The scope of the problem in the American housing market is illustrated by the statistics that total negative equity is presently estimated at $750 billion, and about 15 million homes are "underwater."1 One proposal gaining traction is the concept of a "free" principal reduction for underwater borrowers. We argue that this and all other government and policy proposals to "fix the housing market" the last few years fail because they throw good money after bad in targeting only the most distressed and riskiest borrowers, many of whom previously acted recklessly and/or may not be able to stay in any home -- or even pay a modest rent -- without outright government subsidies. Such borrowers are beyond rescue and efforts to "save" them are neither worthwhile nor truly aimed at helping the housing market or the lenders whose credit is essential for real estate finance.
We present a proposal which flips so-called conventional wisdom on its head. Under our proposal, homeowners making substantial prepayments of at least $50,000 would have their principal reduced by two dollars for each dollar of prepayment. Our proposal targets the most responsible and financially savvy homeowners. These homeowners are also the likeliest to strategically default on their mortgages, not out of fiscal irresponsibility or immorality, but out of economic rationality and a desire (however perverse) to be treated equally and capitalize on disastrously misguided government policies incentivizing irresponsibility. A strategy that rewards the borrowers most likely to be the bedrock of communities will discourage strategic defaults and depress the supply of homes. Meanwhile, the strategy helps the lending banks most necessary for the healthy functioning of a real estate market dependent on third party financing, thereby encouraging the extension of mortgage credit to meet demand. The ultimate recovery of the housing market requires the true equilibrium between supply and demand. The anemic demand of the past few years strongly indicates a substantial decline in home prices from current levels is necessary to boost demand and, barring a sustained economic recovery that is unlikely in the current regulatory climate, may be the only way to accomplish equilibrium.
THE ERROR OF THE CONVENTIONAL PARADIGMS
Current misguided (or Machiavellian) government strategies are only encouraging banks to refuse to foreclose and encouraging defaults, thus delaying the unavoidable price decline (if not a second crash) and pushing the tsunami of pent-up supply farther down the road so as to delay any recovery and prolong the housing depression. The key premise is that the housing market will recover only when foreclosures stop and the supply of homes for sale decreases. This is mistaken, for among other things it totally ignores the demand side of the equation. The problem is that foreclosures have been replaced by long-time defaults whose homes are perceived to ultimately be going on the market, hence supply has been pushed back and buyer expectations are for future significant losses in housing. Intelligent, rational prospective buyers who will willingly buy a home while expecting its future value to decline quickly and substantially shall be few and far between. In fact, efforts to constrain the flood of supply have only depressed the demand, and reduced the price point at which that demand arises. By contrast, our strategy that fosters self-sustaining demand while encouraging good homeowners to stay current on their mortgages will discourage a flood of high-end real estate from ever hitting the for-sale market. This natural, permanent decline in a key driver of supply will help stabilize the supply end of the equation and help the housing market reach the equilibrium between supply and demand necessary for recovery.
This will contrast with the disastrous mistakes of the last four years. Banks are already, quietly, rolling out principal reduction programs targeted at the worst credit risks, the homeowners who have already become delinquent or who have already defaulted.2 Principal reduction was once thought a radical plan but has gradually gained acceptance; indeed, a 2010 draft study from three economists at the New York Fed concluded that reducing mortgage principal, instead of just reducing monthly payments, was the most effective way to keep homeowners in their homes.3 The banks are doing this only for mortgages which they hold (they cannot force RMBS investors to agree to principal reductions for the mortgages they own). The banks are already willingly writing down the value of these mortgages, without any return except the illusory risk reduction based on the questionable premise that delinquent or defaulting borrowers who could or would not make previous monthly payments will start doing so for "more affordable" monthly payments. Under this arrangement, the banks consign themselves to reduced cash flow, reduced principal, reduced collateral value, and in our estimation, arguably at the very least, little to no increased likelihood that the former delinquent borrower will become and remain a good, on time payer.
This is writing down asset values -- in other words, destroying wealth -- in order to help the segment of homeowners most likely to redefault and be beyond help. This strategy features no benefit, no return on investment, for the banks. Principal reduction for the worst default risks will only hurt banks and delay the inevitable foreclosures. The sense of inevitability has already prevented value recovery for the homes of their responsible neighbors, while condemning entire neighborhoods to an indefinite prospect of wealth destruction for as long as these pick-the-loser policies delay the price declines necessary for the supply of housing to fall to the price point at which buyer demand will naturally grow. In the meantime, the sense of free and often undeserving relief has encouraged other defaults, setting into action a downward spiral where fewer people stay current on payments, banks suffer greater asset and income losses, and values continue to drop as foreclosures set new lows for "comp" use (as comparable values to use as benchmarks for value of other, nearby, similar homes), in turn depressing buyer demand.
There is no apparent benefit to the banks from principal reduction "for free." That is because the federal government has begun to adopt the philosophy that private enterprise needs only the benefit of being allowed to continue to operate. In essence, the benefit is: do principal reductions, or else we will regulate you out of business, and find crimes so we can prosecute your management. Indeed, the recent foreclosure settlement takes just this approach (although its intent is nowhere as clearly stated as here).4
There is another benefit. Let us be clear on this. The federal government is encouraging banks to do principal reductions in order to gain political support -- votes -- from those who will believe this program is "relief" and "compassion." Just as Machiavellian, this same constituency will remain dependent on the government for future relief. This is the creation of a vicious cycle of dependency, whose victims become trapped and ripe for exploitation.
Our proposal provides for bonuses on substantial prepayments of first lien mortgages. A homeowner prepaying $50,000 would qualify for a principal reduction, not of the amount paid, but for an amount double the prepayment. Even better, the proposal would not have hidden conditions, trap doors and other negative aspects buried in "fine print."
Our proposal succeeds in five ways:
(1) it fosters fairness and appeals to people's sense of fairness and justice, by having equal treatment of all borrowers;
(2) it incentivizes responsible borrowers with a way to make a quick, substantial return on investment;
(3) it reduces the default risk borne by mortgage servicers (banks) which have to pay taxes and property insurance on properties in cases of default;
(4) it reduces the default risk borne by the holders of the mortgage -- either the originating bank or the investors holding mortgage-backed securities -- which lose the cash flow and principal repayment; and
(5) it reduces the temptation of the most financially savvy homeowners -- typically also the ones with the highest home values -- to engage in economically rational strategic defaults.
This proposal succeeds in five more ways than anything coming out of the Obama Administration these past few years. It is fair, effective and balances losses to banks and investors with the benefits of a return of principal and resulting reduction in risk of loss from borrower default.
SUMMARY OF THE PRINCIPAL REDUCTION PROPOSAL
The essence of the proposal is that all homeowners are eligible for a prepayment bonus. This proposal would permit all homeowners current on first mortgages with a remaining principal balance over a set minimum amount of $50,000 to qualify for a home loan principal reduction in an amount that would be double their prepayment amount (which would be a minimum of $25,000). This proposal would have uniform terms offered on all first lien mortgages (but not subsequent liens, such as home equity loans) so there is "one set of rules" for all similarly-situated borrowers. The proposal would be in place for a specified period; for simplicity and ease in application, this could be across one calendar year. The proposal would give a homeowner who prepays $25,000 a $50,000 principal reduction.
The incentive for borrowers would be an immediate return on investment -- the prepayment -- of 100%. However, an important feature is that this investment would not be "free money" as it would not be without risk, because the increased paid-in equity becomes subject to future real estate value declines, so borrowers are trading in cash (whose value is relatively constant, subject to inflation and deflation) for property wealth that can suffer real equity losses -- temporarily at least -- in the future.
Some parties benefit only modestly under this proposal. We admit that we treat everyone equally, but cannot (and do not even try to) achieve equal results. The holder of the mortgage -- whether it be the bank or the investor, typically the holders of a residential mortgage-backed security ("RMBS") -- will suffer a current writedown of the mortgage asset and reduced future cash flow from mortgage payments, but gets an immediate and significant -- and very real -- cash infusion that will act as a partial return of principal and a reduction in the liability of default risk. It is a two dollar asset reduction for each one dollar liability reduction, but mortgage holders get a relatively stable asset in cash. (There is a value judgment here in that there are few assets more stable -- if not necessarily very likely to appreciate -- than cash, and that mortgages won't be repaid in commodities any time soon.) Banks worried about actual liquidity and compliance with stricter capital ratios should welcome the receipt of additional cash from this proposal. Meanwhile, the value to mortgage holders is the certainty of at least some return of principal. RMBS holders get a small return of principal and lose cash flow, while the remainder of their purchased "tranche" of so their lost profit opportunity is greatest and risk reduction the least from the prepayment of the mortgages perhaps least likely to be defaulted upon and the most productive in cash flow terms. However, our proposal does not need to incentivize mortgage holders, so their acquiescence is unnecessary. At a minimum, our proposal is certainly a far better deal for both homeowners and banks that the landmark -- and possibly catastrophic -- foreclosure settlement under which the nation's five largest banks recently agreed to pay $20 billion in the aggregate to the United States Department of Justice in order to provide "relief" which the government contends will be in excess of $20 billion.4 At the very least, the foreclosure settlement demonstrates the banks' willingness to reduce principal on less than a dollar-for-dollar basis as is the case with traditional prepayments. Our proposal is vastly superior, because it provides banks with liquidity from actual cash payments, and real risk reduction.
The proposal's effects on banks are also positive, but understanding how requires knowing whether the bank issued the mortgage (an "originator") or is receiving the monthly payment and making periodic disbursements of taxes and insurance (this bank is a "servicer") on the mortgage.5 Originators will lose future cash flow, but this is a tradeoff of future, speculative profits on monthly payments against the risk of default which exists until repayment. Originators have contingent liabilities for contractual representations as to borrowers' quality and suitability, and can be subject to having to buy back nonperforming loans because of false representations (this is often the product of faulty, outright incompetent or absolutely nonexistent due diligence, and less often a case of fraud), so for originators a default is only a contingent, but larger, liability that follows its already realized profit from selling the mortgage. While originators have obvious "skin in the game," more often servicers -- which commonly are the too big to fail banks -- are contractually bound to pay the property taxes and insurance if the borrowers default. Servicers can -- and do -- face the hammer of an endless money pit of monthly expenses (their own real cash burn) while receiving no servicing fees.6 For servicers, a default is a triple loss: no fee income, the assumption of real expenses for insurance and taxes, and liability for property upkeep plus the risk of deterioration of and damage to abandoned properties.
Banks are already, quietly, rolling out principal reduction programs. These programs are targeted at the worst credit risks, the homeowners who have already become delinquent or who have already defaulted. The banks are doing this only for mortgages which they hold (they cannot force RMBS investors to agree to principal reductions for the mortgages they own). The banks are already willingly writing down the value of these mortgages, without any return except the illusory risk reduction based on the questionable premise that delinquent or defaulting borrowers who could or would not make previous monthly payments will start doing so for "more affordable" monthly payments. Under this arrangement, the banks consign themselves to reduced cash flow, reduced principal, reduced collateral value, and in our estimation, arguably at the very least, little to no increased likelihood that the former delinquent borrower will become and remain a good, on time payer. Worst of all, this is writing down asset values for the segment of homeowners most likely to redefault and be beyond help.
What does this do for the millions of homeowners who have already defaulted? We admit that our proposal does nothing to help "distressed" homeowners. We believe most delinquent or defaulting homeowners cannot and should not be saved, and that their homes should be allowed to go through foreclosure as quickly as due process permits. We believe many delinquent or defaulting homeowners have circumstances which call into doubt their ability to pay even modest rent without receiving a government subsidy; hence, these people will not benefit from any level of principal forgiveness because their ability to make monthly payments may have been so seriously compromised that they may have trouble paying rent at a level substantially less than their mortgage payment. In fact, some of these likely defaulters may be looking at years of living rent-free in a home awaiting foreclosure, and then additional years of living rent-free if they then become delinquent (whether deliberately or by hardship) on rent. However, there may be no solution for these homeowners except to allow the economy to recover so they can become economically self-sufficient, or to simply give them an outright, full housing subsidy and not pretend that is anything but a subsidy.
Our principal reduction plan should be implemented, both to enhance banks' cash reserves at no expense to the taxpayer, and reward responsible homeowners at a time when popular faith in playing by the rules seems to be at an all-time low. It is important to reaffirm the sense of fairness and "equal treatment under the law." Otherwise, the crime waves of tomorrow, engaged in by people who may proclaim a Robin Hood-type of moral righteousness, may rival the urban riots of the 1960s. This is how we keep 21st Century America from descending into chaos.
THE BIG PICTURE
A healthy housing market requires a balance between supply and demand. There are numerous factors like the default and foreclosure pipeline boosting supply well in excess of demand -- at current price points. Almost all government intervention to date (save for the short-term tax credit for home purchases in the spring of 2010) has focused on suppressing supply, when it should be far easier and cheaper to focus on boosting demand. The easiest way to get more demand from the marketplace is perhaps the simplest: remove all price supports and government interventions to allow prices to fall to a natural point where demand picks up naturally and buyers are no longer justifiably worried that future price losses will wipe away any new equity investment they make.
1 Stan Humphries, "Universal Mortgage Principal Reduction: Who's Going To Pay For This?" Zillow Real Estate Research Brief posted Apr. 3, 2012, available at http://www.zillow.com/blog/research/2012/04/03/universal-mortgage-principal-reduction-who%E2%80%99s-going-to-pay-for-this/.
2 Bank of America announced on March 12, 2012 a plan to grant principal reduction to up to 200,000 borrowers who, among other things, must be underwater and at least 60 days delinquent to qualify for principal reduction. See http://www.bankrate.com/financing/mortgages/bofa-offers-principal-reduction/.
3 Andrew Haughwout, Ebiere Okah and Joseph Tracy, "Second Chances: Subprime Mortgage Modification and Re-default," Federal Reserve Bank of New York Staff Report No. 417 (Draft), December 2009.
4 See "$25 Billion Mortgage Servicing Agreement Filed in Federal Court," U.S. Department of Justice, Office of Public Affairs, March 12, 2012. Each of the five banks (Ally, a unit of GMAC; Bank of America; Citibank; JPMorganChase and Wells Fargo) entered into separate consent judgments with the Department of Justice, which judgments are accessible at http://www.justice.gov/opa/opa_mortgage-service.htm. The amount to be dedicated to homeowner relief is an aggregate of $20 billion but the total payouts by the banks was announced as $25 billion.
5 The mechanics and relationships between the various parties in mortgage financing can be distilled by reference to the registration statements and accompanying agreements filed as exhibits to the registration statements and other documents filed with the Securities and Exchange Commission by various issuers of mortgage-backed securities.
6 Kathleen Lynn, "North Jersey foreclosures haunt neighbors," The Record of Hackensack, NJ, May 13, 2012, available at http://www.northjersey.com/news/bergen/bergen_news/151276055_North_Jersey_foreclosures_haunt_neighbors.html.