Solving the Housing Foreclosure Crisis by Cutting Mortgage Principal Balances – Big Mistake

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Mortgage interest rates are at their lowest point in decades (about 4.5%) and the housing credit has been in effect for more than three years, yet the housing market is tepid at best, with foreclosures at record highs and government housing institutions having to put more distressed assets on their books. This has spurred rumors around the web that the Obama administration (via the Treasury) will soon be asking government owned entities Fannie Mae and Freddie Mac to expand their “save the economy” effort by reducing the principal balances for those individuals struggling to pay their mortgage payments.  Keep in mind that the President does not need congressional approval for this change because 1) the government already “owns” Fannie and Freddie and 2) the Treasury has removed the previous limits on the amount of money the organizations can tap into (it was $400 Billion, now – no limit).

Unlike most rumors, this one became more, not less, plausible when you examine the details. The White House has made it clear in recent months that it is frustrated by what the Framers called “the legislative branch,” what President Obama calls “politics” and what I call “the wishes of the American people.” Obama craves a short-term sugar rush for the economy. If he feels cornered, betrayed and alone, he could use his new ownership of Fannie Mae and Freddie Mac as a free federal candy store and tell America to line up and pig out. In more ways than one, Barack Obama seems to want to be known as the Sub-Prime President. (source : New York Post)

While this plan may help a handful of borrowers on the edge of foreclosure, there are many more  fundamental problems with  reducing the principal home loan balances which include:

  • The main issue, politically and practically is that it is very unfair to people who have worked hard to stay current on their mortgages. despite being “underwater” on their homes. In fact it is likely to cause a massive revolt by by responsible tax payers and non-home owners,  if people who are struggling to pay their home loans and facing foreclosure because of excessive spending/borrowing are bailed out. In essence the government is promoting asset deflation, since it is debasing the value of homes, the largest asset for most people.  Imagine if overnight the value of your home is cut by 20 to 30%, thanks to your neighbor’s principal balance reduction.
  • Too many people are “underwater” – they owe more than their house is worth.  About one in six people are upside-down. Thus the cost of reducing principal balances, which would fall on the shoulders of the banks and GSE’s which would create another financial crisis as firms take massive write down losses and protect their capital more closely (meaning less credit available to small business and consumers). This potential credit crunch would trigger another financial meltdown making the financial crisis of 2007-2008 look like a walk in the park. That’s why lenders are willing to cut interest rates, modify/delay payments, even write off some late fees, but are dead set against forgiving even a dollar of the principal balance (some like BoA have initiated mortgage reduction programs, but with very tight restrictions and little real success)
  • If the government allows banks to take tax write-downs for the balance reductions, then tax payers will shoulder the burden of the principal reductions and our national debt will spiral out of control much, much faster. Existing programs like HAMP, to lower payments and modify terms have hardly worked and are subject to so much fraud that it is hard to imagine a principal reduction program being executed any more effectively.
  • Unemployment is high and rising, at least in the near term.  As the old saying goes, you can’t keep let alone buy a home if you don’t have a job.  Even if you have a job, there is a fear you will lose it as companies cut back on spending and hoard capital. Cutting the principal balance does not make repayments go to $0. And if people don’t have any income, then the housing crisis will continue. Insecurity about the future trumps even the best deal in town. So unless Obama and Congress solve the unemployment crisis, cutting home loan principal balances will little or no effect.

It would be very irresponsible of the government to cut principal balances because while it may temporarily help the 10 to 20% of Americans facing or in foreclosure, the remaining 80% of home owners (and tax payers) would pay the long term consequences of this move. Americans feel shame about being irresponsible as shown by many home owners who continue to make payments despite being underwater on their loans. What about the American government?

Disclosure: I am a homeowner who is current on my mortgage!

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{ 8 comments… read them below or add one }

ChrisR October 7, 2010 at 12:25 am

The column does not make a whole lot of sense to me. I am currently about $40-50K underwater on my mortgage and currently have no problems making payments. I bought the house in 2007 (really poor timing on my part). I have never been late or have missed a payment either. The currently stimulous packages to help people in my situation are a joke. Because of my loan-to-value ratio I do not qualify HAMF. Also refiancing right now would only save me about $100-$200 a month but it would also add about $8k to the principle for closing costs. If I short sale the bank siad they will come after me for the difference. So what is keeping me and others in my position to walk away from our loans? I understand it is the right thing to do but at what cost to our future? We could use that money to invest in other avenues besides our homes.

With that being said. If we walk away from the loan the banks will be stuck with another home they will have to pawn off at a huge loss. A loss that would be greater then just reducing the principle! Money they could be using to loan to a small business or another home buyer. Even a percentage of reduction would help reduce the risk of people walking. I could debate all the comments above but I don’t have that time.

My big idea. The government had $780B +/- for the stimulous package to begin with and only $70B +/- has been spent to date. Why not allow the people who are underwater on their loans write off a percentage of the difference every year until loan-to-value difference is zero? The homeowner would be required to submit an appraisal of the property and loan documentation. The payment would be required to go directly to the mortgage company or lean holder. This way it put no more responsiblity on the lending companies to deal with all the paperwork. This way most everyone wins. Less distressed houses on the market, underwater homeowners will be able to see the end of the tunnel, banks would be able to free up more money, government would end up spending less over the long run, and the general public should not feel like their burdened with funding another bailout.

Just my thoughts.

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Brad August 23, 2010 at 9:56 am

All homeowners current on their mortgages need to be refinanced into a loan with a 4.5% so that they could save $200 to $300 a month – this will make a big difference to foreclosures.

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Jeffery001 August 13, 2010 at 1:58 pm

Housing policy watchers expect Washington to consolidate Fannie and Freddie into a single government-backed agency, along the lines of the self-supporting Federal Housing Administration. The new entity would buy mortgages like Fannie and Freddie do now, but would only report to Congress, and not investors. If structured as a quasi-public agency, it could pay for its mortgage purchases by selling bonds. Such an arrangement would preserve liquidity, and also ease the new entity’s eventual transition off the government’s balance sheet. The question now isn’t whether Congress agrees with nationalization; it’s whether the body has the will to follow through.

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arma August 13, 2010 at 11:39 am

While we are on the topic of forgiveness due to a poor investment, what about all the retirees (or soon to retire) who suffer equal or greater perils in their 401(k) accounts. As most homeowners currently suffer losses on their “investment” so do other asset holders, such as 401(k) participants who have purchased stocks and bonds only to watch them melt away over the last couple of years when they needed it most. Where do the bailouts stop? Can everyone claim ignorance where there is risk? I think there is no doubt the government would support housing as an investment and as almost any investment discloses “past performance is no indication of future results.” Over-consumers should suffer the consequences of their choices, otherwise we enable governments to enter win-win situations with the successful speculators and those left holding the bag. The only losers are the ones that are the silent majority – the American Taxpayer. Everyone at some point in life learns a valuable lesson that effects their lives from that point on – let this be theirs.

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Tom August 13, 2010 at 11:37 am

Principal forgiveness is an affront to every responsible, non-delinquent borrower in your book of assets… you are rewarding those who bit off more than they could chew, while those who did not take on excess leverage, or who kept their income-to-debt ratios manageable, see no benefit, even as their home equity values have declined. Even worse, you are denying savers who sit in the cash market the opportunity to purchase inventory from the delinquent.

Capitalism should migrate assets from the weak to the strong, not the contrary… allowing those who are delinquent to now benefit from their financial excesses is a despicable solution that ignores the integrity and responsibility of those who actually finance the lion’s share of your earnings: those who don’t default.

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nanasangels2006 August 13, 2010 at 11:34 am

have a problem and feel I have exhausted all possibilities available to me. I purchased my home back in 93″ and refinanced once. I went with Peoples Choice Home Loan out of California, via Lending Tree. We decided to pay our own property taxes, instead of escrowing the in the amount of $800. We live in Knightstown IN. in a small farming community. The school corp. built a new million dollar high school and as a result, the property taxes doubled. At the time we did not have the homestead exemption in place, so taxes were $1800.00. Needless to say, we got behind on them and during that time our mortgage was sold to another servicer. The taxes were paid by the new servicer and thats when the trouble actually snowballed!!! We paid out thousands of dollars trying to get an arrangement with them, the original mortagae pymt, went from $501.00 to as much as $1500.00. We have struggled with this excrow repayment and have had foreclosure attempts. We were sold another time to Litton Loan Servicing in Houston Tx, a little over a yr ago. Our pymt have been more than $1200.00 and they say they are unable to help us..due to the fact that we make to much money and our bills over exceed what we bring home. Really!!! I could have told them that since our real payment is 501.00 the original mortgage refinance amount was 74,000.00 and we still owe 69,000.00. Our escrow shortage is more than 7,000.00 and we will never get out caught up!! The property taxes keep building on top of the old ones. Our credit report shows 90 days behind over and over, this shortage is killing us! Our bank would not refinance due to the low credit report. we need help! We are not a Freddie or a Fannie. We need to have something done.. Why can’t they just move the shortage to the end of our loan and refinance the loan?? We do not want to loose the home due to escrow shortage..Can you give me any advice..PLEASE!!!

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Gail August 13, 2010 at 10:11 am

If there is any doubt that foreclosures and unemployment are linked, check this out at Yahoo Finance today.:

The number of U.S. homes lost to foreclosure surged in July, another sign lenders are moving quicker to take back properties from homeowners behind in payments. Lenders repossessed 92,858 properties last month, up 9 percent from June and an increase of 6 percent from July 2009, foreclosure listing firm RealtyTrac Inc. said Thursday.

Banks have stepped up repossessions this year to clear out the backlog of bad loans. July makes the eighth month in a row that the pace of homes lost to foreclosure has increased on an annual basis.

Meanwhile, homeowners who are falling behind on their payments are being allowed to stay in their homes longer because lenders are reluctant to add to the glut of foreclosed homes on the market.

The latest data reflect a foreclosure crisis that continues to drag on as many homeowners struggle to make their monthly payments amid high unemployment, slow job growth and an uneven rebound in home prices.

Economic woes, such as unemployment or reduced income, are now the main catalysts for foreclosures. Initially, lax lending standards were the culprit, but homeowners with good credit who took out conventional, fixed-rate loans are now the fastest growing group of foreclosures.

Lenders are offering a variety of programs to help homeowners modify their loans, but their success rates vary. Hundreds of thousands of homeowners can’t qualify or fall back into default.

The Obama administration has rolled out numerous attempts to tackle the foreclosure crisis but has made only a small dent in the problem. More than 40 percent, or about 530,000 homeowners, have fallen out of the administration’s main effort to assist those facing foreclosure.

That program, known as Making Home Affordable, has provided permanent help to about 390,000 homeowners, or 30 percent of the 1.3 million who have enrolled since March 2009.

Still, RealtyTrac estimates more than 1 million American households are likely to lose their homes to foreclosure this year.

In all, 325,229 properties received a foreclosure-related warning in July, up 4 percent from June, but down 10 percent from the same month last year, RealtyTrac said. That translates to one in 397 U.S. homes.

Among states, Nevada posted the highest foreclosure rate in July, with one in every 82 households receiving a foreclosure notice. The number of properties in Nevada receiving a foreclosure warning last month rose nearly 7 percent from June, but fell nearly 30 percent from the same month last year.

Rounding out the top 10 states with the highest foreclosure rate last month were: Arizona, Florida, California, Idaho, Michigan, Utah, Illinois, Georgia and Maryland.

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JoeT August 13, 2010 at 10:04 am

Uncle Sam’s attempts to stem the tide of foreclosures and arrest the baleful fall in home prices have been, in a word, pathetic. This scheme will just be another bad program. Let capitalism and free markets take care of this problem. It will be painful, but in the longer term the nation will be better off. People will learn to buy what they can afford.

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