30 May 2009

Our Mortgaged Future

A.D. Freudenheim, The Editor

An article (“Recovery begins at home”) from last week’s issue of The Economist, about Shaun Donovan, the new Secretary of the Department of Housing and Urban Development (HUD) caught my attention—not for the analysis of Donovan’s early assertion of leadership, but because of the statistics included about the continuing problem of home foreclosures. The Economist reports that “foreclosure filings last month increased by 32% over April 2008; one in every 374 housing units received a filing.” The article also noted that HUD “announced that a $8,000 tax credit for first-time homebuyers could be used as down-payment on a mortgage…” and that “it would provide $2 billion in stimulus funds to stabilise neighbourhoods hit by foreclosure.”

Reading this article reminded me of how adrift we are in the middle of this vast sea of foreclosed homes, and that we cannot seem to find the dry land beyond the horizon. The collapse of our economy has been spurred on in large part by our collective capacity to over-borrow, and our collective desire to over-inflate the value of our homes. While the cracks in the broader economy are more complicated—the housing asset bubble is only one factor—this problem of over-mortgaged homes with over-inflated values is probably the thing most average people are able to focus on. The housing bubble was aided by the robust market in “sub-Prime” mortgages, and part of the problem with these mortgages was their inherent short-termism: banks loved the fees associated with mortgage creation, and the near-term monthly payments, without caring about the long-term impact of the potential failure of the housing market. If the goal was to maximize near-term profits, all of this made sense.

But there was always a logical inconsistency in the sub-Prime mortgage market, waiting for someone to notice it: it is difficult to make money over the long-term with loans you can almost guarantee that no one will be able to afford to pay off. If you know the borrower won’t be able to pay up over the life of the loan, then your short-term profits will ultimately be undermined by the long-term collapse. No amount of mortgage insurance will cover this potential deficit. It’s like building the George Washington bridge out of cardboard: it’s only structurally sound until the first rainfall, and coating it in plastic wrap is not long-term protection from the rain.

News that HUD is offering a credit to first-time homebuyers is great, but helps none of the people who currently have mortgages with unreasonable interest rates or already face foreclosure proceedings. And $2 billion to “stabilize” neighborhoods is all well and good, but it’s hard to know what impact it will have on affected homeowners. These initiatives are part of what the department is calling its “Homeowner Affordability and Stability Plan.” It seems to me that the best way to achieve this would be to encourage mortgage lenders to make loans more affordable, in order to bring stability to the turbulent world of home ownership. All of this led me to ask a different question: is the solution to the failed investment in mortgages ... more investment in mortgages?

Here’s how this investment program might work, as a formal process implemented with government backing, and in lieu of the purchasing of “distressed debt” mortgages by external vultures. Instead of foreclosing on a property, or simply refinancing the mortgage on more favorable terms, banks would refinance while also taking an additional equity stake in these homes. The bank’s investment might be 20-25% of the total value of the mortgage. The mortgage interest rates offered by the banks for these new loans would be fixed within a small range corresponding to the Federally set prime rate; some higher rates would be permitted, but only by one or two percentage points. All mortgages would be fixed rate loans on a 15, 20, or 30 year schedule.

The payoff (so to speak) of this process would be three-fold:

First, it would shift the process of dealing with many of these problem mortgages from a challenge over impending foreclosure back to focus on continued ownership. As with the bursting of many asset bubbles, part of the problem with the collapse of the market is the glut of houses available at reduced prices, which depresses the value of the newly foreclosed assets even further. This is not good for banks looking to recover from the sale of these assets, and it doesn’t help homeowners with legitimate (that is to say, normal) reasons for wanting to sell. Therefore, removing some homes from the market by keeping them owner-occupied would help return some stability to the market.

Second, this refinancing structure would reduce the monthly mortgage payments owed by the homeowners, by refinancing at a rate that owner-occupants can actually afford, on a schedule that makes rational economic sense (which most adjustable rate and sub-Prime mortgages do not, except on a short-term basis). What is the bank’s incentive to refinance this way? That leads to the third point...

By refinancing at a reasonable rate, banks enable homeowners to invest in their properties—keeping their homes and neighborhoods cleaner and more desirable—while the bank still, even at 6 or 7%, makes money. Well-kept homes in cleaner neighborhoods will likely have better resale values over the long-term.

The biggest benefit of this new process will be that it creates a mutual incentive for long-term success, for both the owner-occupant and the bank: the owner's incentive is the opportunity to stay in their house at a monthly payment rate they can afford. The bank will recoup its additional costs over time by taking that addition 20% equity stake, thus giving them 20% of the profit when the home is eventually sold. Since part of the allure of sub-prime mortgages was the higher interest rates being charged, and thus the higher rate of return to those who invested in these mortgages, this equity based approach will also help address the loss of profit that will result from bringing a 14% mortgage interest rate down to 7%.

Why should these homeowners accept this 20% reduction of their equity in their own homes? Well, for one thing, this new bank stake would reduce the amount the borrower owes by the same percentage, in effect reassessing the near-term value of the home. Given the inflated market in which many people purchased their homes, such a readjustment might be welcome. But the long-term rationale is even stronger: a 20% reduction in one’s investment is almost always better than a 100% loss of both equity and one’s actual home. For homeowners, choosing between 80% and 0% should not be so hard—and as banks might be starting to learn for themselves, 100% ownership of many, many houses may not be a good investment for their own shareholders.



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