Obama Administration Housing InitiativesDouglas J. Elliott

July 2, 2009

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Douglas J. Elliott delliott@brookings.edu

Agenda• The problem

• Alternative solutions

• Approach of the Obama Administration

• Progress report

• Issues for the future

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Douglas J. Elliott delliott@brookings.edu

The Problem• Delinquency rates on mortgages are very high and

rising

• House prices have plummeted by 32% from their peak and are forecast to fall further

• 19% of mortgages are underwater. 1 in 10 borrowers were underwater by at least 10% as of the end of 2008

• Unemployment rate is 9.4% and will likely peak over 10%

• As a result of these factors, a high proportion of delinquent mortgages are likely to default

Sources: S&P/Case-Shiller Composite-20 Home Price Index; Moody’s Economy; First American Corelogic; Bureau of Labor Statistics

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Douglas J. Elliott delliott@brookings.edu

Delinquency rates are very high and rising

Mortgage Delinquency Rates

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Source: Mortgage Bankers Association National Delinquency Survey, seasonally-adjusted 30-day delinquency rates; Alt-A loans are split between prime and subprime based on self-reporting by survey respondents

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Douglas J. Elliott delliott@brookings.edu

House prices have plummeted by 32% from their peak

S&P/Case-Shiller Home Price Index

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Douglas J. Elliott delliott@brookings.edu

Some alternative solutions are undesirable or appear infeasible • Directly intervene to raise house prices

» Very expensive

» Hard to implement

» Works against market forces finding a new equilibrium

• Subsidize income of borrowers

» Very expensive

» Raises fairness issues

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Douglas J. Elliott delliott@brookings.edu

Infeasible Solutions, cont’d• Let foreclosures occur and cushion the rest of the economy

» Foreclosure process is expensive, traumatic, and damages confidence in the economy

» Toxic assets tied to mortgages are very difficult to handle

» Public and politicians demand relief for homeowners to balance bank rescues

• Force the mortgage holders to restructure the loans

» May violate the “takings” clause of the Constitution

» Securitization makes implementation difficult

» Would probably damage already-weakened banks that rely on government aid

» Difficult for the government to determine the right restructuring formula

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Douglas J. Elliott delliott@brookings.edu

Main alternatives center on subsidizing restructurings • Both the Bush and Obama Administrations

subsidized mortgage restructurings

• Interest subsidies are designed to deal with cash flow problems of homeowners

• Subsidizing principal reductions

» Would get at true solvency issues

» Would create economic incentives for those whose

mortgages are significantly underwater

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Douglas J. Elliott delliott@brookings.edu

One potential nightmare: What if homeowners start behaving rationally?• Homeowners generally try hard to hang onto their

homes, even when their mortgages are underwater

» Recent FRB Boston paper found that “less than 10 percent of a group of homeowners likely to have had negative equity eventually defaulted on their mortgages”

• There are likely to be four main reasons for this

» Desire to preserve credit ratings

» Wanting to remain in their family home

» A desire to do “the right thing,” avoiding the shame of foreclosure

» Value of option on future price appreciation of the house

Sources: Foote, Christopher, Kristopher Gerardi, and Paul Willen. “Negative Equity and Foreclosure: Theory and Evidence.” 2008 FRB of Boston Public Policy Discussion Paper No. 08-3.

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Douglas J. Elliott delliott@brookings.edu

Nightmare, cont’d• But, we have never had so many homeowners

so far underwater on their mortgages

• What happens if the culture and environment change?

» Credit providers may stop giving as much weight to foreclosures.

» Worse, individuals may stop feeling virtuous for continuing to pay on underwater mortgages and may start to feel like fools when they see neighbors just turning in the keys

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Douglas J. Elliott delliott@brookings.edu

Make Home Affordable Program• Refinance

» Homeowners with conforming loans with up to 105% Loan to Value (LTV) ratio can refinance at better rates

• Modification

» Lenders, servicers, and borrowers given incentives to lower monthly payments to 31% of income

– Lender reduces payments to 38% of income, government matches further reductions to 31%

– First, through interest reduction, then longer amortization, then principal reduction

– “Pay for success”: Servicers get $1,000 for each modification, and additional $1,000 per year for 3 years if borrowers stay in program

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Douglas J. Elliott delliott@brookings.edu

Make Home Affordable, cont’d• Additional incentives for borrowers to stay current

» $1,500 for borrower, $500 for servicer if modification is made while current

» $1,000 principal reduction for borrower each year for 5 years if they stay current

• Servicers are encouraged to pursue alternatives to bankruptcy (deeds-in-lieu, short sales)

» Servicers get $1,000 for successful D-I-L or short sale

» Borrowers get $1,500 for relocation costs

• Judicial “cramdowns” of principal in bankruptcy proposed

• Industry-wide guidelines specified to reduce fear of lawsuits and clarify restructuring process

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Douglas J. Elliott delliott@brookings.edu

Progress Report• It is too early to assess the effectiveness of the plan

• 14 servicers, including major ones, are signed up

• About 50,000 trial mortgage modifications have been performed, out of long-term target of 3-4 million

• Roughly 100,000 applications have been received

• At the least this is better than the ONE loan modified under the earlier Hope for Homeowners plan

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Douglas J. Elliott delliott@brookings.edu

Issues for the future • How many loan modifications will be done? Biggest risk

may be that interest rate reductions alone are insufficient to motivate enough homeowners, if solvency is the real issue

• What will the redefault rate be? Earlier programs involving interest rate reductions alone had a poor record, but they had often resulted in HIGHER monthly payments through fees and rolling past unpaid interest into principal

• Will principal reductions be essential? It appears that principal reductions make more of a difference, and may be the only way to deal with mortgages that are significantly underwater. However, lenders and servicers have been reluctant. Sharing in future appreciation may help, but is complicated

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Douglas J. Elliott delliott@brookings.edu

Issues, cont’d• What can be done for homeowners with

Option ARMs mortgages? Their interest rates are already low at this point, so interest rate reduction has little effect in the near-term

• What can be done for the unemployed? They need more help now, but may be able to make mortgage payments again later on. Unfortunately, targeting the unemployed could have undesirable labor force effects