Mortgage Rescue Options

Mortgage Rescue Options
An Interest-Rate Subsidy,
Debt-Purchase Plans Come
With Moral, Legal Hazards
March 24, 2008; Page C12

Pressure is growing in Washington to help ease the housing crisis. Last week's move by regulators to reduce the amount of surplus capital held by mortgage titans Fannie Mae and Freddie Mac could help make home loans easier to find. But more direct efforts to stem foreclosures seem inevitable. The Federal Reserve's bailout of Bear Stearns may add to the political pressure to do something for homeowners, too.

If the government chooses to rescue ailing homeowners, it should aim to keep its costs and legal hassles to a minimum. And any plan should acknowledge that most people want to remain in their homes -- even if their mortgage is worth slightly more than their house. Those who send their keys to the bank -- known as "jingle-mail" -- have serious negative equity in their homes, cash-flow problems or both. If the government can ease pressure on these homeowners' cash flows, there should be fewer foreclosures.

There are options. The federal government could intervene directly, perhaps by subsidizing a temporary half-point reduction in interest rates for every percentage point a mortgage servicer cuts the rate. As government intervention goes, that approach would be fast and relatively efficient. It also would minimize moral hazard -- the reckless behavior of those who don't bear the full consequences of their actions.

Other plans are more problematic. Economist Martin Feldstein, for example, proposed that the government refinance those with negative equity on their first mortgages into lower-rate loans. But that doesn't make much sense. Given the choice between walking away from a loan worth more than the value of a house, or replacing the debt with a nondischargeable government obligation for the same amount at a slightly lower rate, few would chose the latter. It would also be an unfair boon to investors in second-lien mortgages.

Rep. Barney Frank and Sen. Christopher Dodd take a different approach. The Democrats' closely related proposals would pressure lenders to write off part of the loans held by some two million households. The borrowers would then refinance into as much as $400 billion of new loans, insured by the Federal Housing Administration.

Reducing the debt burden on these households would give underwater borrowers an incentive to stay put along with breathing room to make payments. But it isn't clear whether lenders will play along and reduce their loans by 15% of the current value of the homes, as the plan calls for.

If not, the government might consider another option -- that is, if it wants to go down the route of actually creating equity for homeowners. A lot of the homeowners with 2006- and 2007-vintage adjustable-rate mortgages who are now losing their houses actually have positive equity on their first mortgage. The problem is, they also have second-lien mortgages. If the government were to buy that debt at a steep discount and slash the rates or principal amounts, it would ease borrowers' cash-flow problems and allow them to stay in their homes.

The holders of the second-lien debt would probably jump at the opportunity, because, if the houses go into foreclosure, that debt would be worth less than whatever the government offers. Of course, this approach still creates moral hazard. But limiting the plan to those with positive equity on their first mortgages would minimize its total cost.

However, it wouldn't be easy. The government would have to vet appraisals carefully to ensure it was dealing with borrowers with positive equity. Also, a lot of the loans are wrapped inside mortgage-backed securities. Pulling loans out of those securities could pit one class of investor against another, and could hurt those who have bet the securities will decline in value. The government would have to craft legislation to allow it to purchase the loans without setting off a firestorm of litigation. But if it succeeded, this approach might be a cheap and effective way to stem the rising tide of foreclosures.

--Robert Cyran