Last week's economic indicators were grim. Home-loan delinquency has risen to its highest level in 25 years -- nearly 8 percent of all borrowers are behind on payments, and 3.3 percent of all home loans are in foreclosure, the highest rate ever. Driven by job losses and plummeting home values, these defaults don't just affect families and neighborhoods; they also continue the vicious cycle of the current crisis by further dragging down home values and undermining the broader financial system.
But as the rate of mortgage delinquency continues to rise, the Obama administration's housing plan is coming under scrutiny. The most serious critique, which comes from both the left and the right, is that the administration's focus on reducing monthly payments, instead of writing down loan value, is only a temporary solution. But this critique doesn't take into account the administration's new approach to loan modification, the challenges of working with mortgage securities, or the impact of the rest of the president's economic agenda. Nonetheless, given concerns about the administration's ability to enforce accountability among financial firms, it may be time to consider a more aggressive intervention in the housing market: seizing mortgage pools by eminent domain.
The administration's housing plan comes in two major parts; the first and least controversial allows the refinancing of certain "underwater" mortgages -- loans for more money than the present value of the home -- owned by Fannie Mae and Freddie Mac. That provision would affect some 4 million to 5 million homeowners. The second part of the plan provides for the modification of perhaps 4 million mortgage loans that are delinquent or in danger of delinquency to prevent further foreclosures. This is the section that the Rick Santellis of the world call a bailout for "losers," even though the administration is targeting people who acted responsibly and were hurt by job loss or the housing-market crash. Speculators cannot participate, conforming loan size is capped at a little over $700,000 (though most qualifying will be smaller), and income-to-debt requirements should ensure that borrowers who will be unable to pay even modified loans won't by strung along.
The more important question is, will the plan do enough? Housing reporter Alyssa Katz raises this question in a piece for Salon and concludes that the Obama plan is "a short term fix. … The loan mods that these brokers are selling, and that the Obama administration is now promoting, are new and improved variations on the exotic mortgages that seduce borrowers in the first place." Katz worries that mortgage servicers will take advantage of distressed borrowers with modifications that won't ultimately help them.
But the administration's loan modification is much different from what the industry has offered consumers in recent years, experts say. "Loan modifications over the last year and a half were mostly PR efforts by the lending industry," says Ira Rheingold, executive director of the National Association of Consumer Advocates. Kathleen Day of the Center for Responsible Lending, an anti-predatory lending group, says the two divergent initiatives "are as different as a pickle and an olive. They may both be in brine, but they're different edible commodities."
"What [the industry] calls a loan-modification is really a workout plan. It is designed to bring their arrears up to date because of a one-time economic dislocation," Day adds. "That is not a remedy for someone who holds a loan that is fundamentally flawed and unaffordable."
In fact, administration officials specifically designed the plan to differentiate it from standard industry loan modifications, which don't usually lower monthly payments enough to keep borrowers in their homes. Even the best industry modifications attempt to make mortgage payments 38 percent of monthly income, while the administration's plan will lower housing payments to 31 percent. If servicers don't meet government standards, they won't receive government incentives -- and could end up facing a forcible loan modification from a bankruptcy judge without any financial assistance at all.
Given that, observers think that the new modifications will likely keep borrowers in their home. But Katz and others, like economic blogger Yves Smith, worry about another part of the program: After five years at modified rates, interest will rise at 1 percent a year until the loans reach the interest rate at the time of modification. Smith compares this modification to the adjustable-rate mortgages issued at the height of the housing boom that started off with teaser interest rates that then ballooned. Smith worries that in five years we will see more defaults resulting from inability to pay or from homeowners walking away from houses where they own little equity but face rising rates. But experts disagree with this argument as well.
"The old loans you're comparing them to had a much larger sticker shock," Rheingold says "I don't like the incremental step up, but the incremental step up is in no way comparable to the terrible lending practices we've seen before."
Cristian de Ritis, an economist at Moody's Economy.com, also doesn't see a problem with the five-year window, observing that the traditional teaser-rate mortgages would shoot up 6 percent in a year and that the ultimate target rate of the Obama plan -- the interest rate available at the time of the modification -- is historically low.
The last major criticism of the plan concerns overall debt. If the problem is that homes are not worth the value of their loans anymore, then why, critics ask, doesn't the plan simply demand that mortgage holders write down the principal on the loan to make it conform with the home's present value, transferring losses onto investors and lowering payment rates for borrowers?. Even if loan modifications are successful, these critics argue, borrowers could still end up five years down the line with little-to-no equity in their home. While many experts I spoke to see value in principal write-downs, some don't see them as an easy or cheap fix and question whether write-downs would result in a lack of equity in homes or even increased default.
There are technical objections to principal write-downs. Contracts between mortgage servicers and investors traditionally grant much more leeway on adjusting loan conditions than on adjusting principal, and so it is easier to create a broad system to adjust interest rates. Preferring modification over write-down also spreads out cost over a longer period of time, rather than calling on investors to take immediate losses in the billions of dollars when the financial system is already in crisis. And despite the costs of foreclosures, mortgage holders have incentives to hold on to their investments at face value in the hopes that a future increase in housing value will allay their losses.
"Everyone knows that someone is going to have to absorb these losses," says Day of the Center for Responsible Lending. "Right now it's at $7 trillion. … How do you absorb these losses in a way that is most beneficial to everyone?"
Nonetheless, the administration does provide incentives for mortgage lenders who wish to write down principal, although it is unclear if many lenders will participate in that program. The loan-modification plan also provides for an approximately $5,000 write-down over the course of five years. Day and others also cite research showing that affordable monthly payments, not equity, are the primary incentive for borrowers to stay in their homes, especially for moderate-income people targeted by the plan. As well, there are hopes that in the next five years, the economy will begin to recover, creating more jobs, improving income, and also reversing the trend toward declining home values, leading to more equity for homeowners.
"It's reasonable for the Obama advisers to assume that … if this plan stabilizes the market, five years out your house value will have crept back up," says David Abromowitz, a housing-policy expert at the Center for American Progress. "Say today your loan is 90 percent of value; in a couple years it could become 80 percent of value. That would be about 3 percent a year on average, assuming the current year is negative."
No one I spoke to defends the plan as perfect, though all agree it is the best public policy solution thus far. De Ritis wishes that lenders were provided a "safe harbor" provision that protected them from lawsuits from investors who objected to loan modifications. Rheingold argues that the plan should have put modified lenders in 30-year fixed-rate mortgages or, even better, focused on principal write-downs. He also suggests that servicers who seek to foreclose on a home be legally required to do an administration loan modification first. Another idea that should be on the table, some observers say, is a national foreclosure moratorium. Everyone agrees that the carrots in the plan depend on final Senate approval of the administration's main stick, legislation that would allow bankruptcy judges to modify primary home loans at will. But most of all, they are concerned with the government's ability to administer the program effectively and prevent fraud.
"There's the whole issue of competence and staffing," Rheingold says. "I don't have a lot of faith in this industry that they're going to get it right, which is why it's so important that there is strong oversight over them and a requirement that holds them accountable."
It's a major concern. For example, though all lenders who have participated in the government's bank bailout are required to participate in the modification program, it is unclear what consequences they face if they refuse. On Sunday, The Washington Post reported that the Federal Housing Administration, which along with Fannie Mae and Freddie Mac is behind a majority of new mortgages being issued, is already facing numerous delinquencies resulting from fraud. The FHA's fraud unit used to have 130 investigators who worked with the FBI to prosecute bad actors, but the office closed in 2003. And Katz's reporting raises serious questions about a lending industry already planning to target desperate consumers. While the administration is already trying to spread the word -- one headline on the plan's Web site reads, "Beware of Foreclosure Rescue Scams -- Help Is Free!" -- it will take serious enforcement efforts to prevent further predatory behavior.
One solution would be to take the modification program entirely out of the hands of the current private servicers. Abromowitz suggests that the government should use the power of eminent domain to buy mortgage pools from servicers, paying them for the loans at roughly market value. The servicer would be left to split up the money among mortgage investors, while the government could modify loans under its standards to minimize the number of foreclosures. The government could keep ownership of mortgages until they are paid back or sell them back to private investors when homeowners are stabilized. It's similar to the approach used by the Home Owner's Loan Corporation during the Great Depression.
"People may say, 'it's too radical,' 'nobody likes eminent domain,' or some other things like that," Abromowitz says. "The history over the last 18 months is that by the time we get the political will to do a major effort, we're already behind what's happening in the market."
It's clear, at least, that the administration's plan isn't setting the U.S. economy up for another housing crash in five years and has the right architecture to push back against burgeoning foreclosures. But execution is everything. If the government's program only encourages further fraud, it will fail.
