Rescuing America's Homeowners

Of the 52 million U.S. homeowners with a mortgage, more than a quarter -- nearly 14 million -- are underwater. They owe more on their mortgage than their home is worth. The Homeowner Affordability and Stability Plan, announced by President Barack Obama on Feb. 18, is intended to help some of these families stay in their home.

The first group to get help is homeowners whose mortgage is higher than the value of their home and who have been keeping up with their monthly payment. They would like to refinance to today's lower interest rates but can't do this because banks won't let homeowners refinance if they have little or no equity in their home.

The president's plan will benefit homeowners still barely above water or only slightly underwater -- those whose home price is no more than 5 percent below what they owe on their mortgage. The catch is that they can only refinance if Fannie Mae or Freddie Mac owns or guarantees their mortgage. Fannie and Freddie will get an additional $200 billion from funds already allocated by Congress for this and other mortgage lending. So a homeowner's ability to refinance depends on who holds the mortgage and not on whether a person has kept up with payments.

But the president's plan won't do anything for homeowners in California, Florida, or Arizona or in cities like Las Vegas, Cleveland, and Detroit whose homes are much further underwater. Moody's estimates that fewer than 1 million of the nearly 14 million underwater homeowners will be helped by this part of the plan.

Most homeowners who are helped by the president's plan will see their monthly mortgage payment go down. But this is because their interest payments are lower -- not because of any adjustment to the amount they owe on their mortgage. For many, a monthly mortgage payment will still be higher than the cost of renting a similar home. And because these homeowners are still underwater or close to it, they won't be able to build up the equity in their home.

Unless housing prices inflate again, most of these homeowners are "owners" in name only. Essentially, they are renters. And, like renters, when they get ready to sell their home and move, they will have little or no equity in their home to help them make a new start. The median period of homeownership is seven years, and many of the homeowners who are underwater today purchased their home two or three years ago at the height of the housing bubble. In just a few years, when they go to sell their home, they will confront this problem directly.

For the banks and other lenders who hold these mortgages, the day of reckoning has merely been postponed. When the homeowner gets ready to sell the house, the lender will either have to accept a short sale and get less than the amount still owed on the mortgage or will simply foreclose on the homeowner at that point.

The second group to be helped is homeowners who can no longer afford the monthly payment on their home, either because their income has fallen or because they have an adjustable-rate mortgage and their monthly payment has ballooned. The president's plan will take $75 billion from the taxpayer bailout funds for financial institutions to help some homeowners in this situation stay in their home.

If your monthly mortgage payment is now more than 38 percent but below 43 percent of your income, you may be able to get help to reduce your monthly payment. Here's how:

First, the bank or lender that holds the mortgage would have to voluntarily agree to temporarily reduce the interest rate on your mortgage, usually below market rates, to bring your monthly payment down to 38 percent of your income. The government will then subsidize the lender to bring the mortgage payment down to 31 percent of the homeowner's income. If it's necessary to reduce principal payments as well as interest payments in order to get the homeowner's monthly payment down to this level, the Treasury will subsidize the lenders for this as well, matching half their losses.

After five years, lenders will be able to raise the interest rates on these mortgages back to the market rate. It's like having an adjustable-rate mortgage -- homeowners' monthly payments will suddenly begin to rise again.

There are sweeteners in the plan to encourage mortgage holders and mortgage servicers to do this, but it is still up to them -- and the homeowner -- whether they want to go along with the president's plan. There are rewards for the homeowners as well for making their new mortgage payments on time.

JP Morgan Chase has already said it welcomes this plan. It's easy to see why. Lenders can take their worst non-performing loans, arrange a reduction in scheduled payments to 38 percent of the borrower's income and then have the government kick in another 7 percent of the borrower's income. For a family with an income of $60,000, the bank will receive a subsidy of $4,200 from taxpayers -- plus an additional $1,000 from taxpayers as a sweetener for restructuring the mortgage.

If a lender takes a seriously non-performing loan on which it has little hope of collecting anything at all and writes down the mortgage principal, it will also receive a subsidy from taxpayers. Suppose a bank holds a $300,000 mortgage on a home worth $200,000. It can write down the principal by, say, $80,000 and reduce what the homeowner owes on the mortgage to $220,000. In this case, it will collect $40,000 from taxpayers. The homeowner will still be underwater -- owing $220,000 on a home that is only worth $200,000 and may still be falling in price. But the bank will come out ahead.

While this plan is much better than earlier proposals by the Bush administration, it is still largely tilted toward bailing out banks rather than homeowners. Most homeowners will remain seriously underwater under the president's plan and will build up little or no equity in their home. In this respect, they are essentially just renting their home.

With homeowners still underwater even after restructuring their mortgages, this will again just postpone the day of reckoning for lenders -- this time at great cost to taxpayers and with little benefit to homeowners. When the homeowner gets ready to move, the bank or mortgage holder will either have to accept a short sale or foreclose on the homeowner.

The best part of the president's plan is that it calls on Congress to amend the bankruptcy laws to allow judges to modify mortgages in cases where homeowners declare bankruptcy. This measure, if passed, will provide real relief for financially strapped homeowners. Amending the bankruptcy laws in this way will help homeowners -- especially those who have lost their job in this long and steep recession or whose income has been decimated by illness or divorce. Homeowners who are not able to come to terms with their lender to modify their mortgage would be able to turn to a court for this protection. The threat of court action provides a huge incentive to lenders to reduce the amount owed on the mortgage. The result is that homeowners who can afford the new mortgage payments will get a fresh start at building up the equity in their home.

The bottom line: President Obama's plan is a mixed bag. It is a serious effort to help homeowners and not just banks, as was the case under President Bush, but it is still heavily tilted toward lenders. It will make mortgage payments more affordable for some homeowners, at least temporarily, and should slow the current rate of foreclosure. It may also slow the fall in house prices due to a glut of vacant homes in some of the worst-hit neighborhoods. But it will not stop the decline in home prices in many housing markets where homes are still overvalued and will continue to fall. The president's plan is not big enough to really prop up home prices -- and that's a good thing. It would not be desirable to artificially maintain high prices for homes for years to come and put homeownership out of reach of young people or other first-time home buyers. It's definitely a good thing that Fannie and Freddie will have the resources to be able to continue making mortgage loans, but there is no sign that private-sector lenders will get back into the mortgage market in any appreciable numbers.

What should be done? If the outcome of the president's plan is to turn many of the homeowners whose mortgage is restructured essentially into renters, there is a cheaper and fairer way to do this. Dean Baker at the Center for Economic and Policy Research has proposed changing the rules on foreclosure to allow homeowners facing foreclosure to remain in their home as tenants for a substantial period of time, say 10 years, paying the fair market rent to the lenders. For most homeowners, these rents will be far lower than their monthly mortgage payments even after these payments are restructured. Under the Baker plan, the judge handling the foreclosure would arrange an appraisal to determine the market rent for the house. The tenant would then have the option to remain in the house as a renter. This would stabilize neighborhoods and stop the blight of vacant homes that is reducing property values for other homeowners. The merit of this proposal is that it requires no taxpayer dollars and would go into effect the moment Congress passed it. It does not bail out the lenders who made predatory mortgages or made risky gambles on mortgage-backed securities. And there are no windfalls for homeowners facing foreclosure -- they will have the right to stay in their home and will have lower monthly payments, but they will no longer own the home. Taxpayers who were more prudent will not be on the hook to bailout either lenders or homeowners facing foreclosure.