DATE: February 24, 2011
TO: redacted
FROM: Scott redacted
SUBJECT: Subsidizing Housing for Homeowners
SUMMARY
The Obama administration is pushing for a settlement with home mortgage servicers which would require them to grant principal reductions to homeowners. Only those homeowners who owe more than their house’s current market value will benefit. This paper looks at whether this or similar efforts will benefit the slumping housing market. The inappropriate nature of the plan as well as its implications is considered as well.
INTRODUCTION
The U.S. housing market began a massive slump beginning near the end of 2007, a time which many declare was the bursting of a housing bubble. Month after month since that time, the number of foreclosures has been at exceptional highs. High unemployment and a record recession have only exacerbated the problem. The banking industry has had serious difficulty dealing with the large volume of foreclosures. On the other side, the great number of homeowners who stand to lose their home has garnered much public concern. In response, the government created a program called HAMP (Home Affordable Modification Program) as part of the TARP.
In the February 24 issue of the Wall Street Journal, an article entitled “U.S. Pushes Mortgage Deal” describes a settlement being pursued by the Obama administration with mortgage servicers. This is from a case against the servicers claiming they improperly handled foreclosure proceedings. The settlement would force the banks who service those mortgages to award principal reductions to homeowners whose house’s market value is less than the amount owed.
ECONOMIC EFFECT
The outcome to the economy of any sort of principal reduction program is like that of a subsidy. In this instance, demand moves right, which will increase price and quantity. In a market where house prices have already reset ten to fifteen years, increased prices would be welcome. However, an increase in the quantity of houses would further exacerbate competition in the already flooded market.
For those homeowners who receive modifications, reducing principals would have an effect such that they would feel as though they can afford more house. Yet, in their cases, the “more house” would just mean they can afford the house they are currently living in (maybe.) Therefore, as long as they do not sell their home, there may be no effect on demand. From that perspective, no harm is done. Although, from the lender’s perspective, it is as though the borrower came to him for, say, $100k and received $110k, but still only repaid the first amount.
The subsidy effect would touch the market when those subsidized homeowners sell their homes. They will essentially be able and/or willing to sell their homes at a lower price than those homeowner’s who were not subsidized. The effect would be greater for those who sell within a year or so of receiving the principal reduction and diminish as more time passes.
An increase in construction costs could be another side effect. However, since the program would not (hopefully) go to the same homeowner more than once, this may not be the case.
Each party (banks, investors, homeowners, etc.) who has to accept all or part of the burden of any program designed to help foreclosing homeowners, such as principal reductions, will have an impact on the economy. Whatever portion banks bear (and according to the article it may be all) will return to the economy in reduced lending capacity, lower savings rates, and lower quality investment products as the banks work to recoup their losses. Whatever burden investors accept will show up in the economy through their reduced investing and spending.
For the proposed settlement, the banks themselves will be responsible, as servicers, for the entire amount. Investors will likely not take a part of the loss. It is curious that they would not. They were invested in a risk product, as apposed to a CD or government bond where returns are guaranteed. Potential losses are part of that risk. It seems that they should take a part of the loss along with the bank. Spreading the burden would have a smaller impact on the economy overall.
PSYCHOLOGICAL EFFECT
Along with economic effects, a principal reduction program can have psychological effects that may influence the market. The largest of these is the dangerous precedent it sets for any future housing market troubles. Once these types of measures have been taken to solve a housing crisis, it will be difficult not to revert to them in the event of another. Not to mention, once government programs get going, they are hard to end: even the supposedly temporary ones.
There will also be a negative effect on current homeowner’s in regards to their home and home value. As Diana Olick put it, most homeowner’s would rather see their “home's value go down than see the guy next door who made a poor/negligent financial decision get a mulligan” at their expense. Not to mention, if home values begin to climb back to any sort of profitable equity levels as it concerns those subsidized homeowners, there could be serious resentment from the homeowners who didn’t receive any help.
A last psychological effect will be the tendency to inspire more defaults. When other homeowner’s discover that there may be a financial gain to be had from letting their mortgage payments get behind, they may be inspired to join the foreclosure bandwagon.
ALTERNATIVELY
When HAMP was passed, it set a freeze on all foreclosures. Through various other measures from that bill, foreclosure proceedings since the bill’s passage have been stalled. As a result, the housing market is not being allowed to clear as it should. Consequently, the housing market troubles will only continue to worsen unless foreclosures are allowed to proceed as they normally would.
Even if housing prices were to return to their 2007 highs, as impractical as it would be, that hypothetical situation would really only benefit those mortgage holders who were speculators. This is because they would then be able to sell at a price that releases them from the financial burden without suffering a loss. Those who are genuinely having trouble paying their mortgage now, will not magically be able to start making payments just because their house’s value has increased. Sure, they also would be able to sell their homes. But they would be just as homeless in that hypothetical case as they would be if they went through a foreclosure now.
The point being, if homeowner’s are not able to make their mortgage payments, the best solution for everyone is to go through with the foreclosure. No one will actually be homeless, they will just become renters.
Banks should simply begin enforcing foreclosure as outlined in mortgage documents. Once it has become clear to everyone that there will be no chance of forbearance, debt reduction, principal reduction, or any other type of rescue, those borrowers who do have the means to continue paying their mortgages will do so. Those who truly cannot will have to face the reality of their situations.
The price correction needed to clear the housing market is a heavy weight. As mentioned above, it is better if the burden is spread among many, rather than a few. It will eventually be bore by the majority any way, but allowing market forces to perform as they should will bring us to recovery levels quicker.
The burden laid on individual homeowners will show up in different ways depending on how each homeowner handles their own situation. This will, of course, be dependent on each person’s financial situation. There will be those who keep their homes and those who have to let their homes go.
Those homeowner’s who, for whatever reason, are able to catch up their mortgage payments and keep their homes, their effect on the economy will be neutral to positive. Staying in their home will not affect the supply or demand for homes in the market. As investors in and maintainers of their property, though, they will have a positive effect on prices in the long run.
Those who genuinely cannot bear the burden of their mortgage will have to give up their home. This will result in a loss to the homeowner’s, the banks and the investors. The loss to the homeowner would be any equity they have in the property.** They may possibly face a higher cost of rent. Investors would lose whatever portion of their investment that cannot be recovered in a resale of the property. Banks would lose the income and fees received as servicers of the loans.
For the most part, there would surely be a net loss for everyone, but there would also be some gains for each party. No longer tied to their homes, the homeowners would regain mobility which may prove beneficial when seeking employment. For investors, where their money was once tied up in an unprofitable investment with sporadic returns, they would regain the liquidity to move their investment capital to better investments. The banks, it seems, have the least to gain. Their biggest positive would be freed up resources (personnel etc.) who were engaged in billing and foreclosure dealings with the homeowner.
Homeowners who have never had difficulty with their mortgage payments will also be affected as their home prices fall along with the entire market. This has already happened. On the positive side, they would gain the confidence of knowing that the crisis is over, the market is on track again, and the economy can reasonably be expected to begin an unimpeded improvement.
CONCLUSION
Instead of the constant government involvement intending to help homeowners stay in their homes, what the market needs is to allow foreclosures to proceed as they normally would. This is a natural function of the free market. It would not be easy on those directly affected and the effects would ripple throughout the entire economy. However, the result would be a quicker recovery for the markets, and a preservation of our economic freedoms.
Works Cited
"Calculated Risk: New Research on Mortgage Modifications and Principal Reduction." Calculated Risk. N.p., 6 Jan. 2010. Web. 2 Mar. 2011.
Ellis, Timothy. "Seattle Bubble Friday Flashback: Case-Shiller Home Price Losses Mapped." Seattle Bubble. N.p., 25 Feb. 2011. Web. 2 Mar. 2011.
Haughwout, Andrew, Ebiere Okah, and Joseph Tracey. Second Chances: Subprime Mortgage Modification and Re-Default. New York: Federal Reserve Bank Of New York, 2009. Web. 2 Mar. 2011
Olick, Diana. "Are Principal Writedowns the Answer to Housing Crisis? - CNBC." Stock Market News, Business News, Financial, Earnings, World Market News and Information - CNBC. CNBC, 6 Jan. 2010. Web. 2 Mar. 2011.
Timiraos, Nick, Dan Fitzpatrick, and Ruth Simon. "U.S. Pushes Mortgage Deal - WSJ.com." Business News & Financial News - The Wall Street Journal - Wsj.com. Wall Street Journal, 24 Feb. 2011. Web. 2 Mar. 2011.
**For the homeowner’s equity, it would be noteworthy to know more about what comprises that equity. What portion of their equity is based on actual dollars paid towards the down payment and mortgage and what portion is a factor of perceived value as a result of increasing property values. Also, mortgage payments as a function of rent should be considered; putting mortgage payments on the debit side as an expense, rather than an investment. Equally so, this same type of analysis would be of note from the investor’s perspective. In other words, how much of each party’s real values will be lost in a foreclosure. Then, the true economic impact could be assessed more clearly.
