Thursday, March 5, 2009

The Mortgage Shuffle

The current housing market is a mess, at least it is in California, Nevada, and Florida. One in five homeowners owes more than their house is worth and one in eight are either in foreclusure or behind on their monthly payments (a total of 5.8 million homeowners). However, the housing plan currently proposed by President Obama has several flaws, not the least of which is that it rewards people and banks who acted irresponsibly. Banks are "encouraged" to accept lower payments equal to 38% of the homeowners income while borrowers only have to pay 31% with the government stepping in to make up the difference. This ignores how much the house is worth originally or how much it is worth today.
The justification for the plan is that not stepping in will result in further declines in home value for people that are paying their mortgages. Preventing foreclosures and forcing rescheduling of payments through cram-down bankruptcies is not the only solution. A better solution matches owners with homes that they can afford and encourages homeowners to increase, or at least maintain, the value of their home.
There are really two issues involved: how much are homes worth and how much home can a person afford. Both of these factors are important and we must distinguish between them. Homes sell in an illiquid market and it is difficult to measure home values unless there is activity in the housing market. The second issue is how much house someone can afford. Traditional measures suggest that housing payments should be no higher than 31% of income, although that may be adjusted for the amount of other debt and the level of wealth.
One in five homeowners are upside down in that they owe more than the house is worth. This results from some combination of putting little to no money down on their house, having an interest-only loan, and declining home values. Upside-down (or underwater) homeowners that can still afford their house by conventional measures must be encouraged to keep making their payments – any plan that encourages default will only lead to more problems. They also need to have an incentive to maintain the value of their home through general upkeep and maintenance.
If they can’t afford the payments, then they will have to sell the property. Foreclosed homes lose value both for themselves and their neighbors. However, the problem is not the foreclosure, it is the vacancy. Empty homes fall into disrepair, become an eyesore in the community, and discourage current and potential residents. Home values are not independent of the homeowner. Taking care of their property, making needed repairs, and putting on a good face (Sweat Equity) may not turn a home rightside up, but it can keep it from sinking further. Instead of foreclosing on the house, the bank needs to encourage the upkeep and selling of the house, perhaps by hiring a realtor or contractors to assist in repairs. If a $10,000 investment can bump the home value up by $20,000, then everyone wins.
But who is going to buy the house and what is going to happen to the current homeowners (a term I am using loosely)? To a large extent, that depends on how much the homeowner can afford. Suppose a homeowner buys a house for $500,000 that is only worth $400,000. Unfortunately, the homeowner can only afford the payment on a $300,000 loan. The solution is to let the homeowner pay $200,000 (resulting in negative equity of $100,000) for a house that used to be worth $250,000 but was recently vacated by a homeowner who could only afford a payment on a $150,000 house.
Clearly there is a downsizing effect going on here as homeowners leave expensive houses that they can’t afford for cheap houses they can afford. After the fall out, there will admittedly still be expensive houses that remain unsold and poor people left without a home. Some of these losses will be tabsorbed by banks, some by, homeowners, and some by taxpayers. This is much more viable for the government to step into those situations and help out than the massive undertaking it is currently taking (and which will ultimately fail).
Government can assist in this plan by supporting these negative equity loans as long as they conform to the payments are less than 31% of income. I realize that government support of subprime loans through Fannie Mae and Freddie Mac helped to create the situation in which we find ourselves, but a market for these loans can help get us out. The government can go even further in offering loans directly at a fixed rate of 6.5% (or at the current rate) through their soon to be nationalized banks.
A second change is to allow homeowners and or banks to realize a capital loss on the sale of their homes. Currently home sales are considered personal assets and losses are not tax deductible (and gains are generally tax exempt). In reality, homes are the single largest investment for most homeowners and a tax deduction for losses would relieve some of the current pain. Whether or not to change the exclusion on gains is a separate issue.
This solution achieves a few desirable outcomes that are preferable to the current proposal. First and foremost it matches people with homes they can afford. In doing so it creates a market for homes so that they can be fairly valued. It also encourages the maintaining of home values by encouraging people and banks to put in sweat equity in selling their homes as opposed to just walking away or having banks foreclose on the home. Losses are primarily distributed among homeowners who made bad investments and banks who made bad loans with taxpayers only having limited exposure.

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