The government’s efforts to combat the worst financial crisis since the 1930s can be divided into three phases. Phase one, executed in good part in catch-as-catch-can fashion, was directed toward shoring up financial firms that were undercapitalized and had lost the confidence of their creditors. The goal was to prevent their failure, which would have made the crisis worse — far worse.

Phase one is still far from over, new flare-ups continue to arise, and new approaches for recapitalizing banks are being considered.

The government’s efforts to combat the worst financial crisis since the 1930s can be divided into three phases. Phase one, executed in good part in catch-as-catch-can fashion, was directed toward shoring up financial firms that were undercapitalized and had lost the confidence of their creditors. The goal was to prevent their failure, which would have made the crisis worse — far worse.

Phase one is still far from over, new flare-ups continue to arise, and new approaches for recapitalizing banks are being considered. But the threat of major failures that would further destabilize the system has largely receded.

Phase two, executed in much more deliberate fashion, was to reduce interest rates to mortgage borrowers. Where phase one had the highest priority, phase two is low priority, adopted largely because it is easy to implement and helps some homeowners, even if not those who most need it.

Lower rates have generated a refinance boom in the midst of a growing recession, like an oasis in the desert. The impact is limited because access is restricted to homeowners who qualify for loans that can be purchased by Fannie Mae or Freddie Mac, or insured by FHA. To lower their rates, borrowers must have equity in their property and good credit — the thirstiest homeowners can’t drink from this oasis.

Phase three has yet to be defined, but the focus has to be on shrinking the foreclosure rate. The financial crisis started in the housing market and will not end until home prices stop declining and foreclosed homes stop flooding the market.

None of the existing programs, including loan programs (Hope for Homeowners and FHA Secure), counseling programs (Hope Hotline) and foreclosure moratoriums, have made a significant dent in the foreclosure rate. The same will be the case if bankruptcy laws are amended to allow judges to modify mortgage contracts, a proposal currently under discussion.

To make major inroads into the foreclosure rate, we need a marked increase in contract modifications of mortgages on the path to foreclosure, returning these loans to good standing and keeping them there. The private sector has made efforts in this direction, but the loans they have modified are too few and the modifications too small to make a substantial difference. In particular, very few modifications reduce the loan balance, which is why about half of them re-default within six months.

Another important objective of phase three is to begin the process of restoring confidence in the quality of financial assets, which the crisis has undermined. With the loss of confidence has come the loss of ascertainable values and marketability. This is the major reason why borrowers today who need loans larger than those that can be sold to Fannie Mae or Freddie Mac have to pay a rate premium of about 2 percent, which is about eight times larger than it was before the crisis.

The following are the main features of a plan directed to these objectives that a colleague and I submitted to the U.S. Treasury. A detailed version is on my Web site (see "Breaking the Back of the Financial Crisis").

Government will encourage servicers/investors to mark down loan balances to 90 percent of current market value by contributing to the markdowns, and by guaranteeing timely payment of principal and interest on modified loans. Eliminating negative equity on modified loans will lower payments and incent borrowers to remain in their homes, which will reduce the incidence of re-defaults.

The government outlays required to support balance write-downs will be large, but will be secured by second liens, which borrowers will be obliged to repay in the future. In this way, the government will be able to recover some (if not all) of the outlays.

Government will encourage private mortgage insurers (PMIs) to underwrite and provide payment insurance on modified loans by offering to share losses with the PMIs. In addition, the payment insurance would carry full faith and credit back-up insurance by the Government National Mortgage Association (GNMA), which will make it highly desirable to investors.

Payment insurance supported by GNMA will make modified loans marketable, and shift some of the workload in processing modifications from understaffed servicers to PMIs. GNMA will receive a piece of the insurance premiums, which should make this part of the program self-supporting or even profitable for the government.

For space reasons, I have left out such topics as how the interest rate will be set on modified loans, and the terms imposed on borrowers for repayment of the advances made by government. I have also left out the long-run role of mortgage payment insurance in stabilizing the housing finance system of the future. These topics are discussed in the Web version.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He is indebted to Igor Roitburg for helpful suggestions. Comments and questions can be left at www.mtgprofessor.com.

***

What’s your opinion? Leave your comments below or send a letter to the editor. To contact the writer, click the byline at the top of the story.

Show Comments Hide Comments
Sign up for Inman’s Morning Headlines
What you need to know to start your day with all the latest industry developments
By submitting your email address, you agree to receive marketing emails from Inman.
Success!
Thank you for subscribing to Morning Headlines.
Back to top
Only 3 days left to register for Inman Connect Las Vegas before prices go up! Don't miss the premier event for real estate pros.Register Now ×
Limited Time Offer: Get 1 year of Inman Select for $199SUBSCRIBE×
Log in
If you created your account with Google or Facebook
Don't have an account?
Forgot your password?
No Problem

Simply enter the email address you used to create your account and click "Reset Password". You will receive additional instructions via email.

Forgot your username? If so please contact customer support at (510) 658-9252

Password Reset Confirmation

Password Reset Instructions have been sent to

Subscribe to The Weekender
Get the week's leading headlines delivered straight to your inbox.
Top headlines from around the real estate industry. Breaking news as it happens.
15 stories covering tech, special reports, video and opinion.
Unique features from hacker profiles to portal watch and video interviews.
Unique features from hacker profiles to portal watch and video interviews.
It looks like you’re already a Select Member!
To subscribe to exclusive newsletters, visit your email preferences in the account settings.
Up-to-the-minute news and interviews in your inbox, ticket discounts for Inman events and more
1-Step CheckoutPay with a credit card
By continuing, you agree to Inman’s Terms of Use and Privacy Policy.

You will be charged . Your subscription will automatically renew for on . For more details on our payment terms and how to cancel, click here.

Interested in a group subscription?
Finish setting up your subscription
×