Friday, November 23, 2012

The Hangover From The Fall In Housing Prices

We had two big problems as a result of the housing boom and bust.  All but one or two of our investment banks would fail without a government rescue plan.  Homeowners were also stuck with mortgage payments that they could not afford.  The Bush and Obama administrations pulled out all of the stops to rescue the Wall Street banks that played a major role in creating the problem.  Very little was done to deal with the collapse of home prices.  This article reviews some the discussions within the Obama administration that shaped the administrations response.  I will refer to Sheila Bair's description of the policy discussions from her recent book Bull By The Horn.

Bair and her organization (FDIC) had a lot of experience working with banks that needed to resolve bad loans.  They understood that banks were often faced with the problem of either renegotiating non-performing mortgages or going into foreclosure.  Most of the time it was less costly to the bank to modify a mortgage than it was to foreclose.  Bair was also concerned about the effect of widespread mortgage foreclosures on housing prices.  She believed that foreclosures would cause home prices to fall, and that would create more problem loans for the banks to resolve. She had also witnessed the effect that foreclosures had on homeowners who were trying hard to maintain payments and how their credit was effected by foreclosure.  The FDIC proposed a program that would help banks to modify mortgages and cut down on foreclosures.

The economists in the Treasury department, most of whom were free market types left over from the Bush administration, shot down her proposal.  They argued that home prices would not be effected by increases in the number of foreclosures. They argued that markets are self correcting. Tim Geithner, who was appointed to head up Treasury by Obama, decided to go with a plan that was proposed during the Bush administration.  He was supported by Larry Summers, who was a key economic adviser to the president.  The president announced the Home Affordable Mortgage Program (HAMP) and claimed that it would help 3-4 million borrowers to avoid foreclosure.

Only 522,000 successful mortgage modifications were made with HAMP.  Banks, working outside of HAMP made four times the number of modifications.  Bair was at the announcement and she winced at the claim made the president. She knew that the plan would not work, and she did not believe that Geithner or Summers were really committed to preventing foreclosures.  They were primarily focused on saving the Wall Street banks.

There were many problems with HAMP according to Bair.  Borrowers were required to submit documents to support the modification that were the same as if they were applying for new loan.  The problem was to modify the existing mortgage and not to get a new mortgage.  The mortgage servicing organizations were not staffed to deal with a complex and costly program to underwrite new mortgages.  They were staffed and funded to collect payments on existing mortgages. It would cost the servicing organizations more money than they could afford to implement HAMP.

The other major problem with HAMP was that most of the mortgages had been securitized and the securities were owned by investors.  The securities had also been packaged and sold as tranches.  The investors who owned each of the tranches had conflicting financial incentives.  Some investors were better off with a foreclosure and some were better off with a mortgage modification.  Bair's proposal, had provided a way to resolve the investor conflict, and it also included a streamlined process for modifying the mortgages that could be implemented by the servicing organizations.

The HAMP program served the purpose of providing a good public relations opportunity for the administration, but it has been widely regarded as a failure,  and the administration will have to live with the consequences of that failure for the next few years.  Tim Geithner and Larry Summers are gone, and they can pursue new opportunities. 

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