Stabilize House Prices, Part 6

Over the past several months, economists have been coming up with one proposal after another in an attempt to stabilize falling home prices. This blog has reviewed several of them starting here.

It is clear that, despite the various proposals, the previous administration did very little to alleviate the problem. It’s also clear that it is now a matter of some urgency for the new Obama administration.

The February 19th New York Times article, $275 Billion Plan Seeks to Address Housing Crisis leads with this, “President Obama announced a plan on Wednesday to help as many as nine million American homeowners refinance their mortgages or avert foreclosure, saying that it would shore up housing prices, stabilize neighborhoods and slow a downward spiral released his proposal…” and summarizes it as follows:

The plan has three components. The first would help homeowners who are still current on their payments, but who are paying high interest rates and cannot refinance because they do not have enough equity in their homes, a problem afflicting growing numbers of people as housing values tumble.

A second component would assist about four million people who are at risk of losing their homes. It would provide incentives to lenders who alter the terms of loans to make them affordable for the troubled borrowers. A third component would try to increase the credit available for mortgages in general by giving $200 billion of additional financial backing to Fannie Mae and Freddie Mac.

Beyond luring lenders with government money, the plan also calls on Congress to give bankruptcy judges the power to change the terms of mortgages and reduce the monthly payments.

Questions of fairness and efficacy were immediately raised. While some have criticized the plan as not doing enough, Edward L. Glaeser, a Harvard University economist, believes that one virtue is that it does not try to solve every problem.

For his assessment of the advantages and shortcomings of the Obama initiative, read Housing Plan: The Virtues of Moderation which was published online.

Conclusion

In my opinion, most of the issues facing the Obama administration (and therefore all U.S. citizens) are more complicated than it first appears. Given the depth and breadth of our financial problems, we need reasoned arguments and a nuanced assessment of any new plan. We do not need knee-jerk responses, either pro or con.

Whatever the proposal on the table, there is always room for improvement, and certainly, more initiatives will be needed. We desperately need constructive criticism and cooperation. Professor Glaeser’s analysis delivers a useful starting point.

Stabilize House Prices, Part 2

“The features that Congress added to the initial Treasury plan do nothing to achieve sustained confidence in the financial institutions….They do not address falling home prices.

We need a firewall to break the downward spiral of house prices. ” – Martin Feldstein.

In an October 4th Wall Street Journal editorial, The Problem Is Still Falling House Prices, Martin Feldstein outlines his very direct plan for solving the current financial crisis. Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard University, and a member of The Wall Street Journal’s board of contributors.

A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions.

Briefly, Feldstein proposes a plan that would stop the downward spiral in house prices by reducing incentives that allow homeowners to merely walk away from home ownership. His plan is for the government to make mortgage replacement loans. These replacement loans would be at a reduced interest rate, but with full recourse. The homeowner would save on mortgage expenses but would no longer be able to walk away, from at least a portion of the mortgage.

Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%. The loan would not be secured by the house but would be a loan with full recourse, allowing the government to take other property or income in the unlikely event that the individual does not pay. It would by law be senior to other unsecured debt and not eligible for relief in bankruptcy.

Although the total size of the mortgage-loan program might be as much as $1 trillion, this would not be comparable to other government spending or to a swap of government bonds for impaired assets. The government would instead have a fully offsetting claim on individuals who could be counted on to repay their low-interest government loans. The cash that the banks and other creditors would receive from the government to replace the existing mortgages would be available to finance new loans.

So, Martin Feldstein, who has impeccable, conservative credentials, is proposing a $1 trillion government program. I find this quite remarkable. It will be interesting to see whether or not Professor Feldstein’s plan or the one proposed by R. Glenn Hubbard and Chris Mayer gets any traction.

Incidentally, Professor Feldstein was recently a guest panelist on the September 30th episode of the Charlie Rose Show. 

 

photo credit: respres