Hitting The Reset Button On Mortgages

Alan Blinder, Princeton economics professor and former Vice Chair of the Fed, has a piece in yesterday’s NY Times business section on how to restructure the mortgages that are in trouble and are causing so much heartburn in our financial markets. He is mostly commenting on the "Dodd-Frank" proposal for the government insuring troubled mortgages.

I think this is basically a good idea. If the government is going to bail out the people trading with Bear Stearns in an effort to calm the markets, then they might as well go right to the source of the poison and clean up the mortgage mess. But it has to be done right. And I think that insuring the mortgages instead of buying them, as was done in the depression, is an idea with some merit.

But there are a bunch of things about the Dodd-Frank proposal and Blinder’s additional thoughts that concern me.

As I understand the Dodd-Frank proposal, the lenders will take a write-down on the non-performing loans instead of foreclosing on the loans. The lenders will then trade the non-performing loans for new federally insured loans and realize a loss on the old non-performing loan.

All of that makes sense to me. These loans are not worth 100 cents on the dollar because not only are they non-performing, but the collateral has fallen in value as well. It makes sense to realize the losses and convert the bad paper into good paper. And it makes sense that the government is going to have to do something to comfort the market. Insuring the loans is an idea that at least ought to be explored, even though we are talking about putting taxpayer money at risk.

But here are my questions/concerns:

1) Who sets the value of the new loan? If the government is going to insure it, how can the market really price it? The best approach would be to have the market price the value of the loan based on a non-insured deal, then have the government insure it. That way the taxpayers are only insuring a market deal.

2) How do you avoid giving the homeowner a total bailout in the process? Let’s say I bought a home for $250,000, put no money down, and have monthly mortgage payments of $1,500 a month. Let’s say the home has dropped in value to $200,000 and I can really only afford to pay $1,200 a month. The market value of that loan is probably in the range of $175,000. The current owner should take a $75,000 loss, and let it trade to a new holder (or keep it), get federal insurance, and get paid $1,200 per month for the remainder of the loan. All of that makes sense to me. But do I (as the homeowner) only have to pay off $175,000 or $250,000? If the deal is I only have to pay $175,000, then that’s a great deal for the homeowner and should we be doing that?

I think we need to look at what would happen if the government didn’t step in and then work from there. If the government doesn’t step in, the holder of the loan is going to foreclose on the loan, take the home, sell it (in my example for $200,000 less transaction costs), and take a loss. That loss is going to be between $50,000 and $75,000.

The homeowner is going to lose their home, but since they didn’t have any money down, they don’t have any financial losses. They do have to give up a home that they and their family may have come to love.

If the government can come up with a scheme to get the mortgage holders basically what they would be getting in a foreclosure situation (the market price of the collateral less transaction costs) and allow the homeowners to stay in their homes and have a high probability of staying current on the loan going forward, then we will have achieved a number of good things.

We will avoid a glut of foreclosed homes from coming on the market, further depressing home prices. We will convert bad loans to good loans. And we will keep people as homeowners who have a vested interest in maintaining and improving their homes instead of putting them back into the rental market.

So let’s go back to Blinders’s piece in the Times. As to my first question about how these loans get priced, he suggests:

My suggestion is that the Super F.H.A. categorize the mortgages it
might refinance into, say, “high,” “medium” and “low” qualities and,
based on its best guesses of fair market value, post initial buying
prices for each type.

I don’t like that idea. There’s not enough of a market at work for my taste. I think they should just do a new appraisal on the property and price the loan at 90% of the appraised value. Then apply federal insurance and reset the payment plan so that the homeowner pays off the new appraised value plus a market interest rate in 30 years. That should do the trick.

As to my second question about how you avoid giving the homeowner a windfall, Blinder says:

The proposal would make homeowners relinquish part of any price
appreciation on their houses for as long as their Super F.H.A.
mortgages remain in effect. Good idea. But I’d go further, by
also making beneficiaries of the plan forfeit the right to take out
second mortgages or home equity loans.

There is some sound thinking in this part. First, a homeowner who has a federally insured loan should not be able to borrow against the home as long as that loan is outstanding, period. And as to who captures the "discount", it makes sense to me that the homeowner and the federal agency who insures the mortgage should share in the appreciation of the home between the new loan value and the old loan value. You don’t want to give the entire discount to the homeowner because that’s just a huge gift, possibly at taxpayer expense. But you do want the homeowner to continue to have an interest in making the home better and seeing it appreciate. You also want the the federal agency to get some of this appreciation to offset the risk it is taking. As to what the  percentage should be, I say 20pcnt to the homeowner and 80pcnt to the federal agency.

These are my thoughts on the proposal. As I said, I think it’s basically a good idea. This mortgage mess should be cleaned up and using the traditional method of foreclosure and resale is not a great idea in a time of crisis like we are currently in. Let’s hit the reset button, put the government in the mix, but do it in a way that reflects the market values and doesn’t give the homeowners a huge windfall.