March 27, 2008
Resistance to instituting wide-scale loan modifications to help troubled subprime borrowers stay in their homes is puzzling for multiple reasons. While it is clearly preferable to foreclosure for homeowners, it is also often less costly for lenders. Even though foreclosure -- particularly at the scale that we are currently witnessing -- may be more expensive than modification, it is an arduous task to negotiate every problem loan on an individual basis. It should then be no surprise that, according to analysis by the Center for Responsible Lending, fewer than 3% of borrowers with adjustable-rate mortgages would receive streamlined loan modifications from their lenders under the U.S. Department of Treasury's voluntary modification plan announced earlier this year.
On this topic, Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corp., hit the nail on the head in the New York Times several months ago when she called for modifying all hybrid adjustable-rate mortgage loans for owner-occupied homes in instances in which borrowers have been making timely payments but likely won't be able to continue when their rate jumps to 11%, possibly tripling payments.
And Federal Reserve Chairman Ben S.Bernanke, Bair and Treasury Secretary Henry M. Paulson Jr. have all concluded that loan balances must be reduced to avoid unnecessary foreclosures that could further damage the economy.
Modifications make the most sense through a formulaic approach that simplifies and streamlines the process. And if we are serious about helping borrowers stay in their homes, this simplification will be especially necessary as nearly $300 billion in subprime ARMs are expected to reset in 2008, with the market not hitting the peak until October. Obviously, there is resistance to modifications on the part of loan servicers who fear investor lawsuits. If we instituted a formulaic approach, possibly including some degree of safe harbor for servicers against investor litigation, we could mitigate that fear on the part of the servicers.
Indeed, several servicers, HSBC and Countrywide Financial Corp. have used a residual income approach for modifications in limited circumstances. And, quite frankly, if automated underwriting is sound enough to issue borrowers risky loans, automated loan modifications should be enough to save them.
Before we start thinking of modifications for troubled borrowers as punishing those who are fortunate enough to remain current on their payments, it's estimated that fully 55% of current subprime borrowers -- particularly African Americans and Latinos -- could have qualified for a prime loan at better rates and with better terms in the first place. Had these borrowers not been offered faulty products destined to fail, the subprime meltdown would not be the massive debacle that it is.
I also would suggest that most folks who are managing to remain current on their subprime ARMs would prefer that their less fortunate neighbors remain their neighbors rather than suffer the blight of foreclosed properties, lower property values in an already declining housing market and neighborhood and community instability.
In most cases, modification is a preferable outcome to foreclosure for all parties: lenders, servicers, borrowers and communities. Losses have already occurred on vast numbers of properties. And unlike the costly bailout of Bear Stearns Cos., many homeowners could be helped by a simple tweak to the bankruptcy law that would allow modifications on home loans when foreclosure is the only other option. This would save nearly 600,000 homes and wouldn't cost taxpayers a dime.
Paul Leonard is the director of the California office of the Center for Responsible Lending.
Until now, I have thought that while we may have been on two sides of an issue, we clearly both leaned enough to the center that this Dust-Up has been more of an exercise in point-counterpoint than a true debate from different ideological views. But this time, I have to say in no uncertain words that I not only completely disagree with your idea, but I find the factoids you use to argue for a massive bailout of imperiled homeowners to be at best dubious and more likely an outright distortion of reality. Let's can the spin for a minute and try to focus on reality.
Let me agree with one thing though: The Paulson plans have been entirely useless inasmuch as they pretend, as you do, that the problem in the housing market is simply the terms of the mortgages used to purchase homes and nothing more. Change the terms, reduce the rates, restructure the product and everything is fine. Nobody has to take a hit. It sounds nice but, unfortunately, it is totally wrong.
Interest rates aren't causing foreclosures today. Rather, people are defaulting on their mortgages because they bought homes they couldn't afford, period. The mortgage industry is guilty of allowing people to make such rash decisions by not requiring a proper down payment or income verification. It also offered special low-introductory rates that allowed people to buy something they could never have afforded with a mortgage --a situation begging to blow up.
Here are the facts: In 1999 the median price of a house in Los Angeles County was about $177,000. At that time, the median homeowner earned roughly $62,000. Given interest then for a normal 30-year fixed-rate mortgage, and assuming our home buyer could put $25,000 down on the house, the annual carrying costs (mortgage, insurance and taxes) would have run about 28% of gross annual income. L.A. was still less affordable than most of the U.S., but it was certainly doable for a motivated buyer.
Now zip seven years ahead. By the middle of 2006, the median home price climbed to $550,000, a whopping 210% increase. Homeowner incomes in Los Angeles over the same period grew by a mere 20%, to $75,000. Even with lower interest rates and insurance running at about the same cost, buying a house in 2006 consumed a full 65% of the median homeowner's gross annual income. Take out taxes, and the household now has about $15,000 to spend on retirement, utilities, food, clothing, transportation and other needs. Could you live with that amount of discretionary spending? Not too many people could.
More outrageous is that people bought in this market even though apartment rental rates were still at levels much more in line with incomes. When was homeownership granted this Holy Grail status? The fact is, millions of people have successfully raised their families and lived their lives comfortably in housing units owned by someone else. As a former renter myself, I can tell you that it wasn't nearly as bad as is often said. In fact, it's kind of nice to be able to tell someone else to take care of that broken toilet. Homeownership is simply not good for all people at all times.
But I digress. Let us face the harsh reality. The vast majority of people who bought homes over the last few years using all these subprime products did so with dollar signs in their eyes clouding their better sense. The mentality was practically uniform among these folks: Who cares if I can't afford this house, as in two or three years with the price 30% higher I can cash out and walk away? A no-lose deal!
Here is the reality.
* Prices are falling not because of foreclosures; they are falling because they are unsustainably high given current income levels. Nothing is going to stop this process now; we just have to ride it out.
* Most sub-prime borrowers probably won't be able to afford their homes under any loan modification beyond substantially cutting the principle amount -- a bailout no matter how you look at it.
* Given the pace of current price declines, most subprime borrowers are going to be underwater by the end of 2008. This implies that they are unlikely to want to keep their homes unless there's a reduction in the principle amount -- in other words, a bailout. In many ways, these folks would be better off freed from a debt worth more than the asset against which it was secured. Here, foreclosure is the start of a new beginning.
* The threat of blight is nothing more than a red herring. The good news about foreclosed homes is that they cause prices to fall faster, which is exactly what needs to happen. The faster prices get back in line with incomes, the better off we all are, particularly those prudent potential home buyers who properly stood on the sidelines waiting for this bubble to burst to have their chances at homeownership. These are the people we should be rewarding, not the speculators who rushed in for their chance on the roulette wheel and lost.
* Letting people bankrupt themselves out of their imprudent purchase of a home is nothing more than a bailout; don't pretend otherwise. And it will cost taxpayers, as this will cause the already nasty financial losses on Wall Street to skyrocket, as investors are suddenly offered no recourse in trying to recover some of their funds. The net result will be more banking bailouts by the Federal Reserve at taxpayer expense. There is no free lunch.
I realize that I sound very unsympathetic. For most of the people losing their homes today, frankly, I am. They bought houses they couldn't afford and now they pay the consequences by losing those homes. Yet I also know that a lot of people were simply duped into believing that this was a no-lose situation. My problem is that I don't know how to sort out who is who, and I don't think a blanket approach that benefits speculators is the right approach. Luckily, we have courts that allow people to bring lawsuits and class-action suits if they feel they have been truly wronged. Let that system handle the problem.
This rhetoric and spin disturbs me. It paints the gambler as victim and ignores the true losers: those who purchased prudently and as a result got less than they should have; and those who didn't purchase at all, instead standing for years by the sidelines as prices went crazy. You don't need to save any homes. Once prices return to normal, these folks will gladly buy up those foreclosed units and put them to use. Let's focus on these folks for once, OK?
Christopher Thornberg is a founding partner with Beacon Economics.
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