This problem seems likely to become more severe. The solutions proposed so far have been directed mainly towards helping delinquent borrowers avoid foreclosure, but the incentives have been weak. Remedies are needed to reduce delinquent mortgages to present property values, provide lenders with possible future recovery of the amounts by which they discounted their loans, restore mortgage lender liquidity and make mortgages available for future home buyers.
Many lenders would reduce the principal amount of troubled loans to the present value of the house if they could liquefy part of the loan and share in the eventual upturn in property values. To provide some liquidity, the Federal Housing Administration, the government insurer for low-income housing, should be authorised to guarantee $1 of existing troubled mortgages on primary residences for each $1 forgiven by the lender. The lender would be able to resell the guaranteed portion of its principal amount.
The FHA would receive an insurance premium, as it already does on other mortgages, and on the first resale of the home would receive the lesser of 25 per cent of the gain or the amount it guaranteed. The total of the premiums and appreciation on some sales would more than offset losses on foreclosed homes. The FHA would require that government-approved appraisers confirm the house’s market value. Also, if there were a shortfall on foreclosure and resale, the FHA would not pay a lump sum but instead make the payments when originally due. Therefore, at worst the FHA’s payments would be spread over many years and the FHA’s risk would decline whenever the borrower made payments.
Lenders would be able to sell the guaranteed portion of the loan, thereby restoring their liquidity. Lenders also would receive on the first resale of the home the lesser of 25 per cent of the gain or the amount forgiven. This would enable them to recapture some of the principal amount they forgave, thereby providing them with an incentive to restructure the mortgage rather than foreclose. Appreciation sharing would not carry over to the next owner, but qualified home purchasers would be able to assume these favourable mortgages. Thus the resale market for these properties would be largely self-financing for several years and this would stabilise or improve property values. Meanwhile the original borrower would retain 50 per cent or more of the appreciation on a property that otherwise would have been foreclosed. It would be unreasonable for homeowners to expect a totally free ride on concessions granted by lenders, but retaining half of the upside would motivate the homeowner to make monthly payments even though there initially would be no equity value.
If a mortgage had been $180,000 against an original home value of $200,000 and the loan were now reduced to $160,000, the lender would have lost $20,000. If the home later were sold at its original $200,000 value, the lender would have recovered $10,000, or half of the concession. The FHA would have gained $10,000 and the homeowner would have made $20,000, thereby restoring his original equity position.
This co-operation between public and private sectors would provide both lenders and borrowers with a rational, incentivised alternative to foreclosure.
The government’s present voluntary plan of restructuring brings neither added incentives to the lender nor liquidity to the mortgage market. This FHA-based plan would do both. Lenders and borrowers would negotiate interest and repayment terms without government intervention and existing servicers would continue to service the loan. All parties would benefit from stabilisation of housing markets.
Most important, the process would be voluntary and therefore would not chill the willingness of lenders to make loans in the future. In contrast, the proposed remedies incentivise all parties to negotiate but do not create moral hazard by bailing out reckless lenders or borrowers. The lenders will write down their loans and borrowers initially will lose their original equity. Both will have a chance to recoup and substantial liquidity will be brought back to the mortgage market.
The writer has created the US’s second largest servicer of subprime mortgages by acquiring American Home Mortgage and Option One