Don't just do something, sit there

Could efforts to prevent foreclosures prolong the housing downturn, or even make it worse?

Maybe I wasn't that receptive to the idea when it was pitched by Slate columnist Daniel Gross the other day because he couched his arguments in the language of an economist --  foreclosure prevention efforts, Gross says, interfere with "price discovery." I thought he listed more good reasons we might rather see a gradual decline in home prices than the kind of abrupt price swings you might associate with foreclosures.

But today mortgage broker and syndicated columnist Lou Barnes makes a similar call to "get on with the foreclosure process." Denver, Barnes writes, is near the peak of a seven-year foreclosure cycle, during which average prices "have been remarkably stable throughout."

Most families facing foreclosure today were on weak financial ground, he says, and "will defy every effort" at workouts. "Even extraordinary rewrites will beget re-default, the poorly maintained house creating deeper loss in the ultimate foreclosure, the troubled inventory overhanging the marketplace and preventing recovery," Barnes writes.

Rather than fighting a battle that's already lost, Barnes thinks the number one priority of policymakers should be restoring an adequate supply of credit "to enable quality borrowers to buy." He proposes a radical solution -- for the Fed or Treasury Department to start buying high quality mortgage-backed securities (something Fannie Mae and Freddie Mac are already doing, but their capacity to do so is limited).

The flip side of that coin -- that government should do more to provide liquidity -- is that lawmakers should think twice before doing anything that restricts it, such as imposing new restrictions on lenders. 

On Tuesday the Senate will vote whether to fast-track a foreclosure relief bill that includes bankruptcy "cram down" provisions the lending industry says could raise interest rates by 1.5 percent or more and force lenders to require larger down payments.

In an effort to prevent foreclosures, consumer groups and Senate Democrats want to give bankruptcy judges the power to cram down mortgage loan modifications over the objections of lenders. (see recent blog post, and watch Inman News headlines Monday for details on how the cram down provisions in S 2136 have been rolled into a more sweeping foreclosure prevention bill, S 2636).

Supporters of cram downs say voluntary efforts by loan servicers to engage in workouts with borrowers haven't done much to slow the pace of foreclosures, and that any increase in mortgage rates won't be as drastic as the industry predicts.

Although Barnes didn't address cram downs in his latest column, I thought it was interesting that he raised foreclosures and mortgage market liquidity in the same breath, and concluded that it's the credit crunch, not foreclosures, that pose the biggest threat to a recovery.

There is evidence from academia that supports this idea. As part of the research for a series of stories on the "Subprime Tsunami," last year I stumbled onto a series of papers, co-authored by Andrey Pavlov and Susan Wachter of the University of Pennsylvania's Wharton School of Business, that looked at how lending practices influence housing prices. 

Pavlov and Wachter's December 2006 paper, "Aggressive Lending and Real Estate Markets," looked at the use of ARM loans in 22 Los Angeles neighborhoods where prices fell more than 21 percent between 1990 and 1995. Perhaps not surprisingly, prices fell harder in neighborhoods where ARM loans were more prevalent. But the study's most surprising finding was that it wasn't the higher default rates on ARM loans that sent home prices plummeting, but their lack of availability during the downturn.

If opponents are correct and bankruptcy cram downs result in higher interest rates, that would put further downward pressure on housing prices because homebuyers have less buying power when interest rates go up. Increased down payment requirements would also reduce the pool of available borrowers.

Returning to Gross' worries about price discovery, forget about housing prices -- imagine what allowing bankruptcy judges to modify the terms of loans going back to Jan. 1, 2000 (in the House version) would do to price discovery for MBS and CDOs backed by subprime (or any) mortgages.

There are a lot of smart people who think cram downs are a good idea -- including Mark Zandi, chief economist of Moody's Economy.com. But as seems to the case with the temporary increase in the conforming loan limit, there could be unintended consequences should Congress go down this road.

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