Editor’s note: This is Part 1 of a three-part series. Read Part 2.
Most of the small print about the Obama administration’s plan to help beleaguered mortgage borrowers is now available. In my view, it is coherent and well thought out, but disappointing in its limited scope. The program is designed to provide benefits to owners who deserve to be helped, rather than to reduce foreclosures and stabilize home prices.
The limited scope of the program is why its cost is estimated at only $75 billion, or less than the amount required to bail out AIG. The systemic impact will be correspondingly small.
The major limitation of the program is that it does not attack the problem of negative equity — mortgage balances larger than the value of the homes securing the mortgages. Large and growing negative equity underlies the sharply reduced values of mortgages and mortgage-related assets on the books of the financial institutions holding them. These reductions in asset values have eroded the capital of these institutions, which the government in case after case has had to replenish to prevent failures.
The new program is focused entirely on the capacity of borrowers to make their monthly payments. Indeed, this is evident from the program name, "Making Home Affordable" (MHA). The major tool for reducing the payment is rate reduction, with balance reductions only a last resort in cases where rate reduction and term extension can’t get the payment low enough to be affordable.
This approach flies in the face of evidence that balance reductions are critically important in avoiding subsequent re-defaults. A recent study by Roberto G. Quercia, Lei Ding and Janneke Ratcliffe found that "Among the different types of modifications, the principal forgiveness modification (i.e., balance reductions) has the lowest re-default rate. We believe that this is because it addresses both the short-term issue of mortgage payment affordability and the longer-term problem of negative equity. The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment." (Loan Modifications and Redefault Risk, Center For Community Capital Working Paper, March 2009).
MHA has two parts. Part one is directed toward increasing refinance opportunities for borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac, and who don’t have more than 5 percent negative equity on their first mortgage. Borrowers with negative equity greater than 5 percent don’t qualify.
The second part of the program encourages payment-reducing contract modifications of mortgages that are endangered by adverse events affecting the borrower — such as a job loss or a pending rate increase. As noted, the major tool for reducing the payment is rate reduction, with balance reductions only a last resort. …CONTINUED