Obama Housing Policy Goes from Bad to Worse

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Three related issues are likely to shape financial news and policymaking in 2010: (1) the abject failure of the Obama Administration’s home mortgage modification program, which has not only failed to stem the tide of foreclosures but may actually be exacerbating the situation; (2) the decision to provide unlimited financial support for Fannie Mae and Freddie Mac, which could cause the federal budget deficit to swell by hundreds of billions of dollars; and (3) the Administration’s decision to allow financial institutions to repay TARP investments without resolving the issue of subordinate liens on residential real estate.



Let’s take them in order:



(1)    In February, the Obama Administration launched Making Home Affordable, a $75 billion mortgage modification program aimed at combating foreclosure.  The program has failed miserably.  According to the Making Home Affordable Servicer Performance Report, of the 759,058 mortgages that have been modified on a trial basis only 31,382 (about 4%) have become permanent modifications.  While the “conversion” rate from trial to permanent modifications is likely to increase, a reasonably optimistic long-run estimate for permanent modifications is 25%.  And even then, the data from the Office of the Comptroller of the Currency (OCC)  suggests that more than half of these “successful” modifications will eventually end up re-defaulting.  Thus, optimistic estimates suggest only 12.5% of the Obama Administration’s trial modifications will successfully avoid foreclosure.  Pessimistic estimates are even lower, especially for modifications that do not involve a reduction of principal (for which the successful modification rate has not been demonstrated to be statistically different from zero).  



The Obama Administration’s mortgage modification program is doomed to fail as long as its focus is on payment reduction (lower mortgage rates) rather than a reduction in principal.  Research suggests that foreclosure is caused by owing more on a house than it’s worth, not rate resets (the popular 2007 explanation for rising defaults) or job loss (the 2009 rationalization). 

Say a borrower owes $400,000 on a mortgage with a 6% interest rate.  If the house falls in value to $250,000, the mortgage rate would have to be reduced to 2.1% for the borrower to break even.  Even then, success depends on convincing a borrower to stay current on a mortgage worth 60% more than the underlying property.  This is not an attractive proposition, especially when considering that the borrower’s credit becomes impaired whether he accepts the modification or walks away.

(2)    On Christmas Eve, the Obama Administration announced that it had lifted the $400 billion cap on government support for the government-sponsored enterprises, Fannie Mae and Freddie Mac.  Going forward, there will be no limit on the amount of senior preferred stock the Treasury may purchase to ensure both institutions maintain a positive net worth through the end of 2012 (and the next Presidential election).  If the concern was solely whether the GSEs had sufficient capital to withstand losses on their legacy book of business, this step was unnecessary.  The GSEs have already recognized over $125 billion in losses and have received more than $110 billion in direct investment from the Treasury.  According to Barclays Capital, Fannie Mae could require as much as $180 billion by itself, which would fit under the $200 billion already allocated to each GSE.  While this might give creditors some discomfort – as losses approach the cap, investors might dump Fannie debt due to concerns about potential default – the cap would not be reached suddenly and without warning.  As losses accumulate, Treasury could ask Congress for additional authority well-before the crisis materialized, much as it does with periodic increases in the national debt ceiling.



The more likely reason for the increase was a desire to use Fannie and Freddie to absorb the losses on large-scale write downs of the principal balance on underwater borrowers’ mortgages.  Barclays estimates that it would cost $125 billion for Fannie and Freddie to avoid foreclosure on 2 to 3 million mortgages.  While principal reductions may be the only way to avoid foreclosure, the cost of rescuing these borrowers is roughly four-times the budget for the entire National Institutes of Health (NIH).  Does this expenditure – which was neither authorized nor appropriated by Congress – make sense in a world where the government’s resources are finite and come only from taxation or inflation?



(3)    Efforts to write down the principal balance on underwater mortgages have failed to resolve the problem posed by junior liens on the residence: second mortgages, home equity loans, and revolving home equity lines of credit (HELOCs).  The owners of these junior liens have little incentive to participate in a principal reduction scheme because doing so requires them to realize substantial losses.  Yet, the acquiescence of second mortgage holders is essential for a principal write down.  Consider the home from the previous example now worth $250,000.  Assume its $400,000 in mortgage debt comes from a $350,000 first mortgage and a $50,000 home equity loan.  If the house were liquidated through a short sale or foreclosure, all of the $250,000 in proceeds would go to the first mortgage holder and the junior lien holder would receive nothing.  The first lien holder generally expects that this is how losses should be apportioned in a loan modification: the first lien holder recovers 71% of face value ($250,000/$350,000) and the owner of the home equity loan gets nothing.  Any other arrangement would violate claims priority as governed by contract.



However, this outcome is far from certain and the junior lien holder has its own contractual right to take a “wait and see” approach.  At the end of November, an estimated 10.7 million borrowers owed more on their home than it was worth.  The great majority of these borrowers will continue making timely payments and their second lien will be paid off without ever being impaired.  Even in cases where the borrower has missed a payment, a loan modification requires the second lien holder to crystallize a loss that may not have otherwise occurred, as it’s difficult to know which of the loans being modified would have returned to current status.



Banks holding second liens not only prefer the “wait and see approach,” they generally cannot afford to pursue any other strategy.  According to the FDIC, insured banks hold $885 billion in second liens.  If banks were suddenly forced to write down the value of these assets to anything close to their value at liquidation (which is zero in many cases), the banking system would require another TARP-sized equity infusion to remain solvent.  And that’s why the Obama Administration’s decision to permit some of the largest holders of second liens to repay their TARP funds was so ill advised.  Repayment was indirectly financed by allowing these banks to continue carrying second liens at prices well above their liquidation value.



The Administration announced a program for second liens in April, but by the end of 2009, it was still not up-and-running.  It may never get up-and-running if, as many analysts suspect, the mortgage crisis will not end until second lien holders take substantial write-downs.  Without the ability to leverage TARP investments to seek resolution of this issue, the Obama Administration now must choose between: (A) allowing a record 4.8 million homes to be lost in foreclosure proceedings in the next two years; (B) force large financial institutions to put their own solvency at risk through crippling write-downs on outstanding second mortgages; or (C) use the GSEs or other taxpayer resources to rescue both home borrowers and the banks holding bad mortgage debt.



Based on their performance through the first year in office, the smart money is on option C, implemented in a way that best hides or postpones the associated fiscal costs.