end of year 1.  But this is what 70% of voluntary modifications were about –  missing payments and fees were added at the end of year 1 making the equity even more negative and less attractive for homeowners. So it should be no surprise that the number of foreclosure has actually increased not decreased and people ended up even deeper underwater.
  • Would it make a difference if the bank decreases the amount of the principal (the 60$ at the end of year 1)? Yes, because your equity becomes positive and it is profitable for homeowners to keep paying. There are programs out there that advocate for this.
    Why did not this happen? Because banks would have lost money!  Moreover, some people might stop paying just because they think their principal would be reduced. Another potential problem: second liens. Second lien is a loan that was borrowed against shareholder’s equity. So the problem is that even if the principal is reduced the homeowners would still be underwater, because the injected money would just be a gift to the servicers of the second liens.
  • Government can buy mortgages from the banks for a discounted price (most of the morgages are valued from 30 to 50 cents per dollar and most second liens several cents per dollar) and then reduce principals to make loans affordable to  consumers and then when the homeowners are back on track sell the motgages to the banks potentially for a slight profit. Problem: banks might not be willing to sell mortgages for a discounted price simply because they know the government would want to buy them.
  • Government can legally take over mortgages using so called “eminent domain”.  This method is used when a new freeway needs to be built in some area or the area is contaminated and needs to be demolished.  Basically the government tells the banks that they the houses belong to the government and the banks get market price for it. Of course, not all mortgages should be acquired – only owner-occupied. No Congress approval is needed for this action. The money from allocated for the previous (unsuccessful) modification program – HARP – can be used. Too harsh? Not democratic? Well, it was a democrat congressman who suggested it. A similar program was run by FDR in the 1930s. Moreover, the banks generally already have been treated too nice by the government since the beginning of the recession. This action will also encourage other banks  to modify the mortgages they own if they want to keep them.

General problem with loan modifications: mortgage back securities, sometimes called “toxic assets” that many investors have. What are they? The picture below should help:

 

In fact, many banks do not own the mortgages themselves. They resold them to companies like Fannie Mae and Freddie Mac, who pooled the loans in several pools depending on how likely people that own the money are likely to repay the mortgages. After that these pools were split in securities (like “shares” of the pools)  and sold to different investors. This process is called “securitization”. Investors were supposed to be paid when people pay their mortgages. Further, there exist financial derivatives (stocks that depend) on these MBS such as credit default swaps (CDS) that pay if a person defaults on his mortgage. In other words, default on the mortgages is profitable for the owners of CDS on them (you don’t have to even own the mortgage to own a CDS on it).  So any action by the government would benefit some people and hurt others, so as Adam Levitin put it

the government needs to settle on its policy goal. Why are we trying to prevent foreclosures? Is it a macroeconomic goal of stabilizing the housing market? Is it a macroeconomic goal of deleveraging consumer balance sheets? Is it a moral goal of helping unfortunates? Is it an electoral goal of making people feel that the government is doing something/is on their side?

And then do something, not just say everything is alright. Because 9% unemployment for 3 years is not alright, even if fundamentals are fine.