Housing Affordability and Stability Plan

[The text below was adapted from a speech I gave recently at the 2009 Taylor Symposium at IUPUI regarding the American Promise and its relation to housing]

I would be remiss not to touch on the issue of foreclosures and the recent Housing Affordability and Stability Plan. This program poses two questions, which strike me as close to the mark but not quite on target: 1) can refi requirements be modified in situations where the mortgage balance is higher than the value of the home to allow the borrower to qualify for lower interest rates and 2) is the mortgage payment affordable relative to the borrower's income?

Here are a list of questions that I think lead to a better outcome:

1. if the borrower walks away, what is the lender's next best choice of action? What is the financial result to the lender? If this number is below the mortgage value, then you have an estimate of what a rationale lender should be willing to forgive on the debt. Borrowers have put themselves at risk for the original equity in the home, but once that is gone, it is the lender that bears the cost of further declines in value below the mortgage amount.

2. does the borrower have housing alternatives (e.g. tax credit rental housing limits) and if so what are their costs? This tells you whether or not the borrower has an incentive to walk away (i.e. as opposed to whether the mortgage exceeds the value or the payment vs. income). If the answer is that the borrower's other housing options are more expensive, then the borrower will stay regardless of the share of their income spent on housing. If the answer is that the borrower has other less expensive options, then the borrower has to decide whether to pay the "premium" for their existing arrangement.

So let's walk through a couple of examples:

1. the purchase price is $50,000, the borrower gets a loan for $40,000, the value is now $35,000, and equivalent tax credit rental rates with available units are about $500. Result: the borrower has already lost their $10,000, the lender could take a write down of $5,000, and the resulting mortgage payment would be about $360 (30 year fixed rate at 6% plus about $150 for taxes and insurance). Alternatively, the lender could take no write down and the resulting payment would be $390. So, now we have the negotiating scenario that should be worked out between borrowers and lenders with no governmental involvement (i.e. a mortgage between $35,000 and $40,000 with a resulting payment between $360 and $390, both of which are cheaper than the alternative of $500).

2. the purchase price is $50,000, the borrower gets a loan for $45,000, the value is now $45,000, and the equivalent tax credit rental rates with available units are about $500. Result: the borrower has lost $5,000 but stays in the home, the lender is at risk for nothing, and the resulting payment is $390. No negotiation is necessary and no government involvement is necessary.

Now, you can probably already see that these results are driven in large part by available rental rates that I've assumed. So, let's change this part and say the available rental rate is $350 just to make it interesting.

1. going back to the same scenario #1 as above, the lender has a big incentive to take a substantial writedown because if they don't, the borrower can walk away and find an equivalent unit.

2. going back to the same scenario #2 as above, the lender has no incentive to walk away (i.e. they can sell the home for more than the mortgage), but the borrower has a choice to make - stay in the home and pay more than the alternative or walk away and rent the apartment.

Push it a step further, make the available rental rate $300 (now we are getting extreme but perhaps possible in very distressed housing markets). In this case, the lender consistently has an incentive to write down the debt to the current value. And, the borrower bears the responsibility of paying the premium (i.e. the reset mortgage payment versus the available rental rate) if they choose to stay in the house.

One argument against this approach is that it relies on having available rental units. Yep, it does. And if those units aren't available? The price of rental housing goes up, changing the dynamics for any given scenario noted above but still coming to similar resolutions (i.e. just at higher rental rates for alternative housing choices).

To make this type of policy effective, several issues must be addressed:

1. liability protection for servicers to negotiate as noted above. While the case studies are clean examples, real life is less clean. Servicers need to know that if they follow appropriate guidelines, make decisions in good faith, and apply good judgment, they will not be sued.

2. elimination of debt forgiveness tax for borrowers

3. continued support for the secondary mortgage market (e.g. Fannie, Freddie, and the FHLB) so that credit isn't restricted due to lack of liquidity as long as the loans are safe, sound, etc. For existing loans, if the borrower has maintained their housing payment, other sources of credit default (e.g. credit cards, car payments, etc.) should be given little weight in the analysis as the refinanced loan is no more at risk from of borrower default than the current loan (and in some cases as noted above, less at risk).

4. greater transparency of prices and choices, for both borrower and lenders.

Who gains and loses from this scenario? Lenders may gain or lose, but at least the losses they are taking are voluntary or negotiated reductions and not cramdowns. Borrowers may gain or lose as well as the outcomes are a result largely of their choices and willingness to pay the premium differences for particular choices/outcomes. Taxpayers win because these are resolutions that are largely free of taxpayer funding. And, long-term all potential homeowners win because the validity of mortgage law is maintained and continues to be a desireable lending vehicle for capital markets.