Housing’s Catch-22

What is the optimal policy to deal with our ongoing housing crisis? Should Uncle Sam continue to throw more money at mortgage modifications? Should banks be compelled to implement a principal reduction program? Should Uncle Sam step in and subsidize the principal writedown involved in a principal reduction program? Would that be the mother of all socialized housing programs? Let’s navigate and address these topics knowing full well that none of these questions have any easy answers.

I witness further evidence again this morning of a continued increase in home foreclosures amidst the prime mortgage space. The Wall Street Journal highlights this ongoing development in writing, Foreclosures Grow in Housing Market’s Top Tiers:

The report shows that foreclosures, after declining earlier this year, began to accelerate in the late spring and that more expensive homes have more recently accounted for a growing share of all foreclosures. “The slope of that curve in recent months is much sharper than it was recently,” said Stan Humphries, chief economist for Zillow. Rising foreclosures among more-expensive homes could create added pressure for a housing market that has shown signs of stabilizing in recent months as sales of lower-priced homes pick up.

Foreclosures are rising in more expensive markets as home values in those areas fall, leaving more homeowners with mortgages that exceed the value of their properties. Prime loans accounted for 58% of foreclosure starts in the second quarter, up from 44% last year, according to the Mortgage Bankers Association. Subprime mortgages accounted for one-third of foreclosure starts, down from one-half last year.

The prime category includes so-called exotic mortgages that were increasingly used to buy more expensive homes, including interest-only mortgages that allowed borrowers to defer principal payments during an initial period. Borrowers often aren’t able to refinance out of these products because the drop in home values has left them with little equity in their homes.

Default rates are particularly high and expected to rise on option adjustable-rate mortgages, which allow borrowers to make minimum payments that may not cover the interest due. Monthly payments can increase to sharply higher levels after five years or when the outstanding balance reaches a certain level. A study by Fitch Ratings found that 46% of option ARMs were 30 days past due last month, even though just 12% of such loans have reset to higher monthly payments.

Zillow estimated that nearly one in four homes with mortgages was worth less than the value of the property at the end of June. Mr. Humphries said he didn’t expect to see foreclosure volumes level off until later in 2010. (emphasis added)

With the waves of foreclosures not abating, Uncle Sam’s plans to merely modify mortgages is proving largely insignificant in supporting the overall housing market. Homeowners are clearly showing a strong inclination to default on their mortgages when they are ‘underwater.’ Thus, how does Uncle Sam help people get ‘above water?’ Compel banks to reduce the principal balance of the mortgage. Will they do it? Not quickly, as a principal reduction would imply an immediate hit to the banks’ capital.

Where is a principal reduction program being planned? Let’s revisit Latvia which has proposed a mortgage principal reduction program to support its housing market. The Financial Times addresses this topic this morning in writing, Swedbank Hits Out At Latvia’s Mortgage Plan:

Swedbank, the largest Swedish lender in the Baltic region, has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders .

The bank and other Swedish lenders insist they are strong enough to cope with even the most severe losses in Latvia after fresh political and economic turmoil .

Thomas Backteman, vice-president of corporate affairs for Swedbank, said Latvian proposals to limit mortgage collections to the current value of homes rather than the value of the original loan would “deeply violate” European law and cause a re-evaluation of operations there.

“If these proposals go through, it would be very difficult for us to continue lending in the [Latvian] mortgage market,” he said.

Latvia says that the measures, which were announced last week and are still in the early stages of planning, are aimed at easing pressure on homeowners as the country faces an 18 per cent contraction in its economy this year.

But the proposals would involve huge losses for the Swedish banks that dominate the Latvian market because property prices have fallen more than two-thirds from their peak.

Banks and mortgage investors here in the U.S. have made similar assertions as Swedbank in regard to the implementation of a principal reduction plan. While principal reduction would clearly support homeowners, the aid would come at the expense of further capital commitment and thus a rise in long term mortgage rates. What is a government to do? I see four paths:

  1. An increase in the funding thrown at mortgage modifications, which clearly isn’t working but is politically feasible given the construct within Congress.
  2. Hope . . . always a lousy hedge.
  3. Cease all programs and let the market sort the mess out.
  4. Government funding for a principal reduction program which is the next leg toward a more fully socialized housing policy.

What do you think will happen? What do you think should happen?

Graph: WSJ

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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1 Comment on Housing’s Catch-22

  1. I think this administration is going down the path toward principal reduction. This would be a shame as it would undermine faith in our capitalist system, alleviate responsibility on the homeowners who paid overblown prices, and tend to prop up still-too-high housing values. While all this plus collateral damage is inevitable if they follow this path, it would have little to no effect on the crisis at hand and would in fact stretch it out as it undermines market forces. For a housing market to work, at the end of the day people have to want to buy houses and feel comfortable that the market is not subject to manipulation by the government. Fortunately I think that any principal reduction plan (bank/investor and/or taxpayer-supported) may be the most difficult path to follow through on, as it will bring out the lawyers in droves.

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