Foreclosures and the proper role of government

Should government tackle problems that the free market could conceivably solve but hasn’t?

That’s the fundamental question raised by a novel plan San Bernardino County is considering to avert foreclosures, which have been a huge problem there. Nearly half of the homeowners with mortgages owe more than their homes are worth, increasing the risk that they will default on their loans. But the owners of those loans, particularly the investors in mortgage-backed securities, have been slow to respond to this threat.

As described in a Times editorial Monday, the county is mulling a proposal by Mortgage Resolution Partners to use eminent domain to seize investor-owned underwater loans, pay the investors the current fair market value, then issue a more affordable loan to the homeowner. Backers of the proposal presented it as a win for all concerned: Investors would receive a fair return, borrowers would reduce their debt and gain equity, and neighborhoods would experience fewer foreclosures. Meanwhile, Mortgage Resolution Partners, which would put up the money for the seizures, would make a profit on each one, as would the county.

The Times’ editorial board wasn’t so sanguine, nor were most of the readers who responded to the piece online. Reader “DavidAkre” cited the potential consequences of the intervention:

“Should this tactic be used mortgages will be more difficult for borrowers in those areas to obtain as the remaining lenders (if any) will require larger down payments. Rates will also be higher to offset the risk of future governmental action. And if you think this is an altruistic strategy developed by an objective party that won’t gain financially as a result, you would be wrong.”

And reader “areeda1” wondered about the fairness of the seizures:

“The people who financed these mortgages lent the homeowners money, they didn’t sell them the property. Has the value of the money they lent gone down? Why make them responsible if the value of the property goes down? They certainly did not benefit during the many years property values went up.”

Good points both, and they reflect the readers’ uneasiness with the idea of the county using its power to clean up a mess that market forces will almost certainly clean up without the government’s help -- eventually. In fact, we’re in the middle of the cleansing process as property values slide back toward historic norms.

That’s cold comfort to the people who’ve lost their homes, watched their equity evaporate or become trapped in a house they cannot sell. Nor does the market correct itself with any precision, so values have dipped far below those norms in some communities while remaining elevated in others.

The collapse has hurt the banks, investors and government agencies that own housing debt by making much of that debt worthless. They could help themselves by refinancing struggling homeowners’ loans into less expensive loans, provided that the reduced payments would cost them less than repossessing and selling the property. But overwhelmed by the number of defaulting mortgages, many lenders and loan-servicing companies have done a poor job of minimizing their losses, resulting in too many needless foreclosures.

Against that backdrop, homeowner advocates have pressed federal, state and local governments to do more -- for example, to require lenders to modify loans for defaulting borrowers when it makes financial sense to do so. The Mortgage Resolution Partners proposal takes that thinking to an extreme, targeting borrowers who are underwater but still current on their payments. Their theory is that investors would want to reduce the risk of a costly defaults if only they could, but the securities structure and contracts prevent them from writing down these borrowers’ debt.

They may be right about that, but that was the risk the investors took when they bought those securities. And seizing loans that aren’t in default arguably weakens what’s left of the package and reduces the potential upside for investors if the market starts to improve.

When the government parachutes in to interrupt the natural course of events, the market reacts. Investors recalibrate risks and reallocate capital. That’s where the unintended consequences come from. Reader “DavidAkre” may be right about lenders shying away from communities where the government has seized loans, but the opposite may also be true: Lenders may be less cautious with loans in those communities, knowing that the government is looking to bail out homeowners before they fall behind on their payments. Either result would be unwelcome.

The question, again, isn’t can the government help homeowners more than market forces are doing. It can. The question is whether it should, considering not just the interests of homeowners today but of those in the future.

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