In July, Warren Buffett noted how important the housing market is to fixing our economy. "We will come back big time on employment when residential construction comes back," he told Bloomberg. Getting there simply takes time. "The only way a correction takes place is to have household formation exceed new construction by a significant amount for a significant period of time."
Ever since 2007, there's been a push from both private executives and public policy makers to do more, tweaking every knob in an attempt to end the housing slump sooner rather than later.
Mortgage modifications, or changing the terms of home loans, have been the most popular way to tweak the knobs so far. They've also been a big disappointment. The redefault rate on modified mortgages has been staggering, with upward of one-third of modified mortgages eventually falling back into default.
Why isn't much of a mystery: The vast majority of mortgage modifications lower monthly payments, but few actually reduce the loan balance. That's rendered many modifications worthless because one of the main the reason defaults are so high is because so many homeowners -- about 28% -- owe more on their mortgage than their home is worth. They're going to default on their mortgage regardless of whether they can afford their monthly payments.
Joe Nocera of The New York Times has a suggestion:
The only way to stop the death spiral is through principal reduction. The reason is simple: "The data show that principal modifications work better" than other kinds of modifications, [analyst Laurie Goodman] says. Interest rate reductions can lower monthly payments, but the home remains just as underwater as it was before the modification. And the extent to which a home is underwater is the single best indicator of whether the homeowner will default. The only way to change the imbalance between the size of the mortgage and the value of the home is to reduce principal.
He's right. Reducing principal is by far the most effective way to modify a mortgage. But it's easier said than done.
As the Federal Reserve Bank of Atlanta wrote earlier this year, "The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages."
They won't, of course. Nick Timiraos of The Wall Street Journal recent pointed out, about 20% of all mortgages owned or guaranteed by Fannie Mae and Freddie Mac are underwater, yet 87% are still current on their monthly payments. Many underwater borrowers will walk away from their mortgage, but the majority will not.
So then who gets their principal reduced? In practice, those delinquent on their mortgages are the ones eligible for a modification. The problem is that once you set those boundaries, people will move mountains to meet them. Think about it. If you are underwater on your mortgage but still committed to making your monthly payments, yet you learn that your bank will write down your mortgage principal balance if you become delinquent, that's exactly what you'll do. For private banks like Wells Fargo (NYSE: WFC) and Bank of America (NYSE: BAC), it's an expensive game of chicken. And for taxpayer-owned Fannie and Freddie, there's no political will to throw around tens of billions of dollars right now.
This kind of stuff happens all the time in public policy. As the Atlanta Fed pointed out, "Planners often have a preventative remedy that they have to implement before they know who will actually need the assistance. This inability to identify the individuals in need always raises the cost of the remedy, sometimes dramatically so."
That's why, rather than principal forgiveness, banks have been more eager to grant short sales. In a short sale, banks write down the underwater principal balance, but the home is also sold. Homeowners have to prove they really can't afford the house by giving it up. As JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon put it, "Principal writedown for people who could pay their mortgages? Yeah, that's off the table."
Another reason lenders are hesitant to grant principal writedowns is that a lot of home loans are covered by private mortgage insurance, so if the borrower defaults, the bank (or whoever owns the mortgage) will still likely be repaid in full. According to an industry trade group, $477 billion worth of mortgages were covered by private mortgage insurance in September. Banks and mortgage-bond holders that utilize private mortgage insurance aren't terribly concerned whether the loan defaults. The insurers, companies like MBIA (NYSE: MBI), Assured Guaranty (NYSE: AGO), and Radian (NYSE: RDN), are the ones eating the losses. Unfortunately, they can't order banks to forgive principal, for obvious reasons.
Plus, as Atlantic writer Megan McArdle pointed out:
According to the expert I heard from "Contract interests are property for purposes of the Takings Clause." So the government can mandate that banks write the mortgages down. But eventually, a judge will order them to pay those banks back. Yes, they will, even if those banks are full of bad, irresponsible people who gambled with money that wasn't theirs. ... In other words, there simply is never going to be what I think a lot of pundits are envisioning: a broad based, mandatory program in which banks are forced to "do what's right for the country" and write down all that horrid underwater principal. Legally it can't be done except at enormous cost to the government.
That's why, as Buffett pointed out, the best -- maybe only -- remedy is to wait for housing to recover on its own. This might sound defeatist, but it has the added benefit of being realistic.
