Saturday, April 11, 2009

Los Angeles Times Editorial on Foreclosure and Refinancing

So economists, what should be done with homeowners who are "under water" (i.e current home price - outstanding mortgage<0)? A reasonable thinker might say; "My answer depends on what is the underlying fundamentals of the economy." So here are some scenarios to think about;

Case #1: Matt's home price is low because local job demand growth in metropolitan area has gone sharply negative. IF, my local market is negatively correlated with other local markets and there are other cities hiring people with my skills, then in the name of efficiency --- don't we want Matt to sell or hand the keys to the bank and move to the other city and get a job? Isn't it inefficient for me not to default and remain unemployed in my current house? Would refinancing "solve" this labor market mismatch? I don't think so.

CASE #2: Matt thinks that home prices will soon rise because he believes in Larry Summers and the power of positive thinking offsetting the scare that Ben Bernanke gave us in 2008. In this case, while Matt is currently "under water" --- he will cut back on pizza and beer and keep paying his mortgage because of the option value of owning a valuable asset if home prices do rise again.

Case #3: Today Matt is under-water but he expects that Obama "jaw-boning" will force banks to re-write his loan and this will make them bear the incidence of price declines and put Matt back in a positive-equity state of the world. Here the probability of this event hinges on Matt knowing that there are plenty of other "victims" like him who are all yelling about how much they are suffering from their past "mistakes".

Economists must also make a decision on whether we want more renting and less home ownership in the U.S. For households just at the margin of paying their home payments, should they be renting? By foreclosing --- doesn't this accelerate their transition back to being a renter? Ultimately, is this what a benevolent planner would want this group to be doing given their income stream and asset position? A reasonable question here is; if we want many home owners to transition to being renters; do we force them all to make this transition immediately or do we have an orderly transition? If banks held mortgages of multiple homes in the same physical area such as in the movie Wonderful Life, then the bank would internalize the pecuniary externality that selling a lot of stuff at once will depress prices and may encourage other marginal homeowners to default.

Los Angeles Times
Keeping those keys
Allowing more homeowners who face deep losses to refinance would help ease the foreclosure rates.
April 11, 2009

Recent glimmers of hope about the economy may be lifting the stock market, but there's no sign yet of a let-up in the foreclosures that lie at the root of the problems. The coming weeks could provide more encouraging news about housing too, depending on the success of two new federal programs to avert defaults. Yet one of those initiatives, which helps borrowers refinance their federally owned or guaranteed loans, offers less help than it could -- and should -- to homeowners in California and other states with steep drops in property values.

There are numerous factors behind the stunning increase in foreclosures, including reckless borrowing, predatory lending and increasing unemployment. And in some cases, homeowners simply walked away from homes that were no longer worth the amount borrowed (so-called underwater mortgages). Those who made small down payments are particularly susceptible to this temptation, preferring a few years of bad credit to a long-term investment in a house that's fallen far off its purchase price.

Persuading them not to abandon their homes would slow the pace of foreclosures, easing the downward pressure on housing and the complex mortgage-backed assets that are gumming up the credit markets. One of the administration's new programs attempts to do that, but only for borrowers who have defaulted or may do so soon. It's a costly effort that offers to pay lenders and mortgage-servicing companies to reduce borrowers' monthly payments while rewarding them with up to $5,000 in free home equity if they stay current. In essence, the Treasury would give troubled borrowers a bigger stake in their homes.

The other new program eases Fannie Mae and Freddie Mac rules so that borrowers who aren’t behind on their payments can get government-backed refinancing. This help, which involves no special federal subsidies, is available to borrowers whose mortgages are owned or backed by Freddie or Fannie. Those whose property has depreciated significantly, however, may not qualify -- the firms won't provide refinancing for more than 105% of the current value. That's because the two firms finance many of their loan purchases through mortgage-backed securities that don't permit higher loan-to-value ratios.

Yet borrowers whose homes are the furthest underwater are the ones most likely to mail in their keys and walk away, with Fannie and Freddie -- and the taxpayers who bailed out the firms -- stuck with the loss. Enabling them to refinance into less costly mortgages gives them more incentive to stick with their investments until the housing market rebounds. And it doesn't pose the moral hazard that the other administration initiative does because it's not using tax dollars to ease part of the pain of the bad bets borrowers and lenders made during the housing bubble. The administration should find ways to make refinancings available soon to borrowers who are more deeply underwater, while low mortgage rates could serve as a powerful incentive not to give up on those homes.