Most of the small print about the Administration’s plan to help beleaguered mortgage borrowers is now available at www.makinghomeaffordable.gov. In my view, it is disappointing in its limited scope. The program is ostensibly designed to provide benefits to owners who deserve to be helped, rather than to reduce foreclosures and stabilize home prices which is the root cause of the foreclosure problem.
The program name is "Making Home Affordable", henceforth MHA, and it has two parts. Part one is directed toward increasing refinance opportunities for borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac, and who don’t have more than 5% negative equity on their first mortgage. Borrowers with negative equity greater than 5% don’t qualify.
The second part of the program encourages payment-reducing contract modifications of mortgages that are endangered by adverse events affecting the borrower – such as a job loss or a pending rate increase. The major tool for reducing the payment is rate reduction, with balance reductions only a last resort. Borrowers with investment properties don’t qualify.
The limited scope of the program is why its cost is estimated at only $75 billion, or less than the amount required to bail out AIG. The systemic impact will be correspondingly small.
Failure to Attack Negative Equity
The major limitation of the program is that it does not attack the problem of negative equity – mortgage balances larger than the value of the homes securing the mortgages. Large and growing negative equity underlies the sharply reduced values of mortgages and mortgage-related assets on the books of the financial institutions holding them. These reductions in asset values have eroded the capital of these institutions, which the Government in case after case has had to replenish to prevent failures.
The new program is focused entirely on the capacity of borrowers to make their monthly payments. Indeed, this is evident from the program name, "Making Home Affordable". The major tool for reducing the payment is rate reduction, with balance reductions only a last resort in cases where rate reduction and term extension can’t get the payment low enough to be affordable.
This approach flies in the face of evidence that balance reductions are critically important in avoiding subsequent redefaults. A recent study by Roberto G. Quercia, Lei Ding and Janneke Ratcliffe, found that "Among the different types of modifications, the principal forgiveness modification [ie, balance reductions] has the lowest redefault rate. We believe that this is because it addresses both the short-term issue of mortgage payment affordability and the longer-term problem of negative equity…The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment." [Loan Modifications and Redefault Risk, Center For Community Capital Working Paper, March 2009].
Mindset Underlying the Neglect of Negative Equity
A different mindset is applied to helping borrowers as opposed to helping financial firms. Firms are helped in order to avoid the systemic consequences of the firm’s failure. Whether or not the firm "deserves" to be helped is wholly irrelevant. Indeed, it could be argued that the largest bailouts have been directed to the least-deserving firms. This is unfortunate but unavoidable because it is the system that is as stake.
When it comes to assisting mortgage borrowers, however, the mindset is that assistance should be limited to those who have some moral claim to Government assistance. Eligibility is based on deservedness, with the systemic implications swept aside.
In the minds of the program’s designers, having negative equity is not an indicator of deservedness. True, most negative equity has arisen from broad price declines affecting entire markets.
[Adapted from www.mtgprofessor.com/]
Jack M. Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, and founder of GHR Systems, Inc., a mortgage technology company.
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