A Home Price Firewall
In the Washington Post today, Martin Feldstein gives is view on housing. His view is that a downward spiral is likely unless we act to prevent it. Hisplan is essentially a government bailout. Martin Feldstein is the President of the National Bureau of Economic Research, which determines whether when the U.S. has recessions. He is on record as believing that the data support the conclusion that the U.S. is in recession, even though a formal declaration has not been made.
One reason the present recession is difficult to gauge is that it has not been led by an overheating economy, which triggered an interest rate response by the Federal Reserve. In the US, the recession has been triggered by an implosion in housing. Therefore, housing is a key part of the puzzle to figure out where we go from here.
Here is the article text in full:
A Home Price Firewall
By Martin Feldstein
Thursday, June 19, 2008; A19
Home prices are down 20 percent from their peak in 2006 and are falling rapidly across the country. Experts predict an additional 15 percent decline during the coming year as the housing price bubble is undone.
The danger is that home prices could spiral further down, hurting millions of homeowners and pushing the economy into a deep recession. Nearly 10 million Americans, about one-fifth of all homeowners with mortgages, already have mortgage debts that exceed the value of their homes. As prices fall, that number could double during the coming year. Many people would have mortgages that exceed their home’s value by 20 to 50 percent.
Mortgages are generally no-recourse loans, meaning creditors can take the house of someone who stops paying his or her mortgage but cannot seize other assets or wages. Individuals with negative equity therefore have an incentive to default because the home that they give up is worth less than their mortgage debt. Mortgage defaults and foreclosures hit a 30-year high in the first quarter of this year. As the gap between mortgage amounts and home values widens, that incentive to default will become stronger.
Widespread defaults and the resulting foreclosures could also generate a downward spiral in home prices. It is impossible to know where such a self-reinforcing process would stop.
I believe the federal government should create a firewall to prevent too great a fall in housing prices. It is important to go beyond the legislation that is about to be enacted by the Senate, which would help some homeowners who have negative equity but would not do anything to forestall the growth of this problem. This can best be done through a program of mortgage replacement loans.
Such a program might be structured this way: The federal government would offer all homeowners with mortgages the opportunity to replace one-fifth of their existing mortgage (up to some dollar limit) with a government loan. This loan would carry a substantially lower interest rate than the individual’s mortgage (reflecting the government’s cost of funds). It would be a full-recourse loan that would have to be repaid regardless of what happens to the borrower’s mortgage or home. By law, it would take priority over all non-mortgage debt.
Such a mortgage replacement loan would eliminate the potential incentive to default for almost all homeowners who now have positive equity. In doing so, it would limit the number of foreclosures that could contribute to a downward spiral.
Consider how the program would work for someone who has a $360,000 mortgage on a home worth $400,000, a 90 percent loan-to-value ratio. A 15 percent drop in prices would push that homeowner into a negative equity position, because the house’s value would be only $340,000. But if one-fifth of that $360,000 mortgage ($72,000) were converted to a loan from the government, the mortgage loan be $288,000. As a result, the 15 percent decline in housing prices would still leave the homeowner with $52,000 in positive equity — the difference between the reduced house price of $340,000 and the new mortgage of $288,000. There would be a strong reason not to default.
A program of mortgage replacement loans would act as a circuit breaker to reduce the number of defaults that would otherwise occur as the housing bubble inevitably deflates. In doing so, it would stop prices from overshooting on the way down in the same way they did on the way up.
Because this program would, in effect, swap government bonds for individual IOUs, it would not involve any increase in government spending or in the deficit. Because the loans would appeal primarily to those who now have positive equity in their homes, it would not reward people who made high-risk purchases and now have high negative equity. By lowering the interest rate on one-fifth of their mortgages, it would help participants meet their monthly payments. And the substitution of government bonds for a portion of outstanding loans would provide substantial liquidity in the credit market, which could be used to support new lending.
Yet all these advantages would be incidental to the primary purpose of the mortgage replacement loans: reducing the amount of non-recourse mortgage debt and therefore reducing the risk of a damaging downward spiral in home prices and the economy. Congress needs to act quickly: Home prices fall every week, increasing the number of homeowners who have negative equity — and an incentive to default.
The writer is president of the National Bureau of Economic Research and an economics professor at Harvard University.
This is a mad idea! Why would anyone decide to take on a large chunk of personal debt, that would follow them if they were made redundant and left their house to the mortgage company? At least if you leave the house you can walk away without still owing money.
And how would this help anyway? In the case in the article, the amount owed by the householder is still the same, and the value is still less than the total owed. All that is changed is that the govt can chase the householder for their 20% even if they leave the house.
Plus no govt is going to want to get into the business of being owed money by individuals. The hard luck cases would be all over the media, and the political presssure to write off these loans would be intense. The one paying for all this would be the taxpayer.
The current crisis cannot be solved by financial jiggery-pokery such as this. Too much money has been borrowed, and must either be paid back or defaulted on, causing pain for both borrower and lender. It will be hard but is necessary. Any other solution merely puts off the day of reckoning a little longer.
This proposal should be labeled: “Dead on Arrival.” The recourse nature of the loan is in order to get fiscal hawks like myself to make sure the government is not on the hook for trillions of dollars in bailout money. But it also is mad.
Who in their right mind would exchange non-recourse debt for full-recourse debt? No one! I don’t care how low the interest rate is.
And the phantom equity of $52,000 he mentions is offset against $72,000 of additional debt. Is Feldstein saying the $52,000 gives the debtor, no I mean homeowner, an opportunity to borrow against the home? The last thing we need is even more debt.
This proposal is not very useful.