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Why Banks Should Start Working for Their Money
Commentary on the News
Monday, August 09, 2010
Ed DeShields

Rumors.  They’re everywhere this week that the Obama administration may request government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more on their homes than they are currently worth.   It just could happen.

If it occurs, it would be a political bombshell and offer Democrats a boost in popularity just before a midterm election in which they face massive historic losses.  Watch on August 17 when the Treasury Department holds its much-hyped meeting on the future of Fannie and Freddie.

Twenty million U.S. mortgages - one in four - are underwater with negative equity of some $1 trillion.  The actual bailout vehicle could be the Home Affordable Refinance Program, or HARP.  This program involves payments from the government to mortgage servicers and investors in exchange for lowering mortgage interest rates, and occasionally, principal reductions.   Note that HARP was suddenly extended through June 30, 2011.   

The passage of financial reform is a good time to ask how much money we should expect to hand to the banks through our efforts to “help” homeowners.  The basic story is very straightforward to anyone with more common sense than a Washington policy wonk.

Unfortunately, the majority homeowner do not end up keeping their home even after entering HARP.  They usually fail the trial modification because they are unable to meet their payments after receiving a lower interest rate or principal write-down.  Therefore, they do not get a permanent loan modification and end up losing their home anyway.

Through May 2010, the Treasury Department reported that 340,000 of the 1.5 million homeowners who been offered trial modifications had received permanent modifications.  Amazingly almost as many - 300,000 homeowners - never even started on the trial after it was offered.  Roughly the same number of homeowners had their trial modifications canceled before being offered a permanent modification.

Getting a permanent modification does not guarantee that a homeowner will keep their home anyway.  A former Fannie Mae credit officer estimated that 60 percent of the homeowners who receive permanent modifications will still end up losing their home.

Assuming that this number is overly pessimistic and only 50 percent re-default, then the number of homeowners who will keep their home as a result of the modifications made through HARP thus far is approximately 170,000.  If we assume that the total number will end up being three times this large (assuming HARP continues operating through 2012), then 510,000 homeowners will have kept their home.  The projected price tag for the program is $50 billion, which means that taxpayers will have spent almost $100,000 for every homeowner who was able to keep their home through the program.

This is a steep price for sure;  especially since even many of the people helped still won’t accumulate equity.  

The limited benefit to homeowners from this program would be of concern, except that we know that the money shelled out by the government went to investors and servicers (i.e. banks).  And, as we know from the politicians, money handed out to banks is always money well-spent.

The flow of money from taxpayers to banks is not hard to recognize. It is easy to distinguish between helping banks and helping homeowners.  Homeowners are helped if either their cost of being a homeowner is less than or equal to the cost of renting a comparable unit and/or they accumulate equity in their home.

A serious plan for helping homeowners would have limited taxpayer dollars to modifications where #1 or #2 was likely to be the case. This would involve looking at factors like price to rent ratios, a hugely relevant issue that never seems to come up in policy debates on helping homeowners.   

Much of my work on the road for two months is to study rent ratios and its affect on the major metropolian areas of the country.  It is to see how the system is working from a practical matter.   The point is actually pretty simple: if the ratio is high then homeowners would likely save money by renting.  Furthermore, a high ratio is good evidence of a bubble, which would mean that prices would be lower in future years, guaranteeing that most homeowners will not accumulate equity before they sell.   As it stands, the housing bubble has not fully deflated, so prices in many areas will almost certainly be lower in 2 to 3 years, guaranteeing that many current homeowners will never accumulate equity.

An easy route to helping homeowners is to require the Fed to pursue a policy targeting a modest rate of inflation (e.g. 3-4 percent).  House prices would actually start rising.  An increase of 4 percent over the next 3 years, as opposed to the current 1.0 percent rate, it would give almost $1 trillion in real equity to homeowners by reducing the real value of their mortgages.

Unfortunately, almost no one in Washington talks about this route probably because the Fed has lost control of the balance due to our enormous debit to GDP problem.  

For now at least, we can only talk about helping homeowners if most of the money goes to the banks.  Since we aren’t actually helping homeowners with current policy, maybe we should just end the discussion and make the banks work for their money instead of relying on taxpayer handouts.

About Ed DeShields

Last week: From Woodstock to Communal Living

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