President Obama has three big tasks if he is to get the economy on a path to recovery. One is massive public spending. The second is getting a banking system functioning again. And third is stemming the cycle of home foreclosures.
He is doing admirably on the public-spending front, but not so well in rescuing banking and housing.
The housing sector is where this crisis began. If the administration doesn't succeed in putting a floor under collapsing housing prices and curbing mortgage foreclosures, the economic downdraft will overpower the constructive pull of the stimulus. Stabilizing housing is also the key to determining the market price of the assets that are clogging bank balance sheets, many of which are bonds backed by sub-prime mortgage loans.
The administration's plan, made public Feb. 18, bears the signature of Treasury Secretary Timothy Geithner. It attempts to use the private sector to solve a tangled problem, and it falls far short of the need.
Nearly one home in four now carries a mortgage that exceeds the value of the property. Millions of homes have already been foreclosed upon, and millions more are at risk. All of this creates a property glut and a cascade effect, which depresses the value of other homes. In order to reverse this downward spiral, the government needs to make it possible for people to stay in their home, and for other people to buy and fix up vacant homes.
The people losing their home include people who took out sub-prime loans whose rates are now sharply increasing -- but also those with conventional loans who have suffered a loss in the value of the loan's collateral. With housing prices depressed, many people who want to relocate can't sell their home, because the loan value exceeds the market price of the house.
Solving this problem is harder than it was the last time we had a housing collapse, during the Great Depression. That's because so many of the loans have been "securitized" -- converted into bonds that bundle many loans. So even if a bank, which collects a monthly mortgage on behalf of the bondholder, is willing to reduce the interest rate or principal balance to avert a foreclosure, the bondholder, ultimate owner of the loan, may object and threaten to sue the bank
The administration's plan is in three parts. The first part liberalizes the terms on which the big loan purchasers, Fannie Mae and Freddie Mac, may buy loans. That in turn allows banks to make more loans. Under the plan, homeowners who have been current on their payments can get a refinancing, even if the value of the loan exceeds the value of the house by 5 percent. That's a start, but millions of homeowners are more deeply underwater, and this part of the plan does nothing for them.
A second part of the plan is aimed at helping homeowners stuck paying an excessive share of their income on their mortgage. The administration thinks that so-called mortgage servicers -- banks that collect monthly payments -- are reluctant to lower interest costs or reduce principal balances because the bank loses money on the deal. So the plan essentially bribes loan services to do the right thing. They can get about $4,000 to $6,000 from the government for agreeing to reduce monthly payments for a period of five years; the monthly cost to the homeowner is reduced to as low as 31 percent of income. But here again, more people will be left out of the plan than helped, and the subsidy goes to the bank rather than the distressed homeowner.
The third part of the plan allows bankruptcy judges to modify the terms of the loan, so that bankers will not be sued by bondholders and so that they will have an incentive to work out gentler terms. But the process requires a cumbersome, case-by-case approach and the capacity to get a case before a judge.
At most, a back-of-the-envelope calculation suggests that perhaps a third of the homeowners at risk of foreclosure will be helped.
It would make much more sense for the government to set up something like the Depression-era Home Owners Loan Corporation, which simply used the Treasury's own borrowing rate -- now about 3.5 percent for 30-year bonds -- to refinance mortgages directly. The outstanding principal could also be reduced, making the mortgage affordable. Bondholders could be compensated at so many cents on the dollar, using the government's power of eminent domain.
This approach would get the aid to where it most needs to go: to distressed homeowners. It would also sop up hundreds of billions of dollars worth of toxic mortgage-backed bonds, which currently are not trading at any price.
In the mortgage crisis, the administration's reluctance to cut to the heart of the crisis with direct federal action is similar to its unwillingness to consider nationalizing banks. It prefers to subsidize bankers and bondholders, an approach that only prolongs the agony. Sooner or later, events will force the administration to a simpler and more direct government remedy. Sooner would be better.
