Federal, state and local governments have launched initiative after initiative to save borrowers from foreclosure, leading many Americans to ask why some people should be rescued from the bad bets they made on the housing market while more cautious home buyers were left to absorb the full brunt of the collapse. The question is sure to be raised again in response to Friday’s announcement that the Obama administration will push lenders to reduce the amount that people owe on homes whose values have fallen to less than the amount of their mortgages. It's easy to defend the rescues when they're premised on voluntary decisions by banks to cut their losses. It's more problematic to justify using tax dollars to persuade lenders to do something they should be doing anyway.
The latest administration initiatives respond to the growing belief among housing advocates and lenders that previous loan modifications didn't go far enough to keep borrowers in their homes. One problem has been the reluctance of lenders to write off any part of the principal amount owed. Instead, they've mainly offered to lower interest rates and defer a portion of the debt. A borrower may see little reason to keep pouring money into his home, even at reduced monthly amounts, if it's never likely to be worth as much as he owes on it. That increases the risk that struggling borrowers will give up and walk away, especially if they made only a negligible down payment.
Some leading banks, however, are finally starting to write down "underwater" loans in earnest. Most notably, Bank of America -- owner of the erstwhile subprime loan cheerleader Countrywide Financial -- launched a trial program this week that will write down as much as 30% of the principal owed by 45,000 borrowers if they stay current on their modified loans. As with federal loan modification programs, the relief would be available only to delinquent borrowers who can demonstrate financial hardship and who owe at least 20% more than their homes are worth.
It's not a purely voluntary move by Bank of America; the Massachusetts attorney general threatened to sue the company if it didn't start writing down borrowers' debt. Nevertheless, it makes sense for everyone involved. It's better for the bank to give up 30% of the value of a failing loan than to end up losing 45% or more through the process of repossessing and reselling a home.
Write-downs are a bitter pill for banks to swallow, and yet it was banks that helped cause the wave of defaults by abandoning prudence in pursuit of the fees they could make by originating loans and then selling them to Wall Street. It was a huge mistake for banks to enable home purchases with insignificant down payments and exotic loans, such as mortgages with deceptively low "teaser" rates or monthly payments that piled on more debt. Fannie Mae, Freddie Mac and federal housing programs that supplied money for this kind of profligacy share some of the blame, but the core of the problem was lenders not caring whether the mortgages they issued could be repaid.
The latest federal initiatives move in three new directions. First, the Federal Housing Administration plans to offer a refinancing option later this year for qualified borrowers with underwater loans. If a lender agrees to write down the debt to less than the current property value, the FHA will guarantee refinancing, effectively capping the lender's loss. This option would be available only to borrowers who haven't fallen behind on their payments and whose income and debts are within the agency's usual guidelines for loan guarantees.
Second, the government's current loan modification program would be expanded to encourage lenders to slash or waive payments for three to six months, at no taxpayer expense, for homeowners who have lost their jobs. That's a good addition; someone caught between jobs may not meet the income requirements for the current program. And third, lenders would be required to consider -- but not necessarily to offer -- modification plans that write down the debt for distressed borrowers who owe at least 16% more than their home is worth.
It's a little unnerving to think about the FHA, whose reserves are already being tested by high default rates, taking on the risk of millions of new loan guarantees. The benefit of the refinancing program, though, is that it can help head off problems faced by borrowers who, because of the steep drop in home values, have become trapped in bad loans. It also gives struggling borrowers an incentive to stay current, rather than trying to default their way to relief. And it would do so without paying banks to write down what has proved to be a bad investment.