A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Our Subprime Federal Government
President Obamas mortgage plan imitates the lenders who inflated the housing bubble.
20 October 2009
Earlier this month, a congressional oversight panel released its first analysis of the Obama administrations $75 billion Home Affordable Modification Program (HAMP), an effort to keep 4 million families from losing their homes. The analysis shows that the Treasury, in trying to keep people in homes they cant afford, is relying on the same perverse principle that inflated the housing bubble in the first place: namely, that its fine to borrow recklessly to buy a house, because house prices can only go up and up. Trying to maintain a bubble mentality, rather than help people adjust to life after the bubble has burst, will hobble economic recovery.
President Obama first announced HAMP eight months ago. The program helps struggling borrowers slash their monthly mortgage payments to 31 percent of their gross income (from participants original median of 45 percent). To encourage the financial industry to modify the loans, the government offers inducements to mortgage servicers (the companies that handle paperwork for borrowers and lenders), including a $1,000 payment each year for the first three years of a successful workout. The government also offers lenders partial compensation for the losses that they will take on the workouts. And the government gives borrowers $1,000 a year for up to five years for staying current on their modified loans; the extra money will help pay down their loans. The plan, the president promised, will give millions of families resigned to financial ruin a chance to rebuild.
Reworking bad loans isnt a bad idea; it can prevent even bigger losses for both borrower and lender. Say you purchased a house worth $220,000 in 2006, borrowing 100 percent of the value, and the houses value has since fallen to $150,000. If you can afford a mortgage on $175,000 worth of debt, it likely makes more sense for your lender to cut your mortgage debt down to $175,000 than to sell your house for $150,000. Indeed, such write-downs should be a healthy part of the economys readjustment to a post-bubble world. They would help address the housing bubbles legacy: one-quarter or so of homeowners now owe more than what their houses are worth.
Healthy write-downs of bad debt are not what the White House is encouraging, though. HAMP has been reducing peoples mortgage payments not by cutting the amount they owe in line with realistic home values, but by slashing the interest rates on their mortgages. Of the nearly 2,000 completed workouts so far, mostly of initially fixed-rate mortgages, under 1 percent have included forgiveness of any debt, the congressional oversight panel said; instead, mortgage administrators have cut payments almost exclusively through interest-rate reductions. The HAMP borrowers median annual interest rate has thus fallen from 6.85 percent to an absurdly low 2 percent annually. The cuts have made a big difference in monthly payments, which have dropped from a median $1,419 to just $849.
But theres a catch: the cuts are temporary. Five years from modification, the interest rate on each modified mortgage will begin to increase, either to the original mortgage rate or to the market mortgage rate at the time the loan was modified. As the congressional report notes, the affordability of the loans will move back toward [original] levels eight years from now. Treasury has taken fixed-rate mortgages that borrowers cant afford and transformed them into the very teaser-rate mortgages that grew so popular during the housing bubbleto mask and exacerbate the same problem: the house costs too much for the buyer.
The workouts may result in peoples owing even more on their houses than they did before. Thats because mortgage administrators and lenders can tack on some of the costs of missed payments and other charges to the original mortgage balance. The median homeowner in HAMP owed an untenable 122 percent of the value of his house before entering the program; today, the same owner owes an even more untenable 124 percent. Worse, before modification, 474 of the 2,000 HAMP borrowers werent yet underwaterthat is, owing more than the value of their homes. Now, only 424 remain in that relatively good position. Will the $5,000 (maximum) in government payments to borrowers who stick to their new mortgages cut the amount they owe by more than the lenders will eventually increase it? So far, it looks to be close to a wash.
Notwithstanding the governments best efforts to sustain a bubble, home prices are falling to about where they should be so that people can afford to buy houses again without incurring impossible debt burdens. Consider the Treasurys small universe of HAMP participants. Treasury balks at releasing the raw data behind its program, but the interest rates and monthly payments detailed in the congressional report make it easy to determine that the average HAMP borrower likely owed about $220,000 on his mortgage before and finds himself with a house worth about $180,000 today. Suppose, in an ordinary process of healthy write-downs, lenders reduced that average loan to todays value and lenders of any second mortgages or home-equity loanswhich are supposed to offer less protectionlost all of their money (as they should, but dont, under HAMP). In that case, the borrowers median monthly payment would be less than $1,200, even at the original 6.85 percent interest rate. And at the record-low 5 percent rates that qualified borrowers can secure todaysomething that the government could more reasonably support than the 2 percent ratespayments would fall below $1,000.
The White House, instead of letting the market bring prices down to where they should be, is kicking the problem five years down the road. It hopes that five years from now, home prices will have risen so much that borrowers will no longer be underwater. Borrowers would then be able to sell their homes at prices higher than their mortgage balances, getting out of their still-unaffordable original mortgages without huge losses for lenders. Washington is trying to prearrange this outcome through other programs, such as its $8,000 tax credit for first-time homebuyersanother attempt to keep home prices artificially high with taxpayer money. But this policy isnt good for the economy. Overvalued houses force people to continue borrowing too much and keep their financial resources from going into savings or investmentsthat is, into more productive, job-creating industries. Using borrowed federal money to further this goal also takes funding away from infrastructure and other public investments that a healthy economy needs.
Nor is this policy good for the homeowners whom Treasury is purporting to helpthose who cant afford their mortgages. If housing prices arent substantially higher in five years even after the governments best efforts at distortion, the Treasury program will only have discouraged people from cutting their losses and moving on with their lives.
HAMPs beneficiaries could better adjust to reality without this government intervention. Borrowers are generally free to walk away from their houses without declaring bankruptcy. Under the contracts that mortgage lenders and servicers drew up as well as precedent, mortgage debt is understood to be backed by the value of the house, not by a borrowers full pledge to pay the debt with his personal resources. (In fact, thats why mortgage interest rates have historically been lower than credit-card rates: lenders know that a valuable physical asset secures the home, not a persons ability and willingness to pay his debt.) A borrower who cant afford his house under normal conditions may have to leave the property and start renting instead, but thats hardly sufficient reason for the government to sink tens of billions of dollars into maintaining an irrational environment of high pricesone in which it makes perverse sense to keep mindlessly buying houses.
Instead, the White House should help the economy adjust to lower home prices and force lenders and borrowers to recognize their lossesboth key elements to a recovery. Treasury should say that it wont subsidize mortgage administrators that offer temporary interest-rate cuts; it should use any subsidy to encourage lenders to forgive principal. Someone who couldnt afford a mortgage based on his homes current valueor less, if the mortgage administrator thinks fitwould have to move. All of these steps would make far more sense than Washingtons current policy: becoming the biggest predatory lender of them all, and eating the economy alive.
Nicole Gelinas, contributing editor to the Manhattan Institutes City Journal, is author of the forthcoming After The Fall: Saving Capitalism From Wall Streetand Washington.